Chap008_With Notes.ppt

SKIP * SKIP * SKIP * Possible shortcoming of forward money market hedges is that methods completely eliminate F/X exposure. Must forgo opportunity to benefit from favorable exchange rate changes. Options offer “flexibility” – right, not the obligation (regardless of future spot rate). Firm can decide whether to exercise the option based on the realized spot exchange rate on the expiration date. Assured a minimum dollar receipt. Limits downside risk while preserving upside potential. If a company has receivables in foreign currency, they buy a call option (floor for future dollar proceeds). If a company has payables in foreign currency, they buy a put option (ceiling for future dollar cost). Pays for option , which is called an option premium, which is like paying for insurance. Neither forward or money market hedge involves any upfront cost, but requires the obligation of a contract. * NOT ON EXAM. * SKIP The hedge ratio tells you how fast the option value changes with changes in the value of the underlying currency. With a hedge ratio of 1/5 our put option only changes in value 20 percent as fast as the underlying asset changes in value, so we should buy 5 puts. * SKIP Notice that the dealer has the same net cash flow (￡240 outflow) in either case, S1(￡/€) = ￡1.0/€ or S1(￡/€) = ￡0.75/€. And if he received at least ￡207.79 to write each put then he’s going to be OK, since the future value of today’s option income is just enough to service the known and certain ￡240 outflow at time 1. * SKIP In the next two slides see that we get ￡88,000 with either the “right” number of options or with money market or forward hedges. * Options also used to hedge against contingent exposure. Book describes GE bidding on a Canadian hydroelectric plant (may or may not get accepted). See book for payoff diagrams that show you these are all the same. * * It really doesn’t matter for our cross-currency hedge example here what the interest rate in do