We are pleased to submit the term paper on time letter. Here is the term paper on “case solution”, you asked us to conduct. As you are teaching us about the international business, as per the requirement of syllabus provided from United International University for B.B.A. course, considering its importance, you assigned this task. Sir, we appreciate having this chance to prepare the term paper, when accomplishing it, We have become skilled at valuable contents about business plan that will help to increase our contemplative power in practical use.
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In international trade ‘Currency Derivatives’ is a familiar thing, (Multinational Corporations) MNCs use forward contract is an agreement between a corporation and a commercial bank to exchange a specified amount of a currency at a specified exchange rate on a specified date in the future. When MNCs anticipate a future receive of a foreign currency, they can set up forward contracts to lock in the rate at which they can purchase or sell a particular foreign currency. Virtually all large MNC sues forward contracts. In international trade ‘Option’ is also a popular to MNCs_ which provide the right to purchase or sell currencies at a specified price. Option can be ‘Call Option’ or ‘Put Option’. The MNCs uses call option for many purposes, such as a) to hedge payables _ MNCs can purchase call option s on a currency to hedge future payables, Options may be more appropriate then futures or forward contracts for some situations.
If an order is canceled, in option has the flexibility to let the option contract expire, and in forward contact it would be obligated to fulfill its obligation in the order was canceled. b) to hedge project bidding US. based MNCs that bid for foreign projects may purchase call options to lock in the dollar cost of the potential expenses, c) to hedge target bidding the MNCs firms can also use call options to hedge a possible acquisition. Put Option_ the owner of a currency put option receives the right to sell a currency at a specified price within a specified period of time. As with currency call options, the owner of a put option is not obligated to exercise the option. Therefore, the maximum potential loss to the owner of the put option is the price paid for the option contract. In international trade Exchange rate is a important issue, exchange rate system can be classified as fixed rate, freely floating, managed float and pegged. In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries.
In a freely floating exchange rate system, exchange rate values are determined by market forces without intervention. In managed float system, exchange rates are not restricted by boundaries but are subject to government intervention. In a pegged exchange rate system, a currency’s value is pegged to a foreign currency or a unit of a account and moves in line with that currency against other currencies. Governments can use direct intervention by purchasing or selling currencies in the foreign exchange market, thereby affecting demand and supply conditions and, in turn, affecting the equilibrium values of the currencies. When a government purchases a currency in the foreign exchange market, it puts upward pressure on the currency’s equilibrium value.
When a government sells a currency in the foreign exchange market, it puts downward pressure on the currency’s equilibrium value. Governments can use direct intervention by influencing the economic factors that affect equilibrium exchange rates. When government intervention is used to weaken the U.S. dollar, the weak dollar can stimulate the U.S. economy by reducing the U.S. demand for imports and increasing the foreign demand for U.S. exports. Thus, the weak dollar tends to reduce U.S. unemployment, but it can increase U.S. inflation. When government intervention is used to strengthen the U.S. dollar, the strong dollar can increase the U.S. demand for imports, thereby intensifying foreign competition. The strong can reduce U.S. inflation but may cause a higher level of U.S. unemployment.
Blades, Inc., a U.S. based company. They wanted to purchase supplies from Japanese supplier with payment of 12.5 million yen payable on the delivery date. The order has been made two months ahead of the delivery date. Blades, Inc has two choices- 1. Purchase two call options contract.
2. Purchase one future contract.
Now we see what is called call option contract and future contract. Call Option means an agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument at a specified price within a specific time period. In the commodity markets, it is considered as a less risky trade. When you buy a call option, your risk is limited to the price you pay for the call option (premium) plus commissions and fees. On the other hand future contract means a contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a pre-determined price in the future. Futures contracts detail the quality and quantity of the underlying asset.
The counterparty is obliged to sell the asset at the agreed price and on the agreed date. Because the price is agreed at the outset the seller (buyer) is protected from a fall (rise) in the price of the underlying asset in the intervening time period. Initially developed to protect agricultural producers from unforeseen market fluctuations – hedging. So if Blades Inc. chooses two call options they need to pay 6250000 yen for each option, or if it chooses future contract they need to pay 12.5 million yen. In the case, it indicates that spot rate will remain same at all the time and that is $.0072 for per yen, but in case of using call options, exercise price fluctuates over time but not more than 5% above the existing spot rate and premium would be paid of about 1.5%. In case of purchasing future contract, the future price will lock into one price that is $0.006912 for per yen.
Question 1: If Blades uses call options to hedge its yen payables, should it use the call option with the exercise price of $.00756 or the call option with the exercise price of $.00792? Describe the trade off. In our case there are 2 call options. For the first call option, the exercise price is $.00756 and for 2nd call option, exercise price is $.00792 which is higher than the first call option. Blades Inc. will have to pay no more than 5% above the existing spot rate. Before of event exercise option premium was 1.57, but now has increased to be 2% which more expensive than the firm is willing pay. However, in the 2nd call option, the premium is lower from the exercise price of $ 0.00792. But the exercise price is 10% higher than the spot rate. So, if the firm chooses to continue this attractive option, this firm has to pay lower premium and also higher exercise price. If they decide to use this option, their total premium will be 1417.50. And the amount paid for Yen $ 99,000. Again for the first option the total premium was $1890.00 and amount paid for Yen $94,500.
In the summary, if they use the first option, the total cost will be $ 96,390 ($ 1890 + $ 94500). And in their 2nd call option the total cost will be $ 100417.5 ($ 14750+ $ 99,000) which is higher than the first option. If the firm wants to choose call option between these two options, they can choose first option where there is lower exercise price but higher premium. Question 2: Should Blades allow its Yen position to be un-hedged? Describe the trade off. Blade Inc. has 2 choices – one is call option and another is future contract. Call option can be un-hedged thought the movement of currencies value. It creates new event relative to before event, when the event faced more uncertainty. In our case, table shows that the future contract information where the future price will not be affected by uncertainty. Also in this contract owners are not obliged by this contract relative to the option where owners are obliged. So that, firm can purchase future contract and lock its future payment value at the same future price that has before event.
Question 3: Assume there are speculators who attempt to capitalize on their expectation of the Yen’s movement over the 2 months between the order and delivery dates by either buying or selling Yen futures now and buying or selling Yen at the future spot rate. Given this information, what is the expectation on the order date of the Yen’s spot rate by the delivery dates? If there are speculators who attempt to capitalize on their expectation on the Yen’s movement then they want to equal the future spot rate and the future rate. Suppose, if they expect Yen to appreciate, they will purchase Yen at future rate now.
Or they can purchase the Yen at the future rate in 2 months and sell them at the future spot rate. In this way, if everyone’s expectation is to appreciate Yen, then all are willing to buy Yen now. Then the amount of Yen will be increased and there will be upward pressure on the future rate as well as download pressure on the future spot rate. However, this process will continue up to the equivalent of future spot rate and future rate will be $ 0.006912. Question 4: Assume that the firm shares the market consensus of the future yen spot rate. Given this expectation and given that the firm makes a decision (i.e., option, futures contract, remain un-hedged) purely on a cost basis, what would be its optimal choice? Based on this question 3 if the speculation decision is made on cost basis and purchase on future contract where the actual cost will be $86400 which is calculated by: Future price per unit $.006912
No. of units * 12500000
Total cost = $86400
If they remain un-hedge cost will be $86400 which is computed by, Expected spot rate $.006912
No. of Yen paid * 12500000
Total cost = $86400
This cost will be incurred on the delivery date to purchase Yen can be affected by the movement of Yen between the delivery date and order date. So that Blade Inc. will prefer to go in future contract. Question 5: Will the choice you made as to the optimal hedging strategy in question 4 definitely turn out to be the lowest-cost alternative in terms of actual costs incurred? Why or why not? We know Yen is more volatile than the other currencies. So that in the future contract, there will be no cost advantage when the yen currency will fluctuate because in future contract the price will be paid at the delivery date, so that there is no cost advantage if Yen depreciate. But if they choose option and remain un-hedge there are having the flexibility to buy Yen at the spot rate. Remain un-hedge:
Spot rate $0.006912 Amounts have to be paid for Yen * 12500000 Total payment = $86400.00
In case of purchasing future contract:
Future price per unit $0.006912 Units in contract * 12500000 Total payment = $86400.00 In case of purchasing two options:
For option 1:
Exercise price $0.0075600 Premium per unit $0.0001512 Total units 6250000 Total costs (($0.0075600+$0.0001512)* 6250000) = $48195
For option 2:
Exercise price $0.0079200 Premium per unit $0.0001134 Total units 6250000 Total costs (($0.0079200+$0.0001134)* 6250000) = $50208.75
Total paid for option 1, exercise price is $.00756.
Total premium $1890 Amounts to be paid for Yen + $86400
total paid $88290
In this option they will not exercise the contract as spot rate is less than the exercise rate. In case of 2nd option, the total amounts have to be paid $87817.50 with exercise price $0.00792, which is calculated by: Total premium $1417.50 Amounts have to be paid for Yen + $86400
Total paid $87817.50
So this option will not be exercised as the spot rate is less than the exercise rate.
Question 6: Now assume that you have determined that the historical standard deviation of the yen is about $0.0005. Based on your assessment, you believe it is highly unlikely that the future spot rate will be more than two standard deviations above the expected spot rate by the delivery date. Also assume that the futures price remains at its current level of $0.006912. Based on this expectation of the future spot rate, what is the optimal hedge for the firm? If the standard deviation increases by 2% then the forecasted spot rate will be $0.007912 (calculated by $.006912+ (2*.0005000))
Cost of remain un-hedged will be $98900 (computed by $.007912*12500000) In case of purchasing future contract if 2% standard deviation increases then costs will be $86400 because there is no impact of increasing standard deviation on the future price. In case of purchasing 2 options, for one option cost will be $48195 which is computed by (($.0075600+$.0001512)*6250000) For 2nd option costs will be incurred $50209 which is computed by (($.0079200+.0001134)*6250000) For option 1 exercise price is $0.00756
Total premium $1890 Amounts have to be paid for Yen + $94500
Total paid $96390
For option 2 exercise price is $.00792
Total premium $1417.50 Amounts have to be paid for Yen + $98900
Total paid $100317.50 In 1st option, as because the spot rate is higher than the exercise price Blade Inc can exercise this option. They will be able to generate profit using this option. But in case of 2nd option, spot rate is less than the exercise price. So they will face loss if they exercise this option. So Blade Inc. should not exercise call options rather they should go for future contract. Conclusion:
By analyzing the case study we came to know that, it would be better for Blades Inc. if it purchases future contract rather than two call options. Since selling price is less than the purchasing price, if it exercises two call options company will face loss in future. More than in call option, company is obliged by this contract. There is no advantage to expire it what can be obtained through using future contract. Company can lock into one price in case of purchasing future contract and company is not obliged by it. We have analyzed the case of Blades Inc giving the answer of six questions. In 1st question we have got the conclusion that if firm chooses any one between two call options, firm should choose 1st call option as because it consists lower exercise price but higher premium in compare to 2nd call option. In 2nd question we came to the decision that, it is better for firm to go for future contract and lock it’s future payment value at the same future price that has before the event.
In 3rd question our judgment was that the speculators, who want to capitalize on their expectation on yen’s movement, always want to equal the spot rate and the future rate. In 4th and 5th question our opinion was that Blade Inc. will prefer to go for future contract due to high costs will be incurred in case of purchasing two call options. Finally, we came to the decision that if historical standard deviation of the yen is about $0.0005 and if it is highly unlikely that the future spot rate will be more than two standard deviations above the expected spot rate by the delivery date, then after analyzing, in 1st option, as because the spot rate is higher than the exercise price Blade Inc can exercise this option. They will be able to generate profit using this option. But in case of 2nd option, spot rate is less than the exercise price. So they will face loss if they exercise this option. So Blade Inc. should not exercise call options rather they should go for future contracts.
BLADES, INC. CASE
Assessment of government influence on exchange rates
Aside from factors such as interest rates and inflation, the exchange rate is one of the most important determinants of a country’s relative level of economic health. Exchange rates play a vital role in a country’s level of trade, which is critical to most every free market economy in the world. For this reason, exchange rates are among the most watched analyzed and governmentally manipulated economic measures. In exchange markets government plays a vital rule to control the market. The central bank do all these work on behalf of the government. So when the domestic currency is overvalued, the central bank purchase domestic currency to keep the exchange rate fixed. On the other hand when the domestic currency is undervalued, the central bank sell domestic currency to keep the exchange rate fixed. After that to control currency supply and demand in the market central bank purchase and sell treasury bonds in the market. Now if we talk about government intervention then we see government intervene market in two ways- a) Direct intervention and b) Indirect intervention.
Direct intervention refers to the exchange of currencies that the central bank holds as reserves for other currencies in the foreign exchange market. It is usually more effective when there is a coordinated effort among central banks and when the central banks have high levels of reserves that they can use. On the other hand indirect intervention means government adjustment of inflation, interest rates, income level, expectation of future exchange rates and the change in government control. In this case Blades, the U.S. manufacturer of roller blades, recently had begun exporting roller blades to Thailand. The company has an agreement with Entertainment Products, Inc., a Thai importer, for a 3-year period. According to the agreement they export and import in fixed exchanged rate systems. After that when Asian economic system is going down then in Thailand their is an impact of this economic recessions.
To maintain the bath’s value, the Thai government intervened in the foreign exchange market. Specifically, it swapped its baht reserves for dollar reserves at other central banks and then used its dollar reserves to purchase the baht in the foreign exchange market. However, this agreement required Thailand to reverse this transaction by exchanging dollars for baht at a future date. Unfortunately, the Thai government’s intervention was unsuccessful, as it was overwhelmed by market forces. Consequently, the Thai government ceased its intervention efforts, and the value of the Thai baht declined substantially against the dollar over a 3-month period. The Thai government stopped intervening in the foreign exchange market, after that blade, see there is a positive change in their net profit margin. Case analysis:
Question 1: Did the intervention effort by the Thai government constitute direct or indirect intervention? Explain.
The intervention effort by the Thai government constituted direct intervention, since the government exchanged dollar reserves for baht in order to strengthen the currency. This action would increase the demand for baht and the supply of dollars for sale, which puts upward pressure on the baht. In indirect intervention, a central bank attempts to influence the value of a currency by influencing the factors that determine it. For example, if the Thai government wanted to strengthen the baht, it could have increased interest rates by decreasing the Thai money supply.
Question 2: Did the intervention by the Thai government constitute sterilized or nonsterilized intervention? What is the difference between the two types of intervention? Which type do you think would be more effective in increasing the value of the baht? Why?
The intervention by the Thai government constituted nonsterilized intervention. Using nonsterilized intervention, a central bank intervenes in the foreign exchange market without adjusting for the change in money supply. Using sterilized intervention, a central bank intervenes in the foreign exchange market while retaining the money supply. Since the Thai government exchanged dollar reserves for baht in the foreign exchange market, the dollar money supply is increased. An increase in the money supply may decrease U.S. interest rates, which may additionally weaken the dollar with respect to the baht. Therefore, nonsterilized intervention may compound the desired effects of the intervention effort. If the Thai government’s objective is to increase the value of the baht, nonsterilized intervention may be more effective.
Question 3: If the Thai baht is virtually fixed with respect to the dollar, how could this affect U.S. levels of inflation? Do you think these effects on the U.S. economy will be more pronounced for companies such as Blades that operate under trade arrangements involving commitments or for firms that do not? How are companies such as Blades affected by a fixed exchange rate?
Under a fixed exchange rate system, inflation may be exported from one country to another. For example, if Thailand experienced relatively high levels of inflation during a fixed exchange rate system, Thai consumers may have switched some of their purchases to U.S. products. Similarly, U.S. consumers may have reduced their imports of Thai goods. This would send Thai production down and unemployment up. Also, it could cause higher inflation in the U.S. due to the excessive demand for U.S. products. Thus, the high inflation in Thailand could cause high inflation in the U.S. For companies such as Blades, this effect would probably be more pronounced as their cost of production would rise, but they export at a fixed price.
Question 4: What are some of the potential disadvantages for Thai levels of inflation associated with the floating exchange rate system that is now used in Thailand? Do you think Blades contributes to these disadvantages to a great extent? How are companies such as Blades affected by a freely floating exchange rate?
A freely floating exchange rate may compound Thailand’s inflationary problems. For example, if Thailand experiences high levels of inflation, the baht may weaken. In turn, a weaker baht can cause import prices to be higher, which can increase the prices of Thai materials and supplies and thus increase the price of finished goods. Additionally, higher foreign prices (from the Thai perspective) can force Thai consumers to purchase domestic products. Blades do not contribute to these problems, as both its exports and imports are denominated in baht. Consequently, a weaker baht would have no direct impact on companies importing from Blades. Blades could still be affected by a freely floating exchange rate system, as it is now subject to exchange rate risk when converting the net baht received to dollars.
Question 5: What do you think will happen to the Thai baht’s value when the swap arrangement is completed? How will this affect Blades?
Under the terms of the agreement, completion of the swap arrangement requires Thailand to reverse the swap of its baht reserves for dollars. Specifically, it will have to exchange dollars for baht at a future date. Due to the decline in the value of the baht, however, Thailand’s central bank will need more baht to be exchanged for the dollars needed to repay the other central banks. The purchase of dollars by the Thai government in the foreign exchange market will increase the demand for dollars and the supply of baht for sale, which will put downward pressure on the value of the baht. Since Blades has net inflows in baht, it will be negatively affected by the completion of the swap agreement if the actions needed to complete the agreement result in further weakening of the baht. Conclusion:
In conclusion we see that when Asian economy goes fall then government intervened in the Thai foreign exchange market. Unfortunately, the Thai government’s intervention was unsuccessful, as it was overwhelmed by market forces. Consequently, the Thai government ceased its intervention efforts, and the value of the Thai baht declined substantially against the dollar over a 3-month period. After that Thai government constituted nonsterilized intervention. Using nonsterilized intervention, a central bank intervenes in the foreign exchange market without adjusting for the change in money supply.
The Thai government exchanged dollar reserves for baht in the foreign exchange market, the dollar money supply is increased. After that Thai government face inflation problems. A freely floating exchange rate may compound Thailand’s inflationary problems. If we see the agreement then we see swap arrangement requires Thailand to reverse the swap of its baht reserves for dollars. Specifically, it will have to exchange dollars for baht at a future date. The purchase of dollars by the Thai government in the foreign exchange market will increase the demand for dollars and the supply of baht for sale, which will put downward pressure on the value of the baht.