Blades Inc.

Case Study: Currency Derivative Instruments

Blades Inc. Case Study

Currency Derivative Instruments

By

Patrick Marco

FIN 402

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Blades Inc. Case Study: Currency Derivative Instruments

1. Introduction

Blades Inc. is an US based company which seeks to hedge its financial positions for
purchases of Yen. The company has the possibility to use either currency options or futures
contracts as derivatives instruments for hedging purposes. This essay will include an
overview of the tradeoff between the individual hedging tools that Blades could use in order
to determine the most viable solution.

2. If Blades uses call options to hedge its yen payables, should it use the call option
with the exercise price of $0.00756 or the call option with the exercise price of
$0.00792? Describe the tradeoff.

From the analysis of the case study information one could determine that, if Blades were to
minimize its cost and also satisfy its currency requirement, the company would be put in a
better position if it would use the option with the exercise price of $0.00756. If Blades would
use this option, that it would pay $94,500 in order to purchase the ¥12,500,000 required.
Adding the cost of the option (2%) we get a total cost of $96,390.

On a different idea, if Blades were to use the second currency option, with the exercise price
of $0.00792, the cost of buying the Yen requirements would be of $99,000, excluding the
actual option cost. Taking the latter into account, which is only 1.5% in this case, we get a
total cost $100,485, significantly higher (i.e. 4.2% higher) than the previous value of $96,390.
Given these, we can state that the option would the exercise price of $0.00756 is the best
opportunity.

3. Should Blades allow its yen position to be unhedged? Describe the tradeoff.

The case study information stipulates that the Yen could fluctuate by 5% given a two month
period. As the current price/spot rate is of $0.0072 we can calculate the two month upper and
lower rate boundaries. In this case, the lower boundary would be equal to $0.0072*(1-0.05)=
$0.00684, while the upper limit would be of $ 0.00756.

Given the lower boundary, in two months’ time, the cost of buying the ¥12,500,000, using the
future spot rate, would be of $ 85,500, while the cost for the upper limit would be of $94,500.
If Blades would decide to avoid using the hedging tools, than no premiums would need to be
paid for, which means that the sums previously calculated (i.e. $85,500 and $94,500) would
be the final costs.

We can see that if the Yen current spot rate would decrease by 5% in the next two months,
than the final value paid for buying the Yen would be considerably lower than the value
identified under point 2 above. Similarly, if the USD/YEN exchange rate would depreciate by
5%, meaning that the Yen would become stronger, the final value paid would be of $94,500,
which is the same as the cost of using the option with the maturity price of $0.00756,
excluding the premium costs.

Under these circumstance, I believe that Blades could allow its Yen position to be unhedged,
if the company’s CEO would have s string believe regarding the evolution of the exchange

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Blades Inc. Case Study: Currency Derivative Instruments

rate. However, as the additional cost of using the currency option with the maturity price of
$0.00756 is of only 2%, and given that markets can fluctuate with more than 5%, I believe
that using the first option would be a more risk averse strategy which could mitigate risks.

4. Assume there are speculators who attempt to capitalize on their expectation of

the yen's movement over the two 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 spot rate by the delivery date? (Your answer should consist of
one number.)

At the current time, the present spot rate for the Yen is of $0.0072 and the futures quote is of
$0.006912. This means that there is a favorable difference of $ 0.000288, and an investor
could sell Yen today and buy it back in two months’ time. Furthermore, based on the
assumption of a 5% fluctuation, the future sport rates are of $0.00684 (lower boundary) and $
0.00756 (upper boundary). In this case, a speculative investor could also sell Yen at the
current spot rate and hope to buy it back for the lower boundary rate.

However, to what extend are these assumptions sustainable? First of all, one aspect that
should be analyzed, is the fact that the value of the futures price is not affected by the event;
this could mean that investors already incorporate the event within their risk premium for the
Yen exchange rate. If this were to be true, and this would be the tendency within the market,
than the probability of speculative profits would be lower.

All in all, the evolution of the future delivery sport rate should be expected to be within the
initial assumptions; as a value, the future sport rate would be very close to $0.0072, given the
inflexible futures price and the 5% margin fluctuation.

5. 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 unhedged) purely on a cost basis, what would be its
optimal choice?

If cost would be Blade’s main concern, than the company should use the futures contracts in
order to buy the Yen. In this case, the cost of purchasing the ¥12,500,000 would be of
$86,400, which is lower than the total cost of $90,000 (for a future spot rate of $0.0072) and
$94,500 (for using the currency option with the strike price of $0.00756)

6. 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?

Yes, using the futures would be the most cost efficient method for buying the Yen. First of
all, the futures do not require a premium payment, which means that, unlike the case of the
options, Blades could save on the 2%/1.5% additional costs. Also, when comparing the
final cost of the futures and the option with the strike price of $0.00756 we can see that
there is a large difference of near $8,000 in the favour of the futures. Even if the most

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Blades Inc. Case Study: Currency Derivative Instruments

positive expectations of the investor would be fulfilled, and the future spot rate would
decrease by 5% compared to the present spot rate, the total cost of the transaction would be
of $85,500, which is relatively close to the cost of the futures. Therefore, there is not actual
incentive to avoid using the futures given the very small differences.

7. 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 future spot rate will have two standard deviations of $0.0005 from the expected
delivery spot rate, than the maximum future spot rate would oe of
$0.0072+$0.0010=$0.0082. In this case, the Yen would cost $102,500 which is much higher
compared to the value of the futures contracts of $86,400.

8. Conclusion

Based on the analysis presented above, we can conclude that the best hedging tool that Blades
could use is the futures contract.