International Finance Science and Business Media

Question: Discuss about the case study International Finance for Science and Business Media. Answer: Introduction: Blades will have to incur $94500 if it uses the call option with exercise price of $0.00756 and $99000 for the call option with exercise price of $0.00792. It has to pay option premium of $1890 for the first option and $1417.5 for the second option. Therefore, the company has to bear total cost of ($94500+$1890) $96390 for the first option and ($99000+$1417.5) $100417.5 for the second option. Therefore, it can be stated that if Blades does not consider the future price then it should use the call option with the exercise price of $0.00756 to hedge its yen payables. On the other hand, The future price is expected to be lesser than both the exercise prices. Hence, if the company considers the future price for decision-making, it should go for the exercise price of $0.00792, as the loss on option premium will be lesser for this exercise price than the exercise price of $0.00765 (Jacque, 2013). The company may allow its yen position to be unhedged as the market forecasts exhibits that the future price will be lesser than both the exercise price. Moreover, yens future value was not affected by the uncertainty, caused by the recent event. Hence, it can purchase the supplies through future contract But it should be noted that the future prices are forecasted on part risk calculations and part assumptions. Therefore, it cannot be 100% accurate all the time. Moreover, as stated in the case study, the historical records shows that the yens value was highly volatile. Therefore, the company should hedge its yen payables to avoid the risk factors related to the foreign currency exchange (Kroencke et al., 2014). It is expected that the future purchase price of yen in dollar will fall from $0.0072 to $0.006912. It means that the value of yen is expected to increase in future. Therefore, the speculators, who attempt to capitalize the yens movement over 2 months, will surely become willing to buy yen now at the future spot rate. The more the speculators will buy yen at the specified spot rate, the more the demand of yen will increase, which, on turn, will create upward movement in the future value of yen. This practice will continue until the future value of yen become equal to $0.006912. The expected cost of the contract on the basis of various alternatives are calculated in the following chart:- Cost Analysis:- Call Option 1 Call Option 1 Particulars Future Contract Unhedged Option 1 Option 2 Option 1 Option 2 Total Exercise Price 0.00756 0.00792 0.00756 0.00792 Future Price/ Spot Rate 0.006912 0.006912 Option Premium 0.0001512 0.0001134 0.0001512 0.0001134 Total Unit 12500000 12500000 12500000 12500000 6250000 6250000 12500000 Cost of Contract 86400 86400 96390 100417.5 48195 50208.75 98403.75 Effective Contract Price 86400 86400 86400 86400 86400 Add : Loss for Option Premium 1890 1417.5 945 708.75 1653.75 Total Cost 86400 86400 88290 87817.5 88053.75 As per the calculations shown above, it can be stated that the future contract and the unhedged alternatives should be optimal choice of the company. The future contract options should be considered as the lowest cost alternative in terms of actual cost incurred for the company. The cost analysis, shown above, explains that the call options will cause more expense due to the payment of optional premium. The unhedged alternative will incur same cost as the future contract. But the risk factor in unhedging option is more than the future contract. Therefore, future contract alternative can be considered as the only option, which will incur lesser cost than the call options and includes lesser risk than the unhedging option (Menkhoff et al., 2012). If the yen value increases with the standard deviation by ($0.0005x2)$0.001 on the future spot rate, then the cost analysis of the contract will be as follows:- Cost Analysis:- Call Option 1 Call Option 1 Particulars Future Contract Unhedged Option 1 Option 2 Option 1 Option 2 Total Exercise Price 0.00756 0.00792 0.00756 0.00792 Future Price/ Spot Rate 0.006912 0.006912 Option Premium 0.0001512 0.0001134 0.0001512 0.0001134 Total Unit 12500000 12500000 12500000 12500000 6250000 6250000 12500000 Cost of Contract 86400 86400 96390 100417.5 48195 50208.75 98403.75 Future Price 0.006912 0.006912 0.006912 0.006912 0.006912 Add : Standard Deviation 0.001 0.001 0.001 0.001 0.001 Expected Future Price 0.007912 0.007912 0.007912 0.007912 0.007912 Total Unit 12500000 12500000 12500000 12500000 12500000 Expected Cost 98900 98900 98900 98900 98900 Effective Contract Value 98900 98900 96390 98900 98403.75 Add : Loss for Option Premium 1417.5 Total Cost 98900 98900 96390 100317.5 98403.75 The above table denotes that for the stated consequence, the best alternative of the company will be the call option with the exercise price of $0.00756,plus, option premium of $0.0001512. By exercising this option, the company can save almost $2500. The foreign exchange quotations are not appropriate. There is vast scope of earning profit from arbitraging due to the differences in the bidding and asking rates of the two banks (Singh, 2015). In the following table, it has been shown how the company can earn profit by arbitraging in the given scenario:- Calculation of Profit from Arbitraging :- Particulars Amount Investment in Arbitrage $100,000 Asking rate of MinZu Bank $0.0227 Baht Converted from Dollar 4405286.344 Bidding Rate of Sobat Bank $0.0228 Dollar Converted from Baht $100,440.53 Profit from Arbitage $440.53 The following table describes how the company can earn profit from triangular arbitrage due to differences in the cross exchange rate of dollar, thai baht and yen:- Calculation of Profit from Triangular Arbitraging :- Particulars Amount Investment in Arbitrage $100,000 Asking rate of Thai Baht $0.0227 Baht Converted from Dollar 4405286.344 Bidding Rate of Japanese Yen 2.69 Yen Converted from Baht 11,850,220.26 Bidding Rate of Dollar $0.0085 Dollar Converted from Baht $100,726.87 Profit from Arbitrage $726.87 The company can earn additional profit of $836 from covered arbitrage process. The calculation is presented in the following table:- Calculation of Profit by Investing in Foreign Market:- Paticulars Investment in Thai Money Market Investment in US Money Market Investment in Dollar $100,000.00 $100,000.00 Asking Rate for Thai Baht $0.0227 Dollar Convert into Thai Baht 4405286.34 Interest Rate 3.75% 2% Amount Received on Maturity 4570484.58 $102,000.00 Forward Rate $0.0225 Thai Baht converted into Dollar $102,835.90 Total Future Value of Investment $102,835.90 $102,000.00 Profit from Covered Arbitrage $835.90 The arbitrage opportunities use to disappear soon after they have been discovered due to the activities of the arbitrageurs. When the arbitrageurs use to purchase or sell more foreign currencies to capitalize the arbitrage opportunity, the supply and demand position of the foreign currencies also use to change accordingly and ultimately when supply demand of the currencies reaches to the equilibrium state the arbitrage opportunity disappears (Ranaldo,2012). For example, the covered interest arbitrage would create immediate demand for the Thai Baht, which, in turn, would create upward pressure on the spot rate of Thai Baht and the subsequent sale would create downward pressure on the forward rate of the currency. Thus, due the upward and downward pressures, when the spot rate and forward rate would become equal, then the interest arbitrage would not possible any more (Pasquariello, 2015). The equilibrium state is called as interest rate parity (IRP) Reference List: Jacque, L. L. (2013).Management and control of foreign exchange risk. Springer Science Business Media Kroencke, T. A., Schindler, F., Schrimpf, A. (2014). International diversification benefits with foreign exchange investment styles.Review of Finance,18(5), 1847-1883 Menkhoff, L., Sarno, L., Schmeling, M., Schrimpf, A. (2012). Carry trades and global foreign exchange volatility.The Journal of Finance,67(2), 681-718 Pasquariello, P. (2015). Government Intervention and Arbitrage.Ross School of Business Paper, (1240) Ranaldo, A. (2012). Limits to Arbitrage During the Crisis: Funding Liquidity Constraints and Covered Indterst Parity Singh, S. (2015). IMF, FOREX, and International Business in Emerging Markets. InThe Palgrave Handbook of Experiential Learning in International Business(pp. 714-729). Palgrave Macmillan UK