Situation
Speculative Strategy: Currency options
Option premium = 1,000,000 × 0.0005 = $500
As shown by the diagram, currency options will help ABC Corporation to mitigate the currency risk. It is speculative since it not only protects the firm from unfavourable movements in the exchange rate but also gives it an opportunity to gain profits. It protects the company from downward movements in the exchange rate since the minimum it can receive is $9,200 irrespective of how low the rate falls. However, the gains from forward exchange rate movements are not limited. If the exchange rate is more than the strike price, the only amount the company loses is the option premium (Madura). However, the company’s gain when the spot rate is less than the strike price is not limited to any amount.
Hedging strategy: Forward contract hedge
The company can use a three-month forward contract to mitigate the risk of unfavourable movements in the exchange rate. A forward contract is an agreement to buy or sell a given currency at an agreed rate at a future date (Madura). In this case, ABC Corporation will buy a forward contract to sell Japanese Yen in exchange for US dollars. ABC can purchase a three-month forward contract at $500 with a forward rate of 0.0093. The payout table is as follows:
As shown above, ABC will receive $9,300 irrespective of the prevailing exchange rate. Profit or loss is the difference between the actual payout and the payout at the spot rate. The actual payout is limited to $9,300. The strategy protects the company from downward movements in the exchange rate but does not give it any opportunities for gaining from upward movements (Madura).
Intel Corporation hedging strategy
Intel Corporation uses both forward contracts and currency options to mitigate its foreign currency risk on non-US-dollar cash flows. The forward contracts and currency options expire in 12 months. The forward contracts lock the rate at which Intel exchanges US dollars into the required currency. For instance, if the company’s account payable is in Japanese Yen, it will enter into a contract to buy Japanese Yen and sell US dollars at an agreed rate at a future date. In this case, the company does not lose if the Japanese Yen appreciates against the US dollar. Besides, Intel uses call options to hedge its payables in foreign currencies. Call options give Intel the option to buy foreign currency at the exercise price. If the exchange rate at the time of making the payment is more than the exercise price, Intel will not exercise the option.
Works cited
Madura, Jeff. International Financial Management. 14th ed. New York: Cengage Learning,
2015. Print.
