BLADES, Inc. CASE Use of Currency Derivative Instruments Blades, Inc., needs to order supplies 2 months ahead of the existing spot rate for a transaction 2 months beyond its delivery date. It is considering an order from a Japanese order date, as long as the option premium is no more than supplier that requires a payment of 12.5 million yen pay 1.6 percent of the price it would have to pay per unit when able as of the delivery date. Blades has two choices: exercising the option. Purchase two call options contracts (since each In general, options on the yen have required a pre- option contract represents 6,250,000 yen). mium of about 1.5 percent of the total transaction amount Purchase one futures contract (which represents that would be paid if the option is exercised. For example, 12.5 million yen). recently the yen spot rate was 9.0072, and the firm pur- chased a call option with an exercise price of $.00756, The futures price on yen has historically exhibited a which is 5 percent above the existing spot rate. The pre- slight discount from the existing spot rate. However, mium for this option was 5.0001134, which is 1.5 percent the firm would like to use currency options to hedge of the price to be paid per yen if the option is exercised. payables in Japanese yen for transactions 2 months in A recent event caused more uncertainty about the advance. Blades would prefer hedging its yen payable yen's future value, although it did not affect the spot position because it is uncomfortable leaving the posi rate or the forward or futures rate of the yen. Specifi- tion open given the historical volatility of the yen. cally, the yen's spot rate was still 5.0072, but the option Nevertheless, the firm would be willing to remain premium for a call option with an exercise price of unhedged if the yen becomes more stable someday. $.00756 was now $.0001512. Ben Holt, Blades' chief financial officer (CFO), prefers An alternative call option is available with an expi- the flexibility that options offer over forward contracts or ration date of 2 months from now; it has a premium of futures contracts because he can let the options expire if the $.0001134 (which is the size of the premium that would yen depreciates. He would like to use an exercise price that have existed for the option desired before the event), is about 5 percent above the existing spot rate to ensure that but it is for a call option with an exercise price of Blades will have to pay no more than 5 percent above the $.00792 The table below summarizes the option and futures information available to Blades: AFTER EVENT S.0072 $.0072 S.00756 5% $.00792 10% S.0001512 S.0001134 BEFORE EVENT Spot rate S.0072 Option Information Exercise price (s) S.00756 Exercise price % 5% above spot) Option premium S.0001134 per yen (S) Option premium 1.5% 1% of exercise price) Total premium (8) $1,417.50 Amount paid for 594,500 yen if option is exercised (not including premium) Futures Contract Information Futures price 9.006912 2.0% 1.5% $.00756 or the call option with the exercise price of $.00792? Describe the tradeoff. 2. Should Blades allow its yen position to be unhedged? Describe the tradeoff. 3. Assume there are speculators who attempt to capi- talize 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 informa- tion, what is the expectation on the order date of the yen spot rate by the delivery date? (Your answer should consist of one number.) 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 unhedged) purely on a cost basis, what would be its optimal choice? 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? 6. Now assume that you have determined that the historical standard deviation of the yen is about $.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 $.006912. Based on this expectation of the future spot rate, what is the optimal hedge for the firm? $1,890.00 594,500 $1,417.50 599,000 $.006912 As an analyst for Blades, you have been asked to offer insight on how to hedge. Use a spreadsheet to support your analysis of questions 4 and 6. 1. If Blades uses call options to hedge its yen payables, should it use the call option with the exercise price of