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 $.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 $.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 $.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 9.00756 or the call option with the exercise price of information available to Blades: $.00792? Describe the tradeoff. 2. Should Blades allow its yen position to be BEFORE AFTER unhedged? Describe the tradeoff. EVENT EVENT 3. Assume there are speculators who attempt to capi- Spot rate S.0072 $.0072 8.0072 talize on their expectation of the yen's movement over Option Information the 2 months between the order and delivery dates by either buying or selling yen futures now and buying or Exercise price (s) $.00756 5.00756 9.00792 selling yen at the future spot rate. Given this informa Exercise price 1% 5% 5% 10% tion, what is the expectation on the order date of the above spot) yen spot rate by the delivery date? (Your answer should Option premium $.0001134 3.0001512 $.0001134 consist of one number.) per yen (8) 4. Assume that the firm shares the market consensus Option premium 1.5% 20% 1.5% of the future yen spot rate. Given this expectation and (% of exercise price) given that the firm makes a decision (i.e.. option, futures contract, remain unhedged) purely on a cost Total premium (8) $1,417.50 S1,890.00 $1,417.50 basis, what would be its optimal choice? Amount paid for $94,500 $94,500 $99,000 5. Will the choice you made as to the optimal hedging yen if option is exercised (not strategy in question 4 definitely turn out to be the including lowest-cost alternative in terms of actual costs premium) incurred? Why or why not? Futures Contract Information 6. Now assume that you have determined that the Futures price historical standard deviation of the yen is about $.0005. $.006912 S.006912 Based on your assessment, you believe it is highly unlikely that the future spot rate will be more than two As an analyst for Blades, you have been asked to offer standard deviations above the expected spot rate by the insight on how to hedge. Use a spreadsheet to support delivery date. Also assume that the futures price your analysis of questions 4 and 6. remains at its current level of 5.006912. Based on this 1. If Blades uses call options to hedge its yen payables, expectation of the future spot rate, what is the optimal should it use the call option with the exercise price of hedge for the firm