It is Thursday afternoon, February 14, 2019. Michael Smith, Assistant Treasurer at American Digital Graphics (ADG), sits in his office on the thirty-fourth floor of the building that dominates Rockefeller Plazas west perimeter. Its Valentines Day, and Michael and his wife have dinner reservations with another couple at Balthazar at 7:30. I must get this hedging memo done, thinks Smith, and get out of here. Foreign exchange forward contracts or option contracts? I had better get the story straight before someone in the Finance Committee starts asking questions. Lets see, there are two ways in which I can envision us using options now. One is to hedge a 1 million dividend to be received on September 15th from ADG Germany. The other is to hedge our upcoming payment to Matsumerda for their spring RAM chip statement. With the yen at 110 and decreasing, Im getting nervous. An option to buy yen on June 10 might be just the thing.

Before we delve any further into Michael Smiths musings, let us learn a bit about ADG and about foreign exchange options. American Digital Graphics is a $12 billion sales company engaged in, among other things, the development, manufacture, and marketing of microprocessor-based equipment. Although 30 percent of the firms sales are currently abroad, the firm has full-fledged manufacturing facilities in only three foreign countries, Germany, Canada, and Brazil. An assembly plant in Singapore exists primarily to solder Japanese semiconductor chips onto circuit boards and to screw these into Brazilian-made boxes for shipment to the United States, Canada, and Germany. The German subsidiary has developed half of its sales to France, the Netherlands, and the United Kingdom, billing in euros. The firm needs to convert the 1 million dividend to US dollars by September 15th. The firm has an agreement to buy three hundred thousand RAM chips at 6000 each semi-annually, and it is this payment that will fall due on June 10th.

The conventional means of hedging exchange risk are forward or future contracts. These, however, are fixed and inviolable agreements. In many practical instances the hedger is uncertain whether foreign currency cash inflow or outflow will materialize. In such cases, what is needed is the right, but not the obligation, to buy or sell a designated quantity of a foreign currency at a specified price (exchange rate). This is precisely what a foreign exchange option provides.

A foreign exchange option gives the holder the right to buy or sell a designated quantity of a foreign currency at a specified exchange rate up to or at a stipulated date. The terminal date of the contract is called the expiration date (or maturity date). If the option may be exercised before the expiration date, it is called an American option; if only at the expiration date, a European option.

The party retaining the option is the option buyer; the party giving the option is the option seller (or writer). The exchange rate at which the option can be exercised is called the exercise price or strike price. The buyer of the option must pay the seller some amount, called the option price or the premium, for the rights involved.

The important feature of a foreign exchange option is that the holder of the option has the right, but not the obligation, to exercise it. He will only exercise it if the currency moves in a favorable direction. Thus, once you have paid for an option, you cannot lose (except for the options premium), unlike a forward contract, where you are obliged to exchange the currencies and therefore will lose if the movement is unfavorable.

The disadvantage of an option contract, compared to a forward or futures contract is that you have to pay a price for the option, and this price or premium tends to be quite high for certain options. In general, the options price will be higher the greater the risk to the seller (and the greater the value to the buyer because this is a zero-sum game). The risk of a call option will be greater, and the premium higher, the higher the forward rate relative to the exercise price; after all, one can always lock in a profit by buying at the exercise price and selling at the forward rate. The chance that the option will be exercised profitably is also higher, the more volatile is the currency, and the longer the option has to run before it expires.

Returning to Michael Smith in his Rockefeller Center office, we find that he has been printing spot, forward and currency options, from the companys Bloomberg terminal.

The option prices are quoted in U.S. cents per euro. Yen are quoted in hundredths of a cent. Looking at these prices, Michael realizes that he can work out how much the euro or yen would have to change to make the option worthwhile.

Ill attach these numbers to my memo, mutters Michael, but the truth is he has yet to come to grips with the real question, which is when, if ever, are currency options a better means of hedging exchange risk for an international firm than traditional forward exchange contracts (or futures contracts).

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Please assist Mr. Smith in his analysis of currency hedging for his report to ADGs Finance Committee. In doing so, you may consult the market quotes from Bloomberg in the exhibits below.

In your case write-up, please address the following questions.

1. For the 1 million dividend to be received on September 15 (7 months from now), should Mr. Smith hedge with forward contracts or options contracts? You should calculate the dollars received under each hedging strategy and draw a graph with Excel to show the relation between the dollar amount received and future spot rate 7 months from now. You may make your suggestion based on what your graph shows. Suppose the interest rate is very low and you do not need to compute the effect of time value of money on options premium in your calculation.

2. For the 1800 million to be paid on June 10^th (4 months from now), should Mr. Smith hedge with forward contracts or options contracts? You should calculate the dollars paid under each hedging strategy and draw a graph with Excel to show the relation between the dollar amount paid and future spot rate 4 months from now. You may make your suggestion based on what your graph shows. Suppose the interest rate is very low and you do not need to compute the effect of time value of money on options premium in your calculation.

(Answer the 2 questions stated above).