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Contents
1.Executive Summary ................................................................................................................................... 2
2.Chapter One ............................................................................................................................................... 3
2.1 Use of Currency Derivative Instruments ............................................................................................ 4
3.Chapter Two............................................................................................................................................. 10
3.1 Assessment of Potential Arbitrage Opportunities ............................................................................. 11
4.Chapter Three........................................................................................................................................... 15
4.1 Assessment of Exchange Rate Exposure .......................................................................................... 16
5.Chapter Four ............................................................................................................................................ 20
5.1 .ZAPA Chemical and BuBa (Decision Case) ................................................................................... 21
5.References ................................................................................................................................................ 28

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1.Executive Summary
This report basically divided into Four parts. The five different part of the report are chapter one,
Chapter two, chapter three and chapter four. The first chapter basically deals with the reports
introduction, background, objectives & limitations of the report. The second part of the report
deals with the first case of Blade inc about the Use of currency derivatives. The third chapter
deals with the Blades inc Assessment of Potential Arbitrage Opportunities. Chapter four deals
about the blades inc Assessment of exchange rate exposure, and finally chapter five deals with
the. This report contains four different case studies about different topics related to international
financial management. In chapter one, a case study of Blades Inc. and how it uses currency
derivative instruments is studied. There it is studied, how Blades can hedge its yen payables
using different currency derivative instruments like options and forward contracts, trade off of
using them and not using them (remain unhedged), finding the optimal hedging strategy etc. In
chapter two, the case is about yet another situation of Blades Inc. and assessment of its potential
arbitrage opportunities. This case explores about different arbitrage strategies Blades Inc. can
use, whether it can use locational arbitrage, triangular arbitrage and covered interest arbitrage or
not, and why are arbitrage opportunities likely to disappear soon after they have been discovered
etc. The final chapter, chapter five contains a decision making case study about ZAPA chemical
and Bundes Bank (BuBa). It goes through different real life events, and how they affect the
currency exchange rates, volatility, and value of options and the hedging strategy of ZAPA. All
the cases are related to exchange rate movements and how they can affect the profits of
international organizations etc.

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 2.Chapter One

BLADES, INC. Case One

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2.1 Use of Currency Derivative Instruments
Question 1:
If Blades uses call options to hedge its yen payables, should it use the call option with the
exercise price of $ 0.00756 or the call option with the exercise price of $ 0.00792? Describe
the trade-off.

Answer:
Introduction: Blades, Inc., a U.S. based company wanted to purchase supplies from Japanese
supplier with payment of 12.5 million yen payable on the delivery date. The order has been made
two months ahead of the delivery date. It has two choices:
Call option gives the buyer of call option the right to buy the underlying asset, with no
obligation, from the call option seller within the agreed upon time and when exercised upon, the
seller has no choice but to sell the asset at the strike price.
Futures contract is a legal agreement to buy or sell a particular commodity or asset at a
predetermined price at a specified time in the future. Futures contracts are standardized for
quality and quantity to facilitate trading on a futures exchange.

Analysis: The table in case shows how the option choices have changed for Blades. If it wants to
ensure paying no more than 5 percent above the spot rate, the option with the exercise price of
$0.00756 should be considered, although the premium on that option now has increased to be
worth 2 percent of the exercise price (more expensive). The option premium is higher than what
the firm normally prefers to pay. The firm could pay a lower premium by purchasing the
alternative option with an exercise price of $0.00792, but that exercise price is 10 percent above
the existing spot rate. This alternative option does not achieve the firm’s desire to ensure paying
no more than 5 percent above the existing spot rate. So, if the firm is to continue to use options,
it must accept either pay a higher premium than it would prefer, or a higher exercise price that
limits the effectiveness of the hedge. The preferred option depends on the firm’s assessment
about the yen, but many analysts would select the higher premium (an extra $472.50) to pay for
the lower limit on payables.

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Conclusion: Based on the analysis, it is advisable to go for call option 1 as even though it
requires more premium to be paid but it limits the payable amount to $ 94,500. As a result, the
total payable for call option 1 is lower then call option 2. If Blades goes for call option 2 then it
has to pay $ 4027.5 higher then call option 1. Thus, making a decision only based on premium
might not yield the best results.

Question 2:
Should Blades allow its Yen position to be unhedged? Describe the trade off?

Answer:
Introduction: A hedge is an investment to reduce the risk of changing price movements in an
asset. There is a risk-reward tradeoff that Is a main part of hedging ; while it reduces the risk, it
also destroys the possibilities of potential gains. The most common way of hedging is through
derivatives: options, swaps, futures and forward contracts. Due to volatility in value of
currencies, businesses usually fix a foreign exchange rate for future transaction using the
derivatives mentioned above. Whether the company will go for a hedged payment or unhedged
payment, depends on the business and the current condition of the market

Statement of problem: Deciding on whether to hedge the payment that is to be made by Blades,
Inc. or not. After analyzing the case, it was found that Blades had to pay the suppliers $ 12.5
million yen after 2 months. Blades, Inc. will have to make the payment in Japanese yen, after
trading dollars for yen. If the value of yen in the market changes after two months, then it will
affect the amount of U.S. dollar that is needed to make the payment in yen

Analysis: Blade Inc. has 2 choices – one is call option and another is future contract. Call option
can be unhedged thought the movement of currencies value. It creates new event relative to
before event, when the event faced more uncertainty. In our case, table shows that the future
contract information where the future price will not be affected by uncertainty. Also in this
contract owners are not obliged by this contract relative to the option where owners are obliged.
So that, firm can purchase future contract and lock its future payment value at the same future
price that has before event

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Conclusion: Blades should go for hedging its payment, using futures contract, as yen is a
volatile currency, meaning that its value can change at any time. If there is significant deviation
in the exchange rate of yen for dollar then it will result in Blades paying more than it originally
determined and fixed.

Question 3:
Assume there are speculators who attempt to capitalize 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
information, what is the expectation on the order date of the yen spot rate by the delivery
date? (Your answer should consist of one number.)

Answer:
Introduction:A speculator utilizes strategies and typically a shorter time frame in an attempt to
out-perform traditional longer-term investors. Speculators take on risk, especially with respect to
anticipating future price movements, in the hope of making gains that are large enough to offset
the risk. Speculators attempt to predict price changes and extract profit from the price
movements in an asset.

Statement of the problem: Deciding the normal cost of yen's future spot rate on the day the
future contracts will be requested, making the move of examiners without hesitation. Theorists
attempt to benefit from chances of anticipated that cost all together should make gains in a brief
timeframe. Here, Japanese yen is an unpredictable cash, so the theorists will attempt to exploit its
unpredictability and this thus will influence the cost of the fates contract and the spot cost of
prospects in explicit ways.

Analysis: On the off chance that there are examiners who endeavor to benefit from their desire
for the yen's future development, at that point the desire for the future spot rate would be
equivalent to the prospects rate. For instance, assume examiners anticipate that the yen should

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appreciate. They would purchase yen prospects now. In the event that the yen acknowledges,
they will purchase the yen at the future rate in two months and sell them at the spot rate winning
around then. Along these lines, if the market desire is that the yen will value, all theorists will
take part in comparative activities, which would put upward weight on the prospects rate and
descending weight on the normal future spot rate. This procedure proceeds until the fates rate is
equivalent to the normal future spot rate.

Conclusion: When speculators try to gain from the appreciation or depreciation due to
expectation of price movement that is when the future rate can indicate the future spot rate.

Question 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 costs?

Answer:
Statement of Problem: As we know that Blades Inc. has to make a payment of 12.5 million yen
after 2 months. As the payment will be a cross exchange will be paying the yen amount with
dollars. If the currency value of yen changes in 2 months the amount of dollars will also change.
Blades can hedge using call option or hedge using future contracts.

Analysis: Although remaining unhedged also has an expected cost of $86,400, actual costs
incurred on the delivery date to purchase yen may deviate substantially from this value,
depending on the movements of the yen between the order date and the delivery date.
Consequently, the firm will probably prefer using a futures contract over remaining unhedged.

Conclusion: Finally, firm will hedge. But here we decided the optimal choice based on only cost
basis. As the cost of hedging with future and remaining unheeding is same, it will choose futures,
because it will protect the payment from any price movement in yens price.

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Question 5:
Will the choice you made as to optimal hedging strategy in question 4 definitely turn out to
be the lowest cost alternative in terms of actual cost incurred? Why or why not ?

Answer:
For option 2: Exercise price $0.0079200 Premium per unit $0.0001134 Total units 6250000
Total costs (($0.0079200+$0.0001134)* 6250000) = $50208.75 Total paid for option 1, exercise
price is $.00756. Total premium $1890 Amounts to be paid for Yen + $86400 total paid $88290
In this option they will not exercise the contract as spot rate is less than the exercise rate. In case
of 2nd option, the total amounts have to be paid $87817.50 with exercise price $0.00792, which
is calculated by: Total premium $1417.50 Amounts have to be paid for Yen + $86400 Total paid
$87817.50 So this option will not be exercised as the spot rate is less than the exercise rate.

Question 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?

Answer:
Background: Standard deviation is a statistical term that refers to and shows the volatility of
price in any currency. In essence standard deviation measures how widely values are dispersed
from average. The higher the standard deviation of a currency the more volatile the currency is.
Stable currencies have very low standard deviation.

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Statement of the Problem: The historical standard deviation of yen is $.0005 and it’s unlikely
that the future spot rate will be more than $0.0010 (two standard deviation) higher than expected
spot rate. So now, as the max expected future spot rate can be calculated, what will be the
optimal hedging option for Blades?

Analysis: if the standard deviation increases by 2% then the forecasted spot rate will be
$0.007912 (calculated by $.006912+ (2*.0005000))

Cost of remain unhedged will be $98900 (computed by $.007912*12500000) In case of

purchasing future contract if 2% standard deviation increases then costs will be $86400 because
there is no impact of increasing standard deviation on the future price.

In case of purchasing 2 options, for one option cost will be $48195 which is computed by
(($.0075600+$.0001512)*6250000) For 2nd option costs will be incurred $50209 which is
computed by (($.0079200+.0001134)*6250000)

For option 1 exercise price is $0.00756 Total premium $1890 Amounts have to be paid for Yen
+ $94500 Total paid $96390

For option 2 exercise price is $.00792 Total premium $1417.50 Amounts have to be paid for Yen
+ $98900 Total paid $100317.50 In 1st option, as because the spot rate is higher than the
exercise price Blade Inc can exercise this option.

Conclusion: They will be able to generate profit using this option. But in case of 2nd option,
spot rate is less than the exercise price. So they will face loss if they exercise this option. So
Blade Inc. should not exercise call options rather they should go for future contract.

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 3.Chapter Two

BLADES, INC. CASE 2

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3.1 Assessment of Potential Arbitrage Opportunities

1. The first arbitrage opportunity relates to locational arbitrage. Holt has obtained spot
rate quotations from two banks in Thailand, Minzu Bank and Sobat Bank, both located in
Bangkok. The bid and ask prices of Thai baht for each bank are displayed in the table
below:
Determine whether the foreign exchange quotations are appropriate. If they are not
appropriate, determine the profit you could generate by withdrawing $100,000 from
Blades’ checking account and engaging in arbitrage before the rates are adjusted.
Introduction: When quoted exchange rates vary among locations, participants can capitalize on
the discrepancy. Then they can use locational arbitrage, the process of buying a currency at a
location where it is priced cheap and then immediately selling it at a location where it is priced
higher. Locational arbitrage is possible when a bank's buying. Locational arbitrage is normally
conducted by banks or other foreign exchange dealers, whose computers can continuously
monitor the quotes provided by other banks.

Statement of Problem: How immediate risk-free profit can be earned through locational
arbitrage? Is Locational arbitrage possible based on the bid and ask rate provided by Minzu
Bank and Sobat Bank?

Detailed analysis: Holt has obtained spot rate quotations from two banks in Thailand. Minzu
Bank and Sobat Bank, both are located in Bangkok. In locational arbitrage we can buy currency
at a cheap rate and sell it in high rate, we have to sell it immediately after we purchase it we
can’t wait for longer time. So, immediately we can earn risk-free profit through locational
arbitrage. Here, locational arbitrage is possible. Because price discrepancy exists here. Minzu
Bank and Sobat Bank have different Bid and Ask rate.

Locational Arbitrage
Buying Thai baht from Minzu Bank: The ask rate of Minzu bank is $.0227 which is lower
than
Sobat banks ask rate. So, Baht will be bought from Minzu the amount of withdrawing from
Blades is $100,000.

So, the amount of Thai baht is:

($100,000/$.0227)= 4,405,286.34

Selling Thai baht to Sobat Bank: Baht will be sold at the rate of Sobat Banks Bid rate because
their selling price is higher than Minzu Banks selling (Bid) rate.
The Bid quote of Sobat Bank is $.0228 which is higher than Minzu Bank ($.0224).
Amount of selling Thai Baht is: (฿4405286.34×$.0228)= $100,440.53

So, the Dollar profit will be ($100,440.53-$100,000) = $440.53

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Conclusion: Commercial banks providing foreign exchange services normally quote about the
same currencies. If the demand and supply conditions for a particular currency vary among
banks then a given currency may be priced at different rates, in which case market forces will
lead to realignment. When quoted exchange rates vary among locations, participants in the
foreign exchange market can capitalize on the discrepancy by using locational arbitrage.
Locational arbitrage facilitate exchange rate equilibrium. They try to earn a risk-free profit
whenever there is no exchange rate equilibrium.
2. Besides the bid and ask quotes for the Thai baht provided in the previous question,
Minzu Bank has provided the following quotations for the U.S. dollar and the Japanese
yen:
Determine whether the cross exchange rate between the Thai baht and Japanese yen is
appropriate. If it is not appropriate, determine the profit you could generate for Blades by
withdrawing $100,000 from Blades’ checking account and engaging in triangular
arbitrage before the rates are adjusted.
Introduction: A triangular arbitrage strategy involve three trades, exchanging the initial currency
for a second, the second currency for a third, and the third currency for the initial. During the
second trade, the arbitrageur locks in a zero-risk profit from the discrepancy that exists when the
market cross exchange rate is not aligned with the implicit cross exchange rate. A profitable
trade is only possible if there exist market imperfections. Profitable triangular arbitrage is very
rarely possible because when such opportunities arise, traders execute trades that take advantage
of the imperfections and prices adjust up or down until the opportunity disappears.

Statement of Problem: Bid-Ask Quotations of three currencies USD, Yen and Baht of Minzu
Bank are provided. Are there any mispricing in the quotations of Minzu Bank? Given the
information about the 3 currencies is triangular arbitrage possible here?

Detailed analysis: To know whether triangular arbitrage is possible or not first we will have to
see whether the cross exchange rate between Thai Baht and Japanese yen is right. By calculating
the cross exchange rate, we can see that the exchange rate is not appropriate and the rate should
be 2.63 Yen per Baht. So triangular arbitrage opportunity exists.

Profit = Received amount – Invested amount

=$100,726.87-$100,000
=$726.87

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Conclusion: Triangular arbitrage opportunities may only exist when a bank's quoted exchange
rate is not equal to the market's implicit cross exchange rate. If the market cross exchange rate
quoted by a bank is equal to the implicit cross exchange rate as implied from the exchange rates
of other currencies, then a no-arbitrage condition is sustained. Triangular opportunities are rare
and traders who take advantage of them usually have advanced computer equipment and/or
programs to automate the process.

3. Ben Holt has obtained several forward contract quotations for the Thai baht to
determine whether covered interest arbitrage may be possible. He was quoted a forward
rate of $.0225 per Thai baht for a 90-day forward contract. The current spot rate is $.0227.
Ninety-day interest rates available to Blades in the United States are 2 percent, while 90-
day interest rates in Thailand are 3.75 percent (these rates are not annualized). Holt is
aware that covered interest arbitrage, unlike locational and triangular arbitrage, requires
an investment of funds. Thus, he would like to be able to estimate the dollar profit resulting
from arbitrage over and above the dollar amount available on a 90-day U.S. deposit.
Determine whether the forward rate is priced appropriately. If it is not priced
appropriately, determine the profit you could generate for Blades by withdrawing $100,000
from Blades’ checking account and engaging in covered interest arbitrage.
Measure the profit as the excess amount above what you could generate by investing in the
U.S. money market.

Introduction: Covered interest arbitrage is an arbitrage trading strategy whereby an investor

capitalizes on the interest rate differential between two countries by using a forward contract to
cover exchange rate risk.
Using forward contracts enables arbitrageurs such as individual investors or banks to make use
of the forward premium (or discount) to earn a riskless profit from discrepancies between two
countries' interest rates. The opportunity to earn riskless profits arises from the reality that the
interest rate parity condition does not constantly hold. When spot and forward exchange rate
markets are not in a state of equilibrium, investors will no longer be indifferent among the
available interest rates in two countries and will invest in whichever currency offers a higher rate
of return.

Statement of Problem: There is a dollar-baht interest differential of 1.75%. The interest rate of
U.S. is 2% and the interest rate in Thailand is 3.75%. Given the current spot price of baht is
$0.0227 and 90day forward rate is $0.0225 is available, is covered interest arbitrages possible
here?

Detailed analysis: Forward rate $0.0225 per Thai baht for 90 days forward contract.
Current spot rate is $.0227
Interest rate in U.S 2%
Interest rate in Thailand 3.75%
Covered interest rate is possible here.
Covered interest arbitrage

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Step 1: Converting U.S dollars to Thai baht and setting a 90 day deposit account at a Thai bank
($100,000/$.0227)=4,405,286.34Baht. This is the amount to be sold forward.

Step 2: In 90 days, the Thai deposit will mature to (4,405,286.34×1.0375)

= ฿4,570,484.58

Step 3: Converting Thai baht into U.S dollars (4,570,484.58×$0.0225)

=$102,835.90

Step 4: Dollar amount (if invested in USA) on 90 day U.S deposit ($100,000×1.02)
=$102,000.00

Dollar profit ($102,835.90-$100,000) =$2,835.90

Return: 2.84%
Conclusion: For taking advantage with covered interest arbitrage, it is important to consider the
transaction costs. If transaction cost is not considered the arbitrage can incur loss. Although just
by interest rate it might seem there is a covered interest arbitrage opportunity but high
transaction costs can nullify the advantage.

4. Why are arbitrage opportunities likely to disappear soon after they have been
discovered?
To illustrate your answer, assume that covered interest arbitrage involving the immediate
purchase and forward sale of baht is possible. Discuss how the baht’s spot and forward
rates would adjust until covered interest arbitrage is no longer possible. What is the
resulting equilibrium state called?

Introduction: Arbitrage is the simultaneous purchase and sale of an asset to profit from a
difference in the price. It is a trade that profits by exploiting the price differences of identical or
similar financial instruments on different markets or in different forms. It means trading for
guaranteed profit by buying in one market/asset and selling in another market or equivalent asset
at the same time to lock in a spread. Though arbitrage opportunities are rare in developed
markets but they can occur.

Statement of Problem: What causes the arbitrage opportunities to disappear? How it gets
adjusted and what is the state called where no covered interest arbitrage is possible?

Detailed analysis: Arbitrage opportunity mainly occurs when there is a misprice in the currency
market. They disappear soon after they have been discovered because of market forces. Whenever an
arbitrage opportunity is discovered the arbitrageurs engage in trading to take advantage of the
mispricing. Due to the actions taken by arbitrageurs, supply and demand curve for the foreign
currency shift and adjust to a new equilibrium until the mispricing disappears.
Conclusion: Arbitrage opportunities dissolve because of the sudden increase of trade of
currencies by the arbitrageurs, which leads to shifts in the supply and demand of the currencies
thus adjusting the equilibrium until no arbitrage opportunity exist.

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 4.Chapter Three

BLADES, INC. CASE 3

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4.1 Assessment of Exchange Rate Exposure
Question: 01 What type(s) of exposure (transaction, economic, or translation exposure) is Blades
subject to? Why?

Introduction: Transaction exposure, defined as a type of foreign exchange risk faced by companies that
engage in international trade, exists in any worldwide market ransaction exposure (or translation
exposure) is the level of uncertainty businesses involved in international trade face. Specifically, it is the
risk that currency exchange rates will fluctuate after a firm has already undertaken a financial obligation.
A high level of vulnerability to shifting exchange rates can lead to major capital losses for these
international businesses.One way that firms can limit their exposure to changes in the exchange rate is to
implement a hedging strategy. Through hedging using forward rates, they may lock in a favorable rate of
currency exchange and avoid exposure to risk.

Statement of Problem: What type of exposure the Blades Incorporation is subjected to ? and Why ?

Detailed Analysis: Blades is subject to transaction and economic exposure. Transaction exposure is the
exposure of an organization’s contractual transactions to exchange rate movements. Economic exposure
is any exposure of a company’s cash flows to exchange rate movements. However, it is not subject to
translation exposure. Under economic exposure, Blades present value of its future cash flows is
influenced by changes in exchange rates. Under transaction exposure, Blades value of future cash
transactions is also influenced by changes in exchange rates. Under translation exposure, there was no
exposure of a MNCs “consolidate financial statements” with changes in exchange rates.

Conclusion: Blades is subjected to economic & transaction exposure

Question 2: Using a spreadsheet, conduct a consolidated net cash flow assessment of Blades, Inc.,
and estimate the range of net inflows and outflows for Blades for the coming year. Assume that
Blades enters into the agreement with Jogs, Ltd.

Introduction:A company with multiple subsidiaries combines, or consolidates, the liquidity reports of all
subsidiaries to create a consolidated statement of cash flows. The cash flow statement includes all cash
inflows a company receives from its ongoing operations and external investment sources, as well as all
cash outflows that pay for business activities and investments during a given quarter. In this article, we'll
explain the cash flow statement and how it can help you analyze a company for investing

Statement of Problem: Using a spreadsheet, conduct a consolidated net cashflow assessment of blades,
Inc, and estimate the range of net inflows & outflows for blades for the coming year.

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Detailed Analysis:

Currency Inflow Outflow Net-Inflow Expected Inflow

Outflow Exchange Outflow In
Rate US$
British pound 16,000,000 16,000,000 1.5 24000000
(200000 * 80) inflow
Japanese yen(1700*7440) 12,648,000 12,648,000 0.0083 104,978.40
outflow
Thai 826,920,00 206,712,000 620,208,000 0.024 14,884,992
baht(180000*4594)inflow 0 Inflow
..Outflow(72000*2871)

Currency net inflow- possible e.r. possible e.r. range in U.S. range in U.S. $ to
outflow range from range to $ from
British pound 16,000,000 $1.47 $1.53 $23,520,000.00 $24,480,000.00
Inflow

Japanese yen 12,648,000 $.0079 $0.0087 $99,919.20 $110,037.60

Outflow
Thai baht 620,208,000 $0.020 $0.028 $12,404,160.00 $17,365,824.00
Inflow

Question: 03 3. If Blades does not enter into the agreement with the British firm and continues to
export to Thailand and import from Thailand and Japan, do you think the increased correlations
between the Japanese yen and the Thai baht will increase or reduce Blades' transaction exposure?

Introduction Transaction exposure is the level of uncertainty businesses involved in international trade
face. Specifically, it is the risk that currency exchange rates will fluctuate after a firm has already
undertaken a financial obligation. A high level of vulnerability to shifting exchange rates can lead to
major capital losses for these international businesses. One way that firms can limit their exposure to
changes in the exchange rate is to implement a hedging strategy. Through hedging using forward rates,
they may lock in a favorable rate of currency exchange and avoid exposure to risk

Statement of Problem: If Blades does not enter into the agreement with the British firm & continues to
export to Thailand and import from Thailand and Japan, Do you think the increased correlation between
the Japanese Yen & the Thai Baht will increase or reduce Blades transaction Exposure?

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Detailed Analysis: It will reduce Blades’ transaction exposure. The reason being is that if the dollar
revenue is decreased due to baht depreciation, the dollar cost will also decrease due to the depreciation of
yen (Blades generates baht-denominated net inflows, but its outflows are yen-denominated) If Blades
does not enter into the agreement with the British firm but continues to export to Thailand and import
from Thailand and Japan, the increased correlations between the Japanese yen and the Thai baht will
reduce Blades level of transaction exposure. This is due to that fact that Blades generates its net inflows in
Thai baht and it generates its net outflows in Japanese yen.

Conclusion: If both of the sources have been the Net inflows or Net outflows, then the high correlation
between them would have resulted in a high transaction exposure.

Question: 04 Do you think Blades should import components from Japan to reduce its net
transaction exposure in the long run? Why or why not?

IntroductionThe danger of transaction exposure is typically one-sided. Only the business that completes
a transaction in a foreign currency may feel the vulnerability. The entity that is receiving or paying a bill
using its home currency is not subjected to the same risk. Usually, the buyer agrees to buy the product
using foreign money. If this is the case, the hazard comes it that foreign currency should appreciate,
costing the buyer to spend more than they had budgeted for the goods.

Statement of Problem: Do you think blades should import component from Japan to reduce its net
Transaction exposure in the long run? Why or Why not?

Detailed Analysis: We don’t think it should. Blades’ only way of reducing its net transaction exposure
lies in importing from Japan due to the high correlation level between baht and yen. It is less likely that
the correlation between these two currencies will last for the extended period of time. The correlation has
been low in the past and will most likely return to its normal state in the future. Since Blades decreases
its net transaction exposure from importing from Japan (because of high correlation), we believe that
Blades net transaction exposure will soon increase.

Conclusion: Because there is an unstable correlation between the Japanese yen and Thailand Baht it
might lead to a high transaction exposure in the near future

Question: 05 Introduction

The risk that foreign exchange rate changes will adversely affect a cross currency transaction before it is
settled, can occur in either developed or developing nations. A cross-currency transaction is one that
involves multiple currencies. A business contract may extend over a period of months. Foreign exchange
rates can fluctuate instantaneously. Once a cross-currency contract has been agreed upon, for a specific
quantity of goods and a specific amount of money, subsequent fluctuations in exchange rates can change
the value of that contract. A company that has agreed to but not yet settled a cross-currency contract that
has transaction exposure. The greater the time between the agreement and the settlement of the contract,
the greater the risk associated with exchange rate fluctuations.

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Statement of Problem: Assuming blades enter into the agreement with Jogs ltd, how will its overall
transaction exposure be affected?

Detailed Analysis: The transaction exposure will have a slight increase. In this scenario two factors
impact transaction exposure. Firstly, Blades’ net cash inflows would be denominated in foreign currencies
driving the transaction exposure upwards. Secondly, the correlation between baht and yen on one side,
and British pound on the other, is not significantly high. This means that changes in one currency (BP)
may not drastically affect the other (baht).

Conclusions:If Blades enters into the agreement with Jogs Ltd., its overall transaction exposure would
increase.

Question: 6. Given that Thai roller blade manufacturers located in Thailand have begun targeting
the U.S. roller blade market, how do you think Blades' U.S. sales were affected by the depreciation
of the Thai baht? How do you think its exports to Thailand and its imports from Thailand and
Japan were affected by the depreciation?

IntroductionA fall in the exchange rate is known as a depreciation in the exchange rate (or devaluation in
a fixed exchange rate system). It means the currency is worth less compared to other countries. When
there is a depreciation, and the exchange rate goes down, Exports will be cheaper, Imports will become
more expensive. e.g. a depreciation of the dollar makes US exports more competitive but raises the cost of
importing goods into the US. Therefore, there will be an increase in exports and decrease in the quantity
of imports. Domestic firms will benefit from increased sales. This may lead to job creation and lower
unemployment, especially in export industries. The increase in (X-M will) help increase Aggregate
Demand (AD) and therefore lead to higher economic growth

Statement of Problem: Even That Thai roller Blades Manufactures located in Thailand have begun
targeting the U.S. roller blade market, how do you think blades U.S. sales were affected by the
depreciation of the Thai Baht? How do you think its exports to Thailand and its imports from Japan and
Thailand were affected by the depreciation?

Detailed Analysis: Blades’ U.S. sales were likely negatively affected by the depreciation of the baht. U.S
customers have been buying foreign roller blades because they are cheaper “with a strengthened dollar”.
This resulted in Thailand manufacturers targeting the U.S roller blade industry. We believe that Blades
exports to Thailand would be affected negatively by the depreciation. We also believe that Blades imports
from Thailand would be affected positively by a depreciation of the baht. As previously discussed, the
correlation between Thailand’s currency and Japans currency has been high; we feel the yen would also
depreciate. In the end this would result to a reduced dollar costs for Blades to pay for Japanese imports.

Conclusions: As previously discussed, the correlation between Thailand’s currency and Japans currency
has been high; we feel the yen would also depreciate. In the end this would result to a reduced dollar costs
for Blades to pay for Japanese imports

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 5.Chapter Four

ZAPA Chemical and BuBa

Decision Case

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5.1 .ZAPA Chemical and BuBa (Decision Case)

1. Should Stephanie Mayo sell the put option protection already in place? Use
the current market rates and price to defend your logic.

Introduction: A put option is a financial contract between the buyer and seller of a
securities option allowing the buyer to force the seller (or the writer of the option
contract) to buy the security (Investopedia, 2018). An investor would choose to sell
a put option if her outlook on the underlying security was that it was going to rise,
as opposed to a put buyer whose outlook is bearish. The purchaser of a put option
pays a premium to the writer (seller) for the right to sell the shares at an agreed upon
price in the event that the price heads lower. If the price hikes above the strike price,
the buyer would not exercise the put option since it would be more profitable to sell
at the higher price on the market.

Statement of Problem: As the market as not turned out to be like Stephanie’s

expectations, considering recent market situation should she sell the current put
option protection?

Analysis: Before making a decision, Stephanie had a look at all the alternatives.
Selling a forward contract would’ve been easier the rates were not attractive, also
she believed the value of Dollar will go even lower so the forward rate is in the
opposite direction. So initially she chose to purchase out of the money put options
to hedge.

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 But after buying the put options on August, September month went through
turbulence in the market, and the situation didn’t really follow Stephanie’s
expectations. The following things happened which effected the hedging strategy
of Stephanie,
➢ On 1st September US dollar dropped sharply to all-time low DM1.39/$
➢ On 16th September, market reacted favorably to several actions taken by
several European countries, US dollar appreciated DM1.51/$
➢ Dollars currency volatility increased in September which rapidly increased
the values of options
Because of the significant increase in the values of options, Stephanie observed an
opportunity to sell the put options at higher prices. But although the increased
value of options is a favorable exchange rate movement, it is also an increase in risk
as volatility has increased. But this risk can be hedged by entering a forward
agreement.
Calculations:
th
Current Spot rate: DM1.5015/$ (18 September) 90 day
Forward Rate: DM1.5255/$
Put Option Premium: 1.95 Cents or 0.0195$ per DM

Current Hedging Strategy

Under Current Spot rate:
Receivable Amount = 7,600,000DM ÷1.5015 = $5,061,605.06

Under Worst Case (at 15th December)

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 Receivable Amount = 7,600,000DM ÷1.5152 = $5,015,839.49

Sale of Put Option and enter forward Contract:

Under Current Spot rate:
Sale of Put Option (premium) = 7,600,000 DM x $0.0195
= $148200 After 90 day Forward = 7,600,000DM ÷1.5255
= $4,981,973.12
Receivable amount = $4,981,973.12 + $148200 = $5,130,173.12
Under worst case (at 15th December)
Premium with interest (90 days) = 148200 x (1+0.033125x 90/360)
=$149,427.28 After 90 day Forward = 7,600,000DM ÷1.5255 =
$4,981,973.12
Receivable amount = $4,981,973.12 + $149,427.28 =$5,131,400
So, Stephanie should sell the put option protection and enter a forward
contract as it gives higher outcome in both current spot rate and worst-case
rate.
Conclusion: Stephanie should sell the put option and go for forward contract to
hedge the risk. By selling the put option and enter into a forward contract can help
her to gain higher outcome. Also because of the forward contract currency
movement will not affect the outcome at December when the 7.6 million DM
amount will be retrieved to Dollar.
2. How have the events of September altered Stephanie’s view of the DM/$
exchange rate?
Introduction: Based on the initial view of Stephanie on the DM/$ Exchange rate
she had chosen to use OTM put options for hedging against exchange rate
movement risk. Put option is An options contract is an agreement between a buyer
and seller that gives the purchaser of the option the right to buy or sell a particular
asset at a later date at an agreed upon price. Options contracts are often used in
securities, commodities, and real estate transactions. Out of the money (OTM) is
term used to describe a put option with a strike price that is lower than the market
price of the underlying assets. An out of the money option has no intrinsic value but
only possesses extrinsic or time value.

Statement of Problem: Stephanie’s initial view was the exchange rate will fall
even lower but how did the events of September change her initial view?

Analysis: Stephanie’s initial view on the exchange rate of DM/$ was that the value
of dollar or the DM/$ will fall even lower than the existing rate (DM 1.4649/$).
Some of the reasons behind her expectation on dollar to fall was,

➢ Interest rate differentials: The interest rate in USA was 3.3125% and
Germany had an interest rate of 9.750%. Three-month Eurodollar

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 deposits were paying a 3.3125%, while similar Euro-Deutschemark
were paying 9.75%. And there were no signs of either rate moving
toward the other.
➢ The Bundesbank: BuBa was driving interest rates up to slow monetary
growth, all in an effort to stop the inflationary forces resulting from
reunification. It had already increased the German base lending rate
from 9% to 9.75%.
➢ In US election: 1992 it seemed like the democrats were going to be the
win, and historically the markets have favored the republicans opposed
to the democrat policies.
➢ European Monetary system: Strengthening German interest rate was
also putting pressure on the other European currencies, as they tried to
keep parity with the deutschemark.
But after the following events in September, Stephanie’s views on the exchange
rate has changed and she felt the necessity to reevaluate her hedging decision.

➢ BuBa Cuts Interest Rate: Bundesbank cuts its interest rate by 25 basis
point, from 9.75% to 9.50%. Italy announced its currency will be
devalued. Also the
➢ U.S. Dollar Fall: On 1st September the U.S dollar’s value falls below
DM 1.39/$ which is the all-time lowest rate.
➢ BuBa Refuses to Cut Interest: On September 17, Bundesbank refuses
all pressures to cut interest rates. The Spanish Peseta gets devalued 5%.
The value of Dollar again falls in response to rumors that BundesBank
won’t cut interest until the French Vote on Maastrich.
➢ Market Reacts Favorably: On September 14 the market reacts
positively, Dollar’s value increases and gets an appreciation of 2.4% and
reaches DM 1.49/$ Market waits for Interest cut from Bundesbank.
Mainly After the dollar had fallen, risen, and fallen again, she wished to reevaluate
her put option position as the increase in volatility of dollars value had increased
the options values.

Conclusion: The week of September was a literal nightmare. Especially for dollars
value as it had seen a fall, followed by a rise and again a fall in a very short time.
This made Stephanie change her view on DM/$ exchange rate.

3.How has the volatility of the put option changed between august and September?

Introduction: Volatility is basically the amount or range of price change or

movement of any financial security. In finance, volatility (symbol σ) is the degree

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 of variation of a trading price series over time as measured by the standard
deviation of logarithmic returns. Historic volatility measures a time series of past
market prices. A security is called highly volatile if its price fluctuates up and down
frequently, move irregularly and experiences rapid increases and sharp falls
(finance.zacks.com, 2018). Because human beings by nature feel the pain of loss
more intensely than the joy of gain, the risk of highly volatile securities might feel
to be unnecessary. But Securities with high volatility are riskier than again they also
provide numerous money-making opportunities. On the other side low volatile
securities have lower risk and also lower money-making opportunity.
Statement of Problem: Between August and September how was the volatility of
the put option changed? Did it increase, decrease or stayed the same?
Analysis: The following graph contains the data of daily changes in the DM/$ spot
rate and the DM put option premium.

By looking at the graph we can find out that in August the exchange was decreasing
and in the last days of August and beginning days September we can see the
exchange rate fluctuating and after 14th September we can see the value of dollar
has fallen, risen and fallen again. This volatility in the exchange rate had effect on
the value of options too.
By looking at the graph of the option premium we can see that in August the
volatility was comparatively lower than September as the option premium
fluctuated between 0.5 Cents and
1.50 Cents per DM. But on September the range increased and option premium per unit of DM was
fluctuating between 0.5 Cents and 2.50 Cents. Which means the volatility of Put options increased in
September?

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 Conclusion: Regular fluctuation in the DM/$ spot rate made the exchange rate
more instable which increased risk for the option writers so they also adjusted their
option premium according the frequent changes which increased the volatility of the
options.

4.If you were the vice president for treasury at ZAPA, what benchmarks would
you measure Stephanie’s hedging effectiveness? How would this alter Stephanie’s
hedging?
Introduction Hedging against investment risk means strategically using
instruments in the market to offset the risk of any adverse price movements. In
other words, investors hedge one investment by making another. Technically, to
hedge you would invest in two securities with negative correlations.. It is mainly
used by organizations whose main focus is to minimize risk as hedging with future
contracts eliminates any possible profits due to favorable movement in exchange
rate. On the other hand, if an organization focuses on the profit from exchange
movement along with risk management, they are more likely to choose options as it
allows the organization enjoy potential profits due to favorable exchange rate
movement. However, options can be costlier than future contracts.
Statement of Problem: As a vice president what benchmarks should I use to
measure Stephanie’s hedging effectiveness and how would this alter the hedging?
Analysis: From the case we get to know that Zapa chemical used currency option

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 exclusively although its parent company didn’t use currency options to manage its
risk. At first it seems like the reason of using options is to enjoy additional profits
due to favorable exchange rate movement. But in Zapa chemical the management
considers treasury, a cost center not a profit Centre. They focus on only their cost
and not on profit through speculations. The reason they don’t use forward contracts
is due to previous losses in last year. The management is responsible to follow
conservative management style for any exposure. So, when the expenses of running
the cost center were lower the management was appreciated.
So, If I were the vice president for treasury at Zapa, I would use cost as a benchmark
to measure the hedging effectiveness. Rather than focusing which hedges has more
potential for additional profit I would evaluate effectiveness of hedging of
Stephanie by observing whether its cost is lower than other hedges or not. This
would alter Stephanie’s first decision to use out of the money put options as it was
more costly than forward contracts.
Conclusion: As ZAPA considers treasury as a cost center rather than a profit center
my target as the vice president of treasury would be minimizing the cost of hedging.
So, I would use cost as the benchmark of effectiveness of hedges.

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 5.References
Economictimes.com. (2017). Definition of 'Call Option'. Retrieved from
Economictimes.indiatimes.com:
https://economictimes.indiatimes.com/definition/calloption

Ed Grabianowski. (2018). How Exchange Rates Work. Retrieved from

Howstuffworks.com: https://money.howstuffworks.com/exchange-rate2.htm

finance.zacks.com. (2018). Price Change vs. Volatility. Retrieved from

Finance.zacks.com: https://finance.zacks.com/price-change-vs-volatility-7592.html

Forexop.com. (2018). Covered and Uncovered Interest Arbitrage Explained with

Examples. Retrieved from forexop.com: http://forexop.com/strategy/covered-
uncoveredinterest-arbitrage/

Investopedia. (2018). Options: Calls and Puts - Investopedia. Retrieved from

Investopedia.com: https://www.investopedia.com/exam-guide/cfa-
level1/derivatives/options-calls-puts.asp

Investopedia.com. (2018). How to Lock In an Exchange Rate. Retrieved from

investopedia.com: https://www.investopedia.com/articles/forex/051415/how-
lockexchange-rate.asp

Investopedia.com. (2018). Inflation. Retrieved from Investopedia.com:

https://www.investopedia.com/terms/i/inflation.asp

MindMeister.com. (2018, 02 19). Arbitrage. Retrieved from MindMeister:

https://www.mindmeister.com/1041392006/arbitrage-arbitrage-is-
thesimultaneouspurchase-and-sale-of-an-asset-to-profit-from-a-difference-in-t

https://www.investopedia.com/terms/t/transactionexposure.asp
https://www.investopedia.com/articles/stocks/07/easycashflow.asp
https://strategiccfo.com/transaction-exposure/
https://www.economicshelp.org/blog/437/trade/effects-of-falling-exchange-rates/

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