The foreign exchange market Essay Example for Free

The foreign exchange market Essay The analysis of this paper highlights the importance on the factors that determines the foreign exchange rates at which one country purchases the one unit of the another country’s currency. The foreign exchange market provides a link between the countries through which all countries are working under the umbrella of global trade which works more efficiently than barter. The foreign exchange market provides a hub under which one country exchanges the other country’s currency because every nation uses its own monetary unit. In this particular case, the firm is willing to make a business deal with the Japanese supplier. In order to accomplish the business deal the management of the Blades Inc has two choices one is to purchase two call options contracts and the second is to purchase one futures contract. The tendency of futures price on yen has historically tilted towards discount with respect to the existing spot rate and the firm is willing to use currency options in order to hedge payables in Japanese yen. They prefer currency option because of the uncomfortable leaving the position and also the historical volatility in the yen. But the CFO prefers the options offer over forward contracts or futures contracts due to its flexibility and wants to use the exercise price of 5 percent above the existing spot rate. In general, options on Yen required a premium of 1. 5 percent of the total transaction amount that would be paid if the option is exercised. Moreover, if the firm uses the future yen spot rate, then the decision is purely based on a cost. The optimal hedging strategy is not the lowest-cost alternative because the firm is the in the position of assessing the risk. The firm is working upon hedging because of prevailing unsure market condition. So the perfect hedge reduces the risk associated with the currency. B Answers of the Questions 1. The table shows the option choices for Blades Inc. If they are not willing to pay more than 5% (above spot rate) then the exercise price of $0. 00756 should be considered while on the respective side the premium on that particular option is 2% (more expensive) of exercise price. The option premium is higher is that respective which the firm normally willing to pay. The firm also pays a lower premium by purchasing and considering another option whose exercise price of $0. 00792 but that exercise price is 10% higher than the spot rate. This particular alternative is not feasible for the company because the firm is not willing to pay moire than 5% on the prevailing spot rate. So if the firm wants continue to use option the management of the company either prefers a higher premium than it would prefer, or a higher exercise price that limits the effectiveness of the hedge. If the firm is willing to use an option then the tradeoff is paying a premium of $1,417. 50 to limit the payables amount to $99,000 or paying a premium of $1,890 to limit the payables amount to $94,500. The preference of the option is based upon the assessment of the analyst regarding the Yen (Gerald I. White, Ashwinpaul C Sondhi, and Dov Fried ,2001). 2. Blades Inc also remains unhedged but its preference is towards hedge because of the volatile and fickle movements happen before the events. They are more desirable towards hedge because of the disruption and uncertainty associated with the yen’s future value. Since future prices are not influenced with the doubtful and uncertain events. The management of the company should prefer the futures contracts as an alternative to options. Thus, the firm is willing to purchase future contracts which enable the management to lock its future payments with any undue disruption (Steinherr, 1998). 3. In the market speculators who want to capitalize their expectation and anticipation towards the yen’s future movement, then the anticipation towards future spot rate would be equal to the futures rate. For example, if the speculator wants that Yen should appreciate they should eyeing to buy the Yen. If the Yen appreciates, the speculator buys the Yen’s future rate in two months and sells them at the prevailing sport rate at that particular time. Thus, if the market expectation and sentiments are high towards Yen then the Yen will appreciate and the all the speculators will engage in the similar action. This action enforces towards upward pressure on the future rates and downwards pressure on the expected future spot rate. This ongoing process continues until the future rate is equal to the expected future spot rate. Therefore, the expected spot rate at the point of delivery is equal to the future rate, $0. 006912 (Tsetsekos Varangis, 1997, and, van der Bijl, 1996). 4. The best possible choice at the given future spot rate is described in the question 3 but the decision is solely made on the basis of cost because acquisition of one future contract makes an impact on the actual cost of $86,400 on the delivery date. The actual cost on the delivery dates in the form of purchase of Yen my deviate from this value. It is depending upon moment of Yen between the order and delivery date. Therefore, the firm probably prefers to use future contract over the remaining unhedged time. 5. No as disclose in the case the Yen is very volatile so due to that fact the actual costs might be tilting towards lower side either the firm uses an option to hedge the yen payable or remained unhedged. By applying a future contract to hedge it also locks the price of the firm which they are willing to buy Yen at the given time frame. Moreover, firm forgoes the cost advantage that effects the depreciation of Yen at the given point of time. In that particular scenario, the firm is flexible enough to buy yen at the spot rate but this flexibility is not available with the future contracts (Hunt, Philip and Kennedy, Joanne, 2004).