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Chase Options

1) A US company expects to receive DM 100 million in profits from its German subsidiary. It wants to hedge against the Deutsche Mark appreciating above 1.7 DM/USD but is uncertain about using a forward contract due to German reunification. It can buy a DM put option at a strike of 1.7 DM/USD for a premium of DM 1.64 million to protect profits if the DM rises. 2) A US firm bought equipment from the UK for GBP 5 million payable in 60 days. It believes the pound may fall significantly due to UK uncertainty. It should hedge with GBP call options rather than a forward contract to allow for upside gain if the dollar appreciates. 3) Different

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131 views

Chase Options

1) A US company expects to receive DM 100 million in profits from its German subsidiary. It wants to hedge against the Deutsche Mark appreciating above 1.7 DM/USD but is uncertain about using a forward contract due to German reunification. It can buy a DM put option at a strike of 1.7 DM/USD for a premium of DM 1.64 million to protect profits if the DM rises. 2) A US firm bought equipment from the UK for GBP 5 million payable in 60 days. It believes the pound may fall significantly due to UK uncertainty. It should hedge with GBP call options rather than a forward contract to allow for upside gain if the dollar appreciates. 3) Different

Uploaded by

College08
Copyright
© © All Rights Reserved
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Download as DOCX, PDF, TXT or read online on Scribd
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Kyle Taylor

Kyle Pittman
Fritz Yuwono

Chase Options Case Study

Given the information available about Chase Options, hedging strategies have

been devised for the following scenarios.

In this scenario (1), a U.S company expects DM 100 million in repatriated

profits from its German subsidiary on March 20, 1991. The company believes that

the dollar has reached a long term low at the current level DM/$1.6700; however, it

doesn’t want to lock in a forward exchange contract because of uncertainty

concerning the impact of the German reunification on the currency market. The

company doesn’t want to exchange at greater than DM/$1.700 (e.g., 1.7200). Design

a hedging strategy by using currency options and utilizing rates available. Also,

examine the implications of hedging instead with a forward contract and using a

buy-sell option strategy.

To hedge their risk the company can buy a DM put option against the dollar

at the strike of $1.70 so that if the currency rises above that price the company may

sell at the option strike and if the currency falls the company gains a higher profit

without using the put. The cost of the put would be DM 100,000,000 x 0.0164 = DM

1,640,000. The overall minimum profit of the company is calculated as DM

100,000,000 – DM 1,640,000 x (1.085106 x 272/360) = DM 98,254,544/1.7

=$57,796,791. The foreign exchange rate for one year is given so we multiply that

by the ratio of days till maturity divided by days in the year to give us the actual

interest not gained on the premium amount paid. If the DM were to appreciate than

the company wouldn’t exercise the option and would gain more in profit.
If a forward contract was used the company would stand to make DM

100,000,000/1.6725 DM/$ = $59,790,732 irrespective of exchange rate movement.

Also, they would not be able to make gains on potential appreciation of DM, and

there is no flexibility in the exercise date.

If the company used a buy-sell option hedging strategy, the premium payed

for the put would exactly offset the premium received for the call (i.e. zero cost). If

the exchange rate rose above 1.7 the company would use their put, and if it fell

below 1.647 the counterparty would use their call, while anything in between would

allow the put and call to expire worthless. The amount received would then fall

between DM 100,000,000/1.647 = $60,716,454 and DM 100,000,000/1.700 =

$58,823,529 with no interest amount forgone so minimum profit is approximately 1

million higher than if the company had just bought a put option.

In the next scenario (2), a U.S firm has bought industrial equipment from a

U.K. firm for STG 5 million payable in 60 days. The firm believes that UK’s political

and economic uncertainty might drive the pound sterling down significantly. What

hedging strategy should be devised: forward currency contracts or options?

Locking into a forward contract isn’t appropriate for this scenario since the

firm believes the pound sterling will be driven down and a forward contract would

eliminate their possibility for upside gain. Therefore, they should hedge with STG

call options. The premium is calculated as STG 5,000,000 x 0.0176 = STG 88,000.

If the dollar appreciates then they would allow the option to expire and then they

would buy STG at spot for a cheaper price than a forward contract would have cost.

If not, then the call protects against depreciation of the dollar. They would not use a
buy-sell strategy as that would cap their proceeds to a given interval and not allow

them room for upside gain. They would choose to forgo interest on the STG 88,000,

but since the maturity date is 60 days it is nominal compared with the upside gains

they are hoping to achieve.

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