Foreign Exchange Risk and Options: Calculation and Hedging

ABC Electronics Corporation: Foreign Exchange Risk and Hedging

ABC Electronics Corporation is an American electrical components manufacturer which also owns 100% of a subsidiary in Austria known as ABC Electronics (Austria) Corporation. The parent company regularly buys components from the subsidiary which requires payment in Euros (EUR or �). It also receives dividends from it in Euros. The parent corporation is expecting to have to pay the subsidiary EUR 100m in 6 months (180 days) time for a shipment of components. At present the following market prices prevail:

Spot price EUR 1.0 = USD 1.25

6-month (180 day) money market rates USD: 2% per annum, EUR 1% per annum

To put EUR, USD 0.03 (i.e. 3 US cents)

To call EUR, USD 0.04 (i.e. 4 US cents)

1. What types of foreign exchange risk is the parent company exposed to and in what ways can it hedge these risks?

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2. Using the forward margin methodology,calculate what rate of exchange between EUR and USD the parent company could hedge the exposure arising from the commitment of the parent company to pay EUR 100m in 6 months� time. For this question the �base� currency is the EUR and the �terms� currency is the USD. Note that both currencies use a 360-day convention for one year.

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3. Define the factors determining the prices of the options.�

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4. Explain how the parent company could hedge its foreign currency risk using options.

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You are required to select the appropriate options contract from those shown explain the reason for difference in the prices of the two options contracts.show, and explain, using pay-off diagrams, how the option you select would perform given changes in exchange rates from EUR 0.5 = USD 1 to EUR 1.4 = USD 1. under what circumstances would it be rational for ABC�s parent company to use options rather than the forward foreign exchange market to hedge its exposure to the EUR 100m payment?

On 1 June 20XX, Bling SE anticipated that it would need to borrow �10,000,000 in 6 months (180 days) time to cover a 6-month (180-day) cash shortfall and was concerned that interest rates might rise in the interim, causing higher interest payments on this debt. It considered various means of managing this risk and decided to use the forward rate agreement (FRA) market. The company�s bank sold Bling SE a forward rate agreement (FRA) for 360 days against 180 days (180/360) at 2%.

On 1 December the actual 6-month euro interest rate (Euribor) for 180 days was 2.86%. Bling SE could alternatively have entered into a short-term interest rate (STIR) futures agreement. The index price for the December 3-month interest-rate contract on 1 June was 98.10. On 17 December � the maturity date of the contract � the 3-month (90-day) euro interest rate (Euribor) was 2.36%.

Notes: the contract size for euro STIRs is �1 million. Assume all dates are working dates and not weekends etc.

1. How much would be paid out under the terms of the FRA contract and to which party?

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2. How could Bling have hedged its risk using the December STIR?

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3. What is the price of the STIR at 1 December?

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4. Why would the use of STIRs not provide a perfect hedge of the Bling�s interest rate risk?

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5. What are the advantages of using STIRs rather than FRAs to hedge interest-rate risks?�

Critically review value-at-risk (VaR) as a method for measuring and managing risk. You should do this by applying the following framework:

1. What is the purpose of VaR?

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2. What are the strengths of VaR?�

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3. What are the limitations of VaR?�

Explain the different methods a bank could use to assess the credit quality of, and manage credit exposures to, the following organisations:

1. A corporation with an active presence as a bond issuer in the international financial markets.

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2. A small high-street retailing company trading in only the domestic market.

Review the sections of Unilever�s Annual Report and Accounts 2017 that focus on risk management and assess its overall risk management processes.

1. What do you see as the strengths and weaknesses in Unilever�s risk management processes?�

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2. Explain whether, in your view, Unilever practices enterprise risk management (ERM).�

The price of an option is determined by a combination of factors, including:

1. The underlying asset price: The price of the underlying asset, such as a stock, commodity or currency, is a key factor in determining the price of an option. As the underlying asset price changes, the value of the option also changes.

2. The strike price: The strike price is the price at which the option can be exercised. The difference between the strike price and the underlying asset price is known as the "intrinsic value" of the option, and it is a key factor in determining the price of the option.

3. Time to expiration: The amount of time remaining until the option expires is a key factor in determining the price of the option. The longer the time to expiration, the more valuable the option is, all else being equal.

4. Volatility: Volatility refers to the degree of fluctuation in the price of the underlying asset. Higher volatility generally leads to higher option prices, as there is a greater chance of the option being in-the-money at expiration.