Solutions-Chapter-8-Futures-and-Options

INSTRUCTOR’SMANUAL:MULTINATIONALFINANCIALMANAGEMENT,9THED.1CHAPTER8SUGGESTEDANSWERSTOCHAPTER8QUESTIONS1.OnApril1,thespotpriceoftheBritishpoundwas$1.86andthepriceoftheJunefuturescontractwas$1.85.DuringAprilthepoundappreciated,sothatbyMay1itwassellingfor$1.91.WhatdoyouthinkhappenedtothepriceoftheJunepoundfuturescontractduringApril?Explain.ANSWER.ThepriceoftheJunefuturescontractundoubtedlyrose.Here'swhy.TheJunefuturespriceisbasedontheexpectationsofmarketparticipantsastowhatthespotvalueofthepoundwillbeatthedateofsettlementinJune.SincethespotvalueofthepoundhasriseninduringApril,thebestpredictionisthatthefuturelevelofthepoundwillalsobehigherthanitwasonApril1.ThisexpectationwillundoubtedlybereflectedinaJunepoundfuturespricethatishigheronMay1thanitwasonApril1.2.Whatarethebasicdifferencesbetweenforwardandfuturescontracts?Betweenfuturesandoptionscontracts?ANSWER.ThebasicdifferencesbetweenforwardandfuturescontractsaredescribedinSection3.1.Themostimportantdifferencebetweenthesetwocontractsandanoptionscontractisthatabuyerofaforwardorfuturescontractmusttakedelivery,whilethebuyerofanoptionscontracthastherightbutnottheobligationtocompletethecontract.3.Aforwardmarketalreadyexisted,sowhywasitnecessarytoestablishcurrencyfuturesandcurrencyoptionscontracts?ANSWER.Acurrencyfuturesmarketarosebecauseprivateindividualswereunabletoavailthemselvesoftheforwardmarket.Currencyoptionsarepartlyaresponsetoindividualsandfirmswhowouldliketoeliminatesomecurrencyriskwhileatthesametimepreservingthepossibilityofearningawindfallprofitfromfavorablemovementsintheexchangerate.Optionsalsoenablefirmsbiddingonforeignprojectstolockinthehomecurrencyvalueoftheirbidwithoutexposingthemselvestocurrencyriskiftheirbidisrejected.4.SupposethatTexasInstrumentsmustpayaFrenchsupplier€10millionin90days.a.ExplainhowTIcanusecurrencyfuturestohedgeitsexchangerisk.HowmanyfuturescontractswillTIneedtofullyprotectitself?ANSWER.TIcanhedgeitsexchangeriskbybuyingeurofuturescontractswhoseexpirationdateistheclosesttothedateonwhichitmustpayitsFrenchsupplier.Givenacontractsizeof€125,000,TImustbuy10,000,000/125,000=80futurescontractstohedgeitseuropayable.b.ExplainhowTIcanusecurrencyoptionstohedgeitsexchangerisk.HowmanyoptionscontractswillTIneedtofullyprotectitself?ANSWER.TIcanhedgeitsexchangeriskbybuyingeurocalloptionscontractswhoseexpirationdateistheclosesttothedateonwhichitmustpayitsFrenchsupplier.Givenacontractsizeof€62,500,TImustbuy10,000,000/62,500=160optionscontractstohedgeitspayable.c.DiscusstheadvantagesanddisadvantagesofusingcurrencyfuturesversuscurrencyoptionstohedgeTI'sexchangerisk.ANSWER.Afuturescontractismostvaluablewhenthequantityofforeigncurrencybeinghedgedisknown,asinthecasehere.Anoptioncontractismostvaluablewhenthequantityofforeigncurrencyisunknown.Otherthingsbeingequal,therefore,TIshouldusefuturescontractstohedgeitscurrencyrisk.However,TImusthonoritsfuturescontractsevenifthespotrateatsettlementislessthanthefuturesprice.Incontrast,TIcanchoosenottoexercisecurrencycalloptionsifthecallpriceexceedsthespotprice.Althoughthisfeatureisanadvantageofcurrencyoptions,itisfullypricedoutinthemarketviathecallpremium.Hence,optionsarenotunambiguouslyCHAPTER8:CURRENCYFUTURESANDOPTIONSMARKETS2betterthanfutures.Inthiscase,sincethequantityofthefutureFrenchfrancoutflowisknown,TIshouldusecurrencyfuturestohedgeitsrisk.5.SupposethatBechtelGroupwantstohedgeabidonaJapaneseconstructionproject.Butbecausetheyenexposureiscontingentonacceptanceofitsbid,Bechteldecidestobuyaputoptionforthe¥15billionbidamountratherthansellitforward.Inordertoreduceitshedgingcost,however,Bechtelsimultaneouslysellsacalloptionfor¥15billionwiththesamestrikeprice.Bechtelreasonsthatitwantstoprotectitsdownsideriskonthecontractandiswillingtosacrificetheupsidepotentialinordertocollectthecallpremium.CommentonBechtel'shedgingstrategy.ANSWER.Thecombinationofbuyingaputoptionandsellingacalloptionatthesamestrikepriceisequivalenttoselling¥15billionforwardataforwardrateequaltothestrikepriceontheputandcalloptions.Thatis,Bechtelisnolongerholdinganoption;itisnowholdingaforwardcontract.IftheyenappreciatesandBechtellosesitsbid,itwillfaceanexchangelossequalto15billionx(actualspotrate-exerciseprice).ADDITIONALCHAPTER8QUESTIONSANDANSWERS1.WhatisthelastdayoftradingandthesettlementdayfortheIMMAustraliandollarfuturesforSeptemberofthecurrentyear?ANSWER.ThelastdayoftradingfortheIMMAustraliandollarfuturesforSeptemberwillbethethirdWednesdayofSeptember.Thespecificdatedependsontheparticularyear.For2001itisSeptember19andfor2002itisSeptember18.Settlementtakesplaceeachday.2.Whichcontractislikelytobemorevaluable,anAmericanoraEuropeancalloption?Explain.ANSWER.TheAmericancalloptionislikelytobemorevaluablesinceitcanbeexercisedatanytimepriortomaturity,unliketheEuropeanoptionwhichcanbeexercisedonlyatmaturity.Theoptiontoexerciseearlyisvaluablewheninterestratesonthetwocurrenciesdiffer.3.InExhibit8.9,thevalueofthecalloptionisshownasapproachingitsintrinsicvalueastheoptiongoesdeeperanddeeperin-the-moneyorfurtherandfurtherout-of-the-money.Explainwhythisisso.ANSWER.