This article summarizes the motivations behind the reason why many corporates use (currency) options for risk management. Firstly, the paper would generalize the term of Financial Derivatives and how they benefit investors. Furthermore, it review a great deal of previous scholar works done on the field of risk management by corporates and on general options.
In addition, the following case study of the company named ABC using a protective put strategy in order to hedge its investment in BCA is explored in both situation of increase and decrease in share price in order to understand how companies manage risks. Even though options can be an effective tool that helps companies be successful in grow their firm values options can also become worthless due to a minor modification of share price.
Table of Contents
Executive Summary
Introduction
Literature Review
1. Risk Management in Corporates
2. Hedging strategy and Empirical Literatures
3. Currency Options
Case study
1. Background information
2. Alternatives for Daniel Inc.
3. The strategy
4. Scenario 1
5. Scenario 2
6. Benefits and drawbacks of using options
Conclusions
References
Objectives and Core Topics
The primary objective of this work is to evaluate the general effectiveness of currency options as a strategic instrument for risk management within multinational corporations, focusing on how these financial derivatives help mitigate exposure to volatile foreign exchange markets. The research explores the theoretical motivations behind corporate hedging and provides a practical application through a detailed case study.
- The theoretical role of risk management and hedging in corporate strategy.
- Empirical evidence regarding the impact of foreign currency derivatives on firm value.
- Functional mechanics and flexibility of currency options for hedging purposes.
- A detailed case study analysis of Daniel Inc. and its hedging strategy against USD volatility.
- Comparative scenario analysis of using options versus spot market transactions.
Excerpt from the Book
3. The strategy
In this regard, the company is expects to receive a payment worth USD3,000,000 and has the demand to convert the foreign currency (which is USD) to local currency (which is GBP). The current quoted spot rate of exchange is USD1.5119/GBP1.0. In addition, the table below provides the information of option prices.
The executives of Daniel’s Inc. declare that they would not make any profit if the value of USD depreciates further than $1.56/£1. Consequently, it is reasonable for them to select the call option with the strike price of $1.53/£1. In addition, to make the calculation to be simpler, we can assume that all options are European-style option which means the holders can only exercise the right at maturity.
Due to selecting the option with the strike price of $1.53/£1, the amount of contracts that Daniel’s Inc. needs to purchase is:
$3,000,000/1.53/£31,250 = 62.7 (contracts)
Therefore, the company would take out 62 contracts which is equivalent to $2,964,375. The remaining part of the contract, $35,625 is considered as a relatively minor amount and the risk derived from this amount is probably acceptable for the company.
Summary of Chapters
Executive Summary: Provides an overview of the motivation for corporate currency hedging, the purpose of financial derivatives, and a brief description of the case study approach.
Introduction: Outlines the necessity of risk management in a globalized economy and identifies the primary types of financial derivatives used by multinational corporations.
Literature Review: Examines academic theories on corporate hedging, the breakdown of the Bretton Woods system as a driver for risk management, and empirical findings on the impact of derivatives on firm value.
Case study: Details a specific business scenario involving Daniel Inc., exploring hedging alternatives and evaluating strategy performance through two maturity scenarios.
Conclusions: Summarizes the flexibility of options as a hedging tool and emphasizes the importance of understanding market conditions and exposure levels for successful risk management.
Keywords
Currency Options, Risk Management, Financial Derivatives, Hedging Strategy, Foreign Exchange, Volatility, Multinational Corporations, Firm Value, Spot Rate, Strike Price, Call Option, Protective Put, Financial Exposure, Market Friction, Bretton Woods.
Frequently Asked Questions
What is the primary focus of this paper?
The paper examines the application of currency options as a tool for companies to manage and mitigate risks associated with volatile foreign exchange rates in international business.
What are the central themes discussed in the work?
Central themes include the rationale for corporate hedging, the evolution of risk management since the Bretton Woods era, the empirical impact of derivatives on firm value, and the mechanics of hedging strategies.
What is the core objective of the research?
The objective is to demonstrate how financial derivatives, specifically currency options, provide flexibility and security for companies engaged in cross-border activities against unfavourable currency fluctuations.
Which scientific methodology is employed in the study?
The research combines a literature review of academic theories and empirical studies with a practical, quantitative case study analysis of a specific company (Daniel Inc.).
What topics are covered in the main body of the work?
The main body covers corporate risk management theories, hedging strategies and empirical literature, the technical aspects of currency options, and a multi-scenario analysis of a practical hedge.
How would you characterize this work using keywords?
Key characteristics include currency options, risk management, financial derivatives, hedging, and volatility management in a corporate context.
Why did Daniel Inc. decide to use a call option as their hedging instrument?
The company sought to protect itself against the risk of USD depreciation while maintaining the flexibility to benefit from favourable market movements, which options provide compared to more rigid contracts.
What is the main advantage of using options as highlighted in the case study?
The primary advantage is the grant of a right without an obligation, which allows the company to choose the best financial outcome between exercising the option or using the spot market rate at maturity.
How does the author define the "maximum loss" for an option holder?
The author identifies the maximum loss as the premium paid for the option, which protects the company from unlimited downside risks while keeping upside potential open.
- Quote paper
- Tuan Tran (Author), 2015, How Companies Use Currency Options in Risk Management, Munich, GRIN Verlag, https://www.hausarbeiten.de/document/298380
