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The summary of the case
The American company ZAPA Chemical sold one of its distributions in Germany, and they earned DM 7.6 millions. However, the management did not know when this money could be available for repatriation (Moffett and Barrett 111). The main task was to eliminate or at least minimize the losses that could be caused by exchange rate fluctuations. At that time, the German mark cost $ 1.4649, and it was a historical minimum for the dollar (Moffett and Barrett 111). Nevertheless, Stephanie Mayo, who was the currency analyst of ZAPA Chemical, believed that the value of dollar could decline even further.
In turn, it was necessary for the company to mitigate currency fluctuations risks. Stephanie Mayo chose to acquire out-of-the-money put options. This hedging strategy enables a person to sell the option at a specified price, even though this price is higher than the market value of the asset (Ianieri 8; Madura 151). This approach was critical for minimizing the risks caused by the declining value of the U.S. dollar.
Additionally, the revenues of the company could be affected by various economic trends and political decisions taken by the government. For instance, one can mention the adoption of the Maastricht Treaty that led to the greater integration of European economies (Moffett and Barrett 116). There was a short period during which the value of dollar fluctuated significantly. Moreover, it was not clear how the situation could evolve during the next two months.
In turn, Stephanie Mayo had to select the most optimal hedging strategy. One should note that very soon ZAPA Chemical had to repatriate the assets from Germany. So, she had to decide if it was possible to sell the put options.
Details to Consider
Overall, Stephanie Mayo should consider several details in order to decide if it is possible to sell the put option protection. It should be mentioned that on September 18, the put option premium was 1.95 cent for the German mark (Moffett and Barrett 116). In turn, the strike price was $ 1, 5152 per DM (Moffett and Barrett 111). The price of protection paid by ZAPA Chemical can be calculated according to the formula:
The premium per a unit of currency × the total amount of foreign currency = $ 0. 0140/ DM × DM 7.6 millions = $ 106 400.
The total revenue derived by the company will be determined in this way:
The total amount of foreign currency ÷ the strike price – protection outlay = DM 7.6 million ÷ $ 1. 5152 per DM – $ 106 400 = $ 4 909 439.
In turn, one should consider the use of the forward contract that will be valid for 90 days. In this case, the company can acquire the capital for investment. Its amount is estimated in this way:
(Put option premium on September 18 – Fixed put option premium) × DM 7.6 million = DM7.6 millions ×($0.0195- $0.014) = $41800.
Provided that the company invests this capital for 90 days, it will receive $ 42146. Additionally, according to the contract, the exchange rate will be DM 1, 5255/$. This exchange will yield $ 4 981 973. The total return will be $ 5 024 119. So, by selling the put option, Stephanie Mayo will be able to generate additional revenues for the company. However, this forward contract implies that the owner is obliged to sell the assets at a certain price. In turn, the put option does not impose this obligation on the owner (Zweifel and Eisen 134). This problem can become very important if the value of the U.S. dollar will fluctuate significantly. This possibility should also be considered by the management of the company.
Events Prompting to Re-Evaluation
There were several events that prompted Stephanie Mayo to re-evaluate her views on the value of the U.S. dollar relative to the German mark. In particular, one should speak about the uncertainty caused by the ratification of the Maastricht Treaty. This agreement could lead to the creation of the single currency that could be used in various European countries (Fuchs 10; Roy 30). The very possibility of the new monetary policy could depreciate many European currencies. Therefore, the value of the German mark could decline relative to the U.S. dollar. Furthermore, it was possible that the German government could reduce the interest rates (Moffett and Barrett 116). This measure could also impact the exchange rate.
Furthermore, it is important to mention that the value of dollar tended to fluctuate considerable. So, Stephanie Mayo could not determine how the situation could evolve until the maturation date when the assets had to be repatriated to the United States. Overall, she began to think that the use of put option might not be the best strategy for ZAPA Chemical. To a great extent, these examples suggest that currency analysts have to consider a wide range of factors in order to select the most optimal hedging strategy. Furthermore, they should be responsive to the changes in external environment.
Fuchs, Fabian. The Treaty of Maastricht – the Result of Rational State Preferences?, Munich: GRIN Verlag, 2010. Print.
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Ianieri, Ron. Option Theory and Trading: A Step-by-Step Guide To Control Risk and Generate Profits, New York: John Wiley & Sons, 2009. Print.
Madura, Jeff. International Financial Management, New York: Cengage Learning, 2014. Print.
Moffett, Michael, and Edgar Barrett. Cases in International Finance, New York: Addison Wesley, 2001. Print.
Roy, Joaquin. Euro and the Dollar in a Globalized Economy, New York: Ashgate Publishing, 2007. Print.
Zweifel, Peter, and Roland Eisen. Insurance Economics, New York: Springer Science & Business Media, 2012. Print.