Introduction

Blades, Inc., a U.S. based company wanted to purchase supplies from Japanese supplier with

payment of 12.5 million yen payable on the delivery date. The order has been made two months

ahead of the delivery date. It has two choices. i.e. Blades inc. will purchase two call options

contract or ii. It will purchase one future contract.

Call Option means an agreement that gives an investor the right (but not the obligation) to buy

a stock, bond, commodity, or other instrument at a specified price within a specific time period.

In the commodity markets, it is considered as a less risky trade. When you buy a call option,

your risk is limited to the price you pay for the call option (premium) plus commissions and fees.

Futures contract means a legally binding arrangement where one party commits to buying an

asset from another party on a specified date in the future, but at a price agreed previously. The

counterparty is obliged to sell the asset at the agreed price and on the agreed date. Because the

price is agreed at the outset the seller (buyer) is protected from a fall (rise) in the price of the

underlying asset in the intervening time period. Initially developed to protect agricultural

producers from unforeseen market fluctuations - hedging. Most traders do not exercise call

options (or convert into a futures contract), instead they will close a call option sometime before

it expires.

So, if Blades Inc. chooses two call options they need to pay 6250000 yen for each option, or if it

chooses future contract they need to pay 12.5 million yen. In the case, it indicates that spot rate

will remain same at all the time and that is $.0072 for per yen, but in case of using call options,

exercise price fluctuates over time but not more than 5% above the existing spot rate and

premium would be paid of about 1.5%. In case of purchasing future contract, the future price will

lock into one price that is $0.006912 for per yen. Foreign exchange rates, at the most basic level,

are derived from long-term economic fundamentals. These variables weigh and measure the

value of one currency to another. Over time, these economic fundamentals and macro-factors

will lead to very long-term trends. From the fundamentalist's perspective, the main factors that

USE OF CURRENCY DERIVATIVES INSTRUMENTS

affect foreign exchange rates are Interest rates, Trade balance, Inflation, GDP (Gross Domestic

Product), and Employment Situations.

Problem Statement

Question 1: If Blades uses call options to hedge its yen payables, should it use the call option

with the exercise price of $ or the call option with the exercise price of $? Describe the trade off.

Question 2: Should Blades allow its Yen position to be unhedged? Describe the trade off.

Question 3: Assume there are speculators who attempt to capitalize on their expectation of the

Yen’s movement over the 2 months between the order and delivery dates by either buying or

selling Yen futures now and buying or selling Yen at the future spot rate. Given this

information, what is the expectation on the order date of the Yen’s spot rate by the delivery

dates?

Question 4: Assume that the firm shares the market consensus of the future yen spot rate. Given

this expectation and given that the firm makes a decision (i.e., option, futures contract, remain

unhedged) purely on a cost basis, what would be its optimal choice?

Question 5: Will the choice you made as to the optimal hedging strategy in question 4 definitely

turn out to be the lowest-cost alternative in terms of actual costs incurred? Why or why not?

Question 6: Now assume that you have determined that the historical standard deviation of the

yen is about $0.0005. Based on your assessment, you believe it is highly unlikely that the future

spot rate will be more than two standard deviations above the expected spot rate by the delivery

date. Also assume that the futures price remains at its current level of $0.006912. Based on this

expectation of the future spot rate, what is the optimal hedge for the firm?

Solution of the problem

Question 1: If Blades uses call options to hedge its yen payables, should it use the call option

with the exercise price of $0.00756 or the call option with the exercise price of $0.00792?

Describe the trade off.

Probable Answer:

If they choose call option at exercise price of $ 0.00756:

Selling Price ( Sport rate) $ 0.0072*12500000 $90,000

Buying Price (Exercise price) $0.00756*12500000 $(94,500)

Premium $0.0001512*12500000 $(1,890)

Net Profit or Loss = $(6,390)

If they choose call option at exercise price of $ 0.00792:

Selling Price ( Sport rate) $ 0.0072*12500000 $ 90,000

Buying Price (Exercise price) $0.00792*12500000 $(99,000)

Premium $0.0001134*12500000 $(1,417.50)

Net Profit or Loss = $(10,417.50)

In our case there are 2 call options. For the first call option, the exercise price is $.00756 and for

2nd call option, exercise price is $.00792 which is higher than the first call option. Blades Inc.

will have to pay no more than 5% above the existing spot rate. Before of event exercise option

premium was 1.57, but now has increased to be 2% which more expensive than the firm is

willing pay. However, in the 2nd call option, the premium is lower from the exercise price of $

0.00792. But the exercise price is 10% higher than the spot rate. So, if the firm chooses to

continue this attractive option, this firm has to pay lower premium and also higher exercise price.

If they decide to use this option, their total premium will be $1417.50. And the amount paid for

Yen $ 99,000. Again for the first option the total premium was $1890.00 and amount paid for

Yen $94,500. In the summary, if they use the first option, the total cost will be $ 96,390 ($ 1890

+ $ 94,500). And in their 2nd call option the total cost will be $ 10,0417.5 ($ 14750+ $ 99,000)

which is higher than the first option.

If the firm wants to choose call option between these two options, they can choose first option

where there is lower exercise price but higher premium.

Question 2: Should Blades allow its Yen position to be unhedged? Describe the trade off.

Probable Answer: Blade Inc. has 2 choices – one is call option and another is future contract.

Call option can be unhedged thought the movement of currencies value. It creates new event

relative to before event, when the event faced more uncertainty. In our case, table shows that the

future contract information where the future price will not be affected by uncertainty. Also in

this contract owners are not obliged by this contract relative to the option where owners are

obliged. So that, firm can purchase future contract and lock its future payment value at the same

future price that has before event.

Question 3: Assume there are speculators who attempt to capitalize on their expectation of the

Yen’s movement over the 2 months between the order and delivery dates by either buying or

selling Yen futures now and buying or selling Yen at the future spot rate. Given this

information, what is the expectation on the order date of the Yen’s spot rate by the delivery

dates?

Probable Answer: If there are speculators who attempt to capitalize on their expectation on the

Yen’s movement then they want to equal the future spot rate and the future rate. Suppose, if they

expect Yen to appreciate, they will purchase Yen at future rate now. Or they can purchase the

Yen at the future rate in 2 months and sell them at the future spot rate. In this way, if everyone’s

expectation is to appreciate Yen, then all are willing to buy Yen now. Then the amount of Yen

will be increased and there will be upward pressure on the future rate as well as download

pressure on the future spot rate. However, this process will continue up to the equivalent of

future spot rate and future rate will be $ 0.006912.

Question 4: Assume that the firm shares the market consensus of the future yen spot rate. Given

this expectation and given that the firm makes a decision (i.e., option, futures contract, remain

unhedged) purely on a cost basis, what would be its optimal choice.

Probable answer: based on this question 3 if the speculation decision is made on cost basis and

purchase on future contract where the actual cost will be $86400 which is calculated by:

Future price per unit $.006912

No. of units * 12500000

Total cost = $86400

If they remain unhedge cost will be $86400 which is computed by,

Expected spot rate $.006912

No. of Yen paid * 12500000

Total cost = $86400

This cost will be incurred on the delivery date to purchase Yen can be affected by the movement

of Yen between the delivery date and order date. So that Blade Inc. will prefer to go in future

contract.

Question 5: Will the choice you made as to the optimal hedging strategy in question 4 definitely

turn out to be the lowest-cost alternative in terms of actual costs incurred? Why or why not?

Probable answer: we know Yen is more volatile than the other currencies. So that in the future

contract, there will be no cost advantage when the yen currency will fluctuate because in future

contract the price will be paid at the delivery date, so that there is no cost advantage if Yen

depreciate. But if they choose option and remain unhedge there are having the flexibility to buy

Yen at the spot rate.

Remain unhedge:

Sport Rate $0.006912

Amount Have to be paid Yen * 12500000

Total Payment = $86400.00

In case of purchasing future contract:

Future Price per Unit $0.006912

Amount Have to be paid Yen * 12500000

Total Payment = $86400.00

In case of purchasing two options:

For option 1: The calculation of option contract 1

Exercise Price $0.0075600

Premium per unit $0.0001512

Total units 6250000

Total Cost ($0.0075600+$0.0001512)* 6250000) = $48195

For option 2: The calculation of option contract 2

Exercise Price $0.0079200

Premium per unit $0.0001134

Total units 6250000

Total Cost ($0.0079200+$0.0001134)* 6250000) = $50208.75

In Case of 1st Option: The total amount has to be paid $88290

Total paid for option 1 $.00756

Total premium $1890

Amounts to be paid for Yen + $86400

Total paid = $88290

In this option they will not exercise the contract as spot rate is less than the exercise rate.

In case of 2nd option: The total amounts have to be paid $87817.50

Total paid for option 1 $0.00792

Total premium $1417.50

Amounts to be paid for Yen + $86400

Total paid = $87817.50

So this option will not be exercised as the spot rate is less than the exercise rate.

Question 6: Now assume that you have determined that the historical standard deviation of the

yen is about $0.0005. Based on your assessment, you believe it is highly unlikely that the future

spot rate will be more than two standard deviations above the expected spot rate by the delivery

date. Also assume that the futures price remains at its current level of $0.006912. Based on this

expectation of the future spot rate, what is the optimal hedge for the firm?

Probable answer: If the standard deviation increases by 2% then the forecasted spot rate will be

$0.007912 (calculated by $.006912+ (2*.0005000))

Cost of remain unhedged will be:

Total paid for option 1 $.007912

Amount could be paid 12500000

Cost of Reaming Unhedge 12500000

In case of purchasing future contract if 2% standard deviation increases then costs will be

$86400 because there is no impact of increasing standard deviation on the future price.

In case of purchasing 2 options:

Exercise Price $.0075600

Option Premium $.0001512

Option Contract 6250000

Cost of Purchasing = $48195

For 2nd option costs will be:

Exercise Price $.0079200

Option Premium .0001134

Option Contract 6250000

Cost of Purchasing = $50209

For option 1 exercise price is $0.00756

Total Premium $.0075600

Amounts have to be paid for Yen +$.0001512

Total paid = $6250000

For option 2 exercise price is $.00792

Total Premium $1417.50

Amounts have to be paid for Yen + $98900

Total paid = $100317.50

In 1st option, as because the spot rate is higher than the exercise price Blade Inc can exercise this

option. They will be able to generate profit using this option. But in case of 2nd option, spot rate

is less than the exercise price. So they will face loss if they exercise this option. So Blade Inc.

should not exercise call options rather they should go for future contract.

Conclusion

By analyzing the case study we came to know that, it would be better for Blades Inc. if it

purchases future contract rather than two call options. Since selling price is less than the

purchasing price, if it exercises two call options company will face loss in future. More than in

call option, company is obliged by this contract. There is no advantage to expire it what can be

obtained through using future contract. Company can lock into one price in case of purchasing

future contract and company is not obliged by it. We have analyzed the case of Blades Inc giving

the answer of six questions.

In 1st question we have got the conclusion that if firm chooses any one between two call options,

firm should choose 1st call option as because it consists lower exercise price but higher premium

in compare to 2nd call option.

In 2nd question we came to the decision that, it is better for firm to go for future contract and

lock it’s future payment value at the same future price that has before the event.

In 3rd question our judgment was that the speculators, who want to capitalize on their

expectation on yen’s movement, always want to equal the spot rate and the future rate.

In 4th and 5th question our opinion was that Blade Inc. will prefer to go for future contract due to

high costs will be incurred in case of purchasing two call options.

Finally, we came to the decision that if historical standard deviation of the yen is about $0.0005

and if it is highly unlikely that the future spot rate will be more than two standard deviations

above the expected spot rate by the delivery date, then after analyzing, in 1st option, as because

the spot rate is higher than the exercise price Blade Inc can exercise this option. They will be

able to generate profit using this option. But in case of 2nd option, spot rate is less than the

exercise price. So they will face loss if they exercise this option. So Blade Inc. should not

exercise call options rather they should go for future contracts.

ASIAN CURRENCIES SINK IN 1997

Summery

At the time of 1997 Asian currency rises and it began from Thailand. Currencies and stock

plunged across East Asia were hundreds of banks and industrial became bankrupt. Both Ringgit

pesos and won deprecated by 40% to 80%. But their fundamental look good as by low inflation,

balanced budget, well run central banks, high domestic savings strong export industries and so

on. Investor expects that this positive sign is impending trouble and their exception come true

when large trade deficits rotten financial systems and spread across country to country.

Loss of export competitiveness:

United States is the most important market for exports, growth and development of Japan and

other East Asian countries. During 1995 when dollar value full against yen it boost exports of

Japan and other countries. At the end of 1995 dollar value began to rise and in the mid of 1997

dollar had risen by over 50% against the yen and by 20% against Mark. Dollar appreciation

alone would have made East Asia less price competitive. But their competitiveness problem was

exacerbated by the fact, that Chinese Yuan depreciated by about 25% against dollar. The Yuan

devaluation raised China’s export competitiveness at East Asia’s expense. The loss of export

competitiveness slowed down Asian growth and caused large investments in production capacity

to plunge. This loss gave the Asian Central Banks a mutual incentive to devalue their currencies.

Moral Hazard and Crony Capitalism:

Moral hazard means the tendency to incur risks that one is protected against, lies at the heart of

Asian’s financial problems.

Most Asian banks and finance companies operated with government guarantees.

For example-the Korean government directed the banking system to lend to companies in regard

to their portability.

When combined with poor regulations, these guarantees distorted investments decisions, arguing

financial institutions to fund risky projects in expectation bank would enjoy profits, while

sticking government with any losses.

In Asia, The problem was crony capitalism that is pervasive throughout the region, with lending

decision often control by political and family ties than by market discipline and economic reality.

Risk based lending caused over investments, increased debs and decrease supply of assets such

as land by its inflated prices.

Financial bubble persists as long as the government guarantee is maintained. The excess

production capacity leads to large amount of nonperforming loans and widespread loan defaults.

When reality strikes, investor realizes government does not have the resources so, the bubble is

burst.

Asset values decline causing a loss of confidence on which economic activity depends.

Foreign investors refuse to renew loans sell shares of overvalued local companies. Local

currency falls, increasing the cost of servicing foreign debts. Local firms and banks scramble to

buy foreign exchange, so more downward pressure on the exchange rate. Moreover investors

search other countries. When such country found everyone rushes for exit and another bubble is

burst and currency is sunk.

Capital flows increasing at the time of currency devaluation by raise interest rates which makes

more attractive to hold local currency. This is standard approach but this caused problem to

Asian central banks because cost of fund increase so it more difficult for borrows to service their

debts.

The Bubble Burst:

Taiwan also faced those problems, but their savings are largely invested private capitalist without

government direction or guarantees.

Taiwanese businesses are financed for less by debt than by equity. Taiwanese suffered minimum

loss of exports, competitiveness to china and Japan. Taiwan currency devaluated by 15% and

stock market decline by 17% only.

Asian crises have only way out is through the door said by “Confusions”. Asian crises reduce

when restructure financial system and disposing of the collateral bad loans but it need long time

to recover those crises. Ending government guaranties and politically motivated landing will

transform Asia’s financial sector more transparent financial transaction. The result will be better

investment decisions and healthier economies that attract capital for the right reasons.

Problem Statement

Question 1: What was the origin of Asian currency crisis?

Question 2: What role did the expectations play in Asian currency crisis?

Question 3: How did the appreciation of the US-dollar and depreciation of the year affect the timing and magnitude Asian currency crisis?

Question 4: What is moral hazard and how did it help cause the Asian currency crisis?

Question 5: Why did so many East Asian companies and banks borrow dollars, yen and Deutsche marks instead of their local currencies to finance their operations? What risks were they exposing themselves to?

Solution of the problem

Question 1: What was the origin of Asian currency crisis?

Answer: Asian currency crisis started from the second half of 1997.Crisis began in Thailand first

, were currencies and stock markets fall across East Asia due to bankrupt of banks , builders and

manufacturers .The currencies of such Ringgit (Malaysia) , Peso (Philippine) , Rupiah

(Indonesia) , Won (South Korea) depreciated by 40% to 80%.

Question 2: What role did the expectations play in Asian currency crisis?

Answer: The investors expects that positive signs such as , low inflation , balanced budgets ,

well run central banks , high domestic saving , strong export industries , a large and growing

middle class , a vibrant entrepreneurial class and industries , well-trained , and often well

educated workforces paid relatively low wages was impending trouble for the future . So that

expectations come into real that East Asian economy were locked on a course that was

unsustainable, characterized by large trade deficits, huge short-term foreign debts, overvalued

currencies and financial that were rotten at their core. Each of these played a role in the crisis and

its spread from one country to another.

Question 3: How did the appreciation of the US-dollar and depreciation of the year affect the

timing and magnitude Asian currency crisis?

Answer: United States is the most important market for exports for Japan and East Asian

countries. These exports played a primary role for the growth and development of East Asian

countries because these countries fully depend on them.

Many of East Asian countries tied their currencies to dollar.

Until 1995 tied served well boosted export of Japan as the dollar fell against yen, currency

stability and low inflation led East-Asian banks and companies to finance themselves.

By mid 1997, the dollar had risen by over 50% against the yen and by 20% against the German

mark.

Dollar appreciation alone would made East Asia exports less price competitive. The Chinese Yen

depreciated by 25% against dollar. China exports competitive rose at East Asia expense for Yen

devaluation. The loss of export competitiveness slowed down Asia growth and caused utilization

rates and profits – on huge investments in production capacity to plunge. At last, Asian central

Banks a mutual incentive to devalue their currencies.

Question 4: What is moral hazard and how did it help cause the Asian currency crisis?

Answer: The Asian Financial crisis which was happened in the mid-1997 and one of the reason

Asian Currencies sink is that the US dollar had risen 50% against the yen and 20% against the

German mark. U.S dollar appreciation have made East Asia’s exports less price competitive but

their competitiveness problem was greatly exacerbated by the fact that Chinese yean depreciated

by 25% which is lower than Yen that increased China’s export competitiveness at East Asia’s

expense. This loss of export competitiveness slowed down Asian growth.

The second reason of the Asian Currencies that is Moral Hazard and Crony Capitalism, which

means the tendency to incur risks that one is protected against the problems of Asian finance.

Asian banks and finance companies has some government guarantees to operate, so that they can

operate in a good way. When government takes decision to lend massively to the companies and

industries to earn more profit in return, then they find themselves with poor or less regulation.

Because of that they encouraged to the financial institution to fund in risky projects with this

hope that they can recover through it, but it didn’t happened because of crony capitalism. It

means not carrying the right decision or taking biased decision which is called nepotism such as

politicians and relatives, who get that opportunity of taking loans. As a consequence, the result

was more adverse, because of reinvestment. It increases the debt level vastly and inflated the

price of assets. At this level government guarantee cannot able to maintain but investors realized

it gradually, especially when loans default rates were increasing rapidly. Although government

was not able to help them all to survive, then the bubble is burst. Decline in assets value is the

reason of further loan defaults. Because of that, foreign investors don’t want to get new loans

rather they sell of the shares of local companies, as a result capital flight accelerates and finally

local currency falls. After that local firms and banks also got interest to buy foreign currencies

which letting the local currency fall more, and putting more downward pressure on the exchange

rate. Appreciation of dollar and depreciation of local currency slow down the Asian economic

growth and also affects the corporate profiles. That makes overall financial disasters. This is the

point where Asian financial crisis was touched off.

Question 5: Why did so many East Asian companies and banks borrow dollars, yen and

Deutsche marks instead of their local currencies to finance their operations? What risks were

they exposing themselves to?

Answer: So many East Asian companies and banks borrow dollars, yen and deutsche marks

instead of local currency because foreign currency carried lower interest rate than the local

currencies, which is required to operate their operations.

There are some Risk that arose when dollar began recovering against the yen and other

currencies. Growing competitive exports of China and similar products produced by China was a

contributing factor to East Asian nations' export growth slowdown. Depreciation of Yuan helps

China to produce at a low cost. It raised China’s export competitiveness at East Asia’s expense.

U.S. dollar’s appreciation made the U.S. a more attractive investment destination relative to East

Asia, which had been attracting hot money flows through high short-term interest rates.

Conclusion

At the time Thailand had acquired a burden of foreign debt that made the country effectively

bankrupt even before the collapse of its currency. The drastically reduced import earnings that

resulted from the forced devaluation then made a quick or even medium-term recovery

impossible without strenuous international intervention. Real GDP growth is GDP growth

adjusted for price changes. Calculating real prices allows economists to determine if production

increased or decreased, regardless of changes in the purchasing power of the currency. Mid-May

‘97: Thai Baht was hit by massive speculative attack. Spark: End-June ‘97, Thai Prime Minister

declared that he would not devaluate the Baht and Thai Government failed to defend the Baht

against International speculators and at that time Financial Crisis hits. Financial contagion refers

to the phenomenon when one country’s economy is negatively affected because of changes in the

asset prices of another country's financial market. A more recent crisis where disruptions quickly

spread into other areas of financial markets is the Subprime mortgage financial crisis in August

2007. The "Asian flu" had also put pressure on the US and Japan. Their markets did not collapse,

but they were severely hit. On 27 October 1997, the Dow Jones industrial plunged 554 points or

7.2%, amid ongoing worries about the Asian economies. The New York Stock Exchange briefly

suspended trading. The crisis led to a drop in consumer and spending confidence (October 27,

1997 mini-crash). Japan was affected because its economy is prominent in the region. Asian

countries usually run a trade deficit with Japan because the latter's economy was more than twice

the size of the rest of Asia together as about 40% of Japan's exports go to Asia. The Japanese yen

fell to 147 as mass selling began, but Japan was the world's largest holder of currency reserves at

the time, so it was easily defended, and quickly bounced back. GDP real growth rate slowed

dramatically in 1997, from 5% to 1.6% and even sank into recession in 1998, due to intense

competition from cheapened rivals. The Asian financial crisis also led to more bankruptcies in

Japan. In addition, with South Korea's devalued currency, and China's steady gains, many

companies complained outright that they could not compete. Another longer-term result was the

changing relationship between the U.S. and Japan, with the U.S. no longer openly supporting the

highly artificial trade environment and exchange rates that governed economic relations between

the two countries for almost five decades after World War II. Some economists have advanced

the impact of China on the real economy as a contributing factor to ASEAN nations' export

growth slowdown, though these economists maintain the main cause of the crises was excessive

real estate speculation. China had begun to compete effectively with other Asian exporters

particularly in the 1990s after the implementation of a number of export-oriented reforms. Most

importantly, the Thai and Indonesian currencies were closely tied to the dollar, which was

appreciating in the 1990s. Western importers sought cheaper manufacturers and found them,

indeed, in China whose currency was depreciated relative to the dollar. Other economists dispute

this claim noting that both ASEAN and China experienced simultaneous rapid export growth in

the early 1990s.

Many economists believe that the Asian crisis was created not by market psychology or

technology, but by policies that distorted incentives within the lender-borrower relationship. The

resulting large quantities of credit that became available generated a highly-leveraged economic

climate, and pushed up asset prices to an unsustainable level. These asset prices eventually began

to collapse, causing individuals and companies to default on debt obligations. The resulting panic

among lenders led to a large withdrawal of credit from the crisis countries, causing a credit

crunch and further bankruptcies. In addition, as investors attempted to withdraw their money, the

exchange market was flooded with the currencies of the crisis countries, putting depreciative

pressure on their exchange rates. In order to prevent a collapse of the currency values, these

countries' governments were forced to raise domestic interest rates to exceedingly high levels (to

help diminish the flight of capital by making lending to that country relatively more attractive to

investors) and to intervene in the exchange market, buying up any excess domestic currency at

the fixed exchange rate with foreign reserves. Neither of these policy responses could be

sustained for long. Very high interest rates, which can be extremely damaging to an economy

that is relatively healthy, wreaked further havoc on economies in an already fragile state, while

the central banks were hemorrhaging foreign reserves, of which they had finite amounts. When it

became clear that the tide of capital fleeing these countries was not to be stopped, the authorities

ceased defending their fixed exchange rates and allowed their currencies to float. The resulting

depreciated value of those currencies meant that foreign currency-denominated liabilities grew

substantially in domestic currency terms, causing more bankruptcies and further deepening the

crisis.

In the middle of the 1990s, country interests in Thailand, the Republic of Korea (Korea),

Malaysia, and Indonesia, desiring to protect the dollar values of their assets, exerted pressure on

Ministries of Finance and central banks to maintain exchange rates at overvalued levels. Short

term loans were sought abroad to shore up the overvalued exchange rates. Current account

deficits expanded. When acute foreign investors realized the weakness of the investments they

had funded, they began to withdraw as much short-term capital as they could. Local investors

fled to safe currencies.