Managing Currency Risk: Call Options vs. Futures Contracts
Apex Corporation Currency Risk Management Decision
Apex Corporation must pay its Japanese supplier ¥125 million in three months. It is considering two options to protect against the risk of a rising yen:
Option 1: Buy 20-yen call options
Apex could buy 20-yen call options with a contract size of ¥6.25 million at a strike price of 0.00800. The premium is 0.015 cents per yen.
Option 2: Buy three-month yen futures contracts
Alternatively, Apex could buy 10 three-month yen futures contracts with a contract size of ¥12.5 million at a price of 0.007940 per yen.
The current spot rate is ¥1 = 0.007823. Apex's treasurer believes the most likely value for the yen in 90 days is 0.007900, with a high of 0.008400 and a low of 0.007500.
Which option should Apex choose to protect against the risk of a rising yen?
- Buy 20-yen call options
- Buy three-month yen futures contracts
- Cannot be fixed
Final answer:
Apex can use either call options or futures contracts to mitigate currency risk. Call options require a premium and offer flexibility if the yen rises above the strike price, while futures lock in a current rate and are more suitable if Apex wants certainty at a rate close to their expectations. Option 1, buying 20-yen call options, is the appropriate choice.
Explanation:
To protect against the risk of a rising yen, Apex Corporation must evaluate the options of buying call options or entering into yen futures contracts.
Apex could buy call options to gain the right to purchase yen at 0.00800 per yen, paying a premium of 0.015 cents per yen. With the size of each contract being ¥6.25 million, they would buy enough contracts to cover the ¥125 million payment. The cost to Apex will be the premium paid regardless of the exchange rate movement.
Apex could buy futures contracts to lock in a rate of 0.007940 per yen, obliging them to buy yen at this rate in three months. While this protects from a rising yen, it does not benefit from a falling yen.
If Apex's treasurer believes the yen will appreciate to 0.007900, with the possibility of going as high as 0.008400 or as low as 0.007500, the call options would make more sense if he believes the rise will surpass the strike price. However, futures contracts offer a guaranteed rate close to the expected rate if confidence is lacking in reaching the higher levels.