Question

Chapter 5 Capital Crystal, Inc.

Using Currency Futures and Options Capital Crystal, Inc., is a major importer of crystal glassware from the United Kingdom. The crystal is sold to prestigious retail stores throughout the United States. The imports are denominated in British pounds (£). Every quarter, Capital needs £500 million. It is currently attempting to determine whether it should use currency futures or currency options to hedge imports three months from now, if it will hedge at all. The spot rate of the pound is $1.60. A three-month futures contract on the pound is available for $1.59 per unit. A call option on the pound is available with a three-month expiration date and an exercise price of $1.60. The premium to be paid on the call option is $.01 per unit. Capital is confident that the value of the pound will rise to at least $1.62 in three months. Its previous forecasts of the pound’s value have been very accurate. Capital’s management is extremely risk averse. Managers receive a bonus at the end of the year if they satisfy minimal performance standards. The bonus is the same, regardless of how high above the minimum level a manager’s performance is. If performance is below the minimum, then there is no bonus and future advancement within the company is unlikely.

(A.)As a financial manager of Capital, you have been assigned the task of choosing among three possible strategies: (1) hedge the pound’s position by purchasing futures, (2) hedge the pound’s position by purchasing call options, or (3) do not hedge. Offer your recommendation and justify it.

( B). Assume the previous information provided, except for this difference: Capital has revised its forecast of the pound to be worth $1.57 three months from now. Given 658 Appendix B: Supplemental Cases Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 this revision, recommend whether Capital should (1) hedge the pound’s position by purchasing futures, (2) hedge the pound’s position by purchasing call options, or (3) not hedge. Justify your recommendation. Is your recommendation consistent with maximizing shareholder wealth?

Answer 1

In scenario 1 if you hedge the value of pound against future contract then any row down in the value of pound will not result in profit but by

Buying option you are hedged against any in the value of pound and it will also be benefited in cash market if value of pound decreases

in scenario 2

Capital Inc have predicted a drawdown in the value of pound so hedging is not compulsory but if if the client insist it should be done through option

Recommendation are consistent with the objective of share holders wealth maximization as the manager did not think of it's on bonus but to create a risk-free business opportunity for the client