Question

Hot Kustoms Company estimates that with 30% probability it will have to pay a supplier 10000 Hong Kong dollars in three months. How can Hot Kustoms best hedge this exposure? Explain. Would your answer change if Hot Kustoms had to pay the supplier with 100% certainty? Why or why not?

Answer 1

1.
As the payment is not certain, buy call option on Hong Kong dollars. This is because the hedge should provide gains when Hong Kong dollar appreciates, as that is the key risk. We buy calls because we will have the right but not the obligation. So we will only exercise when the payment has to be compulsorily made and also it is advantageous for us to do so.

2.
As the payment is certain, buy currency forwards on Hong Kong dollars. This is because the hedge should provide gains when Hong Kong dollar appreciates, as that is the key risk. We buy forwards because the payment is certain and in this case if we use calls we would be unnecessarily paying call premiums.