Which would you recommend to Stark Supply Co. to hedge its foreign exchange risk, a put option or a call option? Explain your choice. (10 points)
If Stark Supply Co. uses an exchange traded option to hedge its foreign exchange risk, why is it necessary to buy an option with maturity date no earlier than the date of the payable, May 16? Explain. (10 points)
Consider possible spot rates for the Swiss Franc on May 16. You should consider spot rates at regular intervals. Recall that in February, you do not know the spot rate for the Swiss Franc on May 16. Rather than consider one possible future spot rate, you should consider many. Recall that you have done this for option speculation. Here the objective is hedging, but you can still do the same type of analysis in an excel spreadsheet or with a graph. You need to consider pairs of future spot rates and Total Dollar Cost given hedging with an option. Given an option hedge, calculate the Total Dollar Cost of the cowbell purchase corresponding to each possible future spot rate for the Swiss Franc. (20 points)
You will do these calculations for either all of the call options or all of the put options, depending on how you answered question 1 above. You should do this in an Excel spreadsheet.
Recall Marks' discussion of what he would like to achieve in terms of profit on the cowbell purchase. In response to Marks, Grom recommended that Stark Supply hedge with an option. Which of the options would come closest to allowing the potential for Stark Supply to achieve the desired profit of $188,900 (or Total Dollar Cost of $1,111,100) on the cowbell purchase? Explain. (10 points)
Recall that Stark Supply's objective is hedging, which means in this case reducing the foreign exchange risk. However, Marks still hasn't given up on the idea of reducing the Total Dollar Cost resulting in a higher profit margin.
Assume that the Swiss Franc will not depreciate to less than $0.98. This roughly corresponds to "low depreciation" defined in the (A) case.
The main objective is still hedging. Which option(s) could result in a profit margin of less than 3.1% (or Total Dollar Cost of at least $1,260,000) on the cowbell purchase? Which option(s) does (do) not adequately reduce risk? Explain. (10 points)
Answering this question, you need to recall from the (A) case Stark Supply Co's track record in terms of its profitability and the competition the company faces.
Which one of the 3 options would you recommend to Marks? Explain. (10 points)
Make sure that your answer is consistent with how you answered questions 3, 4 and 5.
Now compare the spot transaction hedge (from the (A) Case), the option hedge that you chose in question 6, and remaining unhedged (from the (A) Case). Consider future spot rates at regular intervals (possible spot rates on May 16). For each possible future spot rate, calculate the Total Dollar cost for 1) the spot transaction hedge, 2) the option hedge, and 3 unhedged. (20 points)
You should do this comparison in an Excel spreadsheet.
Consider risk, Total Dollar Cost, and how well each of the 3 (spot transaction hedge, option hedge, unhedged) achieves Marks' and Stark Supply Co's stated objectives. Which of the 3 do you recommend? Explain. (10 points)
Hint: To correctly graph the results, for the chart type in Excel you will need to use an X Y (Scatter) with Straight Lines and Markers.
Keep in mind that for your assignment, you should enter data for Total Dollar Cost and Future Spot Rate as the Y-axis and X-axis variables. To create the data, you will select hypothetical Future Spot Rates at regular intervals and then enter the corresponding Total Dollar Cost in the same row. Also, you need to make sure to include the strike prices as some of the future spot rates. On a given row Total Dollar Cost corresponds to the Future Spot Rate.