How Companies Use Currency Options in Risk Management

Table of Contents

Executive Summary

Introduction

Literature Review
1. Risk Management in Corporates
2. Hedging strategy and Empirical Literatures
3. Currency Options

Case study
1. Background information
2. Alternatives for Daniel Inc
3. The strategy
4. Scenario
5. Scenario
6. Benefits and drawbacks of using options

Conclusions

References

Executive Summary

This article summarizes the motivations behind the reason why many corporates use (currency) options for risk management. Firstly, the paper would generalize the term of Financial Derivatives and how they benefit investors. Furthermore, it review a great deal of previous scholar works done on the field of risk management by corporates and on general options.

In addition, the following case study of the company named ABC using a protective put strategy in order to hedge its investment in BCA is explored in both situation of increase and decrease in share price in order to understand how companies manage risks.

Even though options can be an effective tool that helps companies be successful in grow their firm values options can also become worthless due to a minor modification of share price.

Introduction

For most of companies, the key of making a sound investment is to maximize profit given a certain level of risk or in other words, to manage risks effectively. Since the 1990s, various studies have proven that risk management was considered by many financial executives as one of the most essential objectives of their corporates (Smithson & Rawls, 1990). Furthermore, with the recent trend of globalization, many new risks arise to a multinational enterprise as it expands their activities aggressively beyond its domestic boundaries. They are now dealing with a variety of issues which potentially involves risks of currency exchange rates, interest rates, overseas political instabilities, material prices etc. As a result, it is reasonable for a multinational corporation to hedge their investments. For example, businesses which conduct series of cross-border activities always have to consider seriously the currency exchange issue since it fluctuates continuously over time and might cause loss to company due to the time lag between the moment contract signed and payment collection. That is the main reason why many corporations with its broad networks globally including IBM or Coca Cola, are engaging extensively in hedging risks by using derivative financial instruments (Allayannis et al., 2001).

Financial derivatives are instruments that have been developed by financial market for decades and now have become popular tools for risk management. In recent time, as the aggressive expansion of multinational enterprises, the utilization of financial tools by these firms is becoming more and more popular with the objectives of hedging against level of exposures. Currently, the market observes four main types of financial derivatives in foreign exchange trading including futures, forwards, swaps, and financial options.

In general, a forward/future contract is an agreement between two parties in which one party, the buyer, agrees to buy from the other party, the seller, an underlying asset or other derivative (in this case, a specific currency), at a future date at a price established at the start of the contract (Chance, 2003). In addition, a company can select another alternative, swap, which is an Over the Counter agreement between two parties to exchange a series of pre-specified future cash flows to gain a comparative advantage (Hull, 2012). Last but not least, buying options equal to buying contracts that give the right, not obligation, to buy or sell an underlying asset (which is a certain currency in this case) (Chance, 2003).

This article would discuss the general use of options as an effective instrument in risk management, particularly in foreign exchange market by revising prior literature and providing a case study as illustration of hedging risk in currency exchange.

Literature Review

1. Risk Management in Corporates

According to the theory suggested by Modigliani and Miller, in the world of efficient exchange market, firms should not engage in hedging activities since investors can artificially replicate corporate hedging activities (Modigliani & Miller, 1958). However, hedging against unfavored movements of the market can be justified in the existence of market friction, and in fact, corporates devote a considerable amount of efforts and resources to do so.

To the extent of currency exchange risk, the demand of exchange rate risk management began to arise after the breakdown of the Bretton Woods system which allowed the existence of floating currency rate ( (Papaioannou, 2001). Therefore, it is also reasonable for firms to hedge against level of exposures since the volatility of foreign exchange rates can be possibly ten times higher than that of inflation rates and four times higher than that of interest rates (Jorion, 1990). Another rationale explaining why firms actively engage in foreign exchange derivatives is that hedging possibly increases value of firm by decreasing the indirect cost of financial distress, or lessening the underinvestment problem associated with costly external financing which mostly caused by volatility in exchange rate (Froot et al., 1993). By using survey data, the study conducted by (Hagelin, 2003) in Swedish enterprises gave the results which are consistent with the conjecture.

Currency risk management is playing a vital role in every firm's decisions about foreign currency exposure (Allayannis et al., 2001). On the other hand, the study by (Burnside et al., 2001) which examines the possible relationship between macroeconomic condition and companies' hedging policy indicates that it would be ideal for enterprises to hedge their foreign exchange rate completely given no guarantees from government.

2. Hedging strategy and Empirical Literatures

In general, one of the earliest works in this field, (Jorion, 1990) emphasized the possible impact of volatility in currency exchange rate to stock return.

Therefore, recently, scholars dedicated considerable efforts to conduct empirical studies finding the effectiveness of foreign currency derivatives (FCD) in managing foreign exchange risk. Nonetheless, different researches produce contradicted results.

Firstly, (Copeland & Joshi, 1996) and (Hentschel & Kothari, 2001) indicated that there was no existence of such association linked FCD with a lower level of foreign exchange exposure. In contrast, based on evidence collected from Australian companies, (Nguyen & Faff, 2003) proposed that use of FCD was associated with lower exposures. Furthermore, this hypothesis was supported by study proposed by (Allayannis & Ofek, 2001). In details, by using a sample of non-financial firms in the list of S&P500 for 1993, it found evidence that decision of using FCD for hedging could significantly enhance firm value due to reducing the exchange rate exposures. In other word, enterprises which select FCD receive a substantial hedging premium.

In addition, after studying 720 large non-financial firms in the US in the period of 1990-1995, (Allayannis & Weston, 2001) concluded that firms that used FCD had a higher value of 4.87% than those chose not to be un-hedged.

Further studies suggested that the level of engagement in currency exchange derivatives could vary at different industries since the volatility of exchange rate affected more to industries that were depend heavily on import and export (Bodnar & Gentry, 1993).

(Nguyen & Faff, 2003) confirmed these results by stating in their conclusions that companies in resource sector accomplished a greater reduction in foreign exchange exposures compared to ones in the industrial sector.

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