The Modern Day Financial Instruments Involving Option Contracts

The Balance of Payments in India mainly relies on services exports, remittances and the course capital flows, both foreign direct investments (FDI) and FII. It is very essential that all market participants, such as banks and other intermediaries be provided with the wherewithal so that they can undertake a risk management in a way that is scientific. One of the ways to access domestic, foreign exchange markets is to hedge on the underlying foreign exchange exposures. In addition, the facilities that are available as the booking of forward contracts were included in the domestic forex market in order to evolve and acquire volumes and depth (Sumanth, 2012). Some of the newer hedging instruments have put in place swaps and options in the

Hedging is a significant measure of financial risk management. Since the 1970s, the increasing number of powerful companies started to control the risk of the exchange rate, the interest rate and commodity by using financial derivatives. ISDA (2013) based on the Global 500 Annual Report 2012 survey found that 88 percent of companies use foreign exchange derivatives. Modigliani & Miller (1958) believed that if the financial markets were under perfect conditions, for instance, there was no agency costs, asymmetric information, taxes and transaction costs, hedging would not increase the company 's value because investors can hedge by themselves. However, a large number of practical studies have shown that hedging is beneficial

When an input (machinery, components, capital, labor, etc.) is denominated in a foreign currency, the risk exists that an unfavorable exchange rate movement will increase the cost of doing business. When the products are priced and sold in a foreign currency, an adverse exchange rate movement will make the product appear more expensive to consumers, decreasing demand or forcing the company to reduce its own profit margin to maintain lower price levels. For companies with integrated international business systems, an exchange rate shock can literally force them out of business, with their operations experiencing pressures from both cost and profit centers.

Since the acceptance of Dozier Industries’ bid, the company CFO has been exploring the methods available to best manage the exchange risk associated with the award payment being dispersed in British Pounds (GBP). He originally considered a forward contract or a spot contract, but is now investigating how currency options could help hedge against uncertain foreign exchange exposure. The CFO needs to decide whether or not options contracts might provide some benefit to hedge the currency risk.

There is also risk of volatility with respect to exchange rates in the short and long term

Then, we took into consideration only a fluctuation of the exchange rate. The scenarios that we analyzed covers different positions of the dollar against the euro: weak dollar (USD 1,48/EUR), stable dollar (USD 1,22/EUR) and strong dollar (USD 1,01/EUR). Different coverage of costs with hedging was also introduced in the analysis. The three main policies are of not hedging, 100% hedging with forward contracts and 100% hedging with options.

Mr. Archer-Lock visualized this „dilemma“ in a two-by-two-matrix that shows three more or less critical scenarios. Starting from this insights Mrs. Tabaczynski developed a spreadsheet which should enable them to optimize their hedging strategies – more or less forwards or options respectivly the quota of hedging at all – by executing multiple sensitivity analysis on the key variables sales and exchange rates at different proportions of contracts (forwards) and options as well as different hedging ratios (0%, 25%, 50%, 75% and 100%). This tool doesn 't solve the risks totally, but seems to help choosing the right hedging strategy.

There has been significant changes in the international economy and politics that has led to uncertainty regarding the direction of foreign exchange rates that lead to volatility and the need to hedge foreign exchange rate risk and interest rate changes (Nobile, 2005). If a price is quoted ahead of time for a contract, the price may not be appropriate at the time of the actual agreement or the performance of the contract because of fluctuations in the foreign currency. The interest rate will have a differential between the two country currencies. A business or individual investor that buys foreign currency to purchase

The operations of the derivative market has become a rising concern today in the world and in the UK in particular as this market could destabilize the efficiency of the financial market and the economy at large if not managed properly by its users or if a major fault occurs in the derivative market, as it plays a vital role as a risk management instrument in the economy. Financial derivatives had been introduced in the financial markets as an instrument to help manage risk cause by fluctuations in exchange rates, interest rates and stock market prices in the financial

In the financial sector, derivative is defined as a contract whose value is derived from the value of an underlying asset.[footnoteRef:1] Derivatives contracts are agreements between two parties who have a deal upon a specific asset. Derivatives are the most innovative and flexible financial instruments, as their application is addressed to market players who need to reduce risk, since they provide a means for shifting risk from one party to another that is willing or better able to monitor that risk.[footnoteRef:2] [1: Michael Chui, Derivatives markets, products and participants: an overview (2012), IFC Bulletin No 35, Bank of International of International Settlements, p 1 ] [2: Alan N. Rechtschaffen and Jean Claude Trichet, Capital Markets, Derivatives and the Law: Evolution After Crisis, Derivative, 2nd edn, Oxford University Press (2014), 2 ]

During the early 2000’s European carmakers were hit hard by the rising Euro and the weak dollar. European carmakers pay for car parts and labor in euros to build cars they export to the United States where customers pay for the cars in dollars. As the dollar weaken manufacturers faced fewer Euros worth of revenue for each dollar sale. They faced raising the price of the cars to compensate the weak dollar or absorbs the difference in lower prices. The purpose of this paper is to show that hedging the exchange rate to profit in swings in the market was very profitable or Porsche however not vey sustainable low term.

There are different types of financial instruments available for companies and investors to hedge against crude oil price volatility. These instruments can be traded financially without the tangible physical delivery of crude oil and different instruments have different time periods. Some of the hedging tools are Options, Futures and Swaps. But for this paper we will only focus on option contracts for management of risk in crude oil trading.

Great Eastern Toys is a company in Hong Kong that exports a huge percent of its total sales to the North American and European markets and hence is exposed to currency risk. Previously, the company was occupied with expanding their business and the company 's management had never given much attention to currency risk until their recent meeting with their banker. The banker pointed out that the depreciation of the European currencies during the previous two years had resulted in a substantial loss of income. The company 's management was indeed convinced that they should begin to devote more time and manage their currency position. In this report, we are going to explore the different options for Great Eastern Toys to hedge

Nestlé S.A. is a Swiss transnational food and beverage company. According to its annual report, this company is exposed to risk from movements in foreign currency exchange rates, interest rate and market prices. The foreign exchange risks come from transactions and translations of foreign operations in Swiss Francs (CHF). The interest rate risk faces the borrowings at fixed and variable rates. The market price risk comes from commodity price and equity price. The former arises from world commodity market for the supplies of coffee, cocoa beans, sugar and others, the latter instead arises from the fluctuations of the prices of investments held (Nestlé annual reports, 2015). Thus, financial derivatives instruments are used by this multinational corporation in order to hedge these risks.

Derivatives are financial instruments whose values are derived from the values of other, more basic, entities, known as the underlying assets. For example, the value of a stock option depends on the price of the relevant stock.