1. What are deep-in-the money currency options? Why is writing deep-in-the-money currency options tantamount to short-term financing?

2. What were the mechanics for Daewoo of writing deep-in-the-money yen-put/dollar-call options?
Transcribed Image Text:Forward Contracts Source Amount Contract Delivery Rate (¥/US$) Receivables SFCB ¥5 billion 17-May-88 10-Feb-89 122.46 $ 40,828,000 $ 40,108,000 $ 39,856,000 FGB ¥5 billion 25-Oct-88 14-Feb-89 124.66 FGB ¥5 billion 28-Oct-88 17-Feb-89 125.45 FBB ¥5 billion 01-Nov-88 16-Feb-89 123.98 $ 40,328,000 Total ¥20 billion 124.14 $161,120,000 The option contracts involved contingent exposures denominated in the Ja- panese yen, which on maturity Daewoo could receive in exchange for the U.S. dol- lar (see Case Exhibit 7.2). Hedging the exposures would simply involve selling yen forward to match the Japanese yen bought on the option contracts. Still, Mr. Ahn felt that he should not hedge his yen position immediately. Indeed, since the Plaza Accord of September 1985, the U.S. dollar had steadily depreciated against the Ja- panese yen and the major European currencies. Many people had expected the dollar to continue its depreciation, breaking the ¥120/US$ level in a few months. When the option contracts were written, the dollar rebounded to ¥129/US$ from its record low of just above ¥120/US$ in early January. Personally, Mr. Ahn strong- ly believed that the dollar would still come back down below ¥120/US$ and that would be the time at which he should hedge. Because of this and his belief that the Japanese yen was the strongest currency at the time in terms of expected ap- preciation, he decided to write yen-put/dollar-call options. Mr. Ahn even thought that the U.S. dollar could fall as low as ¥100/US$1 by the time the options matured. This was the second reason he did not hedge his yen position immediately. If the dollar did fall that low, forward contracts for the pur- pose of hedging would turn out to be a big loss since the options would be left un- exercised. The last reason for leaving his exposure unhedged was to guard against the possibility that South Korea's Office of Bank Supervision and Examination
Transcribed Image Text:(OBSE) would recognize the deal for what it was. OBSE was very emphatic about its dislike for any disguised foreign currency loans, and several previous deals had been denounced as such. The option loans had a good chance of being found out, and if they were hedged with forwards, there would be no excuse available. However, by leaving them open, Mr. Ahn could disclose them as hedging instru- ments for different exposures. After signing the option contracts, Mr. Ahn had his dealers submit to the three banks documents substantiating the evidence of real demand. An export license (E/L) was submitted to SFCB representing the shipment of US$63 million worth of Le Mans passenger cars to be delivered to the Pontiac division of General Motors. To both FGB and FBB, a license issued by the Korean Exchange Bank for overseas construction works in Africa amounting to US$420 million was submitted. Both the export and construction contracts were denominated in U.S. dollars and were in no way connected to the Japanese yen. Even so, the E/L and the license for overseas construction works effectively served to provide proof of real demand for the yen-dollar option contracts. Soon afterward, SFCB sent notice to Daewoo that its lawyers had approved the E/L as an appropriate document. As there were no stated definitions of the nature of functional currencies or accounting curren- cies in the Foreign Exchange Control Regulations, Daewoo could claim that the transactions were simply a conversion of receivables denominated in the weak dollar into the stronger yen through the use of option contracts. As it turned out, the OBSE had previously accepted similar claims in past examinations of foreign banks. After Daewoo successfully completed writing the options with the three banks, market activity suddenly flared up, with many companies following Daewoo's path by structuring option contracts very similar to the option-loan scheme. In- deed, Daewoo had engineered an ingenious way of raising financing now and not worrying about its true cost until much later!
Transcribed Image Text:Premiums Received B/E (¥/US$) Amount Amount Bank Contract Expiry Settlement Date (USS) (Won) SFCB 08-Feb-88 08-Feb-89 10-Feb-89 10-Feb-88 8,850 6,888 126.22 FGB 12-Feb-88 10-Feb-89 14-Feb-89 16-Feb-88 9,000 6,960 126.78 FGB 17-Feb-88 15-Feb-89 17-Feb-89 19-Feb-89 9,175 7,064 127.45 FBB 11-Feb-88 14-Feb-89 16-Feb-89 16-Feb-88 8,800 6,805 126.03 Total 35,825 27,717 126.62 US$ LIBOR Date Yen/US$ Yen LIBOR (1 year) Forward Rateb 08-Feb-88 129.25 4.2500 7.1875 125.71 12-Feb-88 129.70 4.1250 7.0625 126.14 17-Feb-88 130.35 4.3125 7.3125 126.71 21-Feb-88 128.85 4.2500 7.1250 125.39 a The break-even (B/E) rates on the settlement dates were calculated based on very conserva- tive assumptions, specifically that the rate of won appreciation be 5% p.a. and that the financ- ing cost would be 11.5% p.a. (i.e., the official rate). b One-year forward exchange rates were calculated using the interest rate parity theorem. CASE EXHIBIT 7.2 Summary of Results from the Option Loans Daewoo wrote yen-put/dollar-call options and sold the yen forward against the dollar. Forward Contracts Source Amount Contract Delivery Rate (¥/US$) Receivables SFCB ¥5 billion 17-Мay-88 10-Feb-89 122.46 $ 40,828,000 $ 40,108,000 $ 39,856,000 FGB ¥5 billion 25-Oct-88 14-Feb-89 124.66 FGB ¥5 billion 28-Oct-88 17-Feb-89 125.45
Transcribed Image Text:Daewoo Corporation, headquartered in Seoul, South Korea, was established in 1967 by an entrepreneur named Woo Choog Kim and soon became one of the largest corporations in all of South Korea. Its 1987 unconsolidated annual sales amounted to some US$5.6 billion, which made Daewoo the number four chaebol in South Korea. Daewoo was mainly involved in three lines of activities: in- ternational trading, domestic and overseas construction, and textile goods manu- facturing, with 31 domestic and 16 foreign subsidiaries. It was the third-largest exporter in terms of volume among South Korea's seven general trading compa- nies, was the number two general contractor, and was rapidly diversifying into industrial and consumer durables. As for its major rivals, the only check on Dae- woo's explosive growth was its access to capital. As the financing arm of Daewoo's International Trading division, the main re- sponsibilities of the Foreign Exchange and Trade Finance department were trade financing, treasury, and management of foreign exchange risk. At a time when the Bank of Korea was attempting to cool off the economy through a tight mone- tary policy, the department was under mandate to raise as much money as possi- ble to help solve Daewoo's perennial capital shortage. Mr. Y. D. Ahn had become the general manager of the Foreign Exchange and Trade Finance department in 1985 after receiving his MBA from the Wharton School on a company scholarship. Charged with the task of raising capital for Dae- woo, Mr. Ahn, with the help of three part-time dealers, soon turned to creative fi- nancing techniques. Indeed, an exciting opportunity presented itself at the end of 1987 when South Korea's Ministry of Finance allowed the use of currency options by listing them as authorized financial tools in the Foreign Exchange Control Reg- ulations. After a month of research and detailed discussions with a couple of banks, Mr. Ahn and his team concluded that writing deep-in-the-money currency options could become a very effective method of raising funds.
Transcribed Image Text:WRITING DEEP-IN-THE-MONEY OPTIONS In early 1988, Mr. Ahn approached four American banks, Supreme Federal Coun- ty Bank (SFCB), Trace Queens Bank (TQB), Financiers Guild Bank (FGB), and Fabri- cators Bremen Bank (FBB), with his new scheme. By the end of January, SFCB, FGB, and FBB had presented Mr. Ahn with their respective terms and conditions for Daewoo to write ¥-put/$-call options at a strike price of ¥100/US$1. SFCB was the first to give a letter of intent, and its representatives informed Mr. Ahn that no legal difficulties would arise from trading deep-in-the-money options as long as their options were backed by real demand-that is, legitimate underlying transactions. Meanwhile, as options were quickly discovered by the financial community, Mr. Ahn hurriedly approached Mr. I. T. Shan, president of Daewoo Corporation, on February 3, 1988. Although it was relatively easy to explain options to his immedi- ate superior, Managing Director (M/D) T. M. Kang, who was a former central bank official, more detailed explanations were needed for the president and for Mr. M. L. Park, the vice president (V/P) and treasurer. In these few briefings outlining the overall structure of the deals along with the associated risks, Mr. Ahn had to eval- uate the advantages of the new product on the basis of a conservative 5 percent annual won-appreciation scenario and an 11.5 percent internal cost of capital. At that time, the rate of won appreciation was expected to be more than 10 percent per annum, and Daewoo's internal rate of interest to be applied in managerial ac- counting was 14 percent per annum. On February 12, Mr. Ahn obtained final ap- proval from the president of Daewoo Corporation. Permission to write the op- tions, however, was contingent upon the total position being less than US$200 mil- lion and Mr. Ahn maintaining a very conservative approach (i.e., minimizing Dae- woo's undue exposure to foreign exchange risk).
Transcribed Image Text:As shown in Case Exhibit 7.1, Daewoo wrote four option contracts, two with FGB and one each with SFCB and FBB. The principal amount of each contract was ¥5 billion, or US$50 million, and the strike price was ¥100/US$. In fact, two deals had already been completed before final approval was received because Mr. Ahn and M/D Kang had decided to seize the opportunity before the market changed significantly. From the four contracts, Daewoo received a total sum of US$35.8 million in premiums, or 27.7 billion won, on ¥20 billion to be received in one year in exchange for US$200 million, which indicated that the negotiated premiums compared less than favorably with those quoted on the Philadelphia Exchange Market (Case Exhibit 7.2). However, Mr. Ahn was in no position to reject a deal simply because of the high price; the option-loan market had already turned out to be a buyers' market, and Mr. Ahn was especially encouraged by the growing ex- pectations of a substantial won appreciation against the dollar, which according to many forecasts would reach 680 won per dollar by year's end. TO HEDGE OR NOT TO HEDGE? Mr. Ahn was also the convener of Daewoo's Foreign Exchange Rate Committee. With M/D Kang as chairman, the committee met on the second business day of each month and determined the monthly won/dollar exchange rates for the com- ing 12 months to be used in various business plans of the corporation. At the Feb- ruary meeting, the committee revised the year-end rate from 720 won to 650 won per dollar, an appreciation of nearly 22 percent. Since the option loans were de- nominated in U.S. dollars, Daewoo would benefit from savings of roughly 18 per- cent if the predicted won appreciation occurred. CASE EXHIBIT 7.1 Writing options Option style: European; yen-put/dollar-call Contract amount: US$50 million (¥5 billion) each Strike price: 100/USS

Question

1. What are deep-in-the money currency options? Why is writing deep-in-the-money currency options tantamount to short-term financing?

2. What were the mechanics for Daewoo of writing deep-in-the-money yen-put/dollar-call options?

Forward Contracts
Source
Amount
Contract
Delivery
Rate (¥/US$)
Receivables
SFCB
¥5 billion
17-May-88
10-Feb-89
122.46
$ 40,828,000
$ 40,108,000
$ 39,856,000
FGB
¥5 billion
25-Oct-88
14-Feb-89
124.66
FGB
¥5 billion
28-Oct-88
17-Feb-89
125.45
FBB
¥5 billion
01-Nov-88
16-Feb-89
123.98
$ 40,328,000
Total
¥20 billion
124.14
$161,120,000
The option contracts involved contingent exposures denominated in the Ja-
panese yen, which on maturity Daewoo could receive in exchange for the U.S. dol-
lar (see Case Exhibit 7.2). Hedging the exposures would simply involve selling yen
forward to match the Japanese yen bought on the option contracts. Still, Mr. Ahn
felt that he should not hedge his yen position immediately. Indeed, since the Plaza
Accord of September 1985, the U.S. dollar had steadily depreciated against the Ja-
panese yen and the major European currencies. Many people had expected the
dollar to continue its depreciation, breaking the ¥120/US$ level in a few months.
When the option contracts were written, the dollar rebounded to ¥129/US$ from
its record low of just above ¥120/US$ in early January. Personally, Mr. Ahn strong-
ly believed that the dollar would still come back down below ¥120/US$ and that
would be the time at which he should hedge. Because of this and his belief that
the Japanese yen was the strongest currency at the time in terms of expected ap-
preciation, he decided to write yen-put/dollar-call options.
Mr. Ahn even thought that the U.S. dollar could fall as low as ¥100/US$1 by the
time the options matured. This was the second reason he did not hedge his yen
position immediately. If the dollar did fall that low, forward contracts for the pur-
pose of hedging would turn out to be a big loss since the options would be left un-
exercised. The last reason for leaving his exposure unhedged was to guard against
the possibility that South Korea's Office of Bank Supervision and Examination

(OBSE) would recognize the deal for what it was. OBSE was very emphatic about
its dislike for any disguised foreign currency loans, and several previous deals
had been denounced as such. The option loans had a good chance of being found
out, and if they were hedged with forwards, there would be no excuse available.
However, by leaving them open, Mr. Ahn could disclose them as hedging instru-
ments for different exposures.
After signing the option contracts, Mr. Ahn had his dealers submit to the three
banks documents substantiating the evidence of real demand. An export license
(E/L) was submitted to SFCB representing the shipment of US$63 million worth of
Le Mans passenger cars to be delivered to the Pontiac division of General Motors.
To both FGB and FBB, a license issued by the Korean Exchange Bank for overseas
construction works in Africa amounting to US$420 million was submitted. Both
the export and construction contracts were denominated in U.S. dollars and were
in no way connected to the Japanese yen. Even so, the E/L and the license for
overseas construction works effectively served to provide proof of real demand
for the yen-dollar option contracts. Soon afterward, SFCB sent notice to Daewoo
that its lawyers had approved the E/L as an appropriate document. As there were
no stated definitions of the nature of functional currencies or accounting curren-
cies in the Foreign Exchange Control Regulations, Daewoo could claim that the
transactions were simply a conversion of receivables denominated in the weak
dollar into the stronger yen through the use of option contracts. As it turned out,
the OBSE had previously accepted similar claims in past examinations of foreign
banks.
After Daewoo successfully completed writing the options with the three banks,
market activity suddenly flared up, with many companies following Daewoo's
path by structuring option contracts very similar to the option-loan scheme. In-
deed, Daewoo had engineered an ingenious way of raising financing now and not
worrying about its true cost until much later!

Premiums Received
B/E
(¥/US$)
Amount
Amount
Bank
Contract
Expiry
Settlement
Date
(USS)
(Won)
SFCB
08-Feb-88
08-Feb-89
10-Feb-89
10-Feb-88
8,850
6,888
126.22
FGB
12-Feb-88
10-Feb-89
14-Feb-89
16-Feb-88
9,000
6,960
126.78
FGB
17-Feb-88
15-Feb-89
17-Feb-89
19-Feb-89
9,175
7,064
127.45
FBB
11-Feb-88
14-Feb-89
16-Feb-89
16-Feb-88
8,800
6,805
126.03
Total
35,825
27,717
126.62
US$ LIBOR
Date
Yen/US$
Yen LIBOR
(1 year)
Forward Rateb
08-Feb-88
129.25
4.2500
7.1875
125.71
12-Feb-88
129.70
4.1250
7.0625
126.14
17-Feb-88
130.35
4.3125
7.3125
126.71
21-Feb-88
128.85
4.2500
7.1250
125.39
a The break-even (B/E) rates on the settlement dates were calculated based on very conserva-
tive assumptions, specifically that the rate of won appreciation be 5% p.a. and that the financ-
ing cost would be 11.5% p.a. (i.e., the official rate).
b One-year forward exchange rates were calculated using the interest rate parity theorem.
CASE EXHIBIT 7.2 Summary of Results from the Option Loans
Daewoo wrote yen-put/dollar-call options and sold the yen forward against the
dollar.
Forward Contracts
Source
Amount
Contract
Delivery
Rate (¥/US$)
Receivables
SFCB
¥5 billion
17-Мay-88
10-Feb-89
122.46
$ 40,828,000
$ 40,108,000
$ 39,856,000
FGB
¥5 billion
25-Oct-88
14-Feb-89
124.66
FGB
¥5 billion
28-Oct-88
17-Feb-89
125.45

Daewoo Corporation, headquartered in Seoul, South Korea, was established in
1967 by an entrepreneur named Woo Choog Kim and soon became one of the
largest corporations in all of South Korea. Its 1987 unconsolidated annual sales
amounted to some US$5.6 billion, which made Daewoo the number four chaebol
in South Korea. Daewoo was mainly involved in three lines of activities: in-
ternational trading, domestic and overseas construction, and textile goods manu-
facturing, with 31 domestic and 16 foreign subsidiaries. It was the third-largest
exporter in terms of volume among South Korea's seven general trading compa-
nies, was the number two general contractor, and was rapidly diversifying into
industrial and consumer durables. As for its major rivals, the only check on Dae-
woo's explosive growth was its access to capital.
As the financing arm of Daewoo's International Trading division, the main re-
sponsibilities of the Foreign Exchange and Trade Finance department were trade
financing, treasury, and management of foreign exchange risk. At a time when
the Bank of Korea was attempting to cool off the economy through a tight mone-
tary policy, the department was under mandate to raise as much money as possi-
ble to help solve Daewoo's perennial capital shortage.
Mr. Y. D. Ahn had become the general manager of the Foreign Exchange and
Trade Finance department in 1985 after receiving his MBA from the Wharton
School on a company scholarship. Charged with the task of raising capital for Dae-
woo, Mr. Ahn, with the help of three part-time dealers, soon turned to creative fi-
nancing techniques. Indeed, an exciting opportunity presented itself at the end of
1987 when South Korea's Ministry of Finance allowed the use of currency options
by listing them as authorized financial tools in the Foreign Exchange Control Reg-
ulations. After a month of research and detailed discussions with a couple of
banks, Mr. Ahn and his team concluded that writing deep-in-the-money currency
options could become a very effective method of raising funds.

WRITING DEEP-IN-THE-MONEY OPTIONS
In early 1988, Mr. Ahn approached four American banks, Supreme Federal Coun-
ty Bank (SFCB), Trace Queens Bank (TQB), Financiers Guild Bank (FGB), and Fabri-
cators Bremen Bank (FBB), with his new scheme. By the end of January, SFCB,
FGB, and FBB had presented Mr. Ahn with their respective terms and conditions
for Daewoo to write ¥-put/$-call options at a strike price of ¥100/US$1. SFCB was
the first to give a letter of intent, and its representatives informed Mr. Ahn that no
legal difficulties would arise from trading deep-in-the-money options as long as
their options were backed by real demand-that is, legitimate underlying
transactions.
Meanwhile, as options were quickly discovered by the financial community, Mr.
Ahn hurriedly approached Mr. I. T. Shan, president of Daewoo Corporation, on
February 3, 1988. Although it was relatively easy to explain options to his immedi-
ate superior, Managing Director (M/D) T. M. Kang, who was a former central bank
official, more detailed explanations were needed for the president and for Mr. M.
L. Park, the vice president (V/P) and treasurer. In these few briefings outlining the
overall structure of the deals along with the associated risks, Mr. Ahn had to eval-
uate the advantages of the new product on the basis of a conservative 5 percent
annual won-appreciation scenario and an 11.5 percent internal cost of capital. At
that time, the rate of won appreciation was expected to be more than 10 percent
per annum, and Daewoo's internal rate of interest to be applied in managerial ac-
counting was 14 percent per annum. On February 12, Mr. Ahn obtained final ap-
proval from the president of Daewoo Corporation. Permission to write the op-
tions, however, was contingent upon the total position being less than US$200 mil-
lion and Mr. Ahn maintaining a very conservative approach (i.e., minimizing Dae-
woo's undue exposure to foreign exchange risk).

As shown in Case Exhibit 7.1, Daewoo wrote four option contracts, two with
FGB and one each with SFCB and FBB. The principal amount of each contract was
¥5 billion, or US$50 million, and the strike price was ¥100/US$. In fact, two deals
had already been completed before final approval was received because Mr. Ahn
and M/D Kang had decided to seize the opportunity before the market changed
significantly. From the four contracts, Daewoo received a total sum of US$35.8
million in premiums, or 27.7 billion won, on ¥20 billion to be received in one year
in exchange for US$200 million, which indicated that the negotiated premiums
compared less than favorably with those quoted on the Philadelphia Exchange
Market (Case Exhibit 7.2). However, Mr. Ahn was in no position to reject a deal
simply because of the high price; the option-loan market had already turned out
to be a buyers' market, and Mr. Ahn was especially encouraged by the growing ex-
pectations of a substantial won appreciation against the dollar, which according
to many forecasts would reach 680 won per dollar by year's end.
TO HEDGE OR NOT TO HEDGE?
Mr. Ahn was also the convener of Daewoo's Foreign Exchange Rate Committee.
With M/D Kang as chairman, the committee met on the second business day of
each month and determined the monthly won/dollar exchange rates for the com-
ing 12 months to be used in various business plans of the corporation. At the Feb-
ruary meeting, the committee revised the year-end rate from 720 won to 650 won
per dollar, an appreciation of nearly 22 percent. Since the option loans were de-
nominated in U.S. dollars, Daewoo would benefit from savings of roughly 18 per-
cent if the predicted won appreciation occurred.
CASE EXHIBIT 7.1 Writing options
Option style: European; yen-put/dollar-call
Contract amount: US$50 million (¥5 billion) each
Strike price: 100/USS

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