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Risk Management Role of Options
Options are the instruments, which provide right to take an action without the obligation to take that action. It is effective to manage the risk as by using this tool, managers can shift the risks. It plays a role of strategic thinker, which is helpful to improve the project planning and strategic thinking, which is a valid risk mitigation aspect for the firms. Options plays an important role tom reduce the risk level and to increase values from a contract (Damodaran, 2008). Options give right to terminate a contract at any time, in which an investors see the risk at less cost, which is effective to reduce the overall risk for the ...
The following posting helps analyze the risk management role of options, futures and forward contracts.
Risk Management: Forward and Futures Contracts and Risk Management: Option Contracts.
Sofas Express, Inc. (SEI) is a Malaysian firm with a U.S. customer base. Production facilities are located in Kuala Lumpur. The firm is going to raise 5 million dollars of capital in the U.S. in two months in order to develop distribution facilities. SEI's primary investors are Japanese and SEI is concerned with consistent profitability in yen terms. SEI does not want exposure to yen/dollar exchange rate volatility over the two months preceding issuance of US dollar denominated debt.
The current Japanese yen futures price is 0.00889 ($/Y) and two months remain to expiration. The notional amount underlying the futures contract is Y12,500,000.
(a) Construct a hedge to stabilize the value of the raised capital in yen terms. Round to the nearest number of whole contracts when you set up your hedge. Indicate whether Sofas is long or short?
(b) Suppose the margin requirements on Japanese yen futures are as follows:
Initial margin: $3,000 per contract;
Maintenance margin: $2,200 per contract.
How much initial margin does Sofas Express need?
(c) During the next two months, the lowest futures price was 0.00853 ($/Y), and the highest futures price was 0.00934 ($/Y). What was the largest marked-to-market loss on Sofas's futures position? What was the largest marked-to-market gain?
(d) At the end of two months, the futures price becomes the spot price, which was 0.00871 ($/Y). Show that Sofas actually locked in the exchange rate of 0.00889 ($/Y), if it includes the cumulative gains/losses on the futures position.
For each of the following cases, calculate (i) the cash flow today, (ii) the cash flow at maturity, and (iii) the net profit from your option trading (i.e., (i) + (ii)). All options are European style and cover 1,000 shares of the underlying asset.
(a) For a premium of $2.30, you purchase a call option with a strike price of $6. At the expiration date, the stock price is $7.80.
(b) For a premium of $0.80, you purchase a call option with a strike price of $9. At the expiration date, the stock price is $7.90.
(c) You write (i.e., sell) a call option with an exercise price of $5. The option premium is $0.70. The stock price at the expiration date is $5.40.
(d) You write a call option with an exercise price of $5. The option premium is $0.70. The stock price at the expiration date is $4.90.
(e) You buy a put option with strike price of $10 for a premium of $1.20. At the expiration date, the stock price is $8.50.
(f) You short (i.e., write) a put option with strike price $7 for a premium of $0.60. At the expiration date, the stock price is $5.
General Widget, USA manufactures widgets for sale world wide. The firm is expanding production in the U.S. for sale in the U.K. The cost of expansion is $1,000,000 in year 0. The net cash flow from sales in the U.K. is GBP 60,000 per year in perpetuity, starting in year 1. [GBP = pound sterling]
The firm is an all equity firm in the U.S. Its beta is 0.8. Assume that the market risk premium is 8% in the U.S. Assume that the U.S. riskfree interest rate is 6% and the U.K. riskfree interest rate is 7%. The current exchange rate is 1.6 $/GBP.
Should the company undertake this project given the above assumptions? Please compare the answers using the two methods discussed in Unit 9:
Method 1: Discount the GBP cash flows and then convert them to $ at the spot exchange rate;
Method 2: Convert the GBP cash flows into $ using forecasted exchange rates, then discount the cash flows in $.
Are they different? If so, why?