TAKE HOME EXAM

BY AKSHAYA MAYUR ASHISH SHARMA DEREK CHERIAN JOJI GRANTHANA PURNESH JAYAKUMAR MADHAVAN

1. Redcape Corporation expects that the major foreign currencies in which its receivables are denominated will weaken over the course of the next two years, resulting in significant economic or systematic exposure. What steps can Redcape Corp. undertake today to manage this economic exposure? Following are the steps Redcape Corp can adapt to manage their economic exposure: The domestic currency price of the asset and the exchange rate should be negatively correlated. This improves the exchange risk to a very great extent. The domestic currency price of the asset should be fixed resulting in the contractual exposure that can be completely hedged and lastly, Financial hedging having the options such as the use of derivative securities like currency forwards, futures, swaps , currency options among others help in managing economic exposure. 2. Under what conditions do you think that transaction exposure automatically results in economic exposure? That is, under what conditions can a single transaction pose significant economic exposure to a multinational company? Transaction exposure arises from the export or import contract resulting in foreign currency payable or receivables. When the exchange rate changes, the import or export transaction is affected leading to the risk in the domestic currency. The exchange risk results from the foreign currency receivable or liability arising from the export or import transaction, whose value is contractually fixed in nominal terms. Fixed price contracting of ex-rate volatility leads to transaction exposure. On the other hand, economic exposure measures the extent to which change in the currency affects the value of the firm. Changes in the nominal exchange rate affect the value of the domestic currency of the transaction exposure- component of economic exposure because the cash flows are fixed, but only the change in the real exchange rate affects the firms future sales revenue and costs thereby posing a significant economic exposure to a multinational company. 3. Why is it that Bull and Bear Spreads (as constructed in this class) must be considered hedging tools, as opposed to speculative tools? A bear put spread is like a double hedged strategy. The price of the higher strike price is partially set off by the premium received by writing the put with a lower strike price. By this way, the investors investment and the risk of losing the entire premium paid, is reduced or rather hedged.The long put with higher strike hedges the financial risk of the put at the lower strike price. When the investor is assigned an exercise notice on the written put, he must purchase an equal number of underlying shares at the strike price, and then sell the purchased put with the higher strike place in the market. The premium from the puts sale can partially set off the cost of purchasing the shares from the assigned shares. Therefore the net cost to the investor will be

a price less than current market prices. This written put limits the potential maximum profit for the strategy. A bull spread can also be a double hedged strategy. The price payable for the call with the lower strike price can be partially set off by the premium received from writing the call with a higher strike price. In the long call, the investors investment and the risk of losing the entire premium paid is hedged. Meanwhile, the long call with the lower strike price hedges the financial risk of the written call with the higher strike price. When investor is assigned an exercise notice on the written call and sell an equal number of underlying shares at the strike price, these shares can be purchased at a preset price by exercising the call with the lower strike price. This written call limits the potential maximum profit for the strategy. 4) Why is it that call options and put options are priced as if they are risk free instruments? Other than their payoff structures, what is the single most important difference between call and put options? Ans: Call option is the right entrusted to a trader to buy shares for a set strike price. If the price of shares increases than the strike price we can make profit by buying the stock at that price. Then we can sell at a higher rate. Put option is the right entrusted to a trader to sell shares for a set strike price. If the price of the share falls below the strike price then we can make profit by buying the share and sell it at a higher rateCall options is used when investor thinks a stocks price will rise whereas put option is used when the prices are going to fall As we can see its a right to exercise the option and its not a must we can classify it as a risk free instrument. Call option buyer benefit when price of stock increase while the put option buyers gain with fall of stock prices and call option the call writer benefits when the price of stock falls and put writer benefits when stock rises