ACC-FPX5610 Advanced Accounting, Budget Planning, and Control Options Pricing
Options are a familiar concept to many, though they may appear complex at first. However, once the basics are understood, they become more accessible. Investors typically build portfolios using various asset classes, including options. Options offer significant advantages that ETFs and stocks alone cannot provide. They are powerful tools for generating income and, more importantly, for offering protection and leverage. This is particularly useful for managing exchange rate risks, which, while unavoidable, can be substantially mitigated through hedging strategies. Completely avoiding forex risk would require abstaining from international investments, which is not ideal given the benefits of portfolio diversification.
Nature of Derivative Financial Instruments
A derivative is a contract between two or more parties whose value depends on an agreed-upon underlying asset or set of assets (Folger, 2018). These underlying assets include bonds, currencies, stocks, market indexes, and commodities (Folger, 2018). Derivatives are considered advanced investments as they are used for speculating and hedging (Folger, 2018). Speculation involves seeking profits from price changes in the underlying asset, security, or index. For example, a trader might profit from a decline in an index by shorting a futures contract. Hedging involves using derivatives to transfer risks associated with asset prices between parties (Folger, 2018).
For Hopkins, reducing exchange rate risk is crucial. The firm is concerned about fluctuations in the value of the U.S. Dollar against the Ghanaian Cedi. Completely eliminating currency risk would involve avoiding international trade (Picardo, 2018), but this is not feasible for Hopkins, given Ghana’s superior quality and pricing of green cocoa beans. To manage this risk, the firm has purchased a 90-day option. Hopkins is employing an options strategy in the foreign exchange market, where forex options are traded over the counter with customizable prices and expiration dates to meet specific hedging needs (Picardo, 2018). An options contract gives the investor the right, but not the obligation, to exchange currency at a predetermined rate on a specific date (Market Business News, 2016). A call option allows buying the currency, while a put option allows selling it (Market Business News, 2016). This is crucial for Hopkins, as the purchase contract is denominated in Ghanaian Cedi with payment due 90 days after purchase. The option protects Hopkins’ investment if the U.S. dollar loses value within this period.
The Value of the U.S. Dollar
When deciding to buy or sell dollars, a strong economy is essential. A strong economy attracts global investment as investors seek favorable returns (Lioudis, 2018). Investors prefer high, safe, and predictable yields, especially from international investments (Lioudis, 2018). A deficit occurs when imports exceed exports, but a strong economy can attract foreign capital to counteract this deficit. Thus, the U.S. can support the global economy and enable other countries to export to the U.S. (Lioudis, 2018).
Three main factors influence the value of the U.S. dollar: supply and demand, sentiment and market psychology, and technical aspects (Lioudis, 2018). As the U.S. exports goods and services, demand for U.S. dollars increases, as customers must pay in dollars by converting their local currency. Increased foreign purchases create demand and pressure to boost the dollar’s supply (Lioudis, 2018). During global market uncertainty, the USD is often viewed as a safe haven. Additionally, the psychology surrounding the USD plays a role; a weak economy can lead to a sell-off, impacting the dollar’s value (Lioudis, 2018). Technological factors also affect the dollar, with traders monitoring news, events, and data such as GDP and payroll figures (Lioudis, 2018). Market sentiment, influenced by major financial players and historical patterns, significantly impacts the dollar’s value (Lioudis, 2018).
The Live Exchange Rate
As of December 23, 2018, the 90-day option contract is set to expire. The exchange rate is 1 USD = 4.92885 GHS (XE Currency Converter: USD to GHS, n.d.). Consequently, 200,000 USD equals 985,770.61 GHS. The purchase of the 90-day option was successful. Hopkins used the option to hedge against a potential decrease in the USD’s value, which did not occur. The options contract would have allowed Hopkins to buy Cedi at a predetermined price if the USD had decreased. In the worst-case scenario, the contract would have allowed the purchase of 900,000 GHS for 200,000 USD. Ultimately, Hopkins earned 85,770.61 GHS – 39,421.02 GHS (cost of the contract) = 46,349.59 GHS from the contract.
Defined Purchase Contract
Currency hedging aims to reduce the impact of currency fluctuations on the value of investme