ACC FPX 5610 Assessment 1 Option Pricing

ACC FPX 5610 Assessment 1 Option Pricing

Student Name

Capella University

ACC-FPX5610 Advanced Accounting, Budget Planning, and Control

Prof. Name:

Date

 Option Pricing

Options are a concept familiar to most. While they may appear complex, they become easy to grasp once the basics are understood. Investor portfolios typically consist of various asset classes, including options. This asset class provides significant advantages that trading ETFs and stocks may not. Options are powerful because they can generate income and, more importantly, offer protection and leverage. This is particularly useful in hedging against exchange rate risk, which is inevitable but can be significantly mitigated through hedging strategies. The only way to eliminate forex risk entirely would be to avoid international investments altogether, but research has shown that diversification in portfolios is more beneficial.

Nature of Derivative Financial Instruments

A derivative is a contract between two or more parties whose value is derived from an agreed-upon underlying asset or set of assets (Folger, 2018). These underlying assets may include bonds, currencies, stocks, market indices, and commodities (Folger, 2018). Derivatives are considered advanced investments as they serve both speculative and hedging purposes (Folger, 2018). In speculation, the investor aims to profit from changes in the price of the underlying asset, security, or index. For instance, a trader might aim to profit from a decline in an index by shorting a futures contract. In hedging, derivatives are used to transfer the risk associated with asset prices between different parties (Folger, 2018).

Hopkins is currently focused on mitigating exchange rate risk. The firm is concerned that the U.S. Dollar may fluctuate in value against the Ghanaian Cedi. Although avoiding international trade is the only way to completely eliminate currency risk, this is not an option for Hopkins, as Ghana offers the highest quality green cocoa beans at the best price in the global market. To mitigate this risk, the firm purchased a 90-day option. This strategy is commonly used in the foreign exchange market. Forex options trade over-the-counter, allowing traders to choose prices and expiration dates that best suit their hedging needs (Picardo, 2018). With an options contract, the investor has the right, but not the obligation, to exchange one currency for another at a predetermined exchange rate on a specific date (Market Business News, 2016). A call option gives the investor the right to buy the currency, while a put option gives the right to sell (Market Business News, 2016). In essence, foreign exchange transactions involve converting one country’s currency into another for payment settlement (Market Business News, 2016). This is critical for Hopkins since their contract stipulates payment in Ghanaian Cedi 90 days after purchase.

The purpose of purchasing the option is to protect Hopkins’ investment if the U.S. dollar loses value within the 90-day period from purchase to due date.

The Value of the U.S. Dollar

When deciding to buy or sell U.S. dollars, a strong economy plays a crucial role. A robust economy attracts global investment, as investors expect to earn an acceptable rate of return (Lioudis, 2018). Investors, particularly those investing abroad, are always looking for the safest and most predictable yield (Lioudis, 2018). A trade deficit occurs when a country’s imports exceed its exports. However, a strong economy helps attract foreign capital to offset this deficit. This allows the U.S. to continue fueling global economies and enables other countries to export to the U.S., thereby supporting their own economies (Lioudis, 2018).

Three primary factors affect the value of the U.S. dollar: supply and demand, sentiment and market psychology, and technical factors (Lioudis, 2018). When the U.S. exports goods and services, demand for U.S. dollars increases because customers must purchase these services using U.S. currency. As a result, they sell their local currency to buy U.S. dollars. This increases demand for the dollar, putting upward pressure on its supply (Lioudis, 2018). Additionally, the USD is often considered a safe haven during periods of global uncertainty. Market psychology also plays a role. If the economy weakens, for example, due to rising unemployment, the government may face a sell-off, with foreign investors selling U.S. stocks and bonds to convert their assets back to their own national currency (Lioudis, 2018). This can dampen the value of the USD. Lastly, technological factors, including GDP data, payroll figures, and other economic indicators, influence the dollar’s value (Lioudis, 2018). Traders also monitor market sentiment, as it often has a significant impact, sometimes surpassing the effects of supply and demand. Technical traders use historical patterns, such as support and resistance levels, to predict future price movements (Lioudis, 2018).

The Live Exchange Rate

As of December 23, 2018, the 90-day option contract has expired. We are pleased to report that 1 USD is equivalent to 4.92885 GHS (XE Currency Converter: USD to GHS, n.d.). Thus, 200,000 USD is equivalent to 985,770.61 GHS. The 90-day option was a success, as Hopkins purchased the option to hedge the risk of the USD depreciating, which did not occur. The options contract would have allowed Hopkins to purchase the Cedi at a predetermined price had the USD lost value. The worst-case scenario would have involved paying 200,000 USD for 900,000 GHS, utilizing the hedge’s leverage. Hopkins profited 85,770.61 GHS – 39,421.02 GHS (8,000 USD cost of the contract) = 46,349.59 GHS from the contract.

Defined Purchase Contract
Currency hedging is used to reduce the impact of fluctuations in a given currency on investments and international sales (Singer, 2018). For Hopkins, it functioned like an insurance policy, protecting against foreign exchange risk. Essentially, Hopkins entered into a financial contract to safeguard its investment against unexpected or anticipated changes in currency exchange rates (Singer, 2018). This strategy helped mitigate daily fluctuations and enhanced financial planning reliability.

Conclusion

Currency hedging is vital because currency fluctuations significantly affect the returns of firms investing in foreign markets. While it may seem that if the Cedi appreciates in value, Hopkins’ investment will also increase, this is not entirely accurate. The success of the 90-day option is primarily determined by the USD-to-Cedi exchange rate. Hopkins is pleased with the outcome and plans to continue utilizing these sophisticated contracts as part of its strategy to secure the best ingredients globally and, in turn, emerge as a leader in the chocolate industry.

References

Folger, J. (2018, December 21). What is a derivative? Retrieved from https://www.investopedia.com/ask/answers/12/derivative.asp

Lioudis, N. K. (2018, December 21). 3 Factors That Drive the U.S. dollar. Retrieved from https://www.investopedia.com/articles/forex/09/factors­drive­american­dollar.asp

Market Business News. (2016, July 09). What are the types of Foreign Exchange Transactions? Retrieved from https://businessjargons.com/types­of­foreign­exchange­transactions.html

Picardo, E. (2018, November 05). How to Avoid Exchange Rate Risk. Retrieved from https://www.investopedia.com/articles/forex/082515/how­avoid­exchange­rate­risk.asp

Singer, M. (2018, August 18). What is currency hedging? Definition and meaning. Retrieved from https://marketbusinessnews.com/financial­glossary/currency­hedging­definitionmeaning/

ACC FPX 5610 Assessment 1 Option Pricing

XE Currency Converter: USD to GHS. (n.d.). Retrieved December 23, 2018, from https://www.xe.com/currencyconverter/convert/? Amount=200,000&From=USD&To=GHS