Reference no: EM131149687

Finance Forum Post Replies

I need a 125-word reply to each of the following four forum post:

Forum #1

Futures and options are both derivative instruments, which means they derive their value from an underlying asset or instrument. Both futures and options have their own advantages and disadvantages. One of the advantages of options is obvious. An option contract provides the contract buyer the right, but not the obligation, to buy or sell an asset or financial instrument at a fixed price on or before a predetermined future month. That means that the maximum risk to the buyer of an option is limited to the premium paid. A disadvantage of an option contract is that it may expire worthless. This risk increases the greater the extent to which the option is out of the money and the shorter the time until expiration. But futures have some significant advantages over options. A futures contract is a binding agreement between a buyer and seller to buy or sell an asset or financial instrument at a fixed price at a predetermined future month. The disadvantages are: they come with a credit risk, risk of default is high, and they can be hard to cancel. "when China's stock markets were at a relatively high level. The authorities hoped that the bullish markets would provide a buffer for the introduction of the futures contracts and also that the futures could help "smooth out the market fluctuations" of the underlying spot market" (Fung, Hung-Gay; Liu, Qingfeng Wilson. September-October 2013).

What are the costs of each alternative?

Forward contracts do not cost any money upfront. However, if a seller hedges in the price by locking in a forward if a currency depreciates, they face many costs if the currency appreciates. The cost for an option contract is called a premium. It is a deposit paid for a future purchase. If, however that contract expires before it is received, the premium is worthless.

When is one alternative preferred over the other?

Option contracts are becoming more popular over forward contracts because they are less risky, it gives you the right but not the obligation to buy or sell assets, and they are also more flexible than forward contracts.

References

Fung, Hung-Gay; Liu, Qingfeng Wilson. September-October 2013, v. 46, iss. 5, pp. 36-49. What Makes a Successful Futures Contract? Case of China's Stock Index Futures. Retrieved from Ashford Library:https://eds.b.ebscohost.com.proxy-library.ashford.edu/eds/detail/detail?vid=5&sid=d6729a61-4b64-4574-ad50-a44e6784f819%40sessionmgr107&hid=121&bdata=JnNpdGU9ZWRzLWxpdmU%3d#db=eoh&AN=1420908

Forum #2

Hedging is a valuable tool in financial risk management and very important when working with big accounts or portfolios that are not already diversified. Forward contracts are one way in which a firm may manage the risk of exposure to foreign currency exchange rates. A firm can sell (buy) its foreign currency receivables (payables) forward to eliminate its exchange risk exposure (Eun & Renick, 2015). The advantage of the forward contract is that it completely eliminates any risk that exists as a result of exchange rate exposure. The disadvantage is that by essentially being locked in and protected from loss you are also prevented from gain. This alternative is preferred when the market is unstable and you feel you would not be able to make a reliable call on which way the market is headed.

Options contracts offer are another risk management alternative but they work a bit differently. Currency options help a firm secure a flexible "optional" hedge against exchange exposure through buying a foreign currency call (put) option to hedge its foreign currency payables (receivables) (Eun & Renick, 2015). The advantage of the option contract is that you have the opportunity to make a profit if you select your call or put accurately. The disadvantage is that you could suffer a loss if you select poorly. This alternative is preferred when the market is more stable or you feel that through analysis you can make a smart decision on which way it is headed.

Reference

Eun, C., & Renick, B. (2015). International Financial Management, Seventh Edition. New York, NY:McGraw-Hill Education.

Forum #3

"Transaction exposure to currency risk refers to potential changes in the value of future cash flows (committed or anticipated) as a result of unexpected changes in exchange rates" (Hagelin, Niclas. January 2003). For me transaction exposure would be most important. The reason is you're actually dealing with cash flow and cash flow as we all know is very important. If there is a change in the market, be it good or bad it changes the cash flow. When it comes to translation exposure, it deals only with the sale of assets and this includes any liquidation of assets as well. One thing I would certainly do here is still pick a good time to sell my assets at a good time to maximize my gains.

What are the advantages and disadvantages of the common methods for controlling translation exposure?

The common methods for controlling translation exposure are: 1) a balance sheet hedge, and 2) a derivatives hedge. The advantage of a balance sheet hedge is that it eliminates the mismatch between assets and liabilities. The disadvantage however, is that it may create transaction exposure. The advantage of a derivatives hedge is that it uses forward contracts, therefore, any transaction will be taking place in the future, giving the investor or trader time to manage their account. The disadvantage is that it involves a lot of speculation about foreign exchange rate changes; which without the knowledge could result in a loss.

References

Hagelin, Niclas. January 2003, v. 13, iss. 1, pp. 55-69. Why Firms Hedge with Currency Derivatives: An Examination of Transaction and Translation Exposure. Retrieved from Ashford Library:https://eds.b.ebscohost.com.proxy-library.ashford.edu/eds/detail/detail?vid=2&sid=d4aababc-71e8-48f5-bb02-99efc466af81%40sessionmgr101&hid=121&bdata=JnNpdGU9ZWRzLWxpdmU%3d#db=eoh&AN=0634793

Forum #4

It is my opinion that transaction exposure is more important to manage than translation exposure. Transaction exposure is the sensitivity of "realized" domestic currency values of the firm's contractual cash flows (Eun & Renick, 2015). Translation exposure is the potential that a firm's consolidated financial statements can be affected by changes in exchange rates (2015). I think that the key difference there is "realized" meaning an actual loss can occur in transaction exposure. Translation exposure involves no actual loss potential, just the chance that it may appear to be a loss. While that can cause investors to hesitate or avoid making an investment the impact is indirect.

Well one way to control translation exposure is through transaction exposure. Of course by doing this you may be able to profit but you also open yourself to potential realized losses. The other two methods are the balance sheet hedge and the derivatives hedge. I believe that there is some similarity between these two methods and their impact as their was in our first discussion with forward and option contracts. The balance sheet hedge, like the forward contract, eliminates risk from the equation. Once assets and liabilities and balanced only future transactions upsetting the balance can recreate transaction exposure and disrupt the balance sheet hedge. This would be useful for companies who made relatively few transactions in my opinion. The derivatives hedge, like the options contract, is not really a hedge but more of an investment itself. Essentially it enables a profit if the spot rate moves as expected but could result in a loss otherwise.

Reference

Eun, C., & Renick, B. (2015). International Financial Management, Seventh Edition. New York, NY:McGraw-Hill Education.