ACC FPX 5610 Assessment 1

Option Pricing

Options are a familiar concept to the majority, and although they may seem complex at first, they are easy to understand once one knows the fundamentals. Investor portfolios typically consist of various asset classes, and options are one of them. This specific asset class has a lot to offer that trading ETFs and stocks may not. Options are very powerful financial instruments, as they have the capability to generate money and, most importantly, provide protection and leverage. They are particularly convenient while hedging exchange rate risk, which, though unavoidable, can be kept at a bare minimum using smart hedging. Refraining from foreign investment is the sole means of keeping foreign exchange (forex) risk at zero, but research indicates that diversifying a portfolio is the more effective choice. 

Nature of Derivative Financial Instruments

A derivative is a deal between two or more parties whose contract value is rooted in an agreed underlying asset or basket of assets (Folger, 2018).

The underlying assets are bonds, currencies, shares, market indexes, and commodities (Folger, 2018). Derivatives are sophisticated investments since they apply to speculative as well as hedging purposes (Folger, 2018). Speculators aim to profit from movements in the price of an underlying asset, security, or index. For example, a trader can short a futures contract to profit from a decline in an index. Hedging involves transferring the risk of price changes from one party to another (Folger, 2018). Hopkins, an exchange rate risk mitigation specialist company, is interested in the risk of the U.S.

The dollar is fluctuating against the Ghanaian cedi. Even though it can be avoided, foreign trade and currency risk can be eliminated; this cannot be done for Hopkins, as Ghana provides the highest quality green cocoa beans at the best global price. The company purchased a 90-day option to minimize this risk, a practice used extensively in the foreign exchange market. 

ACC FPX 5610 Assessment 1 Option Pricing 

Forex options are bought over-the-counter, and one is able to design the contract in line with one’s hedging requirements through selection of suitable prices and dates to maturity (Picardo, 2018).

With an options contract, the investor is granted the right but not the duty to exchange one currency for another at an exchange rate one desires on a specified date (Market Business News, 2016). A call option provides the investor with the right to purchase a currency, while a put option provides the investor with the right to sell (Market Business News, 2016). For Hopkins, this foreign exchange deal is noteworthy since their contract provides them with an option for payment in Ghanaian cedi after a period of 90 days from purchase. The primary purpose of the option purchase was to hedge Hopkins’ investment in the event that the U.S. dollar lost value over the 90-day period between the date of purchase and the payment due date.

The Value of the U.S. Dollar

Investment choices, whether to sell or purchase U.S. dollars, are greatly influenced by the health of the U.S. economy.

The economy attracts investments from everywhere in the world since investors anticipate earning a desirable rate of return (Lioudis, 2018). Investors, particularly foreign investors, seek the most secure and guaranteed yields (Lioudis, 2018). It is a trade deficit when a country’s imports exceed its exports, but a strong economy can attract foreign funds to offset the deficit. This allows America to continue investing in global economies while allowing other countries to have the ability to export to America, thus increasing their economies (Lioudis, 2018). Three significant factors affecting the value of the U.S. dollar include supply and demand, sentiment and market mood, and technical factors (Lioudis, 2018).

When America exports goods and services to other countries, the demand for American dollars rises as foreigners need to purchase American currency to complete the deals. Demand for the dollar rises, and it has a push factor in raising its value (Lioudis, 2018). Moreover, the U.S. dollar also tends to act as a safe haven during uncertain times across the world. Psychological factors of the market also intervene. For example, if the U.S. economy is declining, as indicated by increasing unemployment, foreign investors can sell U.S. assets for conversion of their money back into local currency, which can undermine the dollar’s value (Lioudis, 2018). Last but not least, technical factors such as GDP announcements, payroll figures, and other economic indicators also set the value of the U.S. dollar (Lioudis, 2018). Market mood, which at times surpasses the influence of supply and demand, is greatly studied by traders. Technical traders also make predictions based on past trends of price, looking into factors like support and resistance levels (Lioudis, 2018).

The Live Exchange Rate

By December 23, 2018, the 90-day option contract had expired. Hopkins could hedge against the currency risk because 1 USD = 4.92885 GHS (XE Currency Converter: USD to GHS, n.d.). The firm could exchange 200,000 USD into 985,770.61 GHS. Had the U.S. dollar depreciated, then the options contract would have benefited the company by allowing it to purchase the Ghanaian cedi at a predetermined price. Hopkins earned a profit of 46,349.59 GHS after paying 8,000 USD for the contract.

Defined Purchase Contract

Currency hedging is crucial in minimizing the effects of currency fluctuations on investments and foreign sales (Singer, 2018). To Hopkins, this hedging tool was an insurance policy that protected the firm from adverse changes in exchange rates. Through a financial transaction, Hopkins was able to shield its investment from unexpected fluctuations in currency exchange rates (Singer, 2018). This tool minimized day-to-day volatility and increased the company’s consistency in financial planning.

Conclusion

Currency hedging is necessary, as currency fluctuations can have a major effect on returns for internationally investing firms. While it might appear that an appreciation in the value of the cedi could lead to gains for Hopkins, the success of the company relies heavily on the exchange rate between the USD and the cedi. Successful execution of the 90-day option contract points to Hopkins’ strategic approach of procuring the world’s best ingredients, solidifying its position in the chocolate industry.