Option Pricing for Hopkins Chocolate Company
Talking about different option costs, hedging, forward contracts, and other derivative instruments can be intimidating, but once the basics have been understood, they can be easily managed. These derivative instruments can protect a company from undue financial stress or risk and add income and leverage when performing risky purchases or investments. Businesses and investment firms can use it to hedge exchange risk. Risks are unavoidable but can be mitigated tremendously with these techniques. The only way to completely avoid all risks when investing internationally is not to invest internationally, which would be very restrictive to businesses or investment firms. This is not a true alternative for businesses or investment firms due to the substantial benefits of portfolio diversification.
Nature of Derivative Financial Instruments
A derivative is a contract based on a pre-determined underlying asset(s) by one or more parties (Chen, 2021). Financial derivative instruments are financial instruments that are directly linked to a more elementary asset, such as a stock, currency, bond, index, or commodity. There are many types of financial derivatives instruments, such as forwards and futures, options, and swaps. These instruments are used by money managers for many investing purposes, such as hedging, speculation, and financial risk management, especially in foreign currency exchange risks (Kumar, 2014 & Glantz & Kissell, 2014). Essentially, these instruments protect a company from financial risk and potential losses. Derivatives are used to speculate and hedge when investing. The investor seeks to use speculation to profit from potentially fluctuating prices in currency in the underlying asset, security, or index. Hedging allows the risk of the investment to be spread amongst multiple parties, mitigating risks (Chen, 2021).
Forwards and Futures are when a financial contract obligates the contracts’ buyers to purchase a good, product, or service for a pre-determined price on a future date. This “locks in” the price so the seller does not incur an unforeseen loss. Options is a contract in that the buyers are afforded the right, but not an obligation, to purchase or sell the asset at the pre-determined price at a future date. Such as, if the foreign currency exchange were to increase before the closing date, the seller could let the option expire and take the sale at the day’s spot price Swaps are derivative contracts that allow the exchange of cash flow between two parties or businesses; with the most common being commodity swaps, interest rate swaps, and currency swaps.
The derivative instruments provide many benefits to companies participating in modern finance. By purchasing a derivative contract that moves in the opposite direction of the valued asset, an investor can offset losses in the underlying asset with collected profits. Another advantage of derivative contracts is that the asset price is determined in the future and will not change despite the current market fluctuations. Spot prices, for reference, can serve as an estimate of a commodity price. These derivatives can afford a company access to markets or assets that may be unavailable. Also, a company can utilize interest rate swaps to achieve an advantageous interest rate for direct borrowing.
Even though there are numerous advantages to derivatives, there are also disadvantages. These derivatives sometimes result in huge losses to a company as they hold significant risk when partaking in them. Derivatives are based largely on speculation, which can produce disastrous results if poorly thought out. Exchange rates are highly unpredictable and take a turn anytime, depending on the current market. Derivatives can also suffer from both parties defaulting on the contract.
Hopkins Chocolate Factory Purchase of Cocoa Beans
The Hopkins Chocolate Company has entered a contract to purchase a 90-day option to exchange $200,000 for 900,000 Cedi for green cocoa beans. This would purchase 100 tons from Abamo Chocolate in Ghana, Africa. The company’s treasurer is concerned that the U.S. Dollar (USD) will change in value against the Ghanaian Cedi (GHS), causing them to purchase the 90-day option. The breakdown of this cost is USD 1, equal to 4.5 GHS in the contract that has been proposed.
The only way to irradicate this risk is to stop trading with Abamo Chocolate and purchase within the U.S. (Picardo, 2021). The company has the best prices for green cocoa beans in the market now; Hopkins Chocolate cannot stop international trading with this company. Due to this risk, Hopkins Chocolate has decided to purchase the 90-day option for $8,000 to help mitigate some of that risk. The trader can choose Forex options to suit their hedging desires by trading over the counter, and prices and expirations can be chosen (Picardo, 2018). OOver-the-counter option purchases typically have a strike price equivalent to the spot rate on the particular day of the ale (Glantz & Kissell, 2014).
This contract requires that both companies come to a pre-determined price despite fluctuations within exchange rates (What is currency hedging? 2018). There are two types of options, call and put options. The call option is the option to purchase the currency by the holder’s option, while the put option is the option to sell the currency by the holder (Glantz & Kissell, 2014). The transaction will involve converting the currency into the seller’s currency to complete the payment, which is in the determined purchase contract between Abamo Chocolate and Hopkins Chocolate (What is currency hedging? 2018). This contract has a call option meaning that Hopkins Chocolate will pay the product’s price in full by the 90-day deadline. The most important factor in this purchase is mitigating the risk involved. Due to this being an option contract, the investor can exchange the currency in one denomination but is not obligated to do so (What is currency hedging? 2018). This decision was made to protect Hopkins Chocolate from a potential fall in the USD within the 90-day purchase window.
Influences on the Value of the U.S. Dollar
A strong economy is critical when exchanging currency, whether for purchasing or selling. This will attract investors from all over the globe due to the assumption that the investor will benefit from the ability to obtain investment returns (Lioudis, 2021). Investors always look for the most lucrative, safe, and predictable exchanges, especially international ones (Lioudis, 2021). A deficit can occur when a country’s imports exceed exports. A strong economy attracts foreign investment and capital to offset that deficit. Due to this, the U.S. will continue to fuel most of the world’s economies and allow other countries to continue to export to the U.S. to provide for their own economy’s sustainability (Lioudis, 2021).
Supply and demand, sentiment and market psychology, and technical factors all affect the value of the USD (Lioudis, 2021). When the U.S. exports goods and products, it creates a demand for USD because customers must purchase these goods and services in USD. This requires the purchasers to convert their currency into USD by selling their currency to settle payment for the goods or services. As more foreign purchasers and investors purchase USD, the greater the demand is and creates pressure to increase supply (Lioudis, 2021). Global market uncertainty is important to acknowledge, as the USD has been considered a refuge.
Nest to consider is the psychology of the USD. If the U.S. economy were to weaken due to unemployment, the government would face a sell-off (Lioudis, 2021). If this results in foreign investors selling bonds and stocks to return their national currency, it can weaken the USD’s strength.
There are technological factors that influence the USD. Traders, international or internal, influence the strength or weakness of the U.S. economy. These traders observe the news and events that may impact the USD, including Gross Domestic Profit (GDP), payroll data, and other economic factors (Lioudis, 2021). While watching those listed previously, they also pay particular attention to large investors in the market, including asset management firms and investment banks, which help to understand the American economic response (Lioudis, 2021). Traders realize that the response plays a meaningful role in the economy, surpassing supply and demand influences. Technical Traders analyze historic patterns, such as support and resistance levels and other indicators (Lioudis, 2021). Traders study these patterns because they believe they are cyclic and can predict future price movement.
The Live Exchange Rate
On August 7, 2021, the 90-day option contract expired. The Ghanaian Cedi (GHS) is currently worth $0.167 of $USD 1 or $USD 5.99for 1 GHS (1 USD to GHS – convert U.S. dollars to Ghanaian Cedis, n.d.), which means that the USD 200,000 is equivalent to 1,198,000 GHS. The purchase of the 90-day option was successful. Hopkins Chocolate purchased the 90-day option to mitigate the risk of the USD decreasing in value over the 90 days. However, it did not. The option contract would have given Hopkins the benefit of purchasing the cocoa beans at the pre-determined rate if the USD did decrease in value compared to the GHS.
By purchasing this option contract, Hopkins Chocolate was guaranteed a price of $200,000 or 900,000 Cedi for the cocoa beans due to the leverage of the hedge. Hopkins Chocolate allowed the option contract to lapse and use the current conversion rate of August 7, 2021. Hopkins Chocolate was then able to save a total cost of 298,000 GHS after paying the cost of the cocoa beans. After subtracting the option contract cost, 47,920 Cedi, it results in a final total of 250,080 Cedi or USD 41,749.58 (when divided by the conversion rate of 5.99 Cedi per USD 1). Hopkins covered the cost of the contract and was able to save from this deal with Abamo Chocolate, only paying USD 150,250.42 for the 100 tons of cocoa beans from Abamo Chocolate.
Defined Purchase Contract
When investors are looking to mitigate the risk of fluctuation in currency on the value of an investment or international purchase, the investor can engage in currency hedging (Singer, 2018). It can be seen as an insurance policy to protect the investor from potential losses that may be incurred when trading internationally. Hopkins Chocolate correctly utilized this option contract, which worked out to their benefit. Hopkins Chocolate entered into a financial contract to protect the firm’s interest and investment from potential loss while not causing a binding deal such as a forward contract. If Hopkins Chocolate had entered into a binding contract, such as a forward contract where they would be obligated to the agreed upon price at the beginning of the purchase agreement, but because they decided to go with an option contract, they were able to let the contract expire and use the price point for the currency of the last day of the option contract and save a significant amount of money on this purchase.
Knowing how and when to use currency hedging is an important derivative financial instrument. Currency fluctuations have a significant impact on foreign market investments and returns. In this case, if the Cedi had increased in value compared to the USD, it would have hurt Hopkins Chocolate financially if they had not purchased the 90-day call option. The value of this investment weighed heavily on the USD-to-Cedi exchange rate, as evidenced by the success of the 90-day call option. The company protected the investment as the treasurer made a safe financial decision. The firm should continue to use these contracts with future investments for the ingredients or other goods needed for production and to continue to grow as a company.
1 USD to GHS – convert U.S. dollars to Ghanaian Cedis. 1 USD to GHS – U.S. Dollars to Ghanaian Cedis Exchange Rate. (n.d.). https://www.xe.com/currencyconverter/convert/? From=USD&To=GHS.
Chen, J. (2021, July 28). Derivative definition. Investopedia. https://www.investopedia.com/ask/answers/12/derivative.asp.
Glantz, M., & Kissell, R. (2014). Multi-Asset risk modeling. Elsevier, Inc.
Lioudis, N. (2021, August 7). Three factors that drive the U.S. Dollar. Investopedia. https://www.investopedia.com/articles/forex/09/factors-drive-american- dollar.asp#:~:text=The%20U.S.%20Dollar-,Factors%20Affecting%20Dollar%20Value,Technical%20factors.
Picardo, E. (2021, June 21). How to avoid exchange rate risk. Investopedia. https://www.investopedia.com/articles/forex/082515/how-avoid-exchange-rate-risk.asp.
What are the types of foreign Exchange Transactions? Business Jargons. (2016, July 9). https://businessjargons.com/types-of-foreign-exchange-transactions.html.
What is currency hedging? Definition and meaning. Market Business News. (2018, August 18). https://marketbusinessnews.com/financial-glossary/currency-hedging-definition-meaning/.
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Prepare a report (2-3 pages) that discusses derivative financial instruments and evaluates the purchase of a hypothetical currency option.
This assessment will allow you to practice two approaches for hedging exposure to the change in a foreign currency.
Demonstration of Proficiency
By completing this assessment, you will demonstrate your proficiency in the following course competencies through corresponding scoring guide criteria:
- Competency 1: Apply advanced accounting techniques to organizational situations.
- Discuss the nature of derivative financial instruments.
- Indicate the factors that might influence the value of the USD against the Ghanaian Cedi.
- Explain how much was won or lost by purchasing a 90-day option.
- Discuss how a defined purchase contract could hedge against a change in the exchange rate between the USD and the Ghanaian Cedi.
- Competency 5: Communicate in a manner that is professional and consistent with expectations for members of the business professions.
- Communicate in a manner that is professional and consistent with expectations for members of the business professions.
Hopkins Chocolate Company buys green cocoa beans that are processed into consumer products. Cocoa beans sell for $2,000 United States Dollars (USD) per metric ton. Hopkins buys 100 tons at a time from Abamo Chocolate in Ghana, Africa. Normal purchase procedures stipulate that the purchase contract is denominated in Ghanaian Cedi, and payment in Cedi is due 90 days after purchase.
Recently, the treasurer of Hopkins became concerned that the U.S. Dollar would change in value against the Ghanaian Cedi. Consequently, Hopkins bought a 90-day option.
You are the controller for Hopkins Chocolate Company.
As the controller of Hopkins Chocolate Company, you work closely with the treasurer. She has requested that you prepare a report to help explain the recent purchase of the 90-day option to the board of directors members. Address the following in your report (3–5 pages):
- Discuss the nature of derivative financial instruments.
- Explain the factors that might influence the value of the USD against the Ghanaian Cedi. Discuss at least three factors.
- Hopkins bought a 90-day option to exchange USD 200,000 for 900,000 Cedi. They paid USD 8,000 for the option; today, it has been 90 days. Locate today’s value of the Cedi at XE.com’s Live Exchange Rates and calculate how much Hopkins won or lost by purchasing the 90-day option. Explain your calculations in detail.
- Discuss how Hopkins could use a defined purchase contract to hedge against a change in the exchange rate between the USD and the Cedi.
Since you plan to share your report with the treasurer and the board of directors, you want this report to be clear, well-organized, and readable. Your supervisor has requested that your report be 2-3 pages so that you have enough space to develop your ideas and provide some scholarly and professional context.
- Communication: Communicate in a scholarly, professional manner and consistent with senior corporate leadership’s and other stakeholders’ needs and expectations. For this scenario, assume the treasurer and the board of directors expect original work, critical thinking, and scholarly sources. Your writing must be free of errors that detract from the overall message.
- Your report is a professional document and should therefore follow the corresponding MBA Academic and Professional Document Guidelines, including single-spaced paragraphs.
- Resources: At least three resources that are scholarly and professional. So that your imaginary board of directors can locate more information about derivative instruments and currency options, include a reference page at the end of your report.
- Report length: Minimum of 2-3 pages, not including reference pages.
- Font and font size: Times New Roman, 12 pt.
Faculty will use the scoring guide to review your deliverable as if they were a director on the board. Review the scoring guide before developing and submitting your assessment.