讲解 Managing Foreign Exchange Risk through Options: A Case Study in International Business

Case Study 2 and Case Study 3 combined: Managing Foreign Exchange Risk through Options: A Case Study in International Business

Release date: Wednesday, March 27, 2024.  Due date: 11:00pm, Wednesday, April 17, 2024

This is a group case study. You can form. a team with no more than four members.

Introduction:

XYZ Corporation, a multinational company with operations in the United States, Europe, and Asia, faces significant foreign exchange risk due to its extensive international operations. The headquarter is in Phoenix, AZ, U.S. The company transacts in multiple currencies, including the US Dollar (USD), Euro (EUR), and Chinese Yuan (CNY). Fluctuations in these currency exchange rates impact the  company's revenues, expenses, and overall profitability.To mitigate this risk, the company adopts a comprehensive risk management strategy, incorporating options on foreign currency as a key component.

1.   Study of historical exchange rates

Before implementing the options strategy, XYZ Corporation conducts a thorough assessment of its foreign exchange risk. This involves identifying key currencies impacting the business (USD, EUR, CNY), and understanding the historical volatility of these currencies.

Your first task is to study the exchange rates by following the steps:

o  Download the package tidyquant, and use the following sample codes to extract historical exchange rates:

#######################################

library(tidyquant)

av_api_key('ILEQRVXY1K13TPUG') # You have to generate your own unique API key.   jpy_usd = tq_get("JPY/USD", get = "alphavantage", av_fun = "FX_DAILY", utputsize = "full")

jpy_usd = as.data.frame(jpy_usd)

#######################################

o  Do a literature review about how to compute the volatility of exchange rates. Implement the computations in R to evaluate the volatility for the currencies in this case study.

2.   Foreign Exchange Risk Assessment

Next, based on the understanding of historical exchange rates, you have to assess the potential impact on financial performance in various scenarios due to the fluctuation of the exchange rates.

Your second task is to evaluate how the expenses and revenue of XYZ company (See Appendix A) would change corresponding to the  fluctuation of exchange rates. You can use appropriate statistics (like percentiles) and plots (like histogram) to show the uncertainty of profit and revenue in dollars from the foreign business.

3.   Hedging Strategy

The finance team decides to use call and/or put options to create a balanced hedging strategy.    Recall call options are used to protect against the depreciation of domestic currencies, while put options are employed to hedge against domestic currency appreciation.

Your third task is to carefully select the option types, the expiration dates and strike prices based on XYZ company's forecasted cash flows (See Appendix A) and risk tolerance. Regarding the risk tolerance, you can define it according to your risk appetite. For instance, with a specified probability level, the potential negative impact (for example, negative profit) is controlled to some amount you can accept.

4.   Evaluation of the hedging cost

Your fourth task is to evaluate the cost (in dollars) of the options you selected in the third task. The estimation is based on binomial option pricing methodology. You can use the R package “derivmkts” and the R function binomopt() will help you price the options you have chosen.

Make sure that the number of binomial steps in this function is set up sufficiently.

5.   Results and Impact

Through the implementation of the options’ strategy, XYZ Corporation is expected to successfully mitigate a significant portion of its foreign exchange risk in USD, EUR, and CNY.

Your fifth task is to quantify and evaluate how the above expectation could be potentially satisfied. For  example,  a  critical  question  would  be:  Will  the  company  experience  enhanced  financial stability, allowing for more accurate budgeting and planning? Stability can be quantified using different metrics, such as reduced uncertainty (i.e., standard deviation) of revenue and profit. Any other comments on this risk management strategy?

Appropriate assumptions could be made if not given in this case study, but you should justify the assumptions that are employed.

Deliverables:

Submit a report to cover the required five tasks, as well as supporting calculations like R codes and Excel work.

Note: In assessing the reports, quality takes precedence over the length of the document. The    expectation is to deliver concise yet comprehensive report that effectively addresses each task   with clarity, depth, and accuracy. Regarding the supporting calculations, make sure your work is readable and clear with appropriate comments/documentation.

Appendix A: XYZ company's forecasted cash flows in year 2025

For the business in China: (in Chinese yuan, CHN, millions)

For the business in Europe: (in Euro, millions)