COMPLETE THE FOLLOWING CASE, PRINT YOUR RESULTS, AND BRING TO NEXT CLASS FOR REVIEW

You have graduated and taken a job as an analyst for Island Educational Tours, a company that runs 3 month long educational trips to Hayes Island.  Hayes Island has a population and business infrastructure like Manhattan, but in a tropical Caribbean climate. The island currency, Hayes Island Dollars (ISK), has recently been extremely volatile. The CFO of the business is concerned about foreign exchange exposures impacting the results next year, 2019 The CFO has asked for your help in analyzing the alternatives for managing those foreign exchange exposures. You are the perfect person for the task since you not only know how to use forwards and options to manage exposures, but you also know how to combine forwards and options to create more complex hedging profiles. 

Business and economic inputs to your analysis

Current spot FX rate               $1.00/ISK

Current forward FX rate             $1.00/ISK

Current option strike price          $1.00/ISK

Premium(cost) of option is 5% of the initial hedge amount:

         cost of option on $1,000 of ISK would be $50

         cost of option on $750 of ISK would be $37.5

         cost of option on $500 of ISK would be $25

         cost of option on $250 of ISK would be $12.5

Cost of forwards is assumed to be $0

Possible range of FX prices

        High                        $1.30/ISK

        Expected                    $1.00/ISK

        Low                         $0.70/ISK

Each customer pays               $2,000

Business costs per customer       1,000 ISK

Forecasted profit per customer   $1,000

Number of customers                200

Total profit forecast          $200,000

Questions to answer for the CFO

What will be the profit per customer assuming no hedges in each of the three scenarios:

                   Exchange rate in 2019 is the High rate ( $1.30/ISK )

                   Exchange rate in 2019 is the Expected rate ( $1.00/ISK )

                   Exchange rate in 2019 is the Low rate ( $0.70/ISK )

Translate the prior question results into a forecast deviation payoff diagram, showing that if the Expected rate is the actual rate in 2019, then you will have zero deviation from forecasted profits, but substantial forecast deviations at the High rate and Low rate.

Per each customer, and at each of the three exchange rates, calculate hedged exposure results for the following hedging scenarios:

          1) Hedging 100% with options

          2) Hedging 75% with options and 25% with forwards

          3) Hedging 50% with options and 50% with forwards

          4) Hedging 25% with options and 75% with forwards

          5) Hedging 100% with forwards

Plot the results on a profit loss diagram using a different color for each of the scenarios

Assume that the equation for demand for bread at a small bakery is Qd = 60 – 10Pb + 3Y, where Qd is the quantity of bread demanded in loaves, Pb is the price of bread in dollars per loaf, and Y is the average income in the town in thousands of dollars. Assume also that the equation for supply of bread is Qs = 30 + 20Pb – 30 Pf, where Qs is the quantity supplied and Pf is the price of flour in dollars per pound. Assume finally that markets clear, so that Qd = Qs.a. If Y is 10 and Pf is $1, solve mathematically for equilibrium Quantity and equilibrium Pb.b. If the average income in the town increases to 15, solve for the new equilibrium Quantity and equilibrium Pb.