Zapa Chemical and Buba

1. Should Stephanie Mayo sell the Put option

protection already in place?
• Background
– First, US dollar declined rapidly (01.09.92: all-time low DM1.39/$)
– Then, US dollar appreciated (16.09.92: DM1.51/$)
– Volatility still high
• Sale of put option would expose ZAPA to adverse XR
movements
– 3 months until repatriation in December
– Increased option value reflects not only the favorable XR
movement, but also the increased volatility (risk!)
– Possible solution to avoid exposure:
sell put and enter into forward agreement
Comparison of different hedging strategies
(DM/$ ) Sep 18th (DM/$ ) Dec 15th
No change of
(1.5015 ) $ 5,061,605 (1.5152) $5,015,839
hedging strategy

(1.5255) $ 4,981,973 (1.5255) $4,981,973

Sale of option & Sale of +$ 148,200 Sale of + $ 149,427
enter into forward put put
[$148,200*(1+0.033125*90 /360)]
option option

$ 5,130,173 $5, 131,400

•Sale of put option & forward hedge (at DM 1.5255/$) lead to higher
outcome than option hedge in the worst case as well as at the current spot
rate.
•Forward hedge does not allow to benefit from falling US dollar.
•Why not uncovered position or replacing option?
2. How have the events of September altered
Stephanie’s view of the DM/$ exchange rate?

• Initially, Stephanie expected the dollar to fall further:

– Buba was driving interest rates up to slow monetary growth
– Interest rate differentials (US: 3.3125%; Germany: 9.750%)

• September turbulence:
– Uncertainty in Europe due to French vote on Maastricht Treaty
– Stress in the EMS (devaluation pressure on LIT and GBP);
GBP and LIT withdrawn from ERM
– Spanish peseta devalued 5%

• After the dollar had fallen, risen, and fallen again, she
wished to re-evaluate her put option position
 3. How has the volatility of the put option changed
between August and September?

• Volatility of the put option has increased

– August: premium oscillated between $0.5 and $1.50 per DM
– September: premium oscillated between $0.5 and $2.50 per DM
 4. What benchmarks would you use to measure the hedging
effectiveness? How would this alter Stephanie’s hedging?

• ZAPA considers Treasury a cost center (not a profit center!).

– Primary responsibility: conservative management of exposure.
– “Management was appreciative when the expenses of running the cost center
were lower”

• Consequence:
– Cost as a benchmark to measure hedging effectiveness
– Standard portfolio theory:
maximize the expected value µ, minimize the variance ( σ 2 = risk )

Cost center benchmark: minimize risk

- Steph might prefer “cheaper” and less speculative forward hedge
- Yet company policy: “because of losses caused by forward contracts in the
past, F/E options were used whenever possible