Option Pricing for Hopkins Chocolate Company

Discussing various option costs, hedging, forward contracts, and other derivative instruments can be scary, but if the fundamentals are grasped, they are simple to manage. When making riskier acquisitions or investments, these derivative products can increase income and leverage while protecting a corporation from excessive financial stress or danger. Companies and financial businesses can use it to reduce exchange risk. Despite being unavoidable, risks can be greatly reduced by using these strategies. The only method to eliminate all risks associated with investing globally is not to do so, which would be extremely constricting for businesses or investment firms. As a result of the significant advantages of portfolio diversity, this is not a real choice for businesses or investment organizations.

Derivative Financial Instruments

Their TypesA derivative is a contract that one or more parties enter into based on one or more predetermined underlying assets (Chen, 2021). Financial instruments directly linked to a more basic asset, like a stock, currency, bond, index, or commodity, are known as financial derivatives. Financial derivatives come in various forms, including forwards and futures, options, and swaps. Money managers utilize these instruments for various investment goals, including hedging, speculating, and managing financial risks, particularly those related to currency exchange risks (Kumar, 2014; Glantz & Kissell, 2014). Essentially, these tools shield a business from monetary risk and prospective losses. When investing, derivatives are utilized for speculating and risk management. The investor speculates to profit from anticipated currency price fluctuations in the underlying asset, investment, or index. Risks can be reduced by hedging by distributing the investment’s risk across many parties (Chen, 2021).

When a financial contract obligates the contract’s buyers to acquire a good, product, or service for a certain price on a future date, the agreement is known as a forward or future. This “locks in” the price to prevent the seller from suffering an unanticipated loss. Options are a type of contract because they give the purchasers the option, but not the duty, to buy or sell the asset at the pre-set price later. For instance, the seller could let the option expire and proceed with the transaction at the day’s spot price if the rate of exchange for the foreign currency rose before the closing date. Commodity swaps, interest rate swaps, and currency swaps are the three most popular types of swaps, which are derivative contracts that enable the exchange of cash flow between two parties or enterprises.

Companies involved in modern finance can gain greatly from derivative instruments. An investor can counter losses in the underlying asset with collected profits by buying a derivative contract that moves in the opposite direction of the valued asset. Derivative contracts also have the benefit of having asset prices that are fixed in the future and that remain constant regardless of current market movements. For reference, spot prices can be used to estimate a commodity’s price. These derivatives can give business access to markets or resources that might otherwise be closed off. A business can also use interest rate swaps to get a good interest rate on direct borrowing.

Derivatives provide a lot of benefits, but they also have some drawbacks. Due to the high risk of using these derivatives, a corporation may occasionally suffer big losses. Derivatives are heavily based on speculation, which, when done incorrectly, can have severe effects. Exchange rates are erratic and can alter at any time, depending on the market. When both sides break their end of the bargain, derivatives can also suffer.

Hopkins Chocolate Factory Purchase of Cocoa Beans

The Hopkins Chocolate Company has made a deal to buy a 90-day option to trade $200,000 for 900,000 Cedis in exchange for green cocoa beans. With this, 100 tons of Abamo Chocolate in Ghana, Africa, would be purchased. The company’s treasurer bought the 90-day option because they fear the U.S. Dollar’s (USD) value may fluctuate about the Ghanaian Cedi (GHS). This cost is broken down into USD 1, equivalent to 4.5 GHS in the proposed contract.

The only way to eliminate this danger is to cease doing business with Abamo Chocolate and limit your purchases to domestic markets (Picardo, 2021). Hopkins Chocolate cannot sever ties with this company because it offers the best prices for green cocoa beans. Hopkins Chocolate has paid $8,000 for the 90-day option to offset this risk. By trading over the counter, the trader can select the prices and expirations of the Forex options that best meet their hedging needs (Picardo, 2018). The strike price for over-the-counter option purchases often corresponds to the spot rate on the specific trading day (Glantz & Kissell, 2014).

According to this contract, the two businesses must agree on a price regardless of changes in exchange rates (What is currency hedging? 2018). Call and put options are the two different categories of options. According to Glantz and Kissell (2014), the call option is the holder’s choice to buy the currency, whereas the put option is the holder’s opportunity to sell the currency. According to the predetermined purchase agreement between Hopkins Chocolate and Abamo Chocolate, the transaction will require currency conversion to fulfill the payment (What is currency hedging? 2018). Hopkins Chocolate will pay the entire purchase price for the product by the 90-day deadline under the terms of this contract, which has a call option. Managing the risk is the most crucial aspect of this purchase. Because this is an option contract, the investor has the option but not the obligation to exchange the currency in one denomination (What is currency hedging? 2018). This choice was made to guard Hopkins Chocolate against a possible decline in the value of the USD throughout the 90-day buying window.

Influences on the U.S. Dollar’s Value

Whether you are buying or selling currency, a robust economy is essential. Due to the presumption that the investor will profit from the potential to acquire investment returns, this will draw investors from all over the world (Lioudis, 2021). Investors constantly seek out the most profitable, secure, and reliable exchanges, particularly those that are global (Lioudis, 2021). When imports surpass exports, a country may experience a deficit. A healthy economy brings capital and foreign investment to compensate for the deficit. As a result, the U.S. will continue to drive most of the world’s economies and permit other nations to export goods to the U.S. to ensure their economies’ viability (Lioudis, 2021).

The USD’s value is influenced by demand and supply, mood and market psychology, technical variables, and other factors (Lioudis, 2021). Because clients must pay for these goods and services in USD, exporting goods and services by the United States increases demand for USD. To settle payment for the goods or services, the buyers must exchange their money for USD by selling it. The demand for USD increases as more foreign investors and buyers buy it, which puts pressure on the supply to rise (Lioudis, 2021). Since the USD has historically been seen as a haven, realizing the uncertainties in the world markets is crucial.

The psychology of the USD should be taken into account. The government would see a sell-off if the U.S. economy were to deteriorate due to unemployment (Lioudis, 2021). The strength of the USD may be weakened if this causes foreign investors to sell bonds and stocks to convert their funds back to their currencies.

Technological considerations influence the USD. Domestic and foreign traders influence the health or weakness of the American economy. These traders keep tabs on news and developments that could affect the USD, such as the Gross Domestic Product (GDP), payroll information, and other economic variables (Lioudis, 2021). While keeping an eye on those previously mentioned, they also pay close attention to major market participants, such as asset management companies and investment banks, which aid in understanding the American economy’s response (Lioudis, 2021). Traders are aware that the response affects the economy more significantly than supply and demand factors. Technical traders examine previous trends using indicators such as support and resistance levels and others (Lioudis, 2021). Because traders think these patterns are cyclical and can forecast price movement, they study them.

Current Exchange Rate

The 90-day option contract expired on August 7, 2021. According to the current exchange rate (1 USD to GHS – convert U.S. dollars to Ghanaian Cedis, n.d.), the Ghanaian Cedi (GHS) is worth $0.167 of 1 USD or $USD 5.99 for 1 GHS. This implies that USD 200,000 is equal to 1,198,000 GHS. The 90-day option was successfully purchased. To reduce the risk of the USD depreciating over the next 90 days, Hopkins Chocolate bought the 90-day option. Nevertheless, it didn’t. If the USD’s value fell relative to the GHS, Hopkins would have had the benefit of buying the cocoa beans at the agreed-upon price thanks to the option contract.

Due to the leverage of the hedge, Hopkins Chocolate has assured a price of $200,000 or 900,000 Cedi for the cocoa beans by purchasing this option contract. Hopkins Chocolate permitted the option agreement to expire and to apply the conversion rate in effect as of August 7, 2021. Once the cost of the cocoa beans was paid, Hopkins Chocolate could make a total cost savings of 298,000 GHS. A total of 250,080 Cedi (divided by the conversion rate of 5.99 Cedi for USD 1) is obtained after deducting the option contract cost of 47,920 Cedi. Hopkins paid only USD 150,250.42 for the 100 tons of cocoa beans from Abamo Chocolate, covering the contract’s cost and saving Hopkins money.

Specified Purchase Agreement

Investors can use currency hedging to reduce the impact of currency fluctuations on the value of an investment or an international transaction (Singer, 2018). It can be viewed as a form of insurance to shield the investor from possible losses experienced when transacting internationally. Hopkins Chocolate effectively used this option contract to its advantage. Hopkins Chocolate entered into a financial agreement to safeguard the company’s interests and investments from possible loss without resulting in a legally enforceable agreement like a forward contract. Hopkins Chocolate would have been required to pay the agreed-upon price at the start of the purchase agreement if they had entered into a binding contract, such as a forward contract, but because they opted for 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 sizable sum of money on this purchase.

Conclusion

Currency hedging is a crucial derivative financial product, so it is necessary to know when and how to utilize it. FCurrency movements significantly impact foreign market investments and returns. In this instance, Hopkins Chocolate would have suffered financially if they had not bought the 90-day call option if the Cedi had appreciated relative to the USD. The performance of the 90-day call option is evidence that the value of this investment had a significant impact on the USD-to-Cedi exchange rate. The corporation safeguarded the investment as the treasurer made a prudent financial choice. The business should keep using these contracts with future investments for supplies or other manufacturing items to expand.

References

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.

Introduction

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.

Scenario

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.

Your Role

You are the controller for Hopkins Chocolate Company.

Requirements

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):

1. Discuss the nature of derivative financial instruments.
2. Explain the factors that might influence the value of the USD against the Ghanaian Cedi. Discuss at least three factors.
3. 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.
4. Discuss how Hopkins could use a defined purchase contract to hedge against a change in the exchange rate between the USD and the Cedi.

Deliverable Format

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.

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