Tiffany & Company 1993 Â Case Solution
1.Â Â Â Â Buy yen put option:
An alternative would be to buy the Yen put option. The key difference in forward contract and put option is that forward contract gives the holder obligation to sell or buy at a certain price and certain date. Whereas on the other hand, the put option gives the holder right to buy or sell yen at a pre-determined price and specified time-period. The put option gives Tiffany right, not the obligation to sell yen to the counter party at predetermine price in the future.
A put option gives the holder a right to sell the foreign currency. If yen falls, a put option would gain in value. It would be an effective risk management tool for Tiffany. One advantage of put option over forward contract is that, the amount of loss is limited to the premium of the option.
According to exhibit 8(c) strike prices of put option exchange rate are given and premium prices are also given.
These two hedging strategies will help Tiffany to minimize the exchange rate. Since Tiffany is a multinational company, the exchange rate significantly effects on its financial performance. Therefore, initiating a risk management program would be a very appropriate option for the company. While using these two strategies, Tiffany will be able to increase their planning capability. Along with that, hedging will help the company increase its value. If the value of firm increases, it will mean a reduction in expected cash flow resulting from unexpected exchange rate changes.
While viewing the history data from 1983 to 1993, it is evident that the Yen/dollar exchange rate could be pretty unstable on annual and even monthly basis; information regarding overvaluation of the yen against the dollar in not certain. Therefore, there is still some uncertainty about yen crashin. Therefore, put option for Tiffany would be more appropriate. If Yen stays strong, then Tiffany can still maintain the upside gain.
Suppose: if Tiffany has to receive 1 million in 3 months, they can buy put options to protect the dollar value of Yen receivables the possible outcomes are:
- Spot rate < Strike Price
If the spot price is greater than the strike price, Tiffany would exercise the put option and get (Strike â€“ Premium) per Yen sold.
For example: the strike price of three month put option is 93.5 for 2.06 and spot rate in the market is 90, which is lower than the strike price. It would be more appropriate for Tiffany; the option will be exercised at 93.5. Tiffany will gain after subtracting the premium price from the strike price. At 93.5 rate, Tiffany will sell 106.97 yen for 1 dollar,
The payoff of the Tiffany will be (Strike price â€“ spot price) â€“ premium
Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â (93.5-90)-2.06= 1.44 is the profit from hedging strategy
(2) Spot rate > Strike Price
Another situation can arise if the market spot price continuously increases and goes higher than the strike price. Tiffany can gain from this situation by not exercising this option. The buyer of put option can never lose more than the premium; loss under this option is limited.
For example: the strike price of three month put option is 93.5 for 2.06, and spot rate in the market is 95, which is higher than the strike price. In this situation, Tiffany will not exercise the option.
The payoff of the Tiffany will be (Strike price â€“ spot price)…………………..
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