Advance Technologies Harvard Case Solution & Analysis

1.                  COLLAR STRATEGY

A.    AT-THE-MONEY COLLAR

At the money collar hedge will enable Advance Industries would effectively lock its foreign exchange rate at a strike price of 1.2536 and this exchange rate is also the current spot foreign exchange rate. With the help of at the money collar hedge if the exchange rate of CAD/USD raises then the call option would become in the money, which means that Advance would exercise the call option, meanwhile, of put option it would let it lapse.

Further, if the if the exchange rate drops below the strike price of 1.2536 then, however, the put option would become in the money and would benefit Advance, hence, Advance would exercise this put option and would let the call option expire because it would not worthwhile for Advance to exercise this option.

Advantages:

Use of collar hedge would require an upfront premium to be paid, but this premium would be lower than the premium of a call option of the put option. This strategy would require a total premium of 0.126% in comparison to a premium of 2.034% in the case of call option and 1.908% in the case of a put option. Hence, an overall premium would be C$64, 000 in comparison to C$1,035,000 in case of the call option.

Disadvantages:

However the use of collar hedge would fix the foreign exchange rate at 1.2536 for Advance and this fixation of rate would make this strategy similar to a forward rate contract. Meanwhile, the use of call option instead of collar would have given the right to enjoy unlimited upside effects which would limited in case of a collar hedge. Additionally, an if Advance opts to write a put option, it would be required to maintain a safety margin of 4% of the contract price which would be equal to C$2, 065,000 (C$51, 637,000 x 4%).

B.     ZERO-COST COLLAR

This hedging strategy is a kind of breakeven streak from hedging instruments because the strike price under this strategy would the one which would almost equal the premium payable on for this strategy. Hence, this hedging strategy would not require any premium to be paid in advance, meanwhile, this hedging strategy would effectively Locke the foreign exchange at the agreed rate.

Under this strategy if the exchange rate of CAD/USD rises above the upper limit as set out in the strategy, then the call option would become in the money for Advance and Advance would exercise the option in order to protect its position. Meanwhile, if CAD/USD exchange rate falls below the prescribed exchange rate than the put option would become in the money and Advance would have to compensate the losses incur by the holder of the put option.

Advantages:

The main advantage of this strategy is that it does not require any upfront premium.

Disadvantages:

Under this strategy Advance will only be able to enjoy the price fluctuation between the call option and put option price, hence the potential gains would be limited, however, in case of a call option Advance would have enjoyed the unlimited upside favorable movements in foreign exchange rates. Additionally, this strategy would require a security margin of C$2, 036,000 (C$50, 894,000 x 4%).

EXCHANGE RATE VOLATILITY:

To calculate the best estimates of exchange rates volatility there are three approaches that can be used for it such as:

1.      Random Walk:

In the random walk of exchange rates the volatility would fluctuate with respect to the time and these fluctuations would result in negative or positive cash flows. If random walk is lower than the current spot rate of exchange than there would be a negative result of cash flow lowering the intrinsic value of the investments.

2.      Stochastic Process:

Stochastic process means assigning the weights to exchange rates that these rates would change within these limits and in advance technologies case the volatility or exchange rates is around 3.03% for all the months.

3.      Implied Volatility:

Implied volatility of exchange rates means that, Advance Technology have to transfer its value more than its investment’s intrinsic values.

ALTERNATIVE DERIVATIVES STRATEGIES

Other than the hedging strategies discussed above, Advance Industries also have other alternative strategies that could be used to hedge its position...............................

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