Ge Toys
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Executive Summary
For many years, Great Eastern Toys has not hedged its transactions and has been very lucky that there were no detrimental changes exchange rates. But now, due to the currency crisis in East Asia, the firm is reconsidering its strategy. The firm is currently deciding between the use of forward contracts, money market hedges, and options.
Each choice has certain advantages and disadvantages. Forward contracts protect against downside risk at no financial cost but also prevent the firm from being able to take advantage of upswings in exchange rates. By using the money market, the firm can avoid exchange rate risk, but still face interest risk. A great benefit to the money market hedge is that it allows the firm to pay off it outstanding loans. Options allow a firm to benefit from upswing potential and protect against downside risk. However, there are required upfront premium payments.
Based on our firm’s analysis in the choice between forward contracts and options, we believe that GE Toys should heavily consider using a combination of forward contracts and options. Although there is an upfront premium to pay, options allow the firm to benefit from a deprecation in HK$ while also allowing the firm to earn a profit if the currency appreciates. We believe that an option is a good choice because the HK$ is most likely to depreciate. However, now that the firm’s working capital has been cut in half, the firm has money constrains and the use of forwards could help to reduce the firm’s costs. A combination of forwards and options allows the firm to minimize costs while profiting from up and down swings in the exchange rate.
In the choice between the use of the money market hedge and forward contracts, we believe the money market to be the best choice for GE Toys. Forward contracts protect against downside risk but have the potential for unlimited losses. And, they do not let the firm benefit from currency appreciation. Although the money market hedge