There was a further explanation for this phenomenon: the European currencies, most notably the British Pound and the Italian Lira, suffered strong devaluations in a short period of time and the investors began to turn to U.S. dollar stability for help. As such, demand subsequently grew for the dollar and its rate rose as to the German Mark.
The put option that Stephanie had bought was an excellent hedging mechanism against a bearish market, as she had expected it to be and as it had manifested itself in the period between July and September. If the dollar began a period of appreciation against the Deutsche Mark, then the put hedging mechanism was no longer necessary, as the market would be bullish. The events in September all pointed out towards this. The lowering interest rates in the German space, corroborated with the tendency of growing demand for the U.S. dollar turned investors towards the dollar and a higher DM/$ exchange rate.
3. Exhibit 4 is relevant in referring to the way the put option price varied between August 17th and September 18th. As such, from an initial premium of 1.40 cents per DM, the price of the put option quickly grew between September 10th and September 18th from 0.5 cents for a DM to almost 2.0 cents per DM, which represented a 75% increase in only one week.
As we can see from the same chart, the trend of the put option premium followed that of the underlying asset, the DM/$ exchange rate. Indeed, the dollar began its appreciation against the Deutsche Mark on September 8th, at 1.39 DM/$, peaked at 1.51 on September 15th and ended on September 18th at...
The put option premium similarly peaked at 2.5 on September 15th, decreased the subsequent two days, only to rise again on September 18th. The volatility of the put option is thus strongly correlated to the volatility of the underlying asset, the DM/$ exchange rate.
4. The Vice President for Treasury at Zapa can evaluate, in my opinion, most effectively Stephanie's hedging effectiveness by comparing the results in Stephanie's case with two different alternatives. First of all, no hedging over the respective period of time and, second of all, a different hedging mechanisms, namely a forward contract.
The forward contract would be simply evaluated by calculating the amount of U.S. dollars the 7,600,000 DM would make following the 120-day forward rate of DM 1.4957 $, that is 5,081,232 USD. On the other hand, changing the dollar at the September 18th rate, at DM 1.50 $ would mean that the Deutsche Marks were the equivalent of $5,066,666. The forward contract would have been more profitable, but the rationality in Stephanie's decision was obvious: evaluating a decreasing trend for the U.S. dollar, there was no logical argument for a higher forward rate.
The put option alternative needs to be compared by including the profit that Stephanie can make by exercising her put option on September 18th. Stephanie loses from the exchange rate, which now trades at 1.50 DM/$, but she wins $41,800 by exercising the put option, which makes an overall profit of $27,234. In my opinion, the Vice President should use to benchmarks for evaluation: first of all, hedging efficiency and,…
