3. You are buying a boat from a company that builds custom boats. You would like

Question

3. You are buying a boat from a company that builds custom boats. You would like a boat priced at $60,000 for delivery June 15, 2018. As the company you are buying from operates from an offshore island location, they prefer all payments be in Bitcoin. You negotiate a deal with the company to buy the boat for $6,000 in cash today as a down payment and a payment of 5 Bitcoins in June 2018 when the boat is delivered.

(a) Explain the currency risk you are taking with this contract

(b) Describe (in general) of hedging the risk in the transaction above using (i) a forward contract and (ii) an alternative method of hedging. (Note you can assume standard derivative contracts are available).

(c) Describe (in general) 2 ways the seller of the boat can hedge the above contract

(d) Draw a diagram showing the hedge in part (b) using a forward contract. Your diagram should show the range of payoffs from the unhedged position, the hedge instrument and the net position

Explanation / Answer

Total Payables in June, 2018 = $ 60000 and Down Payment = $ 6000. Therefore, Payment Due = Total Payables - Down Payment = 60000 - 6000 = $ 54000

(a) As the remaining due payment is intended to be covered through 5 Bitcoins, the price of each bitcoin in June, 2018 should be Payment Due / 5 = $10800

If the price of bitcoins go above $10800, then you would be at loss because you will have to purchase the bitcoins at market price which would be more than the per bitcoin obligation being paid off using them.

(b)

(i) The boat buyer can purchase 5 forward contracts (one for each bitcoin) each at a forward price of $10800. This would ensure that the buyer can purchase the 5 bitcoins for $54000 which is exactly equal to the obligation(amount due) to be paid off.

(ii) Alternative hedging method would involve purchasing 5 call options on 5 bitcoins with a strike price of $10800 per option. This would imply that in June, 2018 the buyer would exercise the call options to purchase 5 bitcois at a total price of $54000 which again is equal to the obligation that needs to be paid off through bitcoins. However, if the market price of bitcoins is less than $10800 then the buyer will not exercise the call option and instead purchase 5 bitcoins at lower market prices, thereby making a profit (If market price of bitcoins is less than $10800, then the buyer purchases 5 bitcoins at an amount less than $54000 and yet uses these 5 bitcoins to pay off an obligation worth $54000).

(c) The boat seller is expecting to be paid the remaining amount through bitcoins each of which should be worth $10800 ( as the total amount due is $54000 and that due is being paid through 5 Bitcoins). However, if the prices of bitcoins fall the seller incurs a loss because even though he accepted 5 bitcoins in lieu of $54000 in cash, the actual market price of the 5 bitcoins possessed by the seller is less than $54000.
The seller can hedge against this risk by selling 5 forward contracts (one for each bitcoin) each with a forward price $10800, thereby ensuring an effective rate of $10800 per bitcoin. The seller can also buy 5 put options on the Bitcoins with strike price of $10800 per option thereby ensuring a price of $10800 per bitcoin.

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