Application How Cadbury Schweppes Uses Currency Options 
Cadbury Schweppes, the British candy manufacturer, uses currency options to hedge uncertain payables. The price of its key product input, cocoa, is quoted in sterling but is really a dollar-based product. That is, as the value of the dollar changes, the sterling price of cocoa changes as well. The objective of the company’s foreign exchange strategy is to eliminate the currency element in the decision to purchase the commodity, thus leaving the company’s buyers able to concentrate on fundamentals. However, this task is complicated by the fact that the company’s projections of its future purchases are highly uncertain.
As a result, Cadbury Schweppes has turned to currency options. After netting its total exposure, the company covers with forward contracts a base number of exposed, known payables. It covers the remaining—uncertain—portion with options. The options act as an insurance policy.
A company could use currency options to hedge its exposure in lieu of forward contracts. However, each type of hedging instrument is more advantageous in some situations, and it makes sense to match the instrument to the specific situation. The three general rules to follow when choosing between currency options and forward contracts for hedging purposes are summarized as follows:
1. When the quantity of a foreign currency cash outflow is known, buy the currency forward; when the quantity is unknown, buy a call option on the currency
2. When the quantity of a foreign currency cash inflow is known, sell the currency forward; when the quantity is unknown, buy a put option on the currency.
3. When the quantity of a foreign currency cash flow is partially known and partially uncertain, use a forward contract to hedge the known portion and an option to hedge the maximum value of the uncertain remainder.9
These rules presume that the financial manager’s objective is to reduce risk and not to speculate on the direction or volatility of future currency movements. They also presume that both forward and options contracts are fairly priced. In an efficient market, the expected value or cost of either of these contracts should be zero. Any other result would introduce the possibility of arbitrage profits. The presence of such profits would attract arbitrageurs as surely as bees are attracted to honey. Their subsequent attempts to profit from inappropriate prices would return these prices to their equilibrium values.
Mini-Case Help DKNY Cover Up Its Mexican Peso Transaction Exposure
DKNY, the apparel design firm, owes Mex$7 million in 30 days for a recent shipment of textiles from Mexico. DKNY’s treasurer is considering hedging the company’s peso exposure on this shipment and is looking for some help in figuring out what her different hedging options might cost and which option is preferable. You call up your favorite foreign exchange trader and receive the following interest rate and exchange rate quotes:
Spot rate:
Mex$13.0/$
Forward rate (30 days):
Mex$13.1/$
30-day put option on dollars at Mex$12.9/$:
1% premium
30-day call option on dollars at Mex$13.1/$:
3% premium
U.S. dollar 30-day interest rate (annualized):
7.5%
Peso 30-day interest rate (annualized):
15%