In April 1995, Lisa Stone ended a conversation with Benjamin Bisno, the president and chief executive officer of Diva Shoes, Inc., concerning his firm's growing exchange rate exposure. Since joining the foreign exchange desk at Merrill Lynch three years ago, Stone had worked with Bisno in executing relatively simple "forex" transactions f6r the company. She provided information and advice on the firm's decision to increase purchases of materials from Italian suppliers and to expand into the Canadian and Japanese markets. Diva Shoes, a U.S.-based company, had first introduced its products in Japan in June 1993, and sales had reached an unexpectedly high level of (Japanese yen) ¥2.4 7 billion ($25 million) the following year. Although Bisno was pleased with his initial success, he questioned how long this demand-and the strong yen that had accompanied it-would last.

What are Diva’s projected profits for the fiscal year ending September 1995?

What factors affect a firm’s exposure to exchange-rate risk? How much exposure to exchange rate risk does Diva Shoes have in April 1995?

Suppose that Diva chooses to hedge its exposure in yen using the forward contract described in case Appendix A or the currency option described in case Appendix B. Assume that you lock in these contracts at the forward price implied by interest-rate parity for September 1995. Draw the payoffs to the position at maturity for each alternative with the exchange rate defined in USD/JPY × 10,000 units (i.e., the same units as the currency option is quoted). What do you see as the trade-offs between the alternatives?

Do you think Bisno should remain strictly a shoe salesman or do you favor hedging his exposure? If you favor hedging, which alternative would you recommend to him?