Arbitrage - forwards, futures and options contracts as tools for risk management

Question 1

Suppose it is September and your company has just agreed to make a sale of machines to a Japanese customer in December. Further:

–The sale price is 80 million Japanese Yen payable at the end of the December, with the cost of making and marketing the product equal to 750,000 Australian dollars;
–The forward exchange rate for December is 80 (meaning that you can enter into a contract to receive 1 Australian Dollar for each 80 Japanese Yen in December); and,
Based on the forward rate of 80, the sale is worth

Answer 1

–worth 80 million Yen / 80 = 1 million Australian dollars giving a profit of 250,000 Australian dollars.

Question 2

. Suppose it is September and your company has just agreed to make a sale of machines to a Japanese customer in December. Further:

–The sale price is 80 million Japanese Yen payable at the end of the December, with the cost of making and marketing the product equal to 750,000 Australian dollars;
–The forward exchange rate for December is 80 (meaning that you can enter into a contract to receive 1 Australian Dollar for each 80 Japanese Yen in December); and,
–Based on the forward rate of 80, the sale is worth 80 million Yen / 80 = 1 million Australian dollars giving a profit of 250,000 Australian dollars.

However, if by December the exchange rate has moved to 160 (meaning one Australian dollar is worth 160 Japanese Yen), and you did not lock in the forward rate of 80 in September, the 80 million Yen we receive

Answer 2

will be worth 80 million / 160 = 500,000 Australian dollars. Since the cost of making and selling the product is 750,000 Australian dollars, the company will make a loss of 250,000 Australian dollars.

Question 3

company’s profit or loss depends upon:

Answer 3

–It’s core business (making and marketing its products); and
It’s foreign exchange speculation business

Question 4

What is Risk Management?

Most companies are good at their

Answer 4

Most companies are good at their core business but no good at all at secondary business such as foreign exchange speculation:

Question 5

Risk management is a way of

Answer 5

minimising exposure to non-core activities such as price fluctuations, foreign exchange fluctuations and interest rate fluctuation

–A company engaged in an appropriate risk management program can be assured that a profitable transaction will not be made unprofitable solely by the above fluctuations.
–Essentially, they will hedge away their exposure to these risks

Question 6

Price Risk

Hedging with Forwards / Futures:

Note that:

–You are a fund manager holding a portfolio that mimics the ASX 200 index;
–The ASX 200 Index started the year at 4,000 and is currently at 4,800;
–The manager’s fund was valued at $80 million at the beginning of the year; and,
–Since the fund has already generated a handsome return for the year, the manager wishes to lock in a value for the portfolio today.

First, say the December SPI futures price is currently 5,000.

Answer 6

–At the December futures price of 5,000, the return on the index, since the beginning of the year, is 5,000/4,000 – 1 = 25%.
–If the manager is able to lock in this return on the fund, the value of the fund will be 1.25 * $80 million = $100 million.
–Since the notional amount underlying a SPI futures contract is $25 * 5,000 = $125,000, the manager can lock in the 25% return by selling December SPI futures contracts.

Question 7

–At the December futures price of 5,000, the return on the index, since the beginning of the year, is 5,000/4,000 – 1 = 25%.
–If the manager is able to lock in this return on the fund, the value of the fund will be 1.25 * $80 million = $100 million.
Since the notional amount underlying a SPI futures contract is $25 * 5,000 = $125,000, the manager can lock in the 25% return by selling December SPI futures contracts

what is the number of contracts to sell given by?

Answer 7

Question 8

while forwards and futures allow hedgers to effectively obtain insurance

Answer 8

the cost of this insurance is they give up the potential for any upside gain

Question 9

Price risk

Options allow hedgers to

Answer 9

retain the potential for any upside gain

• By taking a long position in either a call or put option (the only position someone wanting to hedge would ever take) hedgers have the choice as to whether or not to trade the asset underlying the contract at the pre-arranged exercise price; but,
  –In order to have this choice, the long position must pay an option premium to the writer at the time of entering into the contract. Therefore, the cost of the insurance offered by an option is the option premium.
• This premium is a function of the type of option, its time to maturity, the spot price of the underlying asset, the volatility of the asset’s spot price, the strike price of the option and the prevailing risk-free interest rate.

Question 10

options can

Answer 10

eliminate downside risk without removing the potential for upside gain

Question 11

With option contracts, there are a whole range of values that could be locked in, corresponding to the various exercise prices. As noted previously, the only difference will be the cost of this ‘insurance

For example, while it is obviously more favourable to lock in a lower bound of 5,000 than 4,800

Answer 11

, the cost of doing this will be greater

Question 12

The contract that we will use to lock in a lower bound for the portfolio value is a

Answer 12

a put option on the SPI futures contract.

Question 13

The contract that we will use to lock in a lower bound for the portfolio value is a put option on the SPI futures contract. These securities are known

Answer 13

as index futures options and are identical to regular options except the underlying asset is a futures contract rather than a stock

However, this will make no difference to us at maturity (when we have to decide whether or not to exercise) because the futures price and the value of the underlying index should be identical at maturity

Question 14

the put gives the manager

Answer 14

the right to sell the index at 5,000 when it is currently at 3,800

Question 15

benefit of the option hedge

Answer 15

option hedge has placed a floor of $100 million on the value of the fund without sacrificing any upside potential (if the market should happen to rise above its current 25% return for the year so far)

Question 16

disadvantage of option hedge

Answer 16

this insurance comes at a cost, namely the option premium

Question 17

Foreign exchange risk

You are worried that the Japanese Yen will move between now and the end of the year, turning an otherwise ______. But, _____

Answer 17

You are worried that the Japanese Yen will move between now and the end of the year, turning an otherwise profitable transaction into a loss-making deal. But, this risk can be hedged

Question 18

To hedge the foreign exchange rate risk

Answer 18

you should enter into a forward contract now to sell the 80 million Yen in December at 80. This will ensure that you receive 1 million Australian dollars in exchange for the Japanese Yen.

Question 19

what if the company only wanted to rule out any adverse movements in the exchange rate and capture any favourable movements

Answer 19

They can do this using currency options, assuming they are prepared to pay a premium up front.

Question 20

how do you use an option contract to hedge foreign exchange risk

Answer 20

you could enter into a contract that gives you the right (but not the obligation) to sell the Japanese Yen at 80. You could do this by purchasing a put option on the Japanese Yen with an exercise price of 80.

Question 21

benefit of hedging foreign exchange risk with options

Answer 21

option hedge has placed a floor of $1 million on the proceeds of the sale without sacrificing any upside potential

Question 22

disadvantage of hedging foreign exchange risk with options

Answer 22

hedging using forwards was essentially costless, buying put options is costly as the company must pay an option premium.

Question 23

why may firms hedge against interest rate risk?

Answer 23

A firm may borrow funds at a time when interest rates are relatively low. If, however, interest rates increase over the course of the loan this results in higher interest costs and hence lower profits for the firm.

Question 24

how can a firm protect itself from increases in the interest rate using the BAB futures contract

Answer 24

–If interest rates rise, your company loses by paying higher interest charges on the loan, but your company gains by profiting on the futures position;
–If interest rates fall, your company gains by paying lower interest charges on the loan, but your company loses on the futures position; and,
Ideally, the loss and the gain would exactly cancel, whether interest rates rise or fall

Question 25

Hedging with Options:

why may a firm use it?

Answer 25

protect itself against adverse movements in interest rates and to benefit from favourable movements via interest rate options.

Question 26

primary instruments in Australia are options on the BAB futures contract, which are known as

Answer 26

BAB futures options. A call on a BAB futures contract gives the holder the right, but not the obligation, to buy a BAB futures contract at any time prior to the maturity date of the call.

Question 27

Interest rate risk

for a December call option on a December BAB futures contract

Answer 27

both the call and the futures mature at the same time. Also, recall that the futures price converges to the price of the underlying commodity at maturity