Hedging Practice 2 Flashcards
Assume that the current date is 31 December 20X9
Your firm advises Moon Sport Ltd and you are working on three tasks
Task 1 Foreign Exchange Rate Risk
Sport imports rock climbing equipment from the USA and uses forward contracts to hedge its foreign exchange rate (forex) risk.
The board of sport would like to investigate using money market hedges and over the counter (OTC) currency options as alternatives. Sport is due to make a payment of $1,550,000 in four months’ time on 30 April 20Y0
You have the following information available to you at the close of business on 31 December 20X9:
- Spot exchange rate ($/£): 1.3156 - 1.3160
- 4-month forward contract premium ($/£): 0.0059 - 0.0053
Annual borrowing and depositing interest rates:
Dollar 3.20% - 2.70%
Sterling 4.10% - 3.70%
4-months OTC currency options:
- Call options to buy $ have an exercise price of $/£1.3200 and a premium of £0.03 per $ converted
- Put options to sell $ have an exercise price of $/£1.3050 and a premium of £0.05 per $ converted
The option premium is payable on 31 December 20X9. Sport has an overdraft.
Calculate Sport’s sterling cost of the $1,550,000 payment using:
- A forward contract
The forward rate is: $/£ 1.3097 (1.3156 - 0.0059)
Results in a sterling payment of $1,550,000/$1.3097 = £1,183,477
Assume that the current date is 31 December 20X9
Your firm advises Moon Sport Ltd and you are working on three tasks
Task 1 Foreign Exchange Rate Risk
Sport imports rock climbing equipment from the USA and uses forward contracts to hedge its foreign exchange rate (forex) risk.
The board of sport would like to investigate using money market hedges and over the counter (OTC) currency options as alternatives. Sport is due to make a payment of $1,550,000 in four months’ time on 30 April 20Y0
You have the following information available to you at the close of business on 31 December 20X9:
- Spot exchange rate ($/£): 1.3156 - 1.3160
- 4-month forward contract premium ($/£): 0.0059 - 0.0053
Annual borrowing and depositing interest rates:
Dollar 3.20% - 2.70%
Sterling 4.10% - 3.70%
4-months OTC currency options:
- Call options to buy $ have an exercise price of $/£1.3200 and a premium of £0.03 per $ converted
- Put options to sell $ have an exercise price of $/£1.3050 and a premium of £0.05 per $ converted
The option premium is payable on 31 December 20X9. Sport has an overdraft.
Calculate Sport’s sterling cost of the $1,550,000 payment using:
- A money market hedge
Using the money markets, Moon will invest in $, buy $ at the spot rate and borrow in £.
Invest $1,550,000/ (1 + 0.027 x 4/12) = $1,536,174 = Deposit at the lower dollar rate
Buy $ spot $1,536,174/$1.3156 = £1,167,660
Borrow in £ to give total cost of £1,167,660 x (1 + 0.041 x 4/12) = £1,183,618 - Borrow at the sterling rate
Assume that the current date is 31 December 20X9
Your firm advises Moon Sport Ltd and you are working on three tasks
Task 1 Foreign Exchange Rate Risk
Sport imports rock climbing equipment from the USA and uses forward contracts to hedge its foreign exchange rate (forex) risk.
The board of sport would like to investigate using money market hedges and over the counter (OTC) currency options as alternatives. Sport is due to make a payment of $1,550,000 in four months’ time on 30 April 20Y0
You have the following information available to you at the close of business on 31 December 20X9:
- Spot exchange rate ($/£): 1.3156 - 1.3160
- 4-month forward contract premium ($/£): 0.0059 - 0.0053
Annual borrowing and depositing interest rates:
Dollar 3.20% - 2.70%
Sterling 4.10% - 3.70%
4-months OTC currency options:
- Call options to buy $ have an exercise price of $/£1.3200 and a premium of £0.03 per $ converted
- Put options to sell $ have an exercise price of $/£1.3050 and a premium of £0.05 per $ converted
The option premium is payable on 31 December 20X9. Sport has an overdraft.
Calculate Sport’s sterling cost of the $1,550,000 payment using:
- An OTC currency option
Assume that the spot rate on 30 April 20Y0 will be $/£1.3080 - 1.3090
Over the counter option. Using a call option to buy $.
Exercise price $1.3200. If spot is $1.3080 exercise the option as the exercise price is higher.
The option premium is $1,550,000 x £0.03 = £46,500
The premium with interest is £46,500 x (1 + 0.041 x 4/12) = £47,136 - Sterling borrower rate
The sterling payment will be ($1,550,000/$1.3200) + £47,136 = £1,221,378
Task 2 Bitcoin Price Risk
Sport is intending to sell one of its surplus buildings for £0.5 million in the near future and the purchaser would like to make a payment in a cryptocurrency such as Bitcoins instead of sterling.
The Sport board is worried about the volatility of the Bitcoin price between the time that the sale proceeds are received and the time that the Bitcoins are subsequently sold.
Using Bitcoin prices on 31 December 20X9 you have been asked to illustrate for the Sport board the potential losses that could occur if the value of Bitcoins decreases before they are sold for sterling:
Following info at 31 December 20X9:
Time, £ Equivalent of one Bitcoin
09:00 £2,733.29
10:00 £2,740.30
11:00 £2,698.44
a) Calculate the gains or losses if the purchaser had paid in Bitcoins at 09:00 on 31 December 20X9 and those Bitcoins had then been sold for sterling at either 10 or 11
b) Advise Sport on whether to accept the payment for the building in sterling or Bitcoins
a) 09.00 The receipt in Bitcoin will be = B182.93
500,000/2,733.29
10.00 Sale proceeds = £501,283 (182.93 x 2,740.30). A gain of £1,283
11.00 Sale proceeds = £493,625.63 (182.93 x 2,698.44). A loss of £6,374
b) It can bee seen from the calculations in (a) above that in a matter of only two hours the volatility of the price of Bitcoins is high moving from either a gain of £1,283 to a loss of £6,374
Unless Moon can hedge the risk of the Bitcoin price moving against it, it is not recommended that the company accepts payment in Bitcoins. Attitude to risk can also be mentioned.
Task 3: Interest Rate Risk
Sport is buying new factory premises and arranged to borrow £1,240,000 on 31 March 20Y0. The loan will be for an 18-month period at an interest rate of SONIA + 4% pa. The Sport board is concerned about potential increases in SONIA over the next three months, to 1 March 20Y0, from its current level of 0.90% oa.
You have the following information available to you on 31 December 20X9:
- Traded sterling interest rate futures: March three-month futures price = 98.80
- Standard contract size = £500,000
a) Calculate the interest cost of Sport borrowing £1,240,000 for 18 months if it does not hedge its interest rate risk and SONIA remains at 0.90% pa
If SONIA remains at 0.9% Moon will pay 4.9% interest, which is a total cost of:
£91,140 (1,240,000 x 0.049 x 18/12)
Task 3: Interest Rate Risk
Sport is buying new factory premises and arranged to borrow £1,240,000 on 31 March 20Y0. The loan will be for an 18-month period at an interest rate of SONIA + 4% pa. The Sport board is concerned about potential increases in SONIA over the next three months, to 1 March 20Y0, from its current level of 0.90% oa.
You have the following information available to you on 31 December 20X9:
- Traded sterling interest rate futures: March three-month futures price = 98.80
- Standard contract size = £500,000
b) Calculate the interest cost of Sport borrowing £1,240,000 for 18 months if it uses traded sterling interest rate futures to hedge its interest rate risk, if by 31 March 20Y0
- SONIA increases to 1.50% pa and the futures price moves to 98.30
Using interest rate futures to hedge Moon will SELL March futures at 98.80
The number of contracts = 14.88 (1,240,000/500,000 x 18/3) Round to 15 contracts.
SONIA: 1.5%
SONIA + 4% = 5.5%
Futures sold at: 98.80
Futures bought at: 98.30
—-
Gain = 00.50
Futures total position =
15 x £500,000 x 3/12 = £1,875,000
Gain £1,875,000 x 0.5% = £9,375
Interest cost: £1,240,000 x 5.5% x 18/12 = £102,300
Total cost: 102,300 - 9,375 = £92,925
Task 3: Interest Rate Risk
Sport is buying new factory premises and arranged to borrow £1,240,000 on 31 March 20Y0. The loan will be for an 18-month period at an interest rate of SONIA + 4% pa. The Sport board is concerned about potential increases in SONIA over the next three months, to 1 March 20Y0, from its current level of 0.90% oa.
You have the following information available to you on 31 December 20X9:
- Traded sterling interest rate futures: March three-month futures price = 98.80
- Standard contract size = £500,000
b) Calculate the interest cost of Sport borrowing £1,240,000 for 18 months if it uses traded sterling interest rate futures to hedge its interest rate risk, if by 31 March 20Y0
- SONIA decreases to 0.75% pa and the futures price moves to 99.00
Using interest rate futures to hedge Moon will SELL March futures at 98.80
The number of contracts = 14.88 (1,240,000/500,000 x 18/3) Round to 15 contracts.
SONIA: 0.75%
SONIA + 4% = 4.75%
Futures sold at: 98.80
Futures bought at: 99.00
—-
Loss = (00.20)
Futures total position =
15 x £500,000 x 3/12 = £1,875,000
Loss £1,875,000 x 0.2% = £3,750
Interest cost: £1,240,000 x 4.75% x 18/12 = £88,350
Total cost: 88,350 + 3,750 = £92,100
Explain why the interest rate risk of Sport borrowing the £1,240,000 is not perfectly hedged by the futures contracts?
- The number of contracts: Because the contracts are a standard size it is not possible to hedge a perfect amount and the number of contracts will have to be rounded
- Basis risk - The price of futures will normally be different from the spot price on any given date. This difference is called the basis. The effect of basis is to prevent hedges from being 100% efficient.
Task One: Hedging foreign exchange rate risk for receipts from foreign investors
Jewel is due to receive an investment of $8 million from a client in the USA on 31 March 20X8. It was agreed with the client that Jewel would hedge the foreign exchange rate risk associated with the $ receipt and invest the sterling equivalent of the $8 million on behalf of the client.
You have the following information available to you on 30 November 20X7:
Exchange rates:
Spot rate ($/£) 1.2490 - 1.2492
Four-month forward contract discount ($/£) 0.0031 - 0.0034
Calculate the amount of sterling to be invested on behalf of the US client using:
- A forward contract
$8,000,000 / (1.2492 + 0.0034) = £6,386,716
Add a discount
Task One: Hedging foreign exchange rate risk for receipts from foreign investors
Jewel is due to receive an investment of $8 million from a client in the USA on 31 March 20X8. It was agreed with the client that Jewel would hedge the foreign exchange rate risk associated with the $ receipt and invest the sterling equivalent of the $8 million on behalf of the client.
You have the following information available to you on 30 November 20X7:
Exchange rates:
Spot rate ($/£) 1.2490 - 1.2492
Four-month forward contract discount ($/£) 0.0031 - 0.0034
Over-the-counter (OTC) currency option:
A put option to sell $ is available with an exercise price of $1.2400. The premium is £0.02 per $ and is payable on 30 November 20X7.
Jewel has funds on deposit which earns interest of 3% pa.
Assume that the spot price on 31 March 20X8 is $/£1.2697 - 1.2700
Calculate the amount of sterling to be invested on behalf of the US client using:
- An OTC currency option
The option premium is $8,000,000 x 2p = £160,000
The premium with interest lost is £160,000 x (1 + 0.03 x 4/12) = £161,600
If the spot price on 31 march is $/£1.2700, Orion will exercise the options as this is higher than the exercise price
The sterling receipt will be ($8,000,000/$1.2400) - £161,600 = £6,290,013
Outline whether currency futures would have been more advantageous than using a forward contract to hedge the foreign exchange rate risk associated with the $8 million receipt
Futures are possibly not appropriate, since they have the following disadvantages:
- Not tailored, so it is necessary to round the number of contracts
- Basis risk exists
- Require a margin to be deposited at the exchange
- A need for liquidity if margin calls are made
However, there is a secondary market and if the client decides not to invest it would be possible to close out the position, which could result in a gain or loss on the futures trade.
task 2: One of Jewel’s investments is a portfolio of UK FTSE 100 shares, which is worth £100 million on 30 November 20X7. The finance director of Jewel is concerned about a potential fall in value of the portfolio over the next four months.
You have the following information available to you on 30 November 20X7:
- The FTSE 100 index is 7,261
- The price for a March 20X8 FTSE 100 index future is 7,195
- the face value of a FTSE 100 index futures contract is £10 per index point
a) Calculate the outcome of hedging Jewel’s £100 million portfolio using March 20X8 FTSE 100 index futures. Assume that on 31 March 20X8 both the FTSE 100 index and the FTSE 100 index futures price are 7,010 and that the portfolio value changes exactly in line with the change in the FTSE 100 index
b) Explain why the hedge above will not be 100% efficient
Value of portfolio: £100m
Index futures price: 7,195
Value: £10 x 7,195 = 71,950
100m/71,950 = 1,389.85 contracts, 1,390 contracts rounded.
On 31 March the portfolio value will fall to:
£100,000,000 x (7,010/7,261) = £96,543,176, representing a fall of £3,456,824
Since there is a loss on the portfolio, there will be a gain on the futures contracts.
The futures position will be closed out and the gain will be =
(7,195 - 7,010) x £10 x 1,390 = £2,571,500
The hedge is not 100% efficient due to:
- Basis risk, the futures price at 30 november is not the same as the FTSE 100.
- The rounding of the number of contracts.
Jewel recently bought new premises and borrowed £50 million for a period of 10 years. The loan is at a floating rate of SONIA + 4% pa. SONIA is currently 0.36% pa. The finance director of Jewel believes that interest rates are going to rise and he would like to protect the company against interest rate risk.
The finance director of Jewel identified Nevis plc (Nevis), which is a company that would like to swap £50 million of its 5% pa fixed rate loans to a floating rate. Jewel and Nevis agreed to enter into an interest rate swap with any benefits from the swap being shared equally between the two companies. Jewel can borrow at a fixed rate of 6.5% pa and Nevis can borrow at a floating rate of SONIA + 3.5% pa.
a) Demonstrate how the interest rate swap between Jewel and Nevis would be implemented, with the floating rate leg of the swap set at SONIA.
b) Calculate the:
- Initial difference in annual interest rates for Jewel if it enters into the interest rate swap with Nevis
- The amount to which SONIA would have to rise for the cost of Jewel’s floating rate borrowing to equal the fixed rate achieved through the interest rate swap
First it is necessary to calculate the interest rate differentials:
Fixed rates:
Jewel: 6.5%
Nevis: 5.0%
Differentials: 1.5%
Floating rates:
Jewel: SONIA + 4%
Nevis: SONIA + 3.5%
Differentials: 0.5%
—
Net differential: 1.0%
This net differential will be shared 0.50% each
The interest rates that can be achieved through the swap are:
Fixed market rate:
Jewel: 6.5%
Nevis: —
Floating Market Rate:
Jewel: —
Nevis: SONIA + 3.5%
Less the differential:
Jewel: (0.50%)
Nevis: (0.50%)
—
Rates achieved through swap:
Jewel: 6.5% - 0.5% = 6.0%
Nevis: SONIA + 3.5% - 0.50% = SONIA + 3.0%
Cash flows would typically be: SONIA from Nevis to Jewel and fixed of 2.0% from Jewel to Nevis
b) Jewel is paying 4.36% (0.36 + 4) on its floating rate borrowings, and would be paying a fixed rate of 6% through the swap. The initial difference in interest rates is 1.64% (6.00 - 4.36)
For the floating rate to equal the fixed rate of 6% achieved through the swap, SONIA would have to rise to 2% (1.64 + 0.36)
Identify four advantages for Jewel of entering into an interest rate swap with Nevis
- The arrangement costs are significantly less than terminating an existing loan and taking out a new one
- Interest rate savings are possible, either out of the counterparty or out of the loan markets by using the principle of comparative advantage
- They are available for longer periods than the short-term methods of hedging such as FRAs, futures and options
- They are flexible since they can be arranged for tailor-made amounts and periods. They are also reversible
- It is possible to obtain the type of interest rate, fixed or floating, that the company wants
- Swapping to a fixed interest rate assists in Jewel’s cash flow planning
Lake is fully aware of its exposure to foreign exchange rate risk (forex risk) and the need to hedge it. However, Lake is concerned that there may be other overseas trading risks that it should be protecting itself against..
Following information available at the close of business 30 June 20X7:
Lake is due to receive payments from its US customers in three months’ time totalling $1,300,000. Lake currently has an overdraft.
Spot rate ($/£): 1.3086-1.3092
Three-month forward contract discount ($/£) - 0.0014 - 0.0018
September currency futures price (standard contract size £62,500): $1.3105/£
Annual borrowing and depositing interest rates:
Sterling: 3.20% - 3.10%
Dollar: 3.70% - 3.60%
Three-month over-the-counter currency options:
Call options to buy £ have an exercise price of $/£1.3200 and premium of £0.02 per $ converted
Put options to sell £ have an exercise price of $/£1.3100 and a premium of £0.03 per $ converted
Assuming that the spot exchange rate on 30 September 20X7 will be $/£1.3210 - 1.3250 and that the sterling currency futures price will be $1.3230/£, calculate Lake’s sterling receipt if it uses the following to hedge its forex risk:
- A forward contract
1,300,000 / (1.3092 + 0.0018) = 991,609 (£1,300,0,00/$1.3110)
The sterling receipt will be £991,609
