FINANCIAL MANAGEMENT – Page 4

FM – L2 – Q101 – Hedging with options

Calculate min net interest rate cost for a company borrowing $5m using options with a strike price of 94.50.

Question

It is May and a company intends to borrow $5m for 3 months commencing in September. Options are available on 3 month Canadian interest rate futures with a strike price of 94.50 and are quoted as follows:

Expiry month	Calls	Puts
June	0.10	0.31
September	0.46	0.67
December	0.63	0.84

The contract size of the 3-month Canadian interest rate future is $1 million.
Required
Calculate the minimum net interest rate cost for the company if it hedges using options with a strike price of 94.50.

Answer

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Tags: Borrowing, Currency Risk, Effective interest rate, Financial Risk Management, Futures, Hedging, Interest rate options, Options pricing, SOFRA, Treasury management
Level: Level 2

Topic: Hedging with options

FM – L2 – Q100 – Hedging with futures, Hedging with options

Firestone Ltd plans to borrow $5M and hedge interest rate risk using futures and options, calculating effective borrowing rates.

Question

Firestone Ltd, a Nigerian company, needs to borrow in US dollars to fund its US operations, but the chief financial officer is concerned that interest rates may be volatile given the current US political and economic environment.
It is now March and Firestone intends to borrow $5 million for a period of three months commencing in September.
Futures and options quotes for 3-month US secured overnight financing rate (SOFRA) are given below. Assume that Firestone can borrow at the three-month SOFRA rate.

3 month SOFRA futures price – contract size = $1,000,000

June	September
93.55	93.28

Traded options on 3-month SOFRA futures – contract size = $1,000,000 (premiums quoted are annual rates)

Strike	June (Calls)	September (Calls)	June (Puts)	September (Puts)
93.25	0.437	0.543	0.083	0.187
93.50	0.276	0.387	0.168	0.282
93.75	0.163	0.263	0.302	0.407

Required:
a) Discuss the relevant considerations to be considered when deciding between futures and options to hedge the company’s interest rate risk. (5 marks)
b) Assume that in September 3 month SOFRA is 7% and at that point in time September futures are quoted at 93.96.

Calculate the effective borrowing rate using a futures hedge
Calculate the effective borrowing rate when hedging with options using each of the three available strike prices

Answer

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Tags: Borrowing, Currency Risk, Effective borrowing rate, Financial Risk Management, Futures, Hedging Strategies, Interest rate hedging, Options, SOFRA, Treasury management
Level: Level 2

Topic: Futures and hedging with futures

FM – L2 – Q99 – Hedging with futures

Recommend futures/options to hedge interest rate risk for a company's loan, tender bid, and deposit scenarios.

Question

Three-month euro interest rate futures are available on a derivative exchange. Available delivery months for the future are March, June, September, and December, and the contract size for the future is €1,000,000.

Provide a justified recommendation for the most appropriate futures or options transaction in order to hedge interest rate risk in the following situations:

a) A company, Starlight Ltd, is taking out a loan of €3 million for 6 months from June to fund working capital for a new venture.

b) A company, BrightFuture Ltd, has tendered for a large government project. If it is the successful bidder, it will need to borrow €12 million for three months starting in September to cover initial costs.

c) It is June, a company, Horizon Enterprises, has €7 million on deposit with a bank for one year at 3-month money market rates. The company has become concerned about the possibility that money market interest rates may fall dramatically.

Answer

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Tags: Currency Risk, Derivative exchange, Euro interest rates, Financial Risk Management, Futures, Hedging Strategies, Interest rate hedging, Options, Risk Mitigation, Treasury management
Level: Level 2

Topic: Futures and hedging with futures

FM – L2 – Q98 – Foreign exchange risk and currency risk management

Accra Food and Beverage Co hedges USD189,000 net liability using forward and money market methods.

Question

Accra Food and Beverage Co has recently imported raw materials from Japan with an invoice value of US$264,000 payable in three months’ time. Due to the company’s efficient production capacity, it has finished products and exported finished products to France. Consequent to this, the French customer has been invoiced for US$75,000 payable in three months’ time. Below is the current spot and forward rates for the transactions:

USD/GHS	Spot	3 Months Forward
	0.9850-0.9870	0.9545-0.9570

Current money market rates per annum are as follows:

Currency	Borrowing	Deposits
US$ (USD)	11% – 13.2%	2.7%
GH₵ (GHS)	12.7% – 14.3%	Not provided

Required:
Demonstrate with relevant calculations how Accra Food and Beverage Co can hedge its exposure to foreign exchange risk using:
(a) The forward markets
(b) The money market

Answer

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Tags: Currency hedging, Foreign Exchange Risk, Forward Markets, Forward Rates, Interest rates, Money Markets, Net Exposure, Spot Rates, Transaction risk, USD/GHS
Level: Level 2

Topic: Foreign exchange risk and currency risk management

FM – L2 – Q97 – Hedging with options

UK company hedges $2M USD receipt using currency options, calculates outcome at expiry with given spot rate.

Question

A UK company, PrimeCare Plc, will receive US$2 million in six months’ time. It is now 20th March. The company is not sure whether the US dollar will rise or fall in value against sterling over the next few months, and it has decided to hedge its exposure to currency risk using traded currency options.
On the London Stock Exchange, traded currency options are available in a contract size of £31,250. Options are priced in cents per £1. Assume that option contracts expire on 20th of each month.
The following option prices are currently available:

Exercise price	Calls	Puts
	June	September	June	September
1.8500	1.4	1.9	4.0	5.1

The current spot exchange rate (US$/£1) is 1.8325–1.8375.

Required
(a) Explain how the company’s currency exposure could be hedged using traded currency options.
(b) Show what would happen if the options are still held by the company at expiry and the spot exchange rate is $1.9150–1.9200.

Answer

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Tags: Currency Options, Exchange Rates, Financial Risk Management, Foreign Exchange Risk, Hedging, Sterling, Traded options, US Dollar
Level: Level 2

Topic: Hedging with options

L2 – Q96 – Futures and hedging with futures

US company hedges £400,000 sterling receipt using currency futures, calculating effective exchange rate.

Question

MORE CURRENCY FUTURES
The sterling/US dollar currency future is a contract for £62,500. It is priced in US dollars, and the tick size is $0.0001.
Currency futures are not normally used by companies to hedge currency risks. However, assume that a US company, Apex Innovations Ltd, intends to use currency futures to hedge the following currency exposure.
It is now October. Apex Innovations Ltd expects to receive £400,000 in January from a customer in the UK.
The price of March sterling/US dollar futures is currently 1.8600.
The company is concerned that the value of sterling will fall in the next few months, and it therefore decides to use futures to hedge the exposure to currency risk.

Required
(a) How should Apex Innovations Ltd hedge its currency risk with futures?
(b) Suppose that in January when Apex Innovations Ltd receives the sterling payment, the March futures price is 1.8420 and the spot rate (US$/£1) is 1.8450.
Show what will happen when the futures position is closed, and calculate the effective exchange rate that Apex Innovations Ltd has obtained for the £400,000.

Answer

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Tags: Currency futures, Exchange Rates, Financial Risk Management, Foreign Exchange Risk, Futures contracts, Hedging, Risk Mitigation, Sterling, US Dollar
Level: Level 2

Topic: Futures and hedging with futures

FM – L2 – Q95 – Currency Risk Management

UK company hedges €2,110,000 net euro payment using forward contract, money market hedge, and currency futures; compare costs.

Question

It is now the end of July. A UK company, Zenith Enterprises, expects the following receipts and payments in euros at the end of the month in three months’ time (at the end of October):

| Receipts | €540,000 |
| Payments | €2,650,000 |

The company is concerned about the exposure to a risk of a movement in the sterling/euro exchange rate, and it has decided to hedge the exposure.
It is considering three methods of hedging the exposure:
(a) with a forward exchange contract
(b) using a money market hedge
(c) using currency futures.

Relevant data is as follows:

FX rates, €/£1
Spot	1.4537	1.4542
3 months forward	1.4443	1.4448

3-month interest rates	Borrow	Invest
Sterling (UK)	6.2%	5.6%
Euro	3.8%	3.4%

Currency futures: €/£1
Contract size is €100,000 per contract
December futures price: 0.6929

Required:
Demonstrate with relevant calculations how Zenith Enterprises can hedge its exposure to foreign exchange risk using:
(a) a forward exchange contract (3 marks)
(b) a money market hedge (4 marks)
(c) currency futures (3 marks)
Recommend which method of hedging would be preferable in this situation.

Answer

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Tags: Currency futures, Currency hedging, Euro, Financial Risk Management, Foreign Exchange Risk, Forward Contract, Hedging Strategies, Money Market Hedge, Sterling
Level: Level 2

Topic: Futures and hedging with futures

FM – L2 – Q94 – Futures and hedging with futures

Explain how a Canadian company can hedge USD payment using euro/USD futures.

Question

The euro/US dollar currency future is a contract for €125,000. It is priced in US dollars, and the tick size is $0.0001.

Currency futures are not normally used by companies to hedge currency risks. However, assume that a Canadian company intends to use currency futures to hedge the following currency exposure.

It is now February. The Canadian company has to make a payment of US $640,000 in May to a supplier.

The price of June euro/US dollar futures is currently 1.2800.

The company is concerned that the value of the dollar will increase in the next few months, and it therefore decides to use futures to hedge the exposure to currency risk.

Required

(a) How should the company hedge its currency risk with futures?

(b) Suppose that in May when the company must make the payment in dollars, the June futures price is 1.2690 and the spot rate (US$/€1) is 1.2710.

Show what will happen when the futures position is closed, and calculate the effective exchange rate that the company has obtained for the US $640,000

Answer

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Tags: Basis risk, Currency futures, Effective Exchange Rate, Foreign Exchange Risk, Futures contracts, Hedging
Level: Level 2

Topic: Futures and hedging with futures

FM – L2 – Q93 – Futures and hedging with futures

Illustrate how YSL can hedge FX risk using currency futures for a 140M yen payment.

Question

Zest Inc. is a company located in the USA that has a contract to purchase goods from Japan in two months’ time on 1st September. The payment is to be made in YEN and will total 140 million yen.
The managing director of Zest Inc. wishes to protect the contract against adverse movements in foreign exchange rates and is considering the use of currency futures. The following data are available:
Spot foreign exchange rate $1 = 128.15 yen
Yen currency futures contracts on SIMEX (Singapore Monetary Exchange)
Contract size 12,500,000 yen, contract prices are US$ per yen.
Contract prices:
September 0.007985
December 0.008250
Assume that futures contracts mature at the end of the month.

Required:
(a) Illustrate how Zest Inc. might hedge its foreign exchange risk using currency futures.

(b) Assuming spot exchange rate is 120 yen / $1 on 1 September and that basis risk decreases steadily in a linear manner, calculate what the result of the hedge is expected to be. Briefly discuss why this result might not occur.

Answer

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Tags: Basis risk, Currency futures, Foreign Exchange Risk, Hedge efficiency, Hedging, Japan, USA, Yen, YSL
Level: Level 2

Topic: Futures and hedging with futures

FM – L2 – Q92 – Foreign exchange risk and currency risk management

Calculate unhedged ZMW value of $35M receivable with 5% ZMW depreciation and compare to initial value.

Question

Riverfront Plc has just delivered a major export order to a customer in Canada at a price of $35 million payable in six months’ time and as the company’s finance director you are concerned about the potential impact of currency volatility on the profitability of this particular order.
You have obtained the following exchange rate and interest rate data at the close of business today:

Spot rate (ZMW/$)	ZMW 5 – ZMW 6
6-month forward rate (premium)	0.08 – 0.12

Annual interest rates:

	Deposit	Borrowing
Zambia	10%	14%
Canada	5%	6%

Riverfront Plc’s bank has quoted a premium of ZMW 10,000 (payable up-front) for a $35 million six-month over-the-counter currency put option with an exercise price of ZMW 5.6 = $1.
Riverfront Plc has the ZMW 10,000 available on deposit at the current time and would leave it on deposit for the next six months if it was not used to purchase the currency put option.

Required
(a) Calculate the unhedged ZMW value of the $35 million receivable if, in six months’ time, ZMW has depreciated by 5%. Explain how this compares to the ZMW value of the sale when it was made.

(b) Calculate the hedged ZMW value of the $35 million receivable if Riverfront Plc chooses to use a forward exchange contract.

(c) Calculate the hedged ZMW value of the $35 million receivable if Riverfront Plc chooses to use a money market hedge and calculate the effective forward exchange rate achieved.

(d) Calculate the hedged ZMW value of the $35 million receivable if Riverfront Plc chooses to use an over-the-counter currency put option and the spot exchange rate in six months’ time is:

(1) ZMW 5 = $1

(2) ZMW 6 = $1

Answer

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Tags: Currency Options, Currency Risk, Exchange Rates, Hedging, Put Option
Level: Level 2

Topic: Foreign exchange risk and currency risk management

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FM – L2 – Q101 – Hedging with options

Calculate min net interest rate cost for a company borrowing $5m using options with a strike price of 94.50.

FM – L2 – Q100 – Hedging with futures, Hedging with options

Firestone Ltd plans to borrow $5M and hedge interest rate risk using futures and options, calculating effective borrowing rates.

FM – L2 – Q99 – Hedging with futures

Recommend futures/options to hedge interest rate risk for a company's loan, tender bid, and deposit scenarios.

FM – L2 – Q98 – Foreign exchange risk and currency risk management

Accra Food and Beverage Co hedges USD189,000 net liability using forward and money market methods.

FM – L2 – Q97 – Hedging with options

UK company hedges $2M USD receipt using currency options, calculates outcome at expiry with given spot rate.

L2 – Q96 – Futures and hedging with futures

US company hedges £400,000 sterling receipt using currency futures, calculating effective exchange rate.

FM – L2 – Q95 – Currency Risk Management

UK company hedges €2,110,000 net euro payment using forward contract, money market hedge, and currency futures; compare costs.

FM – L2 – Q94 – Futures and hedging with futures

Explain how a Canadian company can hedge USD payment using euro/USD futures.

FM – L2 – Q93 – Futures and hedging with futures

Illustrate how YSL can hedge FX risk using currency futures for a 140M yen payment.

FM – L2 – Q92 – Foreign exchange risk and currency risk management

Calculate unhedged ZMW value of $35M receivable with 5% ZMW depreciation and compare to initial value.

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Calculate min net interest rate cost for a company borrowing $5m using options with a strike price of 94.50.

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Firestone Ltd plans to borrow $5M and hedge interest rate risk using futures and options, calculating effective borrowing rates.

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Recommend futures/options to hedge interest rate risk for a company's loan, tender bid, and deposit scenarios.

You're reporting an error for "FM – L2 – Q99 – Hedging with futures"

Accra Food and Beverage Co hedges USD189,000 net liability using forward and money market methods.

You're reporting an error for "FM – L2 – Q98 – Foreign exchange risk and currency risk management"

UK company hedges $2M USD receipt using currency options, calculates outcome at expiry with given spot rate.

You're reporting an error for "FM – L2 – Q97 – Hedging with options"

US company hedges £400,000 sterling receipt using currency futures, calculating effective exchange rate.

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UK company hedges €2,110,000 net euro payment using forward contract, money market hedge, and currency futures; compare costs.

You're reporting an error for "FM – L2 – Q95 – Currency Risk Management"

Explain how a Canadian company can hedge USD payment using euro/USD futures.

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Illustrate how YSL can hedge FX risk using currency futures for a 140M yen payment.

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Calculate unhedged ZMW value of $35M receivable with 5% ZMW depreciation and compare to initial value.

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