QUESTION 3

Required

a) Who among the parties bears the exchange rate risk here; exporter or importer?

b) If the spot rate of exchange six months later is MYR5/ £1 what exchange rate gain or

loss will be made by the British exporter?

c) If the spot rate of exchange six months later is MYR4.5/ £1 what exchange rate gain or

loss will be made by the British exporter?

d) A six months forward is available at MYR 4.7/ £1. Show how risk can be reduced using

the forward?

ANSWER

a) Since the Malaysian Importer is paying MYR 4.8 million in its local currency, the British exporter is bearing exchange rate risk. If the pound appreciates against Malaysian Ringgit, the British exporter will have a loss and vice versa.

b) The original sale price in sterling and ringgit was 1 million and 4.8 million respectively. At the time of payment six months from now if the exchange rate become MYR5 / £1 then the 4.8 million paid by Malaysian importer will become = 4,800,000/5 becomes 960,000. This is an exchange rate loss of = 1,000,000- 960,000 becomes 40,000 for the exporter.

c) If the exchange rate becomes MYR4.5/ £1 on payment date, then the MYR 4.8 million paid by importer will become = 4,800,000/4.5 becomes 1,066,666.67. This is an exchange rate gain of = 1,066,666.67- 1,000,000 becomes 66,666.67.

d) Since the exporter is exposed to the risk, he can reduce it by using forward contracts. He agrees to deliver MYR 4.8 ringgit in six months to forward market counterparty. It will receive MYR 4,800,000 / 4.7= 1,021,276.60 regardless of spot exchange rates in six months time.

QUESTION 2

A farmer is concerned about volatility in its revenues. One kilogram of wheat currently sells for $1000 an ounce, but the price is volatile and could fall as low as 900 or rise as high as 1100 in the next year. The farmer will sell 5,000 kilogram of total wheat.

Required

a) What will be the total revenues if the farmer follow do nothing strategy for wheat prices

of 1000, 900, 1100.

b) The forward price of wheat for delivery in one year is 1030. What will be the farmers

total revenues at each wheat price.

c) What will total revenues be if the farmer buys a 1-year put option to sell wheat for

$1050 a kilogram? The option premium is $10 per kg.

ANSWER

Wheat Price ($)
Quantity (kg)
a)Revenue at each price level	5,000,000	4,500,000	5,500,000
b)Forward Contract Revenue (1030*5000)	5,150,000	5,150,000	5,150,000
Profit/ Loss as compared to do nothing scenarios	150,000	650,000	(350, 000)
c)Option Strategy (Exercise Price = 1050)
Sales without option (case a)	5,000,000	4,500,000	5,500,000
Put Option Cost (premium 10*5000)	(50,000)	(50,000)	(50,000)
Put Option Payoff (1050*5000)	5,250,000	5,250,000	0 (No exercise)
Total Revenue under the strategy	5,200,000	5,200,000	5,500,000 – 50,000 = 5,450,000 (sell in the open market)

QUESTION 3

Golden Grain farms (GGE) expects to harvest 50,000 bushels of wheat in March 2014. It is concerned about the possibility of wheat price fluctuations between now and coming March. The futures price for March wheat is $2 per barrel, and one futures contract is for 5,000 bushels.

Required:

a. How many future contracts should GCF sell in order to manage the risk perfectly?

b. Evaluate GGF’s gains and losses by using the Futures strategy if the price of wheat in March actually turns out to be i) $3 ii) $1 per bushle. Ignore transaction costs.

c. Suppose that March put options with a strike price of $2 per bushel cost $.15 per bushel as premium. Assuming that GGF hedges using put options, evaluate its gains and losses for actual wheat prices of $1, $2, and $3.

ANSWER

a. GGF wants to deliver CPO and receive a fixed price, so it needs to sell futures contracts. Each contract calls for delivery of 5,000 bushels, so GGF needs to sell 10 contracts.

b. No money changes hands today. If CPO prices actually turn out to be $3, then GGF will receive $150,000 for its crop, but it will have a loss of $50,000 on its futures position when it closes that position because the contracts require it to sell 50,000 bushels of CPO at $2, when the going price is $3. He thus nets $100,000 overall. If CPO prices turn out to be $1 per bushel, then the crop will be worth only $50,000. However, GGF will have a profit of $50,000 on its futures position, so GGF again nets $100,000.

c. If GGF wants to insure against a price decline only, it can buy 10 put contracts. Each contract is for 5,000 bushels, so the cost per contract is 5,000× $.15= $750. For 10 contracts, the cost will be $7,500. If CPO prices turn out to be $3, then GGF will not exercise the put options (why not?). Its crop is worth $150,000, but it is out the $7,500 cost of the options, so it nets $142,500. If CPO prices fall to $1, the crop is worth $50,000. GGF will exercise its puts (why?) and thereby force the seller of the puts to pay $2 per bushel. GGF receives a total of $100,000. If we subtract the cost of the puts, we see that GGF’s net is $92,500.

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