Question 1 (12 marks)

Imagine you are the treasurer of a NZ company exporting dairy products to the United States.

All revenues are received in USD and all other expenses (e.g., R&D costs, costs of employees etc.) are incurred in NZ dollars.

Required:

(a) Discuss whether you need to hedge the foreign exchange risk and factors you need to consider when designing contracts to hedge the risks. (6 marks)

(b) If the company is able to raise the price of its product in USD if NZD appreciates without affecting the sales volume, how would you adjust your recommendation in part (a) and sell your strategy to other executives? (6 marks)

Provide a typewritten answer to (a) and (b) in no more than one-half (1/2) of a page in total.

Hint: If the company is able to raise the price of its product in USD if NZD appreciates, what does it tell you about the company’s foreign exchange exposure? Which derivative security    (securities) could be used to hedge this risk? There is no model answer to this question, you   just have to provide reasoned explanations.

Question 2 (12 marks)

On 12 Jun 2023, a speculator buys five Nov 2023 US Soybeans futures contracts at a price of 1,369.50 cents per bushel. The speculator closes out her futures position on 10 Jul 2023 at a price of 1,320.00 cent per bushel. The US Soybeans futures contract is written on 5,000 bushels of soybeans and, for a speculator, the initial and maintenance margins are $3,375 and $2,500 per contract respectively. Assume that the speculator does not withdraw any excess out of their margin account.

Data on the daily settlement price for the Nov 2023 US Soybeans futures contract during the period between  12 Jun and  10 Jul 2023 can be found in a spreadsheet titled US Soybeans Futures Prices.xlsx posted on Canvas.

Required:

(a) At the time the futures position is established, what is the minimum price movement that will generate a margin call? Report your answer in cents with 2 decimal places (2 dps). (2 marks)

(b) Construct a table as below to illustrate the daily marking-to-market (and final settlement) of the speculator’s overall futures position.

Table Q2

Note: the table is identical to Table 2.1 on page 30 of the prescribed textbook. (8 marks)

(c) What is the overall profit/loss of the speculator? Decompose the overall profit/loss into two components: (i) total margin calls, and (ii) the change in the margin account balance. (2 marks)

Question 3 (13 marks)

It is now August 1, and you are considering investing in 90-day bank bills in two months’ time (October 1). On this date of October 1, you intend to purchase bank bills with a face value of $2,500,000 at maturity.

You are concerned interest rates will fall and you wish to hedge your interest rate risk using FRA contracts. For the purpose only of deciding on the appropriate FRA contract assume 3 months is equivalent to 90 days – otherwise all FRA settlement amounts are calculated with reference to 90 days.

Also assume there are 365 days in a year.

Current FRA quotes are:

The rates quoted in the table above are simple rates. The FRAs follows the standard Australasian settlement terms (NOT the US terms).

Required:

(a) To hedge the interest rate risk, determine which FRA is the most appropriate to use?

Briefly explain your answers. Also state if you should short (sell) or long (buy) the FRA contract. Please type your answers. (Word limit 100) (3 marks)

(b) Suppose 15 days after the initiation (assume t=15 now), the 45-day interest rate is 5.8%    p.a. and the 135-day interest rate is 5.9% p.a. (both are continuously compounded). Find   the "new" FRA price on a 90-day loan issued 45 days from today and record your answer to 2 decimal places in percentage i.e. x.xx%. What is the fair value of the FRA to you today (i.e. at t=15)? (5 marks)

(c) Suppose your friend advised on not using FRAs to hedge, and commented that “Hedging is costly and unnecessary, and it is not needed even if market interest rate decreases sharply between August 1 and October 1.” Explain whether your friend’s comment is justifiable (word limit 120). (5 marks)

Question 4 (13 marks)

Assume the spot exchange rate of the New Zealand dollar is USD0.6215 and that three-month continuously compounded risk-free rates are 5.0% p.a. and 5.5% p.a. in the US and New Zealand, respectively.

Required

(a) What is the theoretical price of a three-month forward contract on the New Zealand dollar? Round your answer to four decimal places. (4 marks)

(b) Assume that the actual three-month forward rate is USD0.6185. Show in detail how an arbitrageur – initially borrowing either NZD 1 million or USD 1 million could exploit this mispricing to earn an arbitrage profit. Make sure that you clearly identify the profit accruing to the arbitrageur at the expiration of the arbitrage strategy. (9 marks)