Section A: Please answer ALL questions from this Section.

(Section A: Total 70 marks)

Question 1

Alpha International Ltd, a UK company, needs to pay $9,966,250 to an US company in 12 months’ time.

Market Data at 1st Jan 2020:

   Exchange rates: Spot GBP/USD $1.3200/£

   12-month Forward GBP/USD 1.3600

   Currency futures: CME £62,500 Jan 2021 Contract (cash-settled): $1.3400/£

The company is evaluating the following three hedging strategies:

1) The payment is hedged using a future contract

2) The payment is hedged by using Money Market Hedging

3) The payment is not hedged.

The future spot exchange rate is expected to move to either of the following rates:

i.     GBP/USD 1.3544

ii.     GBP/USD 1.2322

The interest rates

-    UK 1% per annum

-    US 4% per annum

Please evaluate the performance of the three alternative hedging methods in 12  months’ time given the two future spot rates scenarios expected by the company, and answer the following questions:

(Keep 2 decimals for money amount, 4 decimals for exchange rates)

a) In both scenarios, if Alpha Int’l Ltd uses futures contracts, explain the following:    How many contracts the company must buy/sell?

[4 marks]    Does the company need to sell or buy the £ futures contract? Explain.

[4 marks]

   What is the gain/loss in number of ticks if the company hedges with

futures contracts? How much is the gain/loss translated into £?

[5 marks]

   What is the total payable amount for the company after hedging with

futures contracts? Briefly explain your results.

[5 marks]

[total a) 18 marks]

b)  In both scenarios, if the company’s financial manager is also considering a money market hedge, explain the following:

   Explain and calculate how Alpha Int’l would use a money market hedge

based on the above market data.

[7 marks]

   Calculate the effective exchange rate for Alpha Int’l in 12 months’ time if

the company uses a money market hedge strategy. Briefly explain when the firm should apply the MMH strategy or using Forward. Calculations are required to complete your explanation.

[5 marks]

[total b) 12 marks]

c)  Compare the three strategies and briefly discuss your result.

[5 marks]

[Total: 35 marks]

Question 2

A UK company named Beta will receive 12,000,000 JPY from another company in three months’ time.

To cover the currency risk, the UK company enters into a forward exchange contract with a bank. The current quoted rates are:

Spot rate       152.5600 JPY/GBP

3m Forward  156.1200 JPY/GBP

The company is considering three alternatives to manage currency risk:

1)  Hedge the receipt using a forward contract at the rate of ¥156.1200/£

2)  Hedge the receipt by using an OTC option bought from a bank, giving Beta the option to exchange JPY at a strike price of ¥157.1200/£ for a premium of £0.02 per 100¥ .

3)  Not to hedge.

In three months’ time the company expects the future exchange rate change moving to be either one of the following:

i)         142.6700 JPY/GBP

ii)        165.2300 JPY/GBP

The current interest rates are 4% p.a. for Japan and 1% p.a. for the UK. (Keep 2 decimals for money amount, 4 decimals for exchange rates)

Calculate  and  evaluate  the  three  alternative  hedging  strategies  given  the  three different future exchange rate scenarios by answering the following questions:

a)  In both scenarios, if Beta enters a Forward contract, how much is the Forward hedge receipt?

[4 marks]

b)  In both scenarios, if Beta buys an option contract, answer the followings:

   Under which circumstances would the company decide to exercise the

option contract?

[5 marks]    How much is the premium Beta must pay to the option writer?

[3 marks]

   What is the gross and net amount received by Beta in each scenarios? [7 marks]

[Total b) 15 marks]

c)  In  both  scenarios,  if  Beta decides to  remain  unhedged,  how  much  is the receivable?

[4 marks]

d)  Compare the three hedging strategies for each scenario future exchange rate and provide a critical discussion explaining for each scenario why the company should prefer one currency management strategy over others.

[7 marks]

e)  Calculate the exchange rate at which it would be beneficial to use the option rather than the forward. Explain your result.

[5 marks]

[Total: 35 marks]

Section B: Please choose ONE question from this Section.

(Section B: Total 30 marks)

Question 3

A U.S. firm holds an asset in Great Britain and faces the following scenario:

where,

P* = Pound sterling price of the asset held by the U.S. firm

(Keep 2 decimals for money amount, 4 decimals for exchange rates)

Required

a)  What is the expected value of the investment in U.S. dollars?

[6 marks]

b)  Calculate the variance of the exchange rate, i.e. Var(S).

[10 marks]

c)  Calculate the covariance between the dollar value of the asset and the exchange rate, i.e. Cov(P,S).

[7 marks]

d)  Estimate your exposure to the exchange risk.  Briefly explain it.

[7 marks]

[Total 30 marks]

Question 4

Company Zulu is a U.S. MNC and wants to borrow €60 million for 3 years. Company Yankee is a French MNC and wants to borrow $90 million for 3 years. Company Zulu wants finance euro denominated asset in Italy and therefore wants to borrow euro. Company Yankee wants to finance a dollar denominated asset and therefore wants to borrow dollars. The current exchange rate is $1.50 = €1.00. If Company Zulu and Company Yankee knew and trusted each other, they could theoretically cut out the swap bank.

$

€

Firm Zulu

$8.5%

€6.8%

Firm Yankee

$9.5%

€5.8%