1 For a number of years Daikon Co has been using forward rate agreements to manage its exposure to interest rate

fluctuations. Recently its chief executive officer (CEO) attended a talk on using exchange-traded derivative products to
manage risks. She wants to find out by how much the extra cost of the borrowing detailed below can be reduced,
when using interest rate futures, options on interest rate futures, and a collar on the options, to manage the interest
rate risk. She asks that detailed calculations for each of the three derivative products be provided and a reasoned
recommendation to be made.
Daikon Co is expecting to borrow $34,000,000 in five months’ time. It expects to make a full repayment of the
borrowed amount in 11 months’ time. Assume it is 1 June 2015 today. Daikon Co can borrow funds at LIBOR plus
70 basis points. LIBOR is currently 3·6%, but Daikon Co expects that interest rates may increase by as much as
80 basis points in five months’ time.
The following information and quotes from an appropriate exchange are provided on LIBOR-based $ futures and
options.
Three-month $ December futures are currently quoted at 95·84. The contract size is $1,000,000, the tick size is
0·01% and the tick value is $25.
Options on three-month $ futures, $1,000,000 contract, tick size 0·01% and tick value $25. Option premiums are
in annual %.
December calls Strike price December puts
0·541 95·50 0·304
0·223 96·00 0·508
Initial assumptions
It can be assumed that settlement for both the futures and options contracts is at the end of the month; that basis
diminishes to zero at a constant rate until the contract matures and time intervals can be counted in months; that
margin requirements may be ignored; and that if the options are in-the-money, they will exercised at the end of the
hedge instead of being sold.
Further isues:

In the talk, the CEO was informed of the f o l l o w i n g i s s u e :

(i) Futures contracts will be marked-to-market daily. The CEO wondered what the impact of this would be if 50
futures contracts were bought at 95·84 on 1 June and 30 futures contracts were sold at 95·61 on 3 June, based
on the $ December futures contract given above. The closing settlement prices are given below for four days:
Date Settlement price
1 June 95·84
2 June 95·76
3 June 95·66
4 June 95·74
(ii) Daikon Co will need to deposit funds into a margin account with a broker for each contract they have opened,
and this margin will need to be adjusted when the contracts are marked-to-market daily.
(iii) It is unlikely that option contracts will be exercised at the end of the hedge period unless they have reached
expiry. Instead, they more likely to be sold and the positions closed..
Required:

(a) Based on the three hedging choices available to Daikon Co and the initial assumptions given above, draft a
response to the chief executive officer’s (CEO) request made in the first paragraph of the question.

\(15 marks)
(b) Discuss the impact on Daikon Co of each of the three further issues given above. As part of the discussion,
include the calculations of the daily impact of the mark-to-market closing prices on the transactions specified by
the CEO. (10 marks)
. (10 marks)

(25 marks)
2 Casasophia Co, based in a European country that uses the Euro (€), constructs and maintains advanced
energy efficient commercial properties around the world. It has just completed a major project in the USA and
is due to receive the final payment of US$20 million in four months.
Casasophia Co is planning to commence a major construction and maintenance project in Mazabia, a small African
country, in six months’ time. This government-owned project is expected to last for three years during which time
Casasophia Co will complete the construction of state-of-the-art energy efficient properties and provide training to a
local Mazabian company in maintaining the properties. The carbon-neutral status of the building project has attracted
some grant funding from the European Union and these funds will be provided to the Mazabian government in
Mazabian Shillings (MShs).
Casasophia Co intends to finance the project using the US$20 million it is due to receive and borrow the rest through
a € loan. It is intended that the US$ receipts will be converted into € and invested in short-dated treasury bills until
they are required. These funds plus the loan will be converted into MShs on the date required, at the spot rate at that
time.
Mazabia’s government requires Casasophia Co to deposit the MShs2·64 billion it needs for the project, with Mazabia’s
central bank, at the commencement of the project. In return, Casasophia Co will receive a fixed sum of
MShs1·5 billion after tax, at the end of each year for a period of three years. Neither of these amounts is subject to
inflationary increases. The relevant risk adjusted discount rate for the project is assumed to be 12%.
Financial Information
Exchange Rates available to Casasophia
Per €1 Per €1
Spot US$1·3585–US$1·3618 MShs116–MShs128
4-month forward US$1·3588–US$1·3623 Not available
Currency Futures (Contract size €125,000, Quotation: US$ per €1)
2-month expiry 1·3633
5-month expiry 1·3698
Currency Options (Contract size €125,000, Exercise price quotation: US$ per €1, cents per Euro)
Calls Puts
Exercise price 2-month expiry 5-month expiry 2-month expiry 5-month expiry
1·36 2·35 2·80 2·47 2·98
1·38 1·88 2·23 4·23 4·64
Casasophia Co Local Government Base Rate 2·20%
Mazabia Government Base Rate 10·80%
Yield on short-dated Euro Treasury Bills 1·80%
(assume 360-day year)
Mazabia’s current annual inflation rate is 9·7% and is expected to remain at this level for the next six months.
However, after that, there is considerable uncertainty about the future and the annual level of inflation could be
anywhere between 5% and 15% for the next few years. The country where Casasophia Co is based is expected to
have a stable level of inflation at 1·2% per year for the foreseeable future. A local bank in Mazabia has offered
Casasophia Co the opportunity to swap the annual income of MShs1.5 billion receivable in each of the next three
years for Euros, at the estimated annual MShs/€ forward rates based on the current government base rates.
Required:
(a) Advise Casasophia Co on, and recommend, an appropriate hedging strategy for the US$ income it is due to
receive in four months. Include all relevant calculations. (15 marks)

(b) Provide a reasoned estimate of the additional amount of loan finance Casasophia Co needs to obtain to
undertake the project in Mazabia in six months. (5 marks)

(c) Given that Casasophia Co agrees to the local bank’s offer of the swap, calculate the net present value of
the project, in six months’ time, in €. Discuss whether the swap would be beneficial to Casasophia Co.
(10 marks)

(30 marks)
3 Alecto Co, a large listed company based in Europe, is expecting to borrow €22,000,000 in four months’ time
on
1 May 2012. It expects to make a full repayment of the borrowed amount nine months from now. Currently there is
some uncertainty in the markets, with higher than normal rates of inflation, but an expectation that the inflation level
may soon come down. This has led some economists to predict a rise in interest rates and others suggesting an
unchanged outlook or maybe even a small fall in interest rates over the next six months.
Although Alecto Co is of the opinion that it is equally likely that interest rates could increase or fall by 0·5% in four
months, it wishes to protect itself from interest rate fluctuations by using derivatives. The company can borrow at
LIBOR plus 80 basis points and LIBOR is currently 3·3%. The company is considering using interest rate futures,
options on interest rate futures or interest rate collars as possible hedging choices.
The following information and quotes from an appropriate exchange are provided on Euro futures and options. Margin
requirements may be ignored.
Three month Euro futures, €1,000,000 contract, tick size 0·01% and tick value €25
March
96·27
June
96.16
September 95·90
Options on three month Euro futures, €1,000,000 contract, tick size 0·01% and tick value €25. Option premiums
are in annual %.
Calls Strike Puts
March June September March June September
0·279 0·391 0·446 96·00 0·006 0·163 0·276
0·012 0·090 0·263 96·50 0·196 0·581 0·754
It can be assumed that settlement for both the futures and options contracts is at the end of the month. It can also
be assumed that basis diminishes to zero at contract maturity at a constant rate and that time intervals can be counted
in months.
Required:

(a) Briefly discuss the main advantage and disadvantage of hedging interest rate risk using an interest rate collar
instead of options. (4 marks)

(b) Based on the three hedging choices Alecto Co is considering and assuming that the company does not face
any basis risk, recommend a hedging strategy for the €22,000,000 loan. Support your recommendation with
appropriate comments and relevant calculations in €. (17 marks)

(c) Explain what is meant by basis risk and how it would affect the recommendation made in part (b) above.
(4 marks)

(25 marks)

4 Cocoa-Mocha-Chai (CMC) Co is a large listed company based in Switzerland and uses Swiss Francs as its currency.
It imports tea, coffee and cocoa from countries around the world, and sells its blended products to supermarkets and
large retailers worldwide. The company has production facilities located in two European ports where raw materials
are brought for processing, and from where finished products are shipped out. All raw material purchases are paid for
in US dollars (US$), while all sales are invoiced in Swiss Francs (CHF).
Until recently CMC Co had no intention of hedging its foreign currency exposures, interest rate exposures or
commodity price fluctuations, and stated this intent in its annual report. However, after consultations with senior and
middle managers, the company’s new Board of Directors (BoD) has been reviewing its risk management and
operations strategies.
2 [P.T.O
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The following two proposals have been put forward by the BoD for further consideration:
Proposal one
Setting up a treasury function to manage the foreign currency and interest rate exposures (but not commodity price
fluctuations) using derivative products. The treasury function would be headed by the finance director. The purchasing
director, who initiated the idea of having a treasury function, was of the opinion that this would enable her
management team to make better decisions. The finance director also supported the idea as he felt this would increase
his influence on the BoD and strengthen his case for an increase in his remuneration.
In order to assist in the further consideration of this proposal, the BoD wants you to use the following upcoming foreign
currency and interest rate exposures to demonstrate how they would be managed by the treasury function:
(i) a payment of US$5,060,000 which is due in four months’ time; and
(ii) a four-year CHF60,000,000 loan taken out to part-fund the setting up of four branches (see proposal two below).
Interest will be payable on the loan at a fixed annual rate of 2·2% or a floating annual rate based on the yield
curve rate plus 0·40%. The loan’s principal amount will be repayable in full at the end of the fourth year.
Proposal two
This proposal suggested setting up four new branches in four different countries. Each branch would have its own
production facilities and sales teams. As a consequence of this, one of the two European-based production facilities
will be closed. Initial cost-benefit analysis indicated that this would reduce costs related to production, distribution
and logistics, as these branches would be closer to the sources of raw materials and also to the customers. The
operations and sales directors supported the proposal, as in addition to above, this would enable sales and marketing
teams in the branches to respond to any changes in nearby markets more quickly. The branches would be controlled
and staffed by the local population in those countries. However, some members of the BoD expressed concern that
such a move would create agency issues between CMC Co’s central management and the management controlling
the branches. They suggested mitigation strategies would need to be established to minimise these issues.
Response from the non-executive directors
When the proposals were put to the non-executive directors, they indicated that they were broadly supportive of the
second proposal if the financial benefits outweigh the costs of setting up and running the four branches. However,
they felt that they could not support the first proposal, as this would reduce shareholder value because the costs
related to undertaking the proposal are likely to outweigh the benefits.
Additional information relating to proposal one
The current spot rate is US$1·0635 per CHF1. The current annual inflation rate in the USA is three times higher than
Switzerland.
The following derivative products are available to CMC Co to manage the exposures of the US$ payment and the
interest on the loan:
Exchange-traded currency futures
Contract size CHF125,000 price quotation: US$ per CHF1
3-month expiry 1·0647
6-month expiry 1·0659

3 [P.T.O
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Exchange-traded
currency options
Contract size CHF125,000, exercise price quotation: US$ per CHF1, premium: cents per CHF1
Call Options Put Options
Exercise price 3-month expiry 6-month expiry 3-month expiry 6-month expiry
1·06 1·87 2·75 1·41 2·16
1·07 1·34 2·22 1·88 2·63
It can be assumed that futures and option contracts expire at the end of the month and transaction costs
related to these can be ignored.
Over-the-counter products
In addition to the exchange-traded products, Pecunia Bank is willing to offer the following over-the-counter
derivative products to CMC Co:
(i) A forward rate between the US$ and the CHF of US$ 1·0677 per CHF1.
(ii) An interest rate swap contract with a counterparty, where the counterparty can borrow at an annual
floating rate based on the yield curve rate plus 0·8% or an annual fixed rate of 3·8%. Pecunia Bank
would charge a fee of
20 basis points each to act as the intermediary of the swap. Both parties will benefit equally from the
swap contract.

Required:
(a) Advise CMC Co on an appropriate hedging strategy to manage the foreign exchange exposure of the
US$ payment in four months’ time. Show all relevant calculations, including the number of
contracts bought or sold in the exchange-traded derivative markets.
(15 marks)

(b) Demonstrate how CMC Co could benefit from the swap offered by Pecunia Bank. (6
marks)

(c) As an alternative to paying the principal on the loan as one lump sum at the end of the fourth year,
CMC Co could pay off the loan in equal annual amounts over the four years similar to an annuity. In this
case, an annual interest rate of 2% would be payable, which is the same as the loan’s gross redemption
yield (yield to maturity).
Required:

Calculate the modified duration of the loan if it is repaid in equal amounts and explain how duration
can be used to measure the sensitivity of the loan to changes in interest rates.
(7 marks)

(d) Prepare a memorandum for the Board of Directors (BoD) of CMC Co which:
(i) Discusses proposal one in light of the concerns raised by the non-executive directors; and (9
marks) (ii) Discusses the agency issues related to proposal two and how these can be mitigated.
(9 marks) Professional marks will be awarded in part (d) for the presentation, structure, logical flow
and clarity of the memorandum.
(4 marks)
(50 marks)