BFF3751 Derivatives 1

Tutorial 2

Reference Material

Lecture 2 (class notes)

Hull Chapters 1 and 2 Hull Chapter 3

BFF3751 Tutorial 2  Philip Gray 2020 1

Question 1

You have recently founded a fashion label that produces high-end ladies garments, many of
which are made from 100% Australian wool. As such, you regularly purchase wool. The
current (spot) price of wool is $14 per kilogram.

While a lot of people are expecting wool price to decrease in coming months, you have
witnessed recent price volatility in the wool market and are concerned that price may in fact
rise before you make your next purchase (in roughly 3 months’ time).

A forward contract is available on wool for delivery in October with a forward price of $14.50
per kg. Assume that you need 500 kilograms of wool.

a) You decide to hedge against movements in wool price. Will you buy or sell wool
forward? That is, will you take a long or short forward contract?

b) On the delivery date for the forward contract, the spot wool price is $12 per kg. Explain
the transactions that occur on that date. Rather than physically taking delivery, answer
this question by assuming that you close-out the forward contract, then buy the required
wool on the spot market.

c) Your business partner, on hearing about your foray into the derivatives market, is
furious that you have effectively paid $14.50 per kilogram for the required wool. ‘Had
you not played the derivatives market,’ she explains, ‘we could have bought the wool
for $12’. How would you respond?

d) Ignore (b). Instead, assume that the spot wool price on the delivery date is $16 per kg.
Explain what transactions occur on that date.

BFF3751 Tutorial 2  Philip Gray 2020 2

You are in charge of risk management for a major US gold mine. Today is the 1 September
and you anticipate having 100,000 ounces of gold ready for sale on the 30 November. All of
your gold is sold locally in the United States. Currently, the spot price of gold is quoted at USD
926 per ounce.

a) Identify the risk your company faces with selling gold?

b) Will we enter long or short futures contracts to eliminate this risk?

Suppose that you enter into gold futures covering 100,000 ounces of gold, maturing on 30
November. Currently, the futures price is quoted at USD 935 per ounce. [nb: futures/forward
quotes are almost always a little above the current spot quote because of the cost of carry
concept we examine in Lecture 3] At expiry of these contracts on 30 November, the spot price
for gold is USD 920 per ounce.

c) Assume that physical delivery is possible under the terms of the futures contract. Explain
what happens at expiry of the November-maturity gold futures and calculate how much
money you receive.

d) Now assume that, rather than physical delivery, you close out your original futures position
and sell the actual gold on the spot market. Describe what happens at the end of November
in this case and calculate how much money is received.

e) Next assume that, rather than physical delivery or closing out, the futures contracts are cash
settled and we subsequently sell the actual gold on the spot market. Describe what happens
at the end of November and calculate how much money is received.

BFF3751 Tutorial 2  Philip Gray 2020 3

Today is 1 July and the spot exchange rate for AUD 1.00 = EUR 0.6000. You have purchased
equipment from a European supplier and the invoice amount is EUR 10,000.

a) If you paid the invoice today, what is the AUD cost of the purchase?

Now assume the invoice will be paid in exactly one year's time. Clearly, since it is impossible
to know what the AUD/EUR exchange rate will be in one year's time, it is impossible to know
what the AUD cost will be. Hence, we face exchange rate risk.

b) If we leave this exposure unhedged, what is the risk we face? Specifically, will we gain
or lose if the AUD strengthens relative to the EUR? And will we gain or lose if the
AUD weakens relative to the EUR?

c) Assume that we leave our exposure unhedged. In one year's time, the spot rate is 0.6500
and we pay the EUR 10,000 invoice. What is the AUD cost of the purchase?

d) Ignore (c). Assume that we leave our exposure unhedged. In one year's time, the spot
rate is 0.5700. What is the AUD cost of the purchase?

Go back to the 1 July information given above. This time we will hedge against exchange rate
movements to lock-in the AUD cost of the EUR 10,000 payment to be made in one year's time.
A forward contract for delivery of EUR 10,000 in one year's time is quoted at 0.6030.

e) To hedge against exchange rate movements, will you take a long or short forward
position? That is, will you buy or sell EUR forward?

f) Assume that the spot exchange rate in one year's time is 0.6500. Calculate (i) the
gain/loss on the forward contract, (ii) the AUD cost of buying EUR 10,000 at that time,
and (iii) the net of these two amounts.

g) Ignore f). Assume that the spot exchange rate in one year's time is 0.5700. Calculate (i)
the gain/loss on the forward contract, (ii) the AUD cost of buying EUR 10,000 at that
time, and (iii) the net of these two amounts.

BFF3751 Tutorial 2  Philip Gray 2020 4

Today is 1 June. Over recent years, you have constructed a portfolio of Australian stocks
currently worth $5 million. Although your portfolio is a well-diversified portfolio, it doesn't
match the S&P/ASX 200 index precisely because you tend to favour banking stocks which are
a little less risky than the overall market. The beta of your portfolio is 0.70.

The S&P/ASX 200 index, which has taken a beating in the last 12 months, is currently 4500.
You are concerned that there is another financial crisis just around the corner that would cause
the stock market to plummet sometime in the next six months. Obviously, this would wipe
considerable value from your portfolio.

You decide to lock-in the current value of your portfolio using SPI200 futures written on the
S&P/ASX 200 index. The November-maturity SPI200 futures are quoted at 4530.

a) What is the dollar value of one November-maturity SPI200 futures contract?

b) You never attended lectures very often in BFF3751, so never really understood
hedging. As such, you engage the service of a financial advisor who instructs you to
hedge by taking a long position on SPI200 futures. How many SPI200 contracts will
you take? (round to nearest whole number).

c) Assume that, on 30 November, the ASX200 index has indeed dropped to 3600. You
close out your futures position by shorting SPI200 futures (the number of contracts was
calculated in b). Given the beta of your portfolio, what is the market value of the
portfolio after the market fall? What is the gain/loss on the futures position? What is
the net of these two amounts?

Assume that the dividend yield on the market portfolio is 5% p.a. and that the riskfree
interest rate is 3% p.a..

d) Ignore c. Assume that, on 30 November, the S&P/ASX 200 index has actually risen to
4950. You close out your futures position by shorting SPI200 futures (the number of
contracts was calculated in b). Given the beta of your portfolio, what is the market value
of the portfolio after the market rise? What is the gain/loss on the futures position? What
is the net of these two amounts?

e) Given your answers to c and d, how effective was your ‘hedge’? What has gone wrong?

f) Repeat parts c, d, and e assuming you short SPI200 futures on 1 June rather than
longing.

BFF3751 Tutorial 2  Philip Gray 2020 5