BBMF2034 BANKING OPERATIONS

TUTORIAL

CHAPTER 11 TREASURY OPERATIONS

1. What is an “at-the-money” option? If an option is at-the-money at its expiry date, explain

whether the option holder should exercise it. (Slide 53)
When the exercise price is exactly the same as the market price of the underlying item. There is
no benefit for the option holder in exercising it.
In-the-money
When the exercise price is more favourable for the option holder than the market price of the
underlying item. An option will be exercised only if it is in-the-money. Put option when exercise
price > market price. Call option when market price > exercise price.
Out-of-the-money
When the exercise price is less favourable for the option holder than the market price of the
underlying item. If an option is out-of-the-money at its expiry date, it will not be exercised. Put
option when exercise price < market price. Call option when market price < exercise price.

2. A Malaysian company wants to pay for goods purchased from Thailand at a cost of
THB30,000, and it must pay the supplier (in Thai baht) in one month’s time. A bank’s
forward rates for contracts for settlement in one month are MYR/THB 8.6505-8.6705. The
company can fix the cost of buying the Thai baht now with a forward contract, for
settlement in one month’s time. Determine the cost to the company (in ringgit).

Bank Sell (Offer) Bank Bid (Bid)

MYR/THB 8.6505 8.6705

THB/MYR 0.1156 0.1153

Malaysian company buys THB, sell MYR. Bank sells THB, buy MYR

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The exchange rate in the contract would be 8.6505 and the cost in ringgits would be RM3,468.01
(30,000/8.6505). The lower rate is the rate at which the bank will sell the quoted variable (THB)
in exchange for the base currency (ringgits). It is therefore the rate at which a customer can buy
the quoted currency. It is also the rate that is more favourable to the bank.

3. Differentiate between futures contracts and forward contracts. (Slide 49 & 50)

- Futures contracts are traded on derivatives exchange and trading is subject to the rules of
the exchange while forward contracts are arranged between a bank and another party.
- Futures contracts are standardised contracts while forward contracts are not standardised
contracts.
- Most futures exchange have settlement dates for all their contracts at the end of March,
June, September and December each year, but there may also be settlement dates for the
current month and the following month, depending on the rules of the exchange. In
constrast, the settlement date for forward contract are agreed to meet the customer’s
requirements.

4. On 14 February 2017, the US dollar climbed to 4-week high as Federal Reserve

Chairwoman, Janet Yellen, had hinted at rate-hike timing. On that note, a US company
which has investments in Malaysia, is concerned over the RM1 million that it is going to
be received in three months’ time. The current exchange rate is MYR1.0000=USD0.2200.

Required:
a. Discuss whether the company should buy a call or put currency option on the Malaysian
Ringgit.
The company should buy a put currency option on ringgit Malaysia. The option gives the
company the right to sell ringgit Malaysia on a pre-determined price. US interest rate increase,
USD strengthens, fix rate to sell MYR.

b. Assume that the option in part (a) above has an exercise price of MYR1.0000=USD0.2000.
On the expiry date, if the exchange rate is MYR1.0000=USD0.2400, discuss the actions
that the company should take on the option and determine the amount that the company
would receive from the above transaction.
If the exchange rate is MYR1.000 = USD.0.2400, the company will not exercise the option at
expiry, and will sell the RM1 million income at the current market spot rate. Thus, the amount
that the company would receive is USD240,000 (RM 1 million × 0.2400). MYR appreciates or
USD depreciates, put option is out of money. Hence, not to exercise the put option.

c. Assume that the exchange rate is MYR1.0000=USD0.1950 on the expiry date instead.

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 Discuss the actions that the company should take on the option and determine the amount
that the company would receive from the above transaction.
If the exchange rate is MYR1.000 = USD.0.1950, the company will exercise the option to sell the
RM1 million income at the exercise price of MYR1.000 = USD 0.2000. Thus, the amount that
the company would receive is USD200,000 (RM 1 million × 0.2000). MYR depreciates / USD
appreciates, put option is in of money. Hence, exercise the put option.

d. Discuss why an investor may buy an out-of-the-money option when there is a strong
possibility that the option will not be exercised. (Slide 54) - Not important
- An out-of-the-money option will cost less to buy than an in-the-money option. If the
option is used to hedge a risk, it is a form of insurance, protecting the investor against the
risk that the spot market price for the underlying item will be worse than the exercise
price for the option.
- If the option is used to speculate, the investor is paying for options in the expectation that
the spot price will be worse than the exercise price for the option, so that the option will
be exercised and the investor will make a profit.
- Options cost less to buy than the underlying item; the investor is therefore risking a
relatively small amount to buy the options in the hope of making a large profit.
- Out-of-the-money option: Put option when exercise price < Market price, call option
when market price < exercise price

5. In May, your bank receives a request from a large company to borrow RM80 million for
three months from August. Your bank has agreed to lend the money at KLIBOR plus
0.50%. However, your bank is worried about the risk of a drop in KLIBOR between May
and August, so decides to hedge its risk exposure with KLIBOR futures.

Given the main contract specifications are as follows:

Underlying instrument Ringgit interbank time deposit in the Kuala Lumpur Wholesale
Money Market with a three month maturity on a 360-day year.
Contract size RM1,000,000
Quoted in index terms (100.00 minus yield)
Contract months Quarterly cycle months of March, June, September and December up
to 5 years ahead and 2 serial months.
Final settlement Cash settlement based on the cash settlement value.

Required:
a. Decide whether your bank should long or short the KLIBOR futures in order to hedge its
interest rate exposure. Justify your answer.
The bank should buy KLIBOR futures. This is because the contract value of KLIBOR futures
will increase when KLIBOR rate drop. By buying KLIBOR futures now, the bank can close its

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position at a higher price when KLIBOR rate decreased. Thus, make a gain in the futures trading.
The gains in futures trading will offset the losses incurred from lower interest gained from the
lending. Expect KLIBOR decrease, KLIBOR futures increase, gain in futures offsets loss in
lending.

b. Identify the contract month and the number of contracts required by your bank to hedge its
interest rate risk exposure.
The futures contract with the nearest settlement date after August is September. So, the contract
month should be September. Since each contract size is RM1 million, the bank needs 80 contracts
to hedge its interest rate exposure on the RM80 millions of borrowing.

c. Assume the three-month KLIBOR rate has dropped to 2% in August, determine the profit
made by your bank on its futures trading if the futures contract price is 96.25.

Initial buying price 96.25

Selling price to close position 98.00 (100.00 – 2.00)

Gain per contract 1.75- 175ticks (98.00 – 96.25)

Value per tick RM25

Total profit from futures trading RM350,000 (175 ticks × RM25 × 80 contracts)

6. Sting Bhd. imported AUD1.0 million worth of honey from Australia. Sting Bhd. has to pay
the Australian company in 3 months’ time. Currently, the exchange rate is AUD1.00 =
MYR3.00.

Required:
(i) Explain the foreign currency risk that Sting Bhd. is exposed to. (Slide 22)
Favorable movements in an exchange rate add to profit, if AUD weakens, but adverse
exchange rate movements reduce profits. If AUD strengthens. In some cases, an adverse
movement in an exchange rate could eliminate the entire expected profit from an
international transaction. In Sting Bhd’s case, if AUD appreciates in 3 months’ time, Sting
Bhd. will have to pay the Australian company more than RM3.0 million.

(ii) Discuss the treasury solution / product which Sting Bhd. can use to mitigate the foreign
currency risk explained in part (i) above. (Slide 24)
Exposure to foreign exchange risk can be reduced by means of forward FX contracts. A
forward FX contract is an agreement made now with a bank to buy or sell a quantity of 1

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 currency in exchange for another, at an exchange rate that is fixed “now” in the contract

7. Assume that the current spot rate for the Malaysian Ringgit against the Thai Baht is
THB7.8700 = MYR1.0000. The three-month (90-day) money market interest rate on Thai
Baht is 1.27% and the three-month money market rate on Malaysian Ringgit is 3.67%.

Using the relevant money market conventions, determine the three-month forward rate for
the Malaysian Ringgit against the Thai Baht, and determine whether the Thai Baht is
quoted forward at a premium or at a discount to the Malaysian Ringgit.

Value of RM1,000 invested now for three months at 3.67%

= RM1,000 × [1 + (0.0367 × 90/365)]
= RM1,009.05

Value of THB 7,870 invested now for three months at 1.27%

= THB 7,870 × [1 + (0.0127 × 90/365)]
= THB 7,894.64

Three-month forward rate = 7,894.64 / 1,009.05 = THB 7.824 / MYR 1 < Spot rate = THB
7.87 / MYR 1

The interest rate on the Thailand baht is lower than on the ringgit; therefore, the Thailand
batt is quoted forward at a premium to the ringgit.

When TH interest rate reduce, investor sell THB buys MYR to place in money market, on
maturity investor sells MYR and buys THB, THB forward rate is at premium.