Tutorial 1
Tutorial 1
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Question 3
You are a star trader and observe two events:
1. A severe drought in Brazil, the world largest orange
juice producer
2. A deadly citrus virus resulting in decrease in orange
crops in the US
Frozen concentrated orange juice (FCOJ) futures
contract
– One FCOJ contract covers 15,000 pounds of orange juice
solids.
– Standard delivery months are Jan, Mar, May, July, Sep and
Nov.
Your action: Traded 10 long Sep-21 FCOJ futures
contracts at F = 200 cents/pound
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Question 3a.
(a) Having entered 10 long FCOJ contracts, what are your
obligations? What is the risk you face that might keep you
awake at night?
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Question 3b:
(b) The futures price for Sep-21 FCOJ has risen sharply to 230
cents per pound. You jump on the computer and sell-to-close 10
Sep-21 FCOJ futures. Calculate your profit from trading these
orange juice futures
Opening trade: Long ten Sep-21 FCOJ contracts: 10 × 15,000 × 200 USD 300,000
Closing trade: Short ten Sep-21 FCOJ contracts: 10 × 15,000 × 230 USD 345,000
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Profit USD 45,000
Question 3c.
To understand the possible payoffs from long futures (and
forward) positions, complete the table below. Plot you
answer to see the payoff diagram
Calculate profit or loss if Sep-21 FCOJ futures
price is:
100 125 150 175 200 225 250 275 300
Profit or loss -150k -112.5k -75k -37.5k nil +37.5 +75k +112.5 +150
on ten long k k k
FCOJ futures
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Question 4
Today is 1 July and the spot exchange rate between
Australian dollars and Swiss francs is AUD 1.00 = CHF
0.74. That is, one AUD buys you 0.74 Swiss franc. Your
local bank quotes a six-month forward rate at AUD 1.00 =
CHF 0.7450
(a) If I talk about the CHF ‘strengthening’ relative to the
AUD, what does this mean? That is, give me an example
of an exchange rate quote after the CHF has
strengthened.
– The convention is to quote an exchange rate as AUD 1.00
buys X foreign dollars (this is referred to as an indirect
quote). For example, AUD 1.00 = CHF 0.74.
– How much does it cost to buy one Swiss franc? AUD
1.3514. This is a direct quotation: CHF 1.00 = AUD 1.3514
– This practice also makes it much easier to understand the
jargon of currencies ‘strengthening’ and ‘weakening’.
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Question 4a
(a) If the CHF strengthens, it becomes more expensive to buy.
Buying CHF 1.00 will cost more than AUD 1.3514. For
example, the cost of one CHF might be AUD 1.40. In such a
case, the quoted exchange rate after strengthening is thus
1/1.40 = 0.7143. (i.e. AUD1.00 = CHF 0.7143)
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Question 4b
However, the question wants us to speculate using the forward
contract.
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Question 4c
The spot exchange rate at 31 December maturity is 0.80.
This represents a weakening of the CHF (thus, our
calculation below must show a loss). The quoted forward
rate for delivery on 31 Dec must also be 0.80 (else trivial
arbitrage opportunity – see Tutorial 1 Question 6).
So the ‘price’ of a CHF is 1.2500 (AUD1.00 = 0.80
CHF1.00 = 1.2500). We close out by shorting CHF 60,000
at this low price.
In July Enter long forward AUD80,538
contract:
CHF60,000*1.3423
In December Close out by AUD75,000
shorting forward
contract
CHF60,000*1.2500
Loss AUD5,538
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Question 4c
Note: when we enter this long forward contract in July, no
money changes hands. It is just a contract which has a
notional value of $A80,538.
Likewise, when we close out by shorting the contract, we
do not receive the notional value of $A75,000. The only
cashflow is us handing over $5,538.
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Question 4d
The spot exchange rate at 31 December maturity is 0.70.
the CHF has strengthened considerably. This what we
were hoping when we entered a long forward on Swiss
Francs. The price of a CHF is AUD1.4286. ( CHF1.00
=1/0.70 = 1.4286AUD)
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Question 5
Plan: A trip at the end of Semester 2.
Today as of 1 August: AUD 1.00 = EUR
0.6800
Budget: EURO 10,000
You fear that the Australian Dollar might
weaken (i.e. EURO might strengthen)
between now and December, thus
impacting on the quality of your vacation
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Question 5a
(a) Assume that you decide to do nothing about your
exposure to exchange rate risk. In December, the day
before your departure, you visit the bank and ask to buy
EUR10,000 for your holiday. Assume that the spot
exchange rate in December is AUD 1.00 = EUR 0.5000.
How much will the EUR10,000 cost you?
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Question 5c
By using a forward contract, we can lock in today the price
at which we can buy Euros in December, thus removing
any risk of exchange-rate movements.
(i) calculate how much it will cost you to buy EUR 10,000 now at the spot
rate,
(ii) arrange a loan from the local bank at 2% p.a. continuously-compounded
interest so that you can buy the Euros now,
(iii) in December, you repay the balance of that loan in full. The effective cost
of your vacation is the payout figure on the loan. How much is it?
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Question 5e
Note that the vacation cost in part e is identical to the
vacation cost when a forward contract was utilised in
part c (with $1 rounding difference).
In Lecture 3, we will see the same logic being used to
establish the fair price for currency forward contracts (i.e.,
factoring in the spot exchange rate and the interest rates
in the two countries). This is how banks determine forward
rates.
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