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Master of Business Administration –
Financial Risk Management
Cohort: MBAFRM/12/PT (Jan 12)
Examinations for 2012 – 2013 Semester II
/ 2013 Semester I
MODULE: FINANCIAL HEDGING AND DERIVATIVES
MODULE CODE: ACCF5224
Duration: 3 Hours
Instructions to Candidates:
1.
This paper consists of Section A and Section B.
2.
Section A is Compulsory.
3.
Answer any two questions from Section B.
4.
Always start a new section on a fresh page.
5.
Total marks: 100.
This question paper contains 5 questions and 9 pages.
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SECTION A: COMPULSORY
QUESTION 1: (60 MARKS)
PART A
Max is the chief financial officer of Vameda Corporation, a global manufacturer of
mobile communication devices. Vameda is headquartered in Germany and reports its
financial statements in Euros (EUR).
Vameda expects to make major financial transactions in the coming months; one of
them is as follows:
 The company will issue a note of 100 million U.S dollars (USD) in three months
(90 days) time. The note will have six-month (180 days) term, and the proceeds
will be used to meet the working capital needs of Vameda’s U.S operations.
Max must first decide whether to hedge the interest rate exposure on the U.S borrowing
with a forward rate agreement (FRA) or with futures contracts.
 Using the information in Exhibit 1 and a 30/360 day count, Max calculates the
FRA rates implicit in the term structure. Stream Partners, a large brokerage
house, offers Vameda an FRA rate of 4.68 percent for the USD 300 million note
in three months time (with settlement at initiation of the loan).

EXHITBIT 1
CURRENT TERM STRUCTURE OF USD LIBOR RATES
(Annualized)
Terms (days)
Rate (%)
30
3.10
60
3.40
90
3.71
180
3.99
270
4.12
360
4.22
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Max assumes that the interest rates in the exhibit are risk-free rates in his analysis.
Required:
a)
Provide the six-month FRA rate three months from now, implicit in the current
term structure of USD LIBOR rates (Exhibit 1).
b)
(8 marks)
Following 30 days in the contract, Max intends to value the contract. The term
structure is as follows:
Terms (days)
Rate (%)
60
3.65
240
4.05
Calculate the market value of the FRA with 30 days into the contract.
(7 marks)
c)
Assuming a 180-day spot rate of 4.38 percent at expiration of the FRA, what will
be the payoff of Vameda from the FRA offered by stream Partners.
(5 marks)
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PART B
Crystal Resort has a credit facility with a Bank in Mauritius which is priced at the floating
rate. The client current commitment is quarterly interest payment and capital repayment
at maturity with a notional principal of USD 100M. The tenor for the facility is 1 year.
Mike has a concern about the volatility of interest rates on the cash flows of the
company. The bank has proposed a swap to Crystal Resort.
EXHIBIT 3
DAYS
Term Structure of Interest Rates
RATE (%)
90
1.90
180
2.15
270
2.25
360
2.50
Required:
(i)
Calculate the swap rate applicable for the facility of Crystal Resort based on the
current prevailing interest rates in Exhibit 3.
(10 marks)
Ninety days after entering the swap agreement, the term structure is as follows:
EXHIBIT 4
DAYS
Term Structure of Interest Rates
RATE (%)
90
2.45
180
2.50
270
2.60
(ii) Calculate the market value of the swap for Crystal Resort.
(10 marks)
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PART C
Assume that you own a dividend-paying stock currently worth USD150. You plan to sell
the stock in 250 days. In order to hedge against a possible price decline, you wish to
take a short position in a forward contract that expires in 250 days. The risk-free rate is
5.25%. Over the next 250 days, the stock will pay dividends according to the table
below:
Days to next dividend
Dividend Per share (USD)
30
1.25
120
1.25
210
1.25
(i) Calculate the forward price of a contract established today and expiring in 250
days.
(10 marks)
(ii) It is now 100 days since you entered the forward contract. The stock price is
USD115. Calculate the value of the forward contract at this point.
(10 marks)
SECTION B: ANSWER ANY TWO QUESTIONS
QUESTION 2: (20 MARKS)
Jacob manages the equity portion of the Bold Beverages Pension Fund, which is
converting its pension plan from defined benefit to defined contribution, effective three
months from now.
Plan participants have three months to elect various investments for the new plan. The
trustees inform Jacob that they wish to keep the value of the pension fund stable during
these three months.
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Accordingly, Jacob wants to eliminate systematic risk in the equity portion of the fund by
using futures on the FTSE 100 Index, which is the benchmark for the fund’s equity
portfolio. She collects the information shown in Exhibit 2.
Required:
(i) State the target beta for Jacob’s hedging strategy.
(5 marks)
(ii) Determine the number of futures contracts that Jacob should sell to achieve the
target. Show your calculations.
(5 marks)
Three months after Jacob implements the hedge, the FTSE 100 Index is up 3.75%. The
equity portion of the Bold Beverages Pension Fund is up 3.50% and the level of the
expiring three-month FTSE 100 futures contract that Jacob sold is 4,824. The trustees
ask Jacob to assess the effectiveness of the hedge that has been in place.
Required:
(iii) Determine the effective beta of the Bold Beverages Pension Fund equity
portfolio, including the futures, assuming that Jacob sold 5,200 futures
contracts. Show your calculations.
(5 marks)
(iv) What are modes of settlement for a futures contract at maturity of the contract?
(5 marks)
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QUESTION 3: (20 MARKS)
Mitsui Plc, a Japan-based automobile company, is contracting two foreign currency
loans for three months which are as follows: USD 450 million EUR 350 million for
working capital purposes in Japan. The loan is a floating rate loan with bullet repayment
in terms of capital and interest. Mitsui Plc home currency is the Japanese yen (JPY). On
1 July 2011, Mitsui is taking the loan and decides to fully hedge the currency risk of the
principal value of the loan for the next three months. Data are presented in Exhibit 1.
Exhibit 1
Foreign Exchange Rates
1 July 2011
Spot rate (JPY/USD)
115.90
Spot rate (JPY/EUR)
155.75
September dollar futures contract
115.70
(size = USD 100,000) (JPY/USD)
September Euro futures contract
156.70
(size = EUR 100,000) (JPY/EUR)
(a) State the futures positions that Mitsui Plc should take on 1 July 2011, to hedge
the loans` currency risk. Calculate the number of contracts needed to hedge.
Show your calculations.
(5 marks)
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On 30 September 2011, Mitsui is informed that loan repayments inclusive of interest are
as follows: USD 472.5 million; and EUR 367.5 million. Current foreign exchange data
are presented in Exhibit 2.
Exhibit 2
Foreign Exchange Rates
30 September 2011
Spot rate (JPY/USD)
125.30
Spot rate (JPY/EUR)
165.40
September dollar futures contract
125.55
(size = USD 100,000) (JPY/USD)
September euro futures contract
166.76
(size = EUR 100,000) (JPY/EUR)
(b) Evaluate the effectiveness of the Mitsui Fund’s hedge by comparing the fully
hedged portfolio cost of fund with the unhedged portfolio cost of fund. Show your
calculations for the hedge portfolio and unhedge portfolio funding cost
separately.
(15 marks)
QUESTION 4 (20 MARKS)
Suppose that you are a US-based importer of goods from the UK. You expect the value
of the pound to increase against the USD over the next 30 days. You will be making
payment on a shipment of imported goods in 30 days and want to hedge your currency
exposure. The US risk-free rate is 5.5% and the UK risk-free rate is 4.5%. These rates
are expected to remain unchanged over the next month. The current spot rate is
USD1.25.
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Required:
a) Indicate whether you should use a long or short forward contract to hedge the
currency risk.
(3 marks)
b) Calculate the no-arbitrage price at which Avalon could enter into a forward
contract that expires in 30 days.
(5 marks)
c) Move forward 10 days. The sport rate is $1.15. Interest rates are the same as
before. Calculate the value of your forward position.
(5 marks)
d) Advise under what scenario it is better to use an accrual forward contract as
compared to a normal forward contract and in the above case, would the use of
an accrual forward contract more beneficial.
(7 marks)
QUESTION 5: (20 MARKS)
a) What are the methods of external currency risk management?
(5 marks)
b) Briefly outline the characteristics of a futures contract and the benefits over a
forward contract.
(6 marks)
c) Briefly explain the process of marking to market in a futures market and how it
reduces risk of default.
(5 marks)
d) Distinguish between a forward contract and a participating forward contract.
(4 marks)
***END OF QUESTION PAPER***
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