Hedging Tools Review and Practice Problems with Answers (Teaching Guide

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1. Forward Contract Textbook Definition: Contracts committing the issuer to sell a financial instrument at a given [interest] rate as of a specific date. Translation: You agree to either buy or sell an amount of currency (or whatever else it is) in the future at a price decided upon today. This "price" could be anything...an exchange rate, an interest rate, etc... Other Notable Vocabulary: Long Position: looking to buy Short Position: looking to sell Example The Cat Empire, Australia's hottest new band, is on its first world tour. They are playing in Mongolia for 100,000 Tugriks (MNT), in Kazakhstan for 100,000 Tenges (KZT), in Botswana for 100,000 Pulas (BWP), and in Suriname for 100,000 SRD over the next three months. The band wants to get the most out of its earnings and is planning to use forward contracts to do so. Current Spot Rate 1 AUD = 1050 MNT 1 AUD = 110 KZT 1 AUD = 5 BWP 1 AUD = 2 SRD 3-month Forward Contract Rate 1 AUD = 1000 MNT 1 AUD = 105 KZT 1 AUD = 5 BWP 1 AUD = 4 SRD 3-month Forward Forecasted Rate 1 AUD = 1100 MNT 1 AUD = 100 KZT 1 AUD = 5 BWP 1 AUD = 6 SRD

1) What forward contracts should Cat Empire use to get the most out of the above posted exchange rates? Answer: Anytime the 3-month contract rate yields more AUD than the 3-month forecasted rates, get a forward contract. In this case, Cat Empire will want to be in the short position for Forward Contracts for the MNT and the SRD. To be safe, the Cat Empire may also want to use a Forward Contract for the BWP as well. 2) How many AUD will the Cat Empire have at the end of their three-month tour? Answer: 46,100 AUD (assuming the Forward contracts were used as stated in question 1) (100,000 MNT x 1 AUD/1000 MNT) + (100,000 KZT x 1AUD/100 KZT) + (100,000 BWP x 1 AUD/5 BWP) + (100,000S RD x 1 AUD/4 SRD) = = 100 AUD + 1000 AUD + 20,000 AUD + 25,000 AUD = 46,100 AUD

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2. Foreign Currency Futures Textbook Definition: An agreement to deliver to another a given amount of a standardized commodity or financial instrument at a designated future date. Translation: This is the same thing as a forward contract, but a futures contract can only be in a set increment (kind of like a bank note), such as $100,000 (which is the most common denomination). So you can buy, say, 5 futures contracts worth $500,000. Other Notable Vocabulary: • Futures Price: the price (exchange rate) that you'll get • Round Turn Cost: the administrative cost on each futures contract • Marked to Market: market price to current market value instead of book value Example Henry Avery, a pirate that has spent his life pillaging and plundering the western hemisphere, wants to retire and buy a condominium in Bangalore in I year. The anticipated price on the condominium is expected to be INR 3 million. The 1 year future price is IUSD = INR 40. The cost of a round turn per contract is USD 75. Each Indian Rupee future contract represents INR 500,000. 1) How many USD will Henry need if he were to secure this position? Answer: $75,450 Step One. How much is condo worth in USD? INR 3,000,000 / 40 (spot) = $75,000 Step Two. How much do round cost? INR 3,000,000/500,000 = 6 x $75 = $450 Step Three. What is the total price in USD? $75,000 + $450 = $75,450. 2) If the 1 year spot rate ends up to be 1 USD = INR 30, how many USD will Henry gain/loose? Answer: -$24.550 loss (if he didn’t hedge) Step One. How much is condo worth in USD in the future? INR 3,000,000/3 0 (spot) = $100,000. Step Two. How much do round turns cost? $ 0 (It's not applicable here). Step Three. What is the total loss? $75,450 - $100,000 = -$24,550 loss

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3. Foreign Currency Options Textbook Definition: The right, but not the obligation to buy or sell an underlying security. Translation: You pay money to be guaranteed the right to buy something at a certain price in the future. You don't have to buy it, but you could if you wanted to. Other Notable Vocabulary: • Exercise price: price at which you can buy the underlying security • Call Option: Right to buy a financial instrument at t a specific price. (Call me the money!) • Put Option: Right to sell a financial instrument at a specific price. (Put the money away!) • American Option: May exercise at anytime (but you usually don't). • European Option: Exercise only at a specific date • Long position: You have the currency you need to do something with. You got money. • Short position: You don't have the currency you need to do something with. You don’t got money. • Writer: Must stand behind obligation bound if buyer demands. Examples SPOT RATE
1 DZD = 0.05 AED

90-DAY FORWARD RATE
1 DZD = 0.10 AED

STRIKE PRICE
1 DZD = 0.075 AED

CALL PREMIUM
0.05 AED/DZD

PUT PREMIUM
0.025 AED/DZD

Omar has decided to take a three-month contract in Algeria that will render 500,000 Algerian dinars (DZD) for services rendered. Omar resides in the United Arab Emirates and will need to convert his earnings into dirhams (AED), so his friend Jay recommends he look into options. 1) Which is better for Omar - buying a call or writing a call? Answer: It depends, but for the sake of argument we'll say “Buying a call". Since Omar needs AED, he needs the option to buy AED at the set price in the future, which he gets from buying a call option. However, if he wrote a call option, he would be giving someone else the option the purchase DZD at some point in the future – there’s no guarantee that Omar will get his needed DZD.

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2) Which is better for Omar - buying a put or writing a put? Answer: It depends, but for the sake of argument we'll say “Buying a put". Since Omar needs AED, he needs the option to sell DZD at a set price in the future, which he gets from buying a put option. However, if he wrote a put option, he would be giving someone else the option to sell their AED at some point in the future – there’s no guarantee that Omar will get his needed DZD. 3) Of the four options - buying a call, writing a call, buying a put, and writing a put which is the best bet for Omar? Answer: Write a Call Step One: Calculate Buying a Call. Exchange: 500,000 DZD x 0.075 AED/1 DZD = 37,500 AED Less Premium: 500,000 DZD x 0.05 AED/1 DZD = 25,000 AED Remainder: 12,500 AED Step Two: Calculate Writing a Call (losses are unlimited). Exchange: 500,000 DZD x 0.075 AED/1 DZD = 37,500 AED Gain of Premium: 500,000 DZD x 0.05 AED/1 DZD = 25,000 AED Total: 37,500 AED + 25,000 AED = 62,500 AED Step Three: Calculate Buying a Put. Exchange: 500,000 DZD x 0.075 AED/1 DZD = 37,500 AED Less Premium: 500,000 DZD x 0.025 AED/1 DZD = 12,500 AED Remainder: 37,500 AED – 12,500 AED = 25,000 AED Step Four: Calculate Writing a Put (losses are limited). Exchange: 500,000 DZD x 0.075 AED/1 DZD = 37,500 AED Gain of Premium: 500,000 DZD x 0.025 AED/1 DZD = 12,500 AED Total: 37,500 AED + 12,500 AED = 50,000 AED

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4. Tunnel Forwards Textbook Definition: Guess what... it's not in the textbook. Translation: This is essentially a forward contract, but instead of negotiating a set exchange rate, you negotiate a range of where your exchange rate could fall. Other Notable Vocabulary: • Zero cost range forward: where there is no premium paid. • Strike price on a put set: exchange rate when you are selling currency. • Strike price on a call set: exchange rate when you are buying currency. Example Charlie's rich, world-traveling uncle died and willed Charlie 10 million South African Rand. Charlie will receive his inheritance in 120 days, after all the paperwork and necessary documents are completed. Charlie wants to profit from a predicted devaluation of the USD, but wants to limit his losses in case the dollar rebounds. The current strike prices on a zero cost range forward is a strike on the Rand put set at USD 0.15 and the strike on the Rand call set at USD 0.2. What is the maximum and minimum that Charlie could receive? Answer: minimum: $1,500,000 m; maximum: $2,000,000 m Step One: Calculate minimum: ZAR 10,000,000 x 0.15= $1,500,000 Step Two: Calculate maximum: ZAR 10,000,000 x 0.2 = $2,000,000

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5. Foreign Currency Loan Textbook Definition: Foreign Currency Loans are not discussed in the textbook. (Aren't you glad you came to the TA session?) Translation: You take out a loan in a foreign currency and convert it to your currency today. You have to pay the loan back with interest in the future. Other Notable Vocabulary: • Prime Rate: Same idea as LIBOR - the best possible interest rate available. • Spread or Premium: Depending on your credit rating, what interest rate you pay along with (in addition to) the prime rate. • Arrangement Fee: Essentially the fee that the bank charges you for their administration costs. Example Kumar Sangakkaraa, cricket player from Sri Lanka, has been offered a new job during the off-season as a little-league cricket coach in India. The job lasts for three months, but he won't get paid his 500,000 INR until the end of his contract. To pay for his living expenses during those three months, Kumar is considering taking out a foreign currency loan. The loan could be made at 3% above the present Indian prime rate of 8% plus an arrangement fee of 0.2%. The Sri Lankan prime rate is currently 10%, and Kumar will not pay a spread above that or an arrangement fee because he is a super star in Sri Lanka. If the spot rate is currently 1 Sri Lankan Rupee (SLR) = 0.35 Indian Rupees (INR) and the 3-month forward rate is 1 Sri Lankan Rupee = 0.30 Indian Rupees, should Kumar take the foreign currency loan? Answer: No! Kumar's best choice would be to convert enough SLR to bring 500,000 INR with him to India - when he gets paid in 3 months, his contract will be worth more than he paid for the 500,000 INR, thanks to depreciation of the INR against the SLR. His second best choice would be to take out a loan in Sri Lanka for enough SLR to bring 500,000 INR and then pay back the interest when he returns to Sri Lanka - again, depreciation of the INR against the SLR makes the 500,000 INR contract worth a lot more in three months. It would be better not to pay a loan back in INR. Step One. How much is the 500,000 INR worth to Kumar today? 500,000 x 1/0.35 = 1,428,571 SLR Step Two. How much will the 500,000 INR be worth in 3 months? 500,000 * 1/0.30 = 1,666,666 SLR Step Three. What are the costs associated with the foreign currency loan? • • • Total Interest Paid: 500,000 x (0.08 + 0.03) = 55,000 INR Total Arrangement Fee: 500,000 x 0.002 = 1,000 INR Amount that Kumar would receive today: 500,000- (55,000+ 1,000) = 444,000 INR 6

What is this worth in SLR: 444,000 x 1/0.35 = 1,268,571 SLR

Step Four. Explore other options…local currency loan!?! Total Paid in 3 Months: 1,428,517 x 1. 1 = 1,571,428 SLR, where 1.1 was derived from (1 + (0.1/4)) – annual rate is adjusted to 3 months. Calculate the opportunity cost (interest rates are adjusted for the 3 months). Step One. Calculate what Kumar will receive after paying the 11% interest. 500,000 / (1+(0.11/4)) = 486,618 Step Two. Calculate the arrangement fee. 500,000 x 0.002 = 1,000 Step Three. Calculate the amount received today using the loan. 486,618 – 1,000 = 485,618 Step Four. Convert into SLR. 485,618 / 0.35 = 1,387,480 Step Five. Calculate the opportunity cost. 1,387,480 x (1 + (0.1/4)) = 1,422,167

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6. Pre-sale of a Foreign Contract Textbook Definition: Again, this isn't in the textbook. It's nice to know this is an option though. Translation: You're expecting to collect on a contract in the future. Instead of waiting for your money, you sell your contract to a third party and get your money today. Example Miss Universe Riyo Mori has been offered a 6-month contract worth 5 million USD to star on an American cable television show. Riyo doesn't want to wait for 6 months to collect on her contract as the Yen is depreciating against the USD. The spot rate is 1 YEN = 5 USD, the 6-month forward rate is 1 YEN = 10 USD, and LIBOR is currently 4%. Riyo could pre-sell her contract for an interest rate of 1.5%+ LIBOR and a flat up-front fee of 1%. Should she take the deal? Answer: Yes!!! She would receive a lot more yen now than she would six months from now. Step One: How much is the contract worth today? 5,000,000 x 1/5 = 1,000,000 YEN Step Two: How much is the contract worth in 6 months? 5,000,000 x 1/10 = 500,000 YEN Step Three: What are the costs associated with the pre-sale of her contract? • • • • Interest Paid: 5,000,000 x (0.04 + 0.015) = 275,000 USD Flat up-front Fee: 5,000,000 x 0.01 = 50,000 USD Amount received today: 5,000,000 - (275,000 - 50,000) = 4,775,000 USD Converted today: 4,775,000 x 1/5 = 955,000 YEN

Calculate opportunity costs (interest rates are adjusted for the 6 months). Step One. Calculate what Riyo will receive after paying the 5.5% interest. 5,000,000 / (1 + (0.055/2)) = 4,866,180 Step Two. Calculate the arrangement fee. 5,000,000 x 0.01 = 50,000 Step Three. Calculate the amount received today through the pre-sale. 4,816,180 / 5 = 963,236 Step Four. Calculate the opportunity cost. 963,236 x (1 + (Rus/2)) = …..

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