Prof.

Roberto Steri Review Session - Midterm Exam Spring 2019

Review Session

Preparation for Midterm Exam

1
Prof. Roberto Steri Review Session - Midterm Exam Spring 2019

1. Tonga Boys Ltd is a US …rm that regularly receives payments denominated in Tonga Pa’anga
(TAP) from its product sales in the Kingdom of Tonga. The 3-month USD risk-free rate
2.50%, the 3-month TAP risk-free rate is 12%. All rates are annualized and continuously
compounded. The 3-month forward USDTAP
exchange rate is 0:6 USD
TAP
.

TAP
a) Determine the spot USD
exchange rate that guarantees no arbitrage in the FOREX
market.
b) Describe exactly what transactions Exotic KickAsset Fund, a US-based trader, would
implement to generate an arbitrage pro…t using the contract described above. Suppose
that the TAP
USD
spot exchange rate is 1:6. How much would be the arbitrage pro…t in TAP
in three months if Exotic KickAsset Fund can borrow at most 1,000 TAP in the Kingdom
of Tonga today?
c) After Exotic KickAsset Funds trades, the forward price converges to its no arbitrage
USD
value of F0 = 0:6103 TAP . Then, suppose Tonga Boys Ltd enters a long position in
the three-month contract above to hedge FOREX receivables to receive USD at F0 for
an amount of 1 mln TAP. At maturity the spot exchange rate is S3 = 0:65 USD TAP
, but
after their client delays the promised payment and gets a three-month extension, Tonga
Boys Ltd would like to roll over the contract and enter another three-month forward
contract. What is Tonga Boys Ltd’s loss three months from now due to the change in the
"intermediate" exchange rate S3 ? Using no other forward contract besides the one
described above, propose a way for Tonga Boys Ltd to hedge completely currency risk
related to variations in S3 . Verify that the …nal payo¤ in six months with your proposed
solution does not depend on S3 . Assume trading commissions, margin requirements,
and transaction costs are negligible, and that there are no arbitrage opportunities in the
market.

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Prof. Roberto Steri Review Session - Midterm Exam Spring 2019

2. Consider the following specs for futures contracts on Ethanol traded on the Chicago Mercantile
Exchange (CME):

Venatine Inc., a gasoline producer, will require 145,000 gallons (gal) of ethanol in April 2015.
The price for April 2015 delivery is 1.47 $/gal. While the spot price today (January 2015) is
1.45 $/gal, Venatine prefers to trade futures instead of incurring costs of storing ethanol to
hedge its price. For logistic reasons, Venatine will not have the ethanol delivered through the
futures contract, but will close its futures position on the April 2015 spot market and buy
ethanol at the spot price.

a) How many contracts should Venatine buy or sell to minimize its exposure to ethanol
price? What is the e¤ective cost of purchasing ethanol if April 2015 price would be 1.45
$/gal, with and without the hedge you propose? What if April 2015 price would be 1.35
$/gal instead?
b) Venatine has mandated a market research company to study the possible scenarios for
the ethanol market in April 2015. After reading their report, Venatine’s management
believes in the following scenario:
April Ethanol
Strong Weak
Probability pS pW
Spot Price 1.55 1.35

where pS and pW are the probability the …rm attaches to the strong and weak market
conditions and the management is trying to evaluate. The company needs to decide how
much of the 145,000 gal. requirement to purchase on the spot market in April 2015, and
how much with the April 2015 futures. Suppose the …rm is risk neutral. What is your
recommendation based on the values of pS and pW ?
c) Venatine has recently decided to modernize its storage technology. In light of this, the
company is now deciding how much ethanol to purchase today (January 2015) on the spot

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Prof. Roberto Steri Review Session - Midterm Exam Spring 2019

market and store until April, and how much to purchase in April and hedge using futures
contracts. Venatine’s new storage technology entails marginally increasing storage costs.
In particular, for each gallon stored from January to May, there is a marginally increasing
cost, whose present value S is given by
Q
S=e

where Q is the stored quantity, = 0:00004.

Since convenience yields and interest rates are expected to be approximately the same, the
time value of money is negligible and can be ignored. The maximum amount of ethanol
Venatine is able to store is 116; 000 gallons. How much ethanol would you recommend
Venatine to store, and how much to purchase in April and hedge using futures? How
$
many futures contracts should Venatine purchase? How much, in gal , is Venatine willing
to pay CoolTanks, a company that outsources storage services for ethanol, to store one
additional gallon purchased now? Is Venatine exposed at all to the risk arising from
‡uctuations in April’s ethanol price?