Hedging Strategies To Manage Risk PDF

Hedging Strategies To Manage Commodity Price Risk
Karen Ósk Finsen
Thesis of 30 ECTS credits

Master of Science in Financial Engineering
June 2018
by
Karen Ósk Finsen
Thesis of 30 ECTS credits submitted to the School of Science and Engineering

at Reykjavík University in partial fulfillment
of the requirements for the degree of
Master of Science (M.Sc.) in Financial Engineering
June 2018
Supervisor:
Dr. Sverrir Ólafsson, Supervisor
Professor, Reykjavík University, Iceland
Examiner:
Dr. Sigurur Pétur Magnússon, Examiner
Arion Banki, Reykjavík, Iceland
i
Copyright
Karen Ósk Finsen
June 2018
ii
Karen Ósk Finsen
June 2018
Abstract
Price fluctuations in commodity markets can have a significant impact on potential profits,
both for those who use and produce that commodity. Commodity prices, which are based
on the supply and demand of a market, are very volatile and it is nearly impossible to predict
exactly which way a price will move in the future. Companies that are impacted by unexpected
commodity price movements should consider managing these risks and minimizing their
effects through the use of financial market instruments. The purpose of this thesis is to use risk
management strategies and derivatives to hedge risks faced by an Icelandic manufacturer that
uses gold as an input. Fluctuating gold prices and foreign exchange rates are causing changes
in cash flows and affecting the company’s profitability. To reduce these risks, the company
can hedge its exposure through the use of derivatives, such as futures contracts, forward
contracts, options and swaps. Historical data on gold prices and foreign exchange rates are
used to predict future prices and to calculate Value at Risk. Black Scholes model and Monte
Carlo simulation are used for option pricing. In conclusion, risk management strategies and
derivatives reduce price uncertainty and stabilize future cash flow. But considerable risk can
also accompany the use of risk management, whereby the price of the underlying asset can
develop in a different direction to what was predicted.
iii
Áhættuvarnir Gegn Versveiflum á Hrávörumarkai
Karen Ósk Finsen
júní 2018
Útdráttur
Versveiflur á hrávörumörkuum geta haft veruleg áhrif á fjárhagslegan ávinning fyrirtækja

sem stunda viskipti me hrávörur. Mikil óvissa ríkir almennt á essum mörkuum og getur
ví áhættan veri mikil bæi fyrir au fyrirtæki sem nota og framleia hrávörur. Til ess
a verjast essum óvæntu versveiflum á markai er hægt a nota aferir áhættust˝ringar
og tryggja ar af leiandi stöugra tekjustreymi í framtíinni. Markmi essara ritgerar
er a s˝na hvernig íslenskt fyrirtæki sem notar gull í framleislu sinni getur nota áhætt-
urvarnir og afleiusamninga til ess a verja sig fyrir áhættum sem a a stendur frammi
fyrir. Helstu áhættu ættir sem hafa áhrif á tekjustreymi fyrirtækisins eru verbreytingar á
gulli, gjaldeyrishreyfingar og vaxtabreytingar. Skoa er hvernig fyrirtæki getur n˝tt sér
framvirka samninga, valrétti og skiptasamninga til ess a draga úr essum helstu áhættu-
áttum. Notast var vi söguleg gögn um ver á gulli og gengis róun krónunnar gagnvart
bandaríkjadal til a spá fyrir um framtíarver og til ess a reikna áhættuviri sem segir
til um hugsanleg tap fyrirtækisins á ákvenu tímabili í framtíinni. Black-Scholes aferin
og Monte Carlo hermun eru notaar til ess a verleggja valréttina. Helstu niurstöur
eru ær a áhættust˝ring og notkun afleiusamninga dregur úr helstu áhættum me ví a
stula a stöugum tekjum og minnka verulega óvæntar versveiflur í rekstri fyrirtækisins.
En a getur líka fylgt ví töluver áhætta a notast vi áhættust˝ringu ar sem veri á
undirliggjandi eign getur róast í ara átt en búi var a spá fyrir um.
iv
Karen Ósk Finsen
Thesis of 30 ECTS credits submitted to the School of Science and Engineering

at Reykjavík University in partial fulfillment of
the requirements for the degree of
Master of Science (M.Sc.) in Financial Engineering
June 2018
Student:
Karen Ósk Finsen
Supervisor:
Dr. Sverrir Ólafsson
Examiner:
Dr. Sigurur Pétur Magnússon
v
The undersigned hereby grants permission to the Reykjavík University Library to reproduce
single copies of this Thesis entitled Hedging Strategies To Manage Commodity Price
Risk and to lend or sell such copies for private, scholarly or scientific research purposes only.
The author reserves all other publication and other rights in association with the copyright
in the Thesis, and except as herein before provided, neither the Thesis nor any substantial
portion thereof may be printed or otherwise reproduced in any material form whatsoever
without the author’s prior written permission.
date
Karen Ósk Finsen

Master of Science
vi
vii
Acknowledgements
I would like to thank my supervisor Dr. Sverrir Ólafsson for all his help and
guidance through this research. I would also like thank my family and friends
for all the support over the last years.
viii
Contents
Acknowledgements viii
Contents ix
List of Figures xi
List of Tables xiii
List of Abbreviations xiv
1 Introduction 1
2 Risk and risk management 2

2.1 What is risk? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
2.2 Financial risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
2.3 Risk management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
2.4 Why manage risk? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
3 Types of risk faced by corporations 4

3.1 Foreign exchange risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
3.2 Interest rate risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
3.3 Commodity price risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
4 How to quantify risk? 6

4.1 Risk as spread in returns . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
4.2 Value at Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
4.3 Risk from foreign investment . . . . . . . . . . . . . . . . . . . . . . . . . 7
4.4 Monte Carlo . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
5 Instruments available for risk management purpose 9

5.1 Forward contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
5.2 Futures contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
5.2.1 Payoffs from forward and future contracts . . . . . . . . . . . . . . 10
5.2.2 Forward contracts on currencies . . . . . . . . . . . . . . . . . . . 10
5.3 Vanilla options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
5.3.1 Options positions . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
5.4 Asian options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
5.5 Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
5.6 Hedging strategies using derivatives . . . . . . . . . . . . . . . . . . . . . 13
ix
6 Valuing and pricing derivatives 14
6.1 Valuing European options . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
6.2 Valuing currency options . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
6.3 Implied volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
6.4 Monte Carlo methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
6.5 Ornstein-Uhlenbeck process . . . . . . . . . . . . . . . . . . . . . . . . . 16
6.6 Valuing a commodity swap . . . . . . . . . . . . . . . . . . . . . . . . . . 16
6.7 Valuing a fixed-floating currency swap . . . . . . . . . . . . . . . . . . . . 17
7 Description of the risks the firm faces 19

7.1 Description of the firm to be discussed . . . . . . . . . . . . . . . . . . . . 19
7.2 Commodity price risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
7.3 Instruments available to manage commodity price risk . . . . . . . . . . . . 27
7.3.1 Commodity futures . . . . . . . . . . . . . . . . . . . . . . . . . . 27
7.3.2 Commodity options . . . . . . . . . . . . . . . . . . . . . . . . . . 27
7.3.3 Commodity swaps . . . . . . . . . . . . . . . . . . . . . . . . . . 27
7.4 Foreign exchange risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
7.5 Instruments available to manage foreign exchange risk . . . . . . . . . . . 31
7.5.1 Forward exchange contract . . . . . . . . . . . . . . . . . . . . . . 31
7.5.2 Currency options . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
7.5.3 Currency swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
7.6 Comparison of the two risk types . . . . . . . . . . . . . . . . . . . . . . . 31
8 Implementation of risk management strategies 35

8.1 Hedging gold price with a future contract . . . . . . . . . . . . . . . . . . 35
8.2 Hedging foreign exchange rate with a forward contract . . . . . . . . . . . . 36
8.3 Pricing a European call option . . . . . . . . . . . . . . . . . . . . . . . . 38
8.4 Pricing Asian call option . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
8.5 Pricing a currency call option . . . . . . . . . . . . . . . . . . . . . . . . . 42
8.6 Pricing a gold swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
8.7 Pricing a currency swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
8.8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
9 Discussion and Conclusion 52
Bibliography 53
x
List of Figures
2.1 Risk management planning process . . . . . . . . . . . . . . . . . . . . . . . . 3

2.2 Risk management implementation process . . . . . . . . . . . . . . . . . . . . 3
5.1 Payoff from a long

position at maturity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
5.2 Payoff from a short
position at maturity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
position in a call option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
position in a call option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
position in a put option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
position in a put option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
7.1 Historical data of gold prices between 4 December 2015 and 4 December 2017. 20
7.2 The daily gold price change . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
7.3 Probability density function for the returns. . . . . . . . . . . . . . . . . . . . 22
7.4 Cumulative probability function for daily gold price changes . . . . . . . . . . 23
7.5 VaR as a function of time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
7.6 Simulated 10,000 price paths for gold using the Ornstein-Uhlenbeck process. . 25
7.7 Profit loss probability density function for June 2018 . . . . . . . . . . . . . . 26
7.8 Profit-and-loss probability density function for December 2018 . . . . . . . . . 26
7.9 Historical data of the foreign exchange rate. . . . . . . . . . . . . . . . . . . . 28
7.10 Daily change in exchange rate . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
7.11 Probability density function for daily rate returns . . . . . . . . . . . . . . . . 30
7.12 Cumulative probability function for daily rate change . . . . . . . . . . . . . . 30
7.13 Daily gold price in ISK/oz. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
7.14 VaR calculations for given months . . . . . . . . . . . . . . . . . . . . . . . . 34
8.1 The profit diagram for the long Gold futures contract with maturity in June 2018. 36
8.2 The profit diagram for the long foreign exchange rate forward contract with
maturity in June 2018. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
8.3 10,000 simulated price paths 252 days into the future. . . . . . . . . . . . . . . 38
8.4 The profit from a long position in a call option with strike 1280 in June 2018. . 40
8.5 Simulated price paths for foreign exchange rate . . . . . . . . . . . . . . . . . 43
8.6 Payoff from a long currency call option . . . . . . . . . . . . . . . . . . . . . . 44
8.7 The present value of the swap contract at different maturities. . . . . . . . . . . 46
xi
8.8 The present value of the currency swap contract at different maturities. . . . . . 48
8.9 The probability density function for the present value of option payments . . . . 50
xii
List of Tables
7.1 The USD Libor rates, required quantities of gold, the future price and the expected
exposure for gold based on information on 4 December 2017. . . . . . . . . . . 20
7.2 Theoretical and Empirical probabilities . . . . . . . . . . . . . . . . . . . . . . 22
7.3 The 95% VaR risk for the gold price. . . . . . . . . . . . . . . . . . . . . . . . 23
7.4 Gold price forecast from January 2018 and December 2018. . . . . . . . . . . 25
7.5 The 95% VaR for the gold price. . . . . . . . . . . . . . . . . . . . . . . . . . 27
7.6 The calculated forward exchange rate . . . . . . . . . . . . . . . . . . . . . . . 28
7.7 Theoretical and Empirical probabilities . . . . . . . . . . . . . . . . . . . . . . 29
7.8 Forward exchange rate and gold future price in USD per oz and ISK per oz. . . 32
7.9 Correlation between the return of gold price and foreign exchange rate . . . . . 33
7.10 The 95% VaR risk for the gold price in ISK. . . . . . . . . . . . . . . . . . . . 33
8.1 The future price for gold ($/oz). . . . . . . . . . . . . . . . . . . . . . . . . . 35

8.2 Calculated forward exchange rate . . . . . . . . . . . . . . . . . . . . . . . . . 37
8.3 Valuation of call options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
8.7 Probabilities for monthly gold price to be greater than the strike price . . . . . 41
8.8 Valuations of Asian call options . . . . . . . . . . . . . . . . . . . . . . . . . 41
8.11 Calculated Monte Carlo price and Black Scholes price for currency call option . 43
8.12 The Swap Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
8.13 The Currency Swap Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
8.14 Compared hedging strategies for gold prices . . . . . . . . . . . . . . . . . . . 49
8.15 Compared hedging strategies for exchange rate . . . . . . . . . . . . . . . . . . 51
8.16 Compared hedging strategies for exchange rate . . . . . . . . . . . . . . . . . . 51
xiii
List of Abbreviations
VaR Value at Risk

OTC Over the counter
SDE Stochastic differential equation
PV Present Value
pdf Probability density function
cdf Cumulative density function
xiv
Chapter 1
Introduction
Uncertainty in commodity prices poses a huge risk to producers, manufactures and con-
sumers, who are all affected by fluctuations in the market prices. Prices are based on supply
and demand of a market and therefore it can be difficult to predict future price movements.
A business operating in the commodity markets should consider managing these risks where
fluctuations in commodity prices may impact business profitability.
Companies that are exposed to commodity risk may also be exposed to foreign exchange
risk, since most commodities are quoted in US dollars. Managing only commodity risk will
leave the company exposed to adverse movements in foreign exchange rates. When locking
the price in US dollars, the foreign exchange risk remains. With fluctuating commodity
prices, foreign exchange rate risk can be complicated to manage. By using appropriate risk
management strategies, the risk of unexpected price movements can be reduced.
Risk management is not always profitable because there can be risk and potential loss if
the price of the underlying asset develops in a different direction to what was predicted or if
the company chooses an inappropriate risk management tool. Therefore, a risk management
plan must be appropriately implemented if it is to be successful.
The objective of this research is to reduce market price risk and foreign exchange risk
of a company operating in the jewelry industry by implementing risk management strategies.
The aim is to find the best way for the company to manage these risks. This thesis will
answer the following main questions:
• What is the purpose of implementing risk management strategies?
• What are the reasons firms seek to manage risk?
The outline of this thesis is as follows. Chapter 2 begins with a description of risk and risk
management. Chapter 3 discusses the description of risks faced by corporations, commodity
price risk, foreign exchange risk and interest rate risk. Chapter 4 introduces methods to
quantify risks. Derivatives are introduced as instruments available for risk management in
Chapter 5 while Chapter 6 demonstrates methods for valuing and pricing these derivatives.
Chapters 7 describe the firm and the risks the firm faces. In Chapter 8, implementation of risk
strategies for the firm is described. Finally, Chapter 9 presents discussion and conclusions.
Chapter 2
Risk and risk management
2.1 What is risk?

Risk is the possibility of something unexpected happening which can lead to a loss of any
type. Everything we do in our daily lives involves some kind of risk. Most people want
to avoid taking more risks in daily life than necessary, which is why high risk exposure or
the possibility of something unexpected happening require us to take corrective action, for
instance insuring our life, home, car and other possessions. Risk is essentially received as
negative but risk can also provide an business opportunities.
2.2 Financial risk

Financial risk is caused by movements in financial variables and involves financial loss to
corporations. Financial risk can be classified as following types of risk, such as market
risk, credit risk, liquidity risk and operational risk. Market risk arises from the unexpected
changes in stock prices, commodity prices, foreign exchange rates, interest rates and so on.
Credit risk is the risk of loss arising from the failure of a counterparty to make a promised
payment. Liquidity risk is the risk that arises when transactions cannot be undertaken at
prevailing market prices due to insufficient market activity. Operational risk is the risk of
loss arising from the failure of management or technology [1].
2.3 Risk management

Risk management involves procedure for becoming aware of risks and the methods used to
analyze risks, asses their impact and minimize them. An objective needs to be defined in
deciding how and when to manage risks and what to do about them. When measuring risk, it
is important to identify all the key risk factors for the company to help identify a company’s
exposure to uncertainty. Measuring these risks requires analysis of the potential exposure
and an understanding of how these risks can affect the company. Financial risk management
is the activity of monitoring financial risk and managing their impact. Risk can be reduced
or even eliminated through hedging and diversification [1].
. . WHY MANAGE RISK 3
Do nothing
Identify risk Quantify risk Optimize exposure to risk Diversify
Hedge
Figure 2.1: Risk management planning process
Successful implementation of risk management requires the following:
Actual outcome
How we plan to manage risk Implement plan Monitor implementation
Target outcome
Figure 2.2: Risk management implementation process
Whenever there is an opportunity there is also a risk. If risk is removed entirely there is little
scope for gains. Risk and opportunity are intrinsically related: risk management is about
understanding the relationship between these [1].
2.4 Why manage risk?

Although risk management provides significant advantages, it does entail some costs and
risks. The cost of risk management relates to the price to be paid for risk control. There can
also be potential loss if the price of the underlying asset or commodity changes against the
expectations of the risk management strategies used. Why would a firm use these strategies to
manage risks? There are a number of different reasons why firms might seek to manage risk.
The firm’s profitability may be sensitive to changes in commodity market prices, interest
rates, foreign exchange rate and other factors. Managing these risks can increase the value
of the firm, i.e. risk management increases the expected value of the firm. The firms might
need to manage risk if losses might be more harmful than profits are beneficial [2].
Chapter 3
Types of risk faced by corporations
There are many different types of risks that corporations and financial institutions might face
and need to overcome. Identifying and managing these risks has become a focus point within
most corporations to minimize their losses and maximize their profit. Before understanding
the techniques to control risk and perform risk management, it is very important to realize
what risk is and what the types of risks are.
3.1 Foreign exchange risk

Foreign exchange risk is the risk that the value of one currency changes against another.
Fluctuations in exchange rates will affect companies that export or import their goods and
services and can have a big impact on company income. Companies importing their goods
and services may end up paying more than expected. Companies that export their goods
and services may be at risk of getting paid less than planned. This is a big risk factor for
businesses that deal in more than one currency but other businesses can also be exposed to
foreign exchange risk if for example their business relies on imported products or services
[3].
3.2 Interest rate risk

Interest rate risk is the risk of fluctuations in interest rates on borrowed or invested money that
can have a big impact on company’s profitability. Cash flows of the borrower or lender are
affected by the changes in interest rates whereby the borrower can face increased costs when
interest costs fluctuate according to interest rate movements during the life of a loan. An
adverse movement in interest rate may potentially increase borrowing costs for borrowers and
reduce returns for investors. When borrowers are generally concerned about rising interest
rates, investors are concerned about falling rates [4].
3.3 Commodity price risk

Commodity price risk is the risk arising from changes in commodity prices that impact
the firms that both use and produce a commodity. Commodities is a term for a basic
good which can generally be classified into three categories: soft commodities, metals and
energy commodities. Soft commodities include agricultural products such as wheat, coffee,
sugar and fruit. Metals include gold, silver, copper and aluminum. Energy commodities
. . COMMODITY PRICE RISK 5
include gas, oil and coal. Commodity price risk is a significant problem for some firms
that use commodities in their manufacturing process and for consumers in general, both
because consuming firms that use raw materials for their production may face increased
production costs due to fluctuations in commodity prices and because producing firms that
sell commodities are exposed to price falls which mean they will receive less revenue for the
commodities they produce [5].
Chapter 4
How to quantify risk?
Measuring risk is important and helps the company to recognize the impact of the risks
involved in the business. When measuring risk, a company can identify which risk factors
are most important and can therefore prepare for the damage these can cause. By identifying
the amount of risk involved, the company can make a decision to either accept or mitigate
the risk. The firms then need to make a decision about how much risk may be acceptable
and how much exposure can be tolerated. This should lead the firm to make strategic choices
about what risks to accept and how risks are to be managed. The most common way of
measuring risk factors is to evaluate the likelihood that events will occur and what their
impact would be. Risk is the volatility of presently unknown future outcomes, for example
returns. This uncertainty implies possible good or bad outcomes. One popular way to
quantify risk exposure is in terms of Value at Risk (VaR).
4.1 Risk as spread in returns

Returns are changes in price that are relative to some initial price. The return series can
visualize the price volatility better than the price series. The percent change in value (returns)
in the time period from t-1 to t is:
St St 1
rt = 100 (4.1)
St 1
where St is the price of an asset at time t. The return series provides the data for a volatility
modeling. By modeling the return distribution, probabilistic quantification of losses and
gains can be calculated and compared between different investments [6]. VaR can be calcu-
lated from the probability distribution for asset values or returns.
In favor of normally distributed historical data of some security returns, their probability
distribution can be presented by:
1 (µ r)2
p(r) = p exp( ) (4.2)
2⇡ 2 2 2
where µ is the mean and is the standard deviation of the historical returns. Cumulative
normal distribution is:
π x0
F(x0 ) = Pr(x  x0 | µ, ) = f (y| µ, ) dy (4.3)
1
. . VALUE AT RISK 7
The probability that a return events is below some fixed value a is:
1 a µ
P(x  a) = (1 + er f ( p )) (4.4)
2 2
1 a µ
P(x a) = (1 er f ( p )) (4.5)
2 2
where the error function and the complementary error function are defined as:
π x
2
er f (x) = p exp( w 2 ) dw (4.6)
⇡ 0
π 1
2
er f (x) = 1 p exp( w 2 ) dw (4.7)
⇡ x
4.2 Value at Risk

Value at Risk (VaR) measures the worst loss expected over a given time interval at a given
confidence level. VaR is defined by the following statement: "I am c percent certain that I
will not loose more than X dollars in the next T days” where the variable X is the VaR of
the portfolio and c is the confidence level. VaR is a popular measure because it provides a
single number summarizing the total risk and it is easy to understand. Given the historical
probability distribution for returns, VaR calculates the probability of suffering certain losses
over a fixed time period. Following the assumption that returns are normally distributed, the
value at risk for the time period of T days is [6]:
V aR(↵, R,T , T, V0 ) = ↵V0 R,T (4.8)
where R,T is the standard deviation for T days calculated as follows:

p
R,T = R,1 T (4.9)
where R,1 is the standard deviation of daily returns. Then the VaR for longer time period of
T days is:
p
V aR(↵, R,T , V0 ) = ↵V0 R,1 T (4.10)
One popular approach to calculate VaR is historical simulation. Historical simulation involves
using past data as a guide to what will happen in the future by creating a database consisting
of the daily movements in all market variables over a period of time. The change in
the portfolio value is calculated for each simulation trial and the VaR is calculated as the
appropriate percentile of the probability distribution of P [7].
4.3 Risk from foreign investment

The risk from foreign investments is affected by returns in the security’s home market and
changes in exchange rates. It is important to understand the relationship between these two
risk factors. The exchange rate X f ,d (t) at time t measures the amount of foreign currency
8 CHAPTER . HOW TO QUANTIFY RISK
per unit of domestic currency [6]. When investing Q d (t) in a foreign security Q f (t) at time
t, the investor buys foreign currency as follows:
Q f (t) = X f ,d (t)Q d (t) (4.11)
The value of the investment in foreign currency at time T is:
Q f (T) = (1 + R f (t, T))Q f (t) (4.12)
and the domestic value of the foreign currency at time T is:
Q d (T) = X d, f (T)Q f (T) (4.13)
where X d, f is the amount of domestic currency per unit of foreign currency.
The percent change (returns) in the exchange rate is:
X d, f (T) X d, f (t)
X d, f (t, T) = (4.14)
X d, f (t)
and the standard deviation of returns:

1
2 2
d =( f + X +2 f ⇢ f ,X X)2 (4.15)
4.4 Monte Carlo

Monte Carlo simulation can be used to create a distribution based on the assumption of certain
stochastic processes for the underlying variables. Monte Carlo simulation is a numerical
procedure that gives potential outcomes of a scenario using stochastic processes to give an
estimate of the range and likelihood of possible future outcomes.
Chapter 5
Instruments available for risk

management purpose
A derivative is a financial instrument whose value depends on, or is derived from, the values
of other underlying variables. These underlying variables can be dependent on almost any
variable, e.g. interest rates, commodities, stocks, bonds or weather. Derivatives play a key
role in transferring risks in the economy. Derivatives are either traded on exchange, such
as the Chicago Board Options Exchange, or over-the-counter (OTC) markets where traders
working for banks, fund managers and corporate treasurers contact each other directly. Three
main types of traders can be identified: hedgers, speculators and arbitrageurs. Hedgers use
derivatives to reduce the risk from a future movement in a market variable. Speculators
use derivatives to bet on the future direction of a market variable to get extra leverage.
Arbitrageurs take a position in two or more markets to lock in a riskless profit. The most
common types of derivatives are forward contracts, future contracts, swaps and options [7].
5.1 Forward contracts

Forward contract is an agreement to buy or sell an asset or commodity at a specific time in the
future for a certain price. The time at which the contract settles is called the expiration date.
The asset or the commodity on which the forward contract is based is called the underlying
asset. A forward contract is traded in the over-the-counter market so the contract can be
customized between any two parties. One party agrees to buy the underlying asset on a
certain future date for a certain price and the other party agrees to sell the asset on the same
date for the same price. The party that agrees to buy has a long position and the party that
agrees to sell has a short position [7].
5.2 Futures contracts

Future contract is an agreement between two parties to buy or sell an asset at a certain time
in the future for certain price. Futures contracts are standardized and traded on exchanges
[7].
10 CHAPTER . INSTRUMENTS AVAILABLE FOR RISK MANAGEMENT PURPOSE
5.2.1 Payoffs from forward and future contracts

The fair or arbitrage free forward price for an asset that pays no dividend or has storage cost,
presently priced at S(t) and to be received at the future time T, is:
F(t, T) = S(t)e R(t,T)(T t)
(5.1)
where R(t,T) is the rate for maturity T-t. The ratio between the forward price F(T,t) and the
spot price S(t) is called the forward premium for maturity T-t:
F(t, T)
FP(t, T) = = e R(t,T)(T t)
(5.2)
S(t)
The forward price for an asset that pays annualized dividend yield [8] is:
(T t) R(t,T)(T t) )(T t)
F(t, T) = S(t)e e = S(t)e(R(t,T) (5.3)
The gains from a long position from futures position happen when the prices increase.
Assume taking a long position in a forward contract, presently priced at F(t, T) = K. The
payoff from a long position in a forward or future contract on one unit of asset is therefore:
P(T) = S(T) K (5.4)
where the holder of the contract is obligated to buy an asset worth S(T), which is the spot
price of the asset at maturity, for K, which is the delivery price of the contract.
When taking a short position in forward or future contract the, gain is when the prices
decrease [7]. The payoff from a short position in a forward or future contract, where K is the
delivery price and S(T) is the spot price of the asset at maturity of the contract on one unit
of asset, is:
P(T) = K S(T) (5.5)
These payoffs are shown graphically in Figure 5.1 and Figure 5.2.
Figure 5.1: Payoff from a long Figure 5.2: Payoff from a short
position at maturity. position at maturity.
5.2.2 Forward contracts on currencies

The forward foreign exchange rate F(t, T) at time t for maturity T is:
r f (t,T))(T t)
F(t, T) = S(t)e(rd (t,T) (5.6)
where S(t) is foreign exchange spot rate, i.e. the amount of domestic currency per unit of
foreign currency, rd is the domestic risk-free rate and the r f is the foreign risk-free rate [8].
. . VANILLA OPTIONS 11
5.3 Vanilla options

There are two types of option: call options and put options. A call option gives the holder
the right to buy the underlying asset by a certain date for a certain price. A put option gives
the holder the right to sell the underlying asset by a certain date for a certain price. Since
an option gives the holder the right and not the obligation to buy or sell an asset, a cost is
incurred when entering an option [7]. This initial cost that the option buyer must pay when
entering into the contract is called the option price or premium. The strike price or the
exercise price is the fixed price at which the option holder can either buy or sell the asset. A
call option is said to be in-the-money if the asset price at maturity S(T) exceeds the strike
price K and out-of-the money if the asset price at maturity is less than the strike price. A put
option is said to be in-the-money if the asset price at maturity is less than the strike price and
out-of-the-money if the asset price at maturity is more than the strike price. If the asset price
at maturity is equal to the strike price, the option is said to be at-the-money. In-the-money
options are exercised but out-of-the-money options are never exercised [2].
5.3.1 Options positions

There are two sides to every option contract. The party agreeing to buy an options is said
to have a long option position and the party agreeing to sell an option has a short option
position. There are four types of option position:
• A long position in a call option is the right to buy
• A short position in a call option is the obligation to sell
• A long position in a put option is the right to sell
• A short position in a put option is the obligation to buy
The payoff from a long position in a European call option is:
P(t, T) = max(ST K, 0) (5.7)
where K is the strike price and ST is the final price of the underlying asset at maturity of the
option. If ST > K the option will be exercised and the underlying asset is bought at the strike
price. If ST < K the option will not be exercised and the underlying asset will be bought at
the market price. The payoff to the holder of a short position in the European call option is:
P(t, T) = min(K ST , 0) (5.8)
The payoff to the holder of a long position in a European put option is:
P(t, T) = max(K ST , 0) (5.9)
where the option holder has the right to sell the underlying asset for the strike price. This
option is only exercised if the ST is less the the strike price.
The payoff from a short position in a European put option is:
P(t, T) = min(ST K, 0) (5.10)
The figures below shows these payoffs graphically.

12 CHAPTER . INSTRUMENTS AVAILABLE FOR RISK MANAGEMENT PURPOSE
position in a call option. position in a call option.
position in a put option. position in a put option.
If neither a long call nor a long put option are exercised, the option holder will lose their
premium [7]. These premiums were not included in the payoff diagrams.
5.4 Asian options

Asian options are options where the payoff depends on the average price of the underlying
asset during the life of the option. The payoff from an average price call is:
P(t, T) = max(Save K, 0) (5.11)

and that from an average price put is:
P(t, T) = max(K Save, 0) (5.12)
where Save is the average price of the underlying asset and K is the strike price. Asian option
is one of the exotic options that are commonly traded in the OTC market and these types of
options are normally less expensive than regular options [7].
5.5 Swaps
A swap is an over-the-counter agreement between two parties to exchange cash flows in the
future. Each cash flow comprises one leg of the swap where one party pays fixed payment
for a certain period of time and the other party pays floating payment for a certain period
. . HEDGING STRATEGIES USING DERIVATIVES 13
of time. Fixed payments are determined at the beginning of the contract but the floating
payment depends on the level of market variables such as commodity price or interest rates
at the time when the payment is made [9].
5.6 Hedging strategies using derivatives

The purpose of hedging is to reduce or eliminate risk by locking in the prices today and
therefore minimizing the unexpected loss. Forward contracts neutralize risk by fixing the
price that the hedger will pay or receive for the underlying asset. Option contracts provide
insurance whereby investors can protect themselves against market movements in the future,
where the option gives the holder the right to exercise but not the obligation to do so. A swap
contract can be used to hedge a stream of risky payments. By entering into a swap, the buyer
confronting a stream of uncertain payments can lock in a fixed price for a period of time.
A short hedge is a hedge that involves a short position in future contracts. A short hedge is
appropriate when the hedge already owns an asset and expects to sell it at some time in the
future. Long hedge is a hedge that involves taking a long position in a futures contract. A
long hedge is appropriate when a company knows it will have to purchase a certain asset in
the future and wants to lock in a price now. Hedging is not always profitable and can lead to a
potential loss if the underlying asset changes against the hedger’s expectations, and therefore
choosing a correct derivative for a risk management strategy is very important [7].
Chapter 6
Valuing and pricing derivatives
6.1 Valuing European options

The value of options can be calculated in various ways. The best known formula for the
options pricing model is the Black Scholes formulas for the prices of European call and put
options. These formulas are:
rT
c = S0 N(d1 ) Ke N(d2 ) (6.1)
and
rT
p = Ke N( d2 ) S0 N( d1 ) (6.2)
where 2
ln( SK0 ) + (r + 2 )T
d1 = p (6.3)
T
2
ln( SK0 ) + (r 2 )T p
d2 = p = d1 T (6.4)
T
The function N(x) is the cumulative probability distribution function for a variable with a
standard normal distribution. It is the probability that a normally distributed variable is less
than x. The variables c and p are the European call and European put prices. S0 is the value
of the underlying asset at time zero, K is the strike price, r is the risk-free rate, is the stock
volatility, and T is the time to maturity of the option, which is measured in years [7].
6.2 Valuing currency options

The pricing of currency options depends on the risk-free interest rate in both currency zones,
rd and r f , where rd is the interest rate in domestic currency and r f is the interest rate in
foreign currency [10]. The holder of foreign currency receives yield equal to the interest rate
in the foreign currency zones.
rf T rd T
c = S0 e N(d1 ) Ke N(d2 ) (6.5)
and
rd T rf T
p = Ke N( d2 ) S0 e N( d1 ) (6.6)
where 2
ln( SK0 ) + (rd r f + 2 )T
d1 = p (6.7)
T
p
d2 = d1 T (6.8)
. . IMPLIED VOLATILITY 15
6.3 Implied volatility

The implied volatility is the value of volatility for which the Black Scholes price equals the
market price of the option. When the option market price is known, the implied volatility
can be calculated by implying it to the option pricing formula, given that the other inputs are
known. The other inputs are the Spot price of underlying asset S, the strike price K, interest
rates r and the actual market value of the options c or p [7].
6.4 Monte Carlo methods

The Monte Carlo approach to asset pricing is based on the simulation of asset prices using
a program. When used to value an option, Monte Carlo simulation uses the risk-neutral
valuation result. Risk-neutrality means that the expected return of the stock is the risk-free
rate and the expected payoff of an option will be discounted with the risk-free rate. A
derivative dependent on a single market variable S provides a payoff at time T. Monte Carlo
simulation involves the following steps when used to value a derivative:
1. Simulate a random path for the stock price starting at today’s value of the asset S0 over
the required time horizon. Each price is then generated using:
2 p
✏ T
ST = S0 e(µ 2 )T+ (6.9)
2. Calculate the payoff of the stock prices.

3. Repeat steps 1 and 2 many times to get many sample values of the payoffs.
4. The mean of all the sample payoffs is calculated to get an estimate of the expected
payoff in a risk-neutral world.
5. The mean of the payoff is then discounted at the risk-free rate to get an estimate of the
value of the stock prices.
The process for the underlying market variable in a risk-neutral world is:
dS = µSdt + Sdz (6.10)
where dz is a Wiener process, µ is the expected return in a risk-neutral world and is

volatility. To simulate the path followed by S,
p
S(t + t) S(t) = µS(t) t + S(t)✏ t (6.11)
where S(t) is the value of S at time t, ✏ is a random sample from a normal distribution with
0 mean and 1 standard deviation. By using Ito’s Lemma the process is:
2
d ln S = (µ )dt + dz (6.12)
2
so that
2 p
ln S(t + t) ln S(t) = (µ ) t+ ✏ t (6.13)
2
or equivalently
2 p
t+ ✏ t
S(t + t) S(t) = S(t)e(µ 2 ) (6.14)
16 CHAPTER . VALUING AND PRICING DERIVATIVES
This equation is used to construct a path for S. If µ and are constant then:
2 p
ln S(T) ln S(0) = (µ )T + ✏ T (6.15)
2
It follows that p
2
✏ T
S(T) = S(0)e(µ 2 )T+ (6.16)
This equation can be used to value derivatives that provide a nonstandard payoff at time T.
If S is the price of a non-dividend stock then µ = r, if it is an exchange rate then µ = rd r f
[7].
6.5 Ornstein-Uhlenbeck process

Most commodity prices follow a mean-reverting process where they tend to get pulled back
to a central value [7]. The long-term mean can be a constant but it can also follow a deter-
ministic or even a stochastic process.
Stochastic processes are often used for risk analysis and pricing derivatives. The evolution
of log series is usually modeled and the result is exponentiated. In the Ornstein-Uhlenbeck
process the evolution of the price St satisfies the following stochastic differential equation
(SDE):
dSt = (µ St )dt + dWt (6.17)
where is the mean reversion rate, µ is the mean price, is the volatility and Wt is the
Wiener process. If the price St is higher than the mean price the price level is pulled down
at a rate determined by the reversion rate. The exact solution of the above SDE is:
r
1 e 2
Si+1 = Si e + µ(1 e )+ N0,1 (6.18)
2
where is the time step and N0,1 is a Gaussian random variable with 0 mean and 1 standard
deviation [11].
6.6 Valuing a commodity swap

Commodity swaps are in essence a series of forward contracts on a commodity with different
maturity dates and the same delivery prices. Swap contracts have one party to the contract
which pays fixed while the other party pays floating. When entering into a swap contract the
fixed payer knows exactly how much needs to be paid at the maturity of the contract but the
floating rate payer needs to pay the market spot price at the maturity of the contract. When
entering into a swap contract at time t, the fixed payer pays fixed amount x at the future times
T1 , T2 ,.....,TN for a certain quantities of commodities Qi given at each time. The discount
factors D(t, Ti ), i = 1, 2, .., N are used for the calculation of the present values of the cash
flow [9]. The present value for the fixed payment is:
’
N
PV(t) f x = xQi D(t, Ti ) (6.19)
i=1
. . VALUING A FIXED-FLOATING CURRENCY SWAP 17
The present value for the floating payers is:

’
N
PV(t) f l = F(t, T j )Q j D(t, T j ) (6.20)
j=1
where F(t, T1 ), F(t, T2 ),..., F(t, TN ) is the forward price at the future time T.
From the condition PV(t) f l = PV(t) f x
’
N ’
N
xQi D(t, Ti ) = F(t, T j )Q j D(t, T j ) (6.21)
i=1 j=1
then solving for x gives: ÕN

F(t, T j )Q j D(t, T j )
ÕN
j=1
x= (6.22)
i=1 Qi D(t, T j )
and this can be written as:
’
N
x= w k F(t, Tk ) (6.23)
k=1
where the swap fixed price x is the weighted average of the forward prices, where the weights
are given by formula:
Q k D(t, Tk )
wk = ÕN (6.24)
i=1 Qi D(t, Ti )
6.7 Valuing a fixed-floating currency swap

In these contracts there is an initial exchange of principals Q d and Q f . The relationship
between the exchanged amounts is defined by the exchange rate X(t) (amount of domestic
currency per unit of foreign currency) between the two currencies at the time t [9].
Q d = X(t)Q f (6.25)
Following this exchange of principals the interest payments take place at a future time as
dictated by the contract. One party pays fixed rate SR and other party pays floating rate. The
present value of the fixed and floating payments is:
’
N
rd (Ti t)
PV(t) f ixed = SR Qi e (6.26)
i=1
’
N
rd (Ti t)
PV(t) f loating = FX (t, Ti )Qi e (6.27)
i=1
where Qi is the principal amount in foreign currency at time Ti and FX (t, Ti ) is the forward
exchange rate calculated by the formula:
r f )(Ti t)
FX (t, Ti ) = X(t)e(rd (6.28)
The exchanged cash flows needs to satisfy the condition that the present values of both
payment schedules be equal:
PV(t) f ixed = PV(t) f loating (6.29)

18 CHAPTER . VALUING AND PRICING DERIVATIVES
after solving for SR we find:

ÕN
FX (t, Ti )Qi e rd (Ti t)
ÕN
i=1
SR = (6.30)
rd (Tj t)
j=1 Q j e
Chapter 7
Description of the risks the firm faces
7.1 Description of the firm to be discussed

Zano is an Icelandic company that manufactures gold jewelry. All the jewelry production
takes place in Iceland and all the products are sold in Icelandic krona. The raw material
(gold) is purchased abroad in US dollars and usually invoices are paid immediately. The
revenue of the company consists of sales of gold jewelry to customers. The sales forecast
is known for the following year so the company can estimate the amount of gold that the
company needs to buy every month over the next year for the manufacture of gold jewelry.
The financial manager of the firm is concerned about how the company’s profit is affected
by increasing gold prices. The company makes a greater profit if the price of gold falls, so
its gold position is short. The company considers that a stable price leads to higher returns
than a volatile price that fluctuates. Therefore, hedging their position against the risk of a
rising gold price is one way to protect against a price risk.
7.2 Commodity price risk

The risk of fluctuating gold prices results in additional production costs. If the gold price
rises, the company faces increased input costs for the jewelry made, which leads to reduced
profitability and reduces the value of the company. But when the gold prices fall, the com-
pany profits from decreased input costs, thus potentially increasing profitability which can
lead to increased value of the business. The company can manage the gold price risk through
derivatives. The financial manager of the firm points out that the strategy is to minimize
input costs and maximize revenue. In order to be able to manage commodity price risk, the
company needs to understand what is causing the risk.
The USD Libor rates [12], required quantities for gold and the future price of gold [13]
are given in the following table based on information on 4 December 2017, the day of data.
The expected exposure in the following months is calculated by multiplying the future price
with the quantity and then discounting at the Libor risk-free rate at time Ti with the formula:
r(t,Ti )(Ti t)
E(t, Ti ) = Qi Fi e (7.1)
The spot price for gold on the day of data is 1274.5 $/oz.
20 CHAPTER . DESCRIPTION OF THE RISKS THE FIRM FACES
Date USD Libor rates Quantity Qi [oz] Future prices Fi [$/oz] Expected Exposure [$]
Jan 2018 1.392% 900 1274.1 1,145,360.79
Feb 2018 1.453% 900 1278.3 1,147,687.32
Mar 2018 1.508% 1100 1280.4 1,403,138.46
Apr 2018 1.570% 800 1282.6 1,020,724.09
May 2018 1.632% 900 1284.8 1,148,485.70
Jun 2018 1.693% 900 1287.1 1,148,624.88
Jul 2018 1.741% 1000 1288.6 1,275,577.77
Aug 2018 1.789% 1100 1290.2 1,402,391.03
Sep 2018 1.837% 1000 1292.0 1,274,317.63
Oct 2018 1.886% 900 1293.8 1,146,267.02
Nov 2018 1.934% 1500 1296.4 1,910,436.37
Dec 2018 1.982% 2000 1299.1 2,547,218.60
Table 7.1: The USD Libor rates, required quantities of gold, the future price and the expected
exposure for gold based on information on 4 December 2017.
After defining expected price exposure for the following months, the company is able to
estimate the effect of gold price fluctuations. Figure 7.1 displays historical data of gold
prices. The data consist of time series of daily gold prices for the period 4 December 2015-
4 December 2017 [14].
Figure 7.1: Historical data of gold prices between 4 December 2015 and 4 December 2017.
The return series visualizes the price volatility better than the price series. To construct the
time series of returns using the daily gold price data, the percentage change in price or the
return is calculated as follows:
St St 1
rt = (7.2)
St 1
Using the data of daily returns, the mean return and the standard deviation of returns are
calculated. The most common measure of market uncertainty is volatility or the standard
deviation of returns. The daily mean return and the daily volatility is:
µ = 0.000384 (7.3)
= 0.008479 (7.4)
The time series of daily price returns for gold prices is shown in Figure 7.2.
Figure 7.2: The daily gold price change
To construct the probability distribution of return, the daily returns are plotted in histogram
format in Matlab and the range of return values are divided into a series of intervals. Then the
number of daily return values that fall into each interval are counted. The probability that the
daily returns will lie within a specific range is given by the area under the pdf curve, between
the upper and lower bounds of that range. The total area under the pdf curve must sum to one.
Figure 7.3 shows the probability distribution of daily returns. The x-axis shows the daily
returns and the y-axis shows the probabilities of the daily returns on these intervals occurring.
The empirical probability that the daily returns are below -1% and above 1% is given in
Figure 7.3. The Theoretical probability is calculated with the formula:
1 r µ
P(x  r) = (1 + er f ( p )) (7.5)
2 2
1 r µ
P(x r) = (1 er f ( p )) (7.6)
2 2
Using the calculated daily mean return and daily volatility, the results are:
Theoretical Empirical
P(r 1%) 12.83% 9.77%
P(r  -1%) 11.03% 8.65%
Table 7.2: Theoretical and Empirical probabilities
Figure 7.3: Probability density function for the returns.
The corresponding cumulative distribution function is shown in Figure 7.4. The y-axis now
shows probabilities that the daily return will be less than or equal to those levels specified on
the x-axis.
Figure 7.4: Cumulative probability function for daily gold price changes
The 95% VaR is calculated using the standard deviation of return with equation:
p
V aR = ↵S0 R,1 T (7.7)
with ↵= 1.645, the spot price of gold at the day of data S0 = 1274.5 $/oz, R,1 is the standard
deviation of daily returns and T is the time in days. These calculations for the following
dates are presented in Table 7.3.
Date 95% VaR for gold price ($/oz)

Jan 2018 81.456
Feb 2018 115.196
Mar 2018 141.085
Apr 2018 162.911
May 2018 182.140
Jun 2018 199.525
Jul 2018 215.511
Aug 2018 230.391
Sep 2018 244.367
Oct 2018 257.585
Nov 2018 270.158
Dec 2018 282.171
Table 7.3: The 95% VaR risk for the gold price.
As seen in Table 7.3, the potential loss increases with the length of time. The calculations
are plotted in Figure 7.5.
Figure 7.5: VaR as a function of time
The model used for simulating the forecast for the gold price is an Ornstein-Uhlenbeck
process with mean reverting drift. The Orstein-Uhlenbeck process is given by the equation:
dS = (µ S)dt + dW (7.8)
The parameters used in the simulation were calculated using the historical price data by
performing a linear regression in Matlab. To avoid negative prices, the log series of prices
is modeled and the result is exponentiated. The formula for the simulated future price ST is:
r
1 e 2
ST = ST 1 e + µ(1 e )+ N0,1 (7.9)
2
The is the estimated value of mean reversion rate, the µ is the estimated value of long-term
mean and the is the estimated value of volatility of the process. To produce annualized
parameter values for the daily price series, the time step used is =1/252, which accounts for
252 business days in a typical year. The results from the Matlab are:
= 1.06483 (7.10)
µ = 1286.22 (7.11)
= 0.1599 (7.12)
The outcome of the result is plotted in the following figure below with 10,000 simulated
price paths for the gold price for the next year or 252 days into the future.
Figure 7.6: Simulated 10,000 price paths for gold using the Ornstein-Uhlenbeck process.
A specific month forecast is calculated by averaging 10,000 simulated price paths for this
specific month. The average price forecasts are shown in the table below.
Date Gold Price Forecast ($/oz)

Jan 2018 1276.8
Feb 2018 1276.9
Mar 2018 1277.3
Apr 2018 1277.7
May 2018 1278.5
Jun 2018 1277.7
Jul 2018 1278.4
Aug 2018 1275.8
Sep 2018 1277.5
Oct 2018 1277.3
Nov 2018 1276.1
Dec 2018 1275.6
Table 7.4: Gold price forecast from January 2018 and December 2018.
These simulated prices were then used to calculate the profit or loss in the difference between
the simulated prices and the gold price today for a specific month. The calculated profit or
loss is plotted in Matlab and the probability distribution of these values is constructed. The
probability that the profit/loss values lie within a specific range in June 2018 and December
2018 is given in Figures 7.7 and 7.8. The 95% VaR was estimated from these calculations.
The area to the left of the green line represents 5% of the total area under the curve and
the area to the right of the green line represent 95% of the total area under the curve. VaR
calculations were done for all the months in the following year and are shown in Table 7.5.
Figure 7.7: Profit loss probability density function for June 2018
Figure 7.8: Profit-and-loss probability density function for December 2018

. . INSTRUMENTS AVAILABLE TO MANAGE COMMODITY PRICE RISK 27
Date 95% VaR for gold price ($/oz)

Jan 2018 -56.640
Feb 2018 -105.794
Mar 2018 -138.253
Apr 2018 -153.545
May 2018 -177.984
Jun 2018 -187.884
Jul 2018 -199.713
Aug 2018 -207.699
Sep 2018 -214.015
Oct 2018 -219.108
Nov 2018 -220.429
Dec 2018 -224.388
Table 7.5: The 95% VaR for the gold price.
7.3 Instruments available to manage commodity price risk

7.3.1 Commodity futures
Commodity futures are standardized agreements to purchase or sell a specific amount of a
commodity on a fixed future date for a certain price. These contracts enable the company to
lock in a fixed price for a future delivery of the gold and provide protection against adverse
movements in the gold price.
7.3.2 Commodity options

Options are agreements between two parties that give the holder the right but not the obligation
to purchase or sell the commodity at a certain date for a certain price. The buyer of a
commodity option pays a premium to the seller of the option. Commodity option insures
against adverse movements of the gold price.
7.3.3 Commodity swaps

Commodity swap is an agreement between two parties to exchange cash flows. With swaps,
the company can lock in the price they have to pay for the gold during the contract period
and guarantee a long-term income stream.
7.4 Foreign exchange risk

The company’s presentation currency is in ISK and there is a risk of exchange rate fluctuation
having an impact on the company cash flow, profit and financial position in ISK. The majority
of company revenue is in ISK. A drop in the strength of ISK against USK will result in a
decline in the translated future cash flow. Some of the company costs are related to raw
materials purchased in USD. Changes in foreign exchange rates affect the future cash flow
of the company.
The forward exchange rate is calculated for the following months with the formula:
r f (t,Ti ))(Ti t)
F(t, Ti ) = X d, f (t)e(rd (t,Ti ) (7.13)
where X d, f (t) is the exchange rate at the day of data, rd is the ISK Reibor rate [15] and r f is
the USD Libor rate at time Ti . The spot exchange rate, X d, f (t) on 4 December 2017, the day
of data, is 103.59. The calculations for the following months are given in Table 7.6.
Date USD Libor rates ISK Reibor rates Exchange rate [ISK/USD]
Jan 2018 1.392% 4.350% 103.8457
Feb 2018 1.453% 4.650% 104.1434
Mar 2018 1.508% 4.650% 104.4068
Apr 2018 1.570% 4.650% 104.6590
May 2018 1.632% 4.650% 104.9011
Jun 2018 1.693% 4.650% 105.1329
Jul 2018 1.741% 4.667% 105.3729
Aug 2018 1.789% 4.683% 105.6080
Sep 2018 1.837% 4.700% 105.8381
Oct 2018 1.886% 4.717% 106.0631
Nov 2018 1.934% 4.733% 106.2830
Dec 2018 1.982% 4.750% 106.4978
Table 7.6: The calculated forward exchange rate
The historical data of the foreign exchange rate movement between Icelandic krona and US
dollar is plotted in Figure 7.9. The data consist of time series of daily exchange rates for the
period 4 December 2015 to 4 December 2017 [16].
Figure 7.9: Historical data of the foreign exchange rate.

. . FOREIGN EXCHANGE RISK 29
The percentage change in daily rate or the return is calculated as follows:
X d, f (t) X d, f (t 1)
r(t) = (7.14)
X d, f (t 1)
The time series of calculated daily rate returns is shown in Figure 7.10.
Figure 7.10: Daily change in exchange rate
From the return series, the calculated daily mean return and the daily standard deviation of
returns are:
µ = 0.000464 (7.15)
= 0.007324 (7.16)
Figure 7.11 show the probability distribution of daily returns and the corresponding cumula-
tive distribution function is shown in Figure 7.12. The probability distribution tells us what
outcomes are possible and how likely these outcomes are. The empirical probabilities that
the daily returns are below -1% and above 1% are also shown in Figure 7.11. Theoretical
probabilities are calculated with Equation 7.5 and 7.6. The results are given in Table 7.7.
Theoretical Empirical
P(r 1%) 7.65% 6.18%
P(r  -1%) 9.65% 6.37%
Table 7.7: Theoretical and Empirical probabilities

Figure 7.11: Probability density function for daily rate returns
Figure 7.12: Cumulative probability function for daily rate change

. . INSTRUMENTS AVAILABLE TO MANAGE FOREIGN EXCHANGE RISK 31
7.5 Instruments available to manage foreign exchange risk
7.5.1 Forward exchange contract

Enables the company to protect itself from adverse movement in exchange rates by locking
in an agreed exchange rate until an agreed date. The company can enter a forward currency
contract for the ISK/USD rate. By entering this contract the uncertainty caused by possible
currency fluctuations can be removed.
7.5.2 Currency options

The company can enter into a currency option to purchase foreign currency under an agree-
ment that allows for the right but not the obligation to undertake the transaction at an agreed
future date. The foreign currency option, which includes the price of a premium, will protect
the company from downward movements in the value of the ISK against the USD and the
company will also benefit from increases in the ISK against the USD.
7.5.3 Currency swaps

The company can enter into a currency swap where the company exchanges a fixed amount
of ISK for USD.
7.6 Comparison of the two risk types

Both commodity price risk and foreign exchange risk have a direct impact on the company
cash flow. Managing both these risks at the same time can be difficult. When locking in
the gold price in US dollars, the company is still exposed to foreign exchange risk. Foreign
exchange risk is complicated to manage when the risk exposure is based on fluctuating gold
prices. Based on previous calculations in this chapter, the gold price is slightly more volatile
than the foreign exchange rate.
The future price in ISK per ounce is calculated by multiplying the future price for gold
($/oz) with the calculated forward exchange rate.
FISK (t, Ti ) = FUSD (t, Ti )FISK/USD (t, Ti ) (7.17)
where FISK is the future price for gold in ISK per oz, FUSD is the future price for gold in USD
per oz, offered by the COMEX division of the CME group, and FISK/USD is the calculated
forward exchange rate. The results of these calculations are given in Table 7.8.
Date Exchange rate [ISK/USD] Future Price[USD/oz] Future Price[ISK/oz]

Jan 2018 103.8457 1274.1 132,310
Feb 2018 104.1434 1278.3 133,310
Mar 2018 104.4068 1280.4 133,682
Apr 2018 104.6590 1282.6 134,236
May 2018 104.9011 1284.8 134,777
Jun 2018 105.1329 1287.1 135,317
Jul 2018 105.3729 1288.6 135,784
Aug 2018 105.6080 1290.2 136,255
Sep 2018 105.8381 1292.0 136,743
Oct 2018 106.0631 1293.8 137,224
Nov 2018 106.2830 1296.4 137,785
Dec 2018 106.4978 1299.1 138,351
Table 7.8: Forward exchange rate and gold future price in USD per oz and ISK per oz.
The historical data of gold prices in USD and the foreign exchange rate between ISK and
USD presented in the previous chapter were used to calculate the historical price of gold in
ISK per oz.
S(t) ISK = X(t)S(t)USD (7.18)
with X(t) as the spot exchange rate at time t and S(t) as the spot price for gold at time t.
The results of the calculations of the spot price for gold in ISK per oz, S(t) ISK , are shown in
Figure 7.13.
Figure 7.13: Daily gold price in ISK/oz.

. . COMPARISON OF THE TWO RISK TYPES 33
The total risk in ISK, ISK , is calculated as follows:
1
2 2
ISK =( USD + FX +2 USD ⇢(USD,F X) F X ) 2 (7.19)
The one day standard deviations of returns are USD and F X and the correlation between
their returns is ⇢(USD,F X) . USD is the standard deviation of gold price in USD and F X is
the standard deviation of foreign exchange rate. The information is given in Table 7.9.
Risk ( ) Correlation
Gold Price [$/oz] 0.008479 1.00 -0.0866
Exchange Rate [ISK/USD] 0.007324 -0.0866 1
Table 7.9: Correlation between the return of gold price and foreign exchange rate
The correlation between the returns of gold price and foreign exchange rate is negative, which
means that their returns tend to move in opposite directions. Using information in Table 7.9,
the total risk or the daily volatility in ISK is:
ISK = 0.010713595 (7.20)
Value at Risk (VaR) for the gold price in ISK is given by the formula:
p
V aRISK = ↵ ISK S0 T (7.21)
where ↵ is 1.645, the spot price for gold today in ISK per oz is S0 = 132,025.46 ISK/oz and
T is the time measured in days. VaR was calculated for the following months and the results
are shown in Table 7.10 and plotted in Figure 7.14.
Date 95% VaR for gold price (ISK/oz)

Jan 2018 10661.78
Feb 2018 15078.04
Mar 2018 18466.75
Apr 2018 21323.56
May 2018 23840.47
Jun 2018 26115.93
Jul 2018 28208.42
Aug 2018 30156.07
Sep 2018 31985.35
Oct 2018 33715.51
Nov 2018 35361.13
Dec 2018 36933.50
Table 7.10: The 95% VaR risk for the gold price in ISK.
Figure 7.14: VaR calculations for given months

Chapter 8
Implementation of risk management

strategies
8.1 Hedging gold price with a future contract

The company can hedge its position by taking a long position in future contracts offered by
the COMEX division of the CME group. Each contract is for the delivery of 100 ounces of
gold [17]. By entering into a long future contract, the company can lock in the price for gold
over the next year. The future price of the gold is given in the following table:
Date Future price [$/oz]

Jan 2018 1274.1
Feb 2018 1278.3
Mar 2018 1280.4
Apr 2018 1282.6
May 2018 1284.8
Jun 2018 1287.1
Jul 2018 1288.6
Aug 2018 1290.2
Sep 2018 1292.0
Oct 2018 1293.8
Nov 2018 1296.4
Dec 2018 1299.1
Table 8.1: The future price for gold ($/oz).
The company can enter into the future contract with agreement to buy gold at the future price
F(t, Ti ) at time Ti . The profit in long position at maturity Ti is:
PH (t, Ti ) = S(Ti ) F(t, Ti ) (8.1)
where S(Ti ) is the spot price of gold at maturity Ti and F(t, Ti ) is the future price at time Ti .
The profit from a unhedged position at time Ti is the difference between the gold spot price
today S0 and the spot price at maturity S(Ti ):
PUH (t, Ti ) = S0 S(Ti ) (8.2)
The figure below compares the profit diagram for the unhedged position and a long future
position in June 2018. It shows a wide range of profit from various future spot price S(T0.5 )
36 CHAPTER . IMPLEMENTATION OF RISK MANAGEMENT STRATEGIES
at maturity T0.5 . It also shows the profit for the 100% hedged position, which is generated by
summing up the future position and the unhedged payoff.
Figure 8.1: The profit diagram for the long Gold futures contract with maturity in June 2018.
The unhedged position shows a loss if the gold price rises higher than 1274.5 $/oz, the spot
price today, and a profit if the price is lower than 1274.5 $/oz. The long future position in
gold shows profit if the price is higher than the future price 1287.1 $/oz in June 2018 and a
loss if the prices are lower.
8.2 Hedging foreign exchange rate with a forward contract

The company can hedge its position by taking a long position in a foreign exchange forward
contract and protect itself from adverse movement in exchange rates by locking in an agreed
exchange rate. The company commits to buy foreign exchange every month for the next
year at the forward exchange rate. The forward exchange rate for the delivery at time Ti is
calculated as follows:
r f (t,Ti ))(Ti t)
F(t, Ti ) = X(t)e(rd (t,Ti ) (8.3)
with spot exchange rate at the day of data, X(t) = 103.59, rd is the ISK Reibor rate and r f is
the USD Libor rate at time Ti . The calculations for the following months are given in Table
8.2.
. . HEDGING FOREIGN EXCHANGE RATE WITH A FORWARD CONTRACT 37
Date USD Libor rates ISK Reibor rates Exchange rate [ISK/USD]
Jan 2018 1.392% 4.350% 103.8457
Feb 2018 1.453% 4.650% 104.1434
Mar 2018 1.508% 4.650% 104.4068
Apr 2018 1.570% 4.650% 104.6590
May 2018 1.632% 4.650% 104.9011
Jun 2018 1.693% 4.650% 105.1329
Jul 2018 1.741% 4.667% 105.3729
Aug 2018 1.789% 4.683% 105.6080
Sep 2018 1.837% 4.700% 105.8381
Oct 2018 1.886% 4.717% 106.0631
Nov 2018 1.934% 4.733% 106.2830
Dec 2018 1.982% 4.750% 106.4978
Table 8.2: Calculated forward exchange rate
The profit in long position at maturity Ti is:
PH (t, Ti ) = X(Ti ) F(t, Ti ) (8.4)
where X(Ti ) is the spot exchange rate at maturity Ti and F(t, Ti ) is forward exchange rate at
time Ti . The profit from a unhedged position at time Ti is:
PUH (t, Ti ) = X(t) X(Ti ) (8.5)
Figure 8.2: The profit diagram for the long foreign exchange rate forward contract with
maturity in June 2018.
The profit diagram for the the unhedged position and a long future position in June 2018
is shown in Figure 8.2. It shows a wide range of profit from various future exchange rates
X(T0.5 ). at maturity T0.5 . The figure also shows 100% hedged position.
The unhedged position shows a loss if the exchange rate rises higher than 103.59 and a
profit if the exchange rate is lower than 103.59. The long future position in gold shows profit
if the exchange rate is higher than 105.13 in June 2018 and a loss if the exchange rate is
lower.
8.3 Pricing a European call option

Rather than lock in the price, the company might like to pay the strike price. If the gold price
is greater than the strike price, K, the company can pay its strike price, K. The company can
accomplish this by buying a call option offered by the COMEX division of the CME group.
Each contract is for the delivery of 100 ounces of gold [18]. The future prices for gold were
simulated using the Monte Carlo simulation method in Matlab with the formula:
2 p
N(0,1) dt
ST = S(T 1) e
(µ 2 )dt+ (8.6)
The inputs used in the formula were the implied volatility, which was calculated from the
Black-Scholes formula with the market value of the option given by the COMEX division
[19], the time step dt as 1/252, the spot price of gold today and the USD Libor rates, µ.
N(0, 1) is a normal random variable with 0 mean and 1 standard deviation. Figure 8.3 shows
10,000 simulated price paths 252 days into the future.
Figure 8.3: 10,000 simulated price paths 252 days into the future.
. . PRICING A EUROPEAN CALL OPTION 39
These 10,000 samples of future prices are used to compute the payoff of the option and the
Monte Carlo price is given by the mean of these payoffs. The Monte Carlo price is:
rT
Call price = e mean(max(ST K, 0)) (8.7)
The following tables represent calculated option values with different strikes, K, and matu-
rities. The tables below show the market values (MV), implied volatility and the calculated
Monte Carlo price (MC) for every call option with different strikes for the next year. The
spot price at the day of data is 1274.5 $/oz.
Jan 2018 Feb 2018 Mar 2018

Strike
MV[$] Impl.Vol MC[$] MV[$] Impl.Vol MC[$] MV[$] Impl.Vol MC[$]
1270 14.4 0.0762 14.49 21.1 0.0824 21.24 33 0.1110 33.22
1275 12.2 0.0798 12.29 18.6 0.0833 18.73 30.1 0.1099 30.31
1280 9.7 0.0789 9.78 16.2 0.0836 16.32 27.9 0.1111 28.11
1285 7.4 0.0769 7.46 13.9 0.0833 14.01 24.9 0.1085 25.09
1290 5.4 0.0747 5.45 11.9 0.0834 12.00 18.5 0.0918 18.65
Table 8.3: Valuation of call options
Apr 2018 May 2018 Jun 2018

Strike
1270 38.3 0.1110 38.56 45.7 0.1189 46.01 50.2 0.1180 50.54
1275 35.6 0.1108 35.85 42.8 0.1180 43.10 47.4 0.1175 47.73
1280 33.0 0.1105 33.24 40.1 0.1175 40.39 44.8 0.1174 45.11
1285 30.6 0.1104 30.83 37.6 0.1173 37.88 42.3 0.1172 42.61
1290 24.3 0.0967 24.49 35.2 0.1170 35.47 39.9 0.1171 40.20
Jul 2018 Aug 2018 Sep 2018

Strike
1270 57.4 0.1251 57.79 61.2 0.1234 61.40 68.0 0.1292 68.47
1275 54.6 0.1247 54.98 58.5 0.1233 58.70 65.2 0.1288 65.66
1280 51.9 0.1243 52.27 55.8 0.1229 55.99 62.4 0.1283 62.85
1285 49.3 0.1239 49.66 53.3 0.1229 53.49 59.8 0.1280 60.24
1290 46.8 0.1236 47.15 50.8 0.1227 50.98 57.3 0.1278 57.73

Oct 2018 Nov 2018 Dec 2018

Strike
1270 71.2 0.1268 71.69 78.0 0.1323 78.53 80.9 0.1297 81.45
1275 68.4 0.1264 68.88 75.2 0.1320 75.72 78.1 0.1294 78.64
1280 65.7 0.1262 66.17 72.5 0.1317 73.01 75.4 0.1292 75.93
1285 63.1 0.1260 63.56 69.9 0.1315 70.41 72.7 0.1288 73.22
1290 60.6 0.1258 61.05 67.4 0.1314 67.90 70.1 0.1286 70.61
If the company buys a call option with strike price 1280 $/oz and maturity in June 2018 for
the price of 45.11 $, the profit at maturity T is:
P(t, T) = C + max(ST K, 0) (8.8)
If the price of gold in June 2018 is greater than 1280 $/oz, the strike price of the option, the
call option will be exercised and the company buys gold for 1280 $/oz. If the price of gold in
June 2018 is less then 1280 $/oz, the option would not be exercised, therefore the option is
worthless at maturity and the company buys gold at the market price. If the price at maturity
is lower than the strike price of the option, the company will only lose the price of the call,
C, which is $45.11 per contract. This is shown in Figure 8.4.
Figure 8.4: The profit from a long position in a call option with strike 1280 in June 2018.
The estimated probabilities of monthly gold prices to be greater than the specific strike prices
in every month were calculated by summing up simulated S(T) that had higher values than
the given strike price K. The results from these calculations are given in Table 8.7.
. . PRICING ASIAN CALL OPTION 41
P(S(T) > K)
Date
K=1270 K=1275 K=1280 K=1285 K=1290
Jan 2018 58.19% 51.02% 44.26% 37.28% 30.39%
Feb 2018 56.65% 51.86% 47.34% 42.74% 38.37%
Mar 2018 54.32% 51.54% 46.68% 45.91% 42.06%
Apr 2018 54.35% 51.91% 45.92% 47.10% 44.20%
May 2018 54.01% 51.99% 49.99% 47.96% 45.96%
Jun 2018 54.24% 52.37% 50.53% 48.65% 46.81%
Jul 2018 53.98% 52.35% 50.73% 49.13% 47.51%
Aug 2018 54.16% 53.59% 51.05% 49.55% 48.01%
Sep 2018 54.11% 52.71% 51.35% 49.99% 48.59%
Oct 2018 54.48% 53.17% 51.83% 50.50% 49.16%
Nov 2018 54.33% 53.11% 51.89% 50.66% 49.48%
Dec 2018 54.75% 53.57% 52.37% 51.18% 50.03%
Table 8.7: Probabilities for monthly gold price to be greater than the strike price
8.4 Pricing Asian call option

The price of the Asian call option was calculated using the Monte Carlo simulation with the
same inputs that were used in the previous chapter. Future prices of gold, ST , were simulated
with Equation 8.6. The payoff on Asian options depends on the average value of each price
path of the simulated prices, therefore the Monte Carlo price calculated for the Asian call
option is:
rT
Call price = e mean(max(mean(ST ) K, 0)) (8.9)
The Monte Carlo price for the Asian call option is calculated for different strikes and
maturities given in the following tables:
Strike price Jan 2018 Feb 2018 Mar 2018 Apr 2018
1270 9.299 13.099 19.853 22.869
1275 6.737 10.403 17.078 20.155
1280 4.530 8.085 14.731 17.635
1285 2.727 6.183 12.079 15.364
1290 1.495 4.543 7.993 11.135
Table 8.8: Valuations of Asian call options
Strike price May 2018 Jun 2018 Jul 2018 Aug 2018
1270 26.984 29.446 33.452 35.629
1275 24.005 26.597 30.652 32.902
1280 21.889 24.412 28.304 30.391
1285 19.311 21.748 25.594 27.935
1290 16.963 19.499 23.219 25.564

Strike price Sep 2018 Oct 2018 Nov 2018 Dec 2018
1270 39.281 41.389 44.907 46.260
1275 37.196 38.159 42.150 43.365
1280 33.890 35.472 39.453 41.142
1285 31.366 33.412 37.368 38.869
1290 29.270 31.444 34.975 35.919
The company can buy an Asian call option with strike price 1280 $/oz and maturity in June
2018 for the price of $24.412 per contract. The profit at maturity is then:
P(t, T) = C + max(Save K, 0) (8.10)
If the average price of gold in June 2018 is greater than 1280 $/oz, the strike price of the
option, the call option will be exercised and the company buys gold for 1280 $/oz. If the
average price of gold in June 2018 is less then 1280 $/oz. the option would not be exercised
and the company buys gold at the market price. If the price at maturity is lower than the
strike price of the option, the company will only lose the price of the call per contract.
8.5 Pricing a currency call option

The pricing of currency call options depends on the risk-free interest rate in both currency
zones. The Black-Scholes price is calculated with the formula:
rf T rd T
c = X0 e N(d1 ) Ke N(d2 ) (8.11)
where
2
ln( XK0 ) + (rd r f + 2 )T
d1 = p (8.12)
T
p
d2 = d1 T (8.13)
using inputs, X0 =103.59 which is the spot exchange rate for ISK/USD, strike price K is the
calculated forward exchange rate, rd as the ISK Reibor rate, r f USD Libor rate, is the
annual volatility of exchange rate calculated from historical data in Chapter 7 and T is the
time measured in years.
The Monte Carlo call price for currency call option is calculated by simulating the future
exchange rate with the formula:
2 p
N(0,1) dt
XT = X(T 1) e
(µ 2 )dt+ (8.14)
where µ= rd - r f and time steps, dt, is 1/252. The 10,000 simulated price paths are shown in
Figure 8.5.
. . PRICING A CURRENCY CALL OPTION 43
Figure 8.5: Simulated price paths for foreign exchange rate
The Monte Carlo price is then calculated as follows:
Call price = e µT
mean(max(XT K, 0)) (8.15)
The Black Scholes price and the Monte Carlo price calculated for the currency call option
are given in Table 8.11.
Date USD Libor rates ISK Reibor rates Exchange rate [ISK/USD] BS price [ISK/USD] MC price [ISK/USD]
Jan 2018 1.392% 4.350% 103.8457 1.385 1.387
Feb 2018 1.453% 4.650% 104.1434 1.957 1.963
Mar 2018 1.508% 4.650% 104.4068 2.393 2.425
Apr 2018 1.570% 4.650% 104.6590 2.759 2.790
May 2018 1.632% 4.650% 104.9011 3.079 3.132
Jun 2018 1.693% 4.650% 105.1329 3.368 3.398
Jul 2018 1.741% 4.667% 105.3729 3.632 3.542
Aug 2018 1.789% 4.683% 105.6080 3.875 3.918
Sep 2018 1.837% 4.700% 105.8381 4.102 4.171
Oct 2018 1.886% 4.717% 106.0631 4.316 4.339
Nov 2018 1.934% 4.733% 106.2830 4.517 4.580
Dec 2018 1.982% 4.750% 106.4978 4.708 4.788
Table 8.11: Calculated Monte Carlo price and Black Scholes price for currency call option
The profit diagram for a call option with strike price 105.13 and maturity in June 2018 is
shown in Figure 8.6. where the profit is calculated as follows:
P(t, T) = C + max(XT K, 0) (8.16)
If the exchange rate in June 2018 is greater than the strike price of 105.13, the call option
will be exercised and the company buys US dollars at the strike price. If the exchange rate in
June 2018 is less than 105.13, the option will not be exercised and is therefore worthless at
maturity, and the company buys US dollars at market rate. If the exchange rate at maturity
is lower than the strike price of the option, the company will lose the price of the call option
which is 3.398 per contract.
Figure 8.6: Payoff from a long currency call option
8.6 Pricing a gold swap

Since the company is confronting a stream of uncertain payments for gold the company can
enter into a gold swap contract and therefore lock in a fixed price for the gold over the next
year. The required quantities Qi , the gold future prices Fi and the USD Libor rates Ri are
given in Table 8.12.
When the company enters into the swaps it agrees to buy the quantity Qi of gold each
month for the next year at a fixed swap price SP. At each payment date Ti the quantities Qi ,
measured in oz, are delivered. The present value of fixed payments is:
’
12
PV(t) f x = SPQi D(t, Ti ) (8.17)
i=1
While the company pays fixed amount for the gold, the floating payer needs to pay the
market spot price for gold at each payment date Ti . The present value of floating payments is
calculated, assuming that the future spot prices Fi , given by the market for one oz of gold at
time Ti , are non-biased predictors for future spot prices. The present value is then calculated
as follows:
’12
j=1
. . PRICING A GOLD SWAP 45
The present values of the cash flows are discounted at the USD Libor risk-free rate, Ri . Swap
price SP is calculated by equating these two present values and solving for SP, which gives:
Õ12
F(t, T j )Q j D(t, T j )
Õ12
j=1
SP = (8.19)
i=1 Qi D(t, Ti )
Using the information given in Table 8.12 the swap price is calculated as:
SP = 1288.7 $/oz (8.20)
The calculated present values in US dollars for fixed and floating payments are given in Table
8.12. The present value of the swap contract is the difference between these two payments
at time Ti .
Date Qi [oz] Fi [$/oz] Ri [%] Di PV f x [$] PV f l [$] PVswap [$]

Jan 2018 900 1274.1 1.392 0.999 1158466 1145361 -13105
Feb 2018 900 1278.3 1.453 0.998 1157005 1147687 -9318
Mar 2018 1100 1280.4 1.508 0.996 1412210 1403138 -9072
Apr 2018 800 1282.6 1.570 0.995 1025561 1020724 -4837
May 2018 900 1284.8 1.632 0.993 1151952 1148486 -3467
Jun 2018 900 1287.1 1.693 0.992 1150033 1148625 -1408
Jul 2018 1000 1288.6 1.741 0.990 1275655 1275578 -77
Aug 2018 1100 1290.2 1.789 0.988 1400737 1402391 1654
Sep 2018 1000 1292.0 1.837 0.986 1271041 1274318 3277
Oct 2018 900 1293.8 1.886 0.984 1141729 1146267 4538
Nov 2018 1500 1296.4 1.934 0.982 1899057 1910436 11379
Dec 2018 2000 1299.1 1.982 0.980 2526784 2547219 20435
Table 8.12: The Swap Contract
The fixed payment the company has to make at each delivery is 1288.7 $/oz for required
quantities of gold. The present value of the swap contract is given in Figure 8.7. When these
figures are summed, they net to zero.
Figure 8.7: The present value of the swap contract at different maturities.
8.7 Pricing a currency swap

The company is able to use currency swap to buy US dollars at a fixed foreign exchange
rate over the next year. The expected quantities of US dollars Qi the company has to buy
is estimated by multiplying the future market price of gold with required quantities of gold
needed at time Ti .
QUSD = Q oz FUSD/oz (8.21)

When the company enters into the swap, it agrees to buy the quantity Qi of US dollars each
month for the next year at a fixed swap exchange rate SR. The present value of fixed payments
is:
’
12
PV(t) f x = SRQi D(t, Ti ) (8.22)
i=1
The present value of floating payments depends on the calculated forward exchange rate
F(t, T j ) at time T j .
’
12
j=1
The forward foreign exchange rate is calculated with the formula:

r f (t,Ti ))(Ti t)
F(t, Ti ) = X(t)e(rd (t,Ti ) (8.24)
. . PRICING A CURRENCY SWAP 47
When a swap contract is entered into the present value of the fixed and floating payments are
equal, so the swap rate can be calculated as:
Õ12
i=1 Qi D(t, Ti )
SR = Õ12 (8.25)
j=1 F(t, T j )Q j D(t, T j )
The required quantities of US dollars Qi , forward exchange rate Fi , ISK Reibor rates Ri and
the discount factor Di , calculated using ISK Reibor rates, are given in Table 8.13. Using this
information, the swap rate is calculated:
SR = 105.38 (8.26)
Therefore the company has locked in the exchange rate at ISK 105.38 per USD for the required
quantities of US dollars. The present value of fixed and floating payments calculated in ISK
are given in the following table. The present value of the swap contract is the difference
between fixed and floating payments at each payment date Ti .
Date Ri [%] Di Fi [ISK/USD] Qi [USD] PVf x [ISK] PVf l [ISK] PVswap [ISK]
Jan 4.350 0.996 103.85 1146690 120402404 118647924 -1754480
Feb 4.650 0.993 104.14 1150470 120302033 118888929 -1413104
Mar 4.650 0.988 104.41 1408440 146707774 145351113 -1356661
Apr 4.650 0.985 104.66 1026080 106466532 105736808 -729724
May 4.650 0.981 104.90 1156320 119516271 118971633 -544637
Jun 4.650 0.977 105.13 1158390 119267167 118986051 -281116
Jul 4.667 0.973 105.37 1288600 132147551 132137101 -10450
Aug 4.683 0.969 105.61 1419220 144961788 145273687 311899
Sep 4.700 0.965 105.84 1292000 131436832 132006563 569731
Oct 4.717 0.961 106.06 1164420 117978515 118741801 763287
Nov 4.733 0.958 106.28 1944600 196223122 197902104 1678982
Dec 4.750 0.954 106.50 2598200 261100102 263866375 2766273
Table 8.13: The Currency Swap Contract
The present values of the swap contract at time t are given in Figure 8.8. As seen in the
figure, the net value of the swap contract at time t is zero. The floating payment may change
in time and change the net value of the swap contract. At any given time, the value of the
swap contract is given by the difference in the present values of the remaining payments.
When the spot exchange rate increases, the net payment goes to the fixed rate payer and when
the spot exchange decreases, the net payment goes to the floating rate payer.
Figure 8.8: The present value of the currency swap contract at different maturities.
8.8 Summary
To choose the best risk management strategies for the company to hedge its risk exposure,
the derivatives contracts are compared.
In future contract, the company pays various future prices for the gold each month. The
present value at time t (today) of the payments made by purchasing required quantities of
gold Q(Ti )gold for a future price F(t, Ti ) at time Ti is:
PV(t, Ti )Future = Q(Ti )gold F(t, Ti )D(t, Ti ) (8.27)
In call option, a fixed strike price at 1270 $/oz or less for the gold is paid each month, plus
the cost of a premium for these contracts C(t, Ti ) premium . If the spot price for gold at maturity
is lower than 1270 $/oz, the company buys the gold at the market price. The present value
of the total cost of entering into a call options to buy required quantities Q(Ti )gold with strike
K=1270 $/oz at time Ti is:
PV(t, Ti )Option = Q(Ti )gold K D(t, Ti ) + C(t, Ti ) premium (8.28)
In swap contract, a fixed swap price of 1288.7 $/oz is paid for the gold price over the next
year. The present value of the fixed payments in swap contract at time t with a fixed swap
price SP = 1288.7 $/oz is:
PV(t, Ti )Swap = SPQ(Ti )gold D(t, Ti ) (8.29)

. . SUMMARY 49
The results from these calculations are shown in the Table 8.14. For the calculations of the
present values, the company uses discount factor D(t, Ti ).
Future contract Call option, K = 1270 $/oz Swap contract

Date D(t, Ti ) Q gold [oz] F(t, Ti )[$/oz] PVFuture [$] Payments[$] Cpremium [$] PVOption [$] PVSwap [$]
Jan 2018 0.999 900 1274.1 1145361 1141675 130.43 1141805 1158466
Feb 2018 0.998 900 1278.3 1147687 1140235 191.14 1140427 1157005
Mar 2018 0.996 1100 1280.4 1403138 1391742 365.46 1392107 1412210
Apr 2018 0.995 800 1282.6 1020724 1010697 308.47 1011005 1025561
May 2018 0.993 900 1284.8 1148486 1135256 414.11 1135670 1151952
Jun 2018 0.992 900 1287.1 1148625 1133365 454.88 1133819 1150033
Jul 2018 0.990 1000 1288.6 1275578 1257166 577.93 1257744 1275655
Aug 2018 0.988 1100 1290.2 1402391 1380435 675.39 1381110 1400737
Sep 2018 0.986 1000 1292.0 1274318 1252619 684.66 1253303 1271041
Oct 2018 0.984 900 1293.8 1146267 1125181 645.17 1125826 1141729
Nov 2018 0.982 1500 1296.4 1910436 1871532 1178.02 1872710 1899057
Dec 2018 0.980 2000 1299.1 2547219 2490161 1629.02 2491790 2526784
Total 16,570,230 16,337,316 16,570,230
Table 8.14: Compared hedging strategies for gold prices
Based on these data, the best way to manage gold price exposure is to buy a call option with
strike price 1270 $/oz. The present value of the future cash flow of the company will be
$16,337,316 or lower, depending on the future spot prices which are not known today. To
predict future spot prices STi at time Ti , Monte Carlo simulation is used with the formula:
2 p
N(0,1) dt
STi = S(Ti 1) e
(µ 2 )dt+ (8.30)
The inputs used in the formula are historical volatility of gold prices, the time step dt as
1/252, the spot price of gold today, St = 1274.5 $/oz, and the USD Libor rates, µ. N(0, 1)
is a normal random variable with 0 mean and 1 standard deviation. 10.000 price paths are
simulated 252 days into the future. Using these simulated future prices, the present value of
the option payments is:
’
12
PV(t)Option = min(STi , K)Q(Ti )gold D(t, Ti ) + C(t, Ti ) premium (8.31)
i=1
where K is 1270 $/oz, STi is the simulated price from the Monte Carlo simulation, C(Ti ) premium
is the call premium and Q(Ti )gold is required quantities for gold at time Ti . The probability
distribution of the calculated present value of option payments is given in Figure 8.9. The
maximum value is $16,337,316. The probability that the future payments will be below the
maximum value is 80.69%. There is 80.69% chance that the future cash flow will be lower
than $16,337,316.
Figure 8.9: The probability density function for the present value of option payments
Table 8.15 compares the best strategies to hedge foreign exchange rates for the company. By
entering into a forward contract, the company agrees to purchase US dollars at the forward
exchange rate each month. The present value at time t for these future payments to buy
required quantities of US dollars Q(Ti )USD at time Ti is:
PV(t, Ti )Forwar d = Q(Ti )USD F(t, Ti )D(t, Ti ) (8.32)
The quantities Q(Ti )USD of US dollars that the company have to purchase depends on the
price of gold at each payment date Ti . The expected quantities of US dollars purchased each
month are calculated with the future price of gold:
Q(Ti )USD = Q(Ti )oz F(t, Ti )USD/oz (8.33)
In swap contract, the company purchases US dollars at a fixed exchange swap rate SR=105.38.
The present value of the fixed payments in the swap contract is:
PVSwap (t, Ti ) = SRQ(Ti )USD D(t, Ti ) (8.34)
The option contract gives the company the right to purchase US dollars at the calculated
forward exchange rate given today at time t. If the forward exchange rate at maturity is higher
than the spot exchange rate, the company can purchase US dollars at the market exchange
rate. The present value of the payments made in option contract at each delivery Ti is:
PVOption (t, Ti ) = Q(Ti )USD K(Ti )D(t, Ti ) + C(t, Ti ) premium (8.35)

. . SUMMARY 51
Forward contract Call option, K = F(t, Ti ) Swap contract

Date D(t, Ti ) QUSD F(t, Ti ) PVForwar d [ISK] Payments[ISK] Cpremium [ISK] PVOption [ISK] PVSwap [ISK]
Jan 2018 0.996 1146690 103.85 118647924 118647924 1588575 120236500 120402404
Feb 2018 0.992 1150470 104.14 118888929 118888929 2251043 121139972 120302033
Mar 2018 0.988 1408440 104.41 145351113 145351113 3370434 148721548 146707774
Apr 2018 0.985 1026080 104.66 105736808 105736808 2831019 108567827 106466532
May 2018 0.981 1156320 104.90 118971633 118971633 3561185 122532819 119516271
Jun 2018 0.977 1158390 105.13 118986051 118986051 3901373 122887424 119267167
Jul 2018 0.973 1288600 105.37 132137101 132137101 4679497 136816598 132147551
Aug 2018 0.969 1419220 105.61 145273687 145273687 5499674 150773361 144961788
Sep 2018 0.965 1292000 105.84 132006563 132006563 5300312 137306875 131436832
Oct 2018 0.961 1164420 106.06 118741801 118741801 5025368 123767169 117978515
Nov 2018 0.958 1944600 106.28 197902104 197902104 8783966 206686070 196223122
Dec 2018 0.954 2598200 106.50 263866375 263866375 12232020 276098395 261100102
Total 1,716,510,091 1,775,534,558 1,716,510,091
Table 8.15: Compared hedging strategies for exchange rate
The best way to manage foreign exchange exposure is to enter into a swap contract to purchase
US dollars at a fixed exchange rate of 105.38 or entering into a long future contract to lock
in the future gold price for the next year.
If the company decides to manage gold price exposure with a long position in a call option
with strike price K = 1270 $/oz, it guarantees that quantities of gold for the next year will be
purchased for 1270 $/oz or lower. The quantities of US dollars the company has to purchase
can now be calculated as:
Q(Ti )USD = Q(Ti )oz KUSD/oz (8.36)
The present value of payments for each contract is now calculated with the new quantities of
US dollars and the results are shown in Table 8.16.
Forward contract Call option, K = F(t, Ti ) Swap contract
Date D(t, Ti ) QUSD F(t, Ti ) PVForwar d [ISK] Payments[ISK] Cpremium [ISK] PVOption [ISK] PVSwap [ISK]
Jan 2018 0.996 1143000 103.85 118266120 118266120 1583463 119849584 120009164
Feb 2018 0.992 1143000 104.14 118116984 118116984 2236426 120353410 119515146
Mar 2018 0.988 1397000 104.41 144170504 144170504 3343058 147513563 145509126
Apr 2018 0.985 1016000 104.66 104698071 104698071 2803207 107501279 105415541
May 2018 0.981 1143000 104.90 117601163 117601163 3520163 121121326 118133827
Jun 2018 0.977 1143000 105.13 117405240 117405240 3849540 121254781 117676944
Jul 2018 0.973 1270000 105.37 130229799 130229799 4611952 134841751 130233814
Aug 2018 0.969 1397000 105.61 142999211 142999211 5413569 148412780 142685312
Sep 2018 0.965 1270000 105.84 129758774 129758774 5210059 134968832 129192511
Oct 2018 0.961 1143000 106.06 116557495 116557495 4932924 121490420 115802663
Nov 2018 0.958 1905000 106.28 193872009 193872009 8605088 202477097 192217944
Dec 2018 0.954 2540000 106.50 257955736 257955736 11958021 269913757 255239114
Total 1,691,631,106 1,749,698,580 1,691,631,106
Table 8.16: Compared hedging strategies for exchange rate
To summarize the results calculated, the best way to manage both gold price risk and foreign
exchange rate risk is to take a long position in a call option to purchase gold at the strike price
K=1270 $/oz for delivery of the required ounces of gold each month. Now the company
knows that the gold price for the next year will be bought for 1270 $/oz, the company can
decide how many US dollars they have to purchase. With this information, the company can
enter into a swap contract with fixed swap exchange rate = 105.38 or enter into a forward
contract with future prices bought at delivery. The company’s future payments for buying
gold and US dollars are now immune to upward movements in the market price.
Chapter 9
Discussion and Conclusion
Companies that use commodities as input should consider implementing risk management
strategies to insure against a rise in prices, where the profit decreases when the price of the
input increases. Hedging strategies for such firms include buying forwards, buying futures,
buying calls or entering into a swap contract. Many companies faced with commodity price
risk can also face a foreign exchange rate risk since most commodities are quoted in US
dollars. Managing both these risks at the same time can be challenging.
The main purpose of this thesis is to use risk management strategies and derivatives to
hedge risks faced by an Icelandic manufacturer that uses gold as an input. The derivatives
used are futures, forwards, options and swaps. Both gold price risk and foreign exchange
rate risk have a great effect on the company’s profitability. Based on the risk-management
tools and analysis, the study shows that a good way to manage gold price risk is by taking a
long position in a call option with a strike price close to the present spot price. Entering into
a swap contract with a fixed foreign exchange rate over the next year can be considered an
effective risk management strategy for the company to manage foreign exchange rate risk.
When implementing risk management strategies, it is important to choose appropriate strate-

gies because there can also be a potential loss if the prices of the underlying commodity
change against risk management strategies and expectations of price fluctuations.
As a result, hedging against market price fluctuations in volatile commodity markets reduces
price uncertainty and stabilizes future cash flow. These non-predictable price fluctuations in
the commodity market can lead to big losses for companies that can be much more harmful
than profits are beneficial.
Bibliography
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2015.
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[5] ——, (2012). A guide to managing commodity risk, [Online]. Available: https :
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[6] S. Ólafsson, “Risk quantification”, Reykjavik: Reykjavik University, 2015.
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Inc., 2015.
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54 BIBLIOGRAPHY
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Hedging Strategies To Manage Commodity Price Risk

Karen Ósk Finsen

Thesis of 30 ECTS credits

Karen Ósk Finsen

Thesis of 30 ECTS credits submitted to the School of Science and Engineering

Versveiflur á hrávörumörkuum geta haft veruleg áhrif á fjárhagslegan ávinning fyrirtækja

Thesis of 30 ECTS credits submitted to the School of Science and Engineering

Karen Ósk Finsen

Dr. Sverrir Ólafsson

Dr. Sigurur Pétur Magnússon

Karen Ósk Finsen

List of Tables xiii

List of Abbreviations xiv

2 Risk and risk management 2

3 Types of risk faced by corporations 4

4 How to quantify risk? 6

5 Instruments available for risk management purpose 9

7 Description of the risks the firm faces 19

8 Implementation of risk management strategies 35

9 Discussion and Conclusion 52

2.1 Risk management planning process . . . . . . . . . . . . . . . . . . . . . . . . 3

5.1 Payoff from a long

8.1 The future price for gold ($/oz). . . . . . . . . . . . . . . . . . . . . . . . . . 35

VaR Value at Risk

• What is the purpose of implementing risk management strategies?

• What are the reasons firms seek to manage risk?

Risk and risk management

2.1 What is risk?

2.2 Financial risk

2.3 Risk management

Identify risk Quantify risk Optimize exposure to risk Diversify

Figure 2.1: Risk management planning process

Successful implementation of risk management requires the following:

How we plan to manage risk Implement plan Monitor implementation

Figure 2.2: Risk management implementation process

2.4 Why manage risk?

Types of risk faced by corporations

3.1 Foreign exchange risk

3.2 Interest rate risk

3.3 Commodity price risk

How to quantify risk?

4.1 Risk as spread in returns

4.2 Value at Risk

V aR(↵, R,T , T, V0 ) = ↵V0 R,T (4.8)

where R,T is the standard deviation for T days calculated as follows:

4.3 Risk from foreign investment

Q f (t) = X f ,d (t)Q d (t) (4.11)

The value of the investment in foreign currency at time T is:

Q f (T) = (1 + R f (t, T))Q f (t) (4.12)

and the domestic value of the foreign currency at time T is:

Q d (T) = X d, f (T)Q f (T) (4.13)

where X d, f is the amount of domestic currency per unit of foreign currency.

The percent change (returns) in the exchange rate is:

and the standard deviation of returns:

4.4 Monte Carlo

Instruments available for risk

5.1 Forward contracts

5.2 Futures contracts

5.2.1 Payoffs from forward and future contracts

5.2.2 Forward contracts on currencies

5.3 Vanilla options

5.3.1 Options positions

• A long position in a call option is the right to buy