Topic: Hedging with options

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  • 7 Marks

FM – Nov 2020 – L2 – Q3b – Futures and hedging with futures | Hedging with options

Explain intrinsic value of an option and calculate the intrinsic value for USD/GH¢ call options over several months.

i) Explain the term intrinsic value of an option. (1 mark)

ii) DUU Ghana Ltd bought USD/GH¢ call options from KASA Ltd. The table below shows the various spot rates and strike prices for the various tenors.

Month Spot Rate USD/GH¢ Exercise Rate/Price USD/GH¢
1 5.1 4.8
2 5.3 5.0
3 5.5 5.4
4 5.8 5.8
5 5.7 6.0
6 6.0 6.4

Required:

Determine the intrinsic value of the option for each trading month and clearly indicate the months in which the option is in-the-money, at-the-money, or out-of-the-money. (6 marks)

i) Intrinsic value of an option:
The intrinsic value of an option is the amount by which the option is in-the-money. It is the positive value or gain that would be realized if the option were exercised immediately. An option has intrinsic value when it is in-the-money, meaning that for a call option, the spot price is above the exercise price.

(1 mark)

ii) Intrinsic value calculation:

Month Spot Rate USD/GH¢ Exercise Rate USD/GH¢ Intrinsic Value (Spot Rate – Exercise Rate) Comments/Interpretation
1 5.1 4.8 0.3 In-the-money
2 5.3 5.0 0.3 In-the-money
3 5.5 5.4 0.1 In-the-money
4 5.8 5.8 0 At-the-money
5 5.7 6.0 (0.3) Out-of-the-money
6 6.0 6.4 (0.4) Out-of-the-money

Interpretation:

  • DUU Ltd was in-the-money for months 1, 2, and 3.
  • The option was at-the-money in month 4.
  • The option was out-of-the-money in months 5 and 6.
  • 10 Marks

FM – May 2020 – L2 – Q3b – Hedging with options

Calculate the variable and fixed interest payments under an interest rate swap agreement and determine if the strategy is an effective hedge.

Asanka Ghana Ltd is a medium-sized business in Ghana that is currently borrowing GH¢1,000,000 from North East Bank at a floating or variable interest rate basis at Ghana Reference Rate (GRR) plus 3% margin which is market determined on a monthly basis. This makes their monthly interest payment volatile depending on where GRR is at the end of the month. They are rather interested in fixed interest payment at the end of the month to manage this volatility.

OTI Bank Ghana Ltd has agreed to do an Interest rate Swap with Asanka where OTI Bank Ghana Ltd pays the variable rate to Asanka but Asanka pays them a fixed rate of 21% per annum paid monthly.

The table below shows the GRR for the last 6 months:

Month GRR (%) Variable Interest (C) Fixed Rate (D) Fixed Interest (E) Net Settlement (F)
1 16% 21%
2 18% 21%
3 20% 21%
4 19% 21%
5 18% 21%
6 17% 21%

Required:

i) Calculate the variable interest, fixed interest, and net settlement under columns (C), (E), and (F) in the table above.
(8 marks)

ii) Will you describe this strategy as an interest rate hedge? Explain.
(2 marks)

i) Calculation of Variable Interest, Fixed Interest, and Net Settlement:

ii) Interest Rate Hedge Explanation:

Yes, this strategy can be described as an interest rate hedge. The variable rate that Asanka will receive under the swap agreement compensates for the variable rate it has to pay to its original lender, North East Bank. This effectively leaves Asanka with a fixed interest payment of 21%, thereby removing the uncertainty and volatility in its monthly interest payments.
(2 marks)

  • 20 Marks

FM – MAY 2016 – L2 – Q5 – Foreign exchange risk and currency risk management | Hedging with options

Discuss differences between forward and futures contracts, types of currency risk exposure, disadvantages of hedging with futures, and reasons for differences in interest rates across different maturities.

a) AD Ventures imports tomato paste from Italy for sale in Ghana. AD Ventures typically buys the tomato paste on an open account and pays the euro invoice value two months after receipt of goods. AD Ventures has suffered heavy exchange rate losses of late due to the continuous depreciation of the Ghanaian cedi against the euro. AD Ventures will receive a consignment of tomato paste on 15th May 2016. The value of this consignment is EUR540,000, which must be settled in two months’ time (settlement deadline being 15th July 2016).

The current spot exchange rate for the euro is GH¢4.7110/EUR. Financial pundits forecast that the Ghanaian cedi will depreciate against the euro in the coming months. The owner-manager of AD Venture, Akua Donkor, is worried about the probable foreign exchange loss her business may suffer when the invoice value is settled in two months’ time.

Akua Donkor has heard of the possibility of hedging AD Ventures’ currency exposure with a forward contract or futures contract but does not know what these contracts are. She has asked you to advise her on what to do to hedge against the underlying exposure relating to the EUR540,000 tomato paste consignment.

You would like to recommend a futures market hedge to Akua Donkor. You searched the derivatives market; and you found a futures contract on the euro that matures in August 2016. Other relevant details of the contract follow:

  • Contract size: EUR100,000
  • Futures contract price: GH¢4.8112/EUR

Required:
i) Explain to Akua Donkor FOUR differences between a forward contract and a futures contract. (4 marks)
ii) Currency risk exposure may be transaction risk, economic risk, or translation risk. Which of the three kinds of currency risk exposure is AD Ventures facing in relation to the EUR540,000 tomato paste consignment? Explain why. (4 marks)
iii) Explain to Akua Donkor THREE disadvantages of hedging the euro exposure with a futures hedge. (6 marks)

b) It has been observed that interest rates on debt securities or loans differ for different maturities. For the week ending 28th August 2015, the annual interest rate on the 1-year Government of Ghana note was 22.5% whereas the annual interest rate on the 2-year note was 23%.

Required:
With THREE reasons, explain why interest rates on debt securities and loans are different for different maturity periods. (6 marks)

a) Currency Risk and Hedging

i) Differences Between Forward and Futures Contracts

  1. Trading Platform:
    • Forward Contracts: Traded over-the-counter (OTC) between two parties and tailored to specific needs.
    • Futures Contracts: Traded on organized exchanges with standardized contract terms.
  2. Contract Size:
    • Forward Contracts: Tailored to the specific needs of the parties involved, allowing for flexible contract sizes.
    • Futures Contracts: Standardized contract sizes (e.g., EUR100,000), not tailored to individual needs.
  3. Settlement/Close-Out Dates:
    • Forward Contracts: Settled on the agreed-upon date, which is fixed.
    • Futures Contracts: Settlement can occur before the maturity date through an opposite transaction (close-out), with flexible dates.
  4. Collateral Requirements:
    • Forward Contracts: Typically, no collateral is required.
    • Futures Contracts: Require margin deposits as collateral to ensure performance.
  6. Dealer/mediators
    margin:
  • Forward Contracts: The exchange profits from
    fees paid by contracting
    parties
  • Futures Contracts: The dealer benefits from
    the bid-ask spread

ii) Type of Currency Risk Exposure

AD Ventures is facing transaction risk in relation to the EUR540,000 tomato paste consignment. Transaction risk arises when a company has fixed contractual cash flows in a foreign currency, such as the obligation to pay EUR540,000 in two months. The risk is that the exchange rate might move unfavorably between the contract date and the settlement date, leading to potential exchange rate losses.

iii) Disadvantages of Hedging with Futures Contracts

  1. Contract Size Inflexibility: Futures contracts have standardized sizes (e.g., EUR100,000), which may not match the exact exposure amount. This could result in either over-hedging or under-hedging.
  2. Maturity Mismatch: The futures contract matures in August 2016, while AD Ventures’ exposure occurs in July 2016. This mismatch in timing can lead to basis risk, where the futures price and the spot price of the currency do not move perfectly in tandem.
  3. Margin Requirements: Futures contracts require margin deposits to be maintained, which ties up capital that could otherwise be used in the business. Additionally, margin calls may occur if the market moves unfavorably, requiring additional funds to be deposited.

b) Differences in Interest Rates Across Different Maturity Periods

  1. Liquidity Preference Theory: Investors prefer liquidity and demand a higher interest rate for longer maturities because they are giving up liquidity for a longer period. This typically results in an upward-sloping yield curve, where longer-term securities have higher interest rates than shorter-term ones.
  2. Expectations Theory: Interest rates for different maturities reflect market expectations of future interest rates. If future interest rates are expected to rise, longer-term interest rates will be higher than shorter-term rates, leading to an upward-sloping yield curve.
  3. Market Segmentation Theory: The yield curve reflects the supply and demand conditions in different segments of the market. For example, if there is high demand for short-term securities and limited supply, short-term rates may be higher. Conversely, if there is a higher demand for long-term securities, long-term rates may rise relative to short-term rates.
  4.  Government policy: Government may influence level of interest rate in the
    economy through its monetary policy. A policy with the effect of keeping interest
    rates relatively high may force short-term interest rates higher than long-term rates.
    For instance, as the Government of Ghana borrows more through the 182-day
    Treasury bill than the 1-year note, the annualised interest rate on the 182-day bill is
    higher than the annual rate on 1-year note as of August 28, 2015.

 

  • 20 Marks

FM – July 2023 – L2 – Q5 – Hedging with options | Working Capital Management

Calculate the overdraft requirement and net working capital, identify the working capital financing policy, and justify using currency futures over options.

a) The Treasury Department of LCM Ltd is preparing financial plans for the ensuing financial year. Annual credit sales revenue is projected to be GH¢500 million while the cost of sales is expected to be GH¢260 million. Its current assets are composed of inventory and trade receivables, while its current liabilities comprise trade payables and bank overdraft. The following targets have been set:

  • Receivables turnover days: 90 days
  • Payables turnover days: 30 days
  • Operating cycle: 150 days
  • Current ratio: 1.1 times

The company’s long-term capital consists only of owners’ equity. The composition and size of long-term capital are expected to remain the same for the ensuing year. The opportunity cost of equity capital is 20%, and the interest rate on the bank overdraft is 18%.

Required:
i) Compute the amount of bank overdraft the company will need in the ensuing year. (6 marks)
ii) Compute the net working capital of the company for the ensuing financial year. (2 marks)
iii) Compute the cost of financing working capital (in GH¢). (3 marks)
iv) Identify the working capital financing policy LCM Ltd is employing. (4 marks)

b) Risk can be hedged through a variety of derivative instruments such as futures, options, and swaps. Each derivative instrument presents its advantages and disadvantages.

Required:
In reference to the above statement, justify why a company would choose a currency futures contract over a currency option contract in hedging currency exposure. (5 marks)

a)
i) Computation of the amount of bank overdraft:
Operating cycle = ITD + RTD
150 days = ITD + 90 days
ITD = 60 day

ii) Computation of the net working capital:
Net working capital = Current assets – Current liabilities
Net working capital = GH¢166,027,397 – GH¢150,933,997 = GH¢15,093,400
(2 marks)

iii) Computation of the cost of financing working capital:

Total cost of financing working capital = GH¢23,321,544 + GH¢3,018,680 = GH¢26,340,224

iv) Identification of the working capital financing policy:

LCM Ltd is likely employing an aggressive working capital financing policy because over 90% of its current assets are financed with short-term financing, which is characteristic of an aggressive policy that emphasizes short-term financing to minimize costs but increases risk.

(Marks allocation: Overview of working capital financing policies = 2 marks, Identification of policy = 2 marks)

b) Justification for using currency futures over options:

The primary advantage of using a currency futures contract over a currency option contract for hedging is the absence of a non-refundable premium. In a futures contract, there is no premium to pay upfront, as required with an options contract. Instead, futures involve a margin deposit, and any unused margin is refundable. However, with futures, there is an obligation to trade at the agreed price regardless of market movements, which can be a disadvantage if the market moves unfavorably.

(5 marks)

  • 10 Marks

FM – MAY 2019 – L2 – Q3b – Foreign exchange risk and currency risk management | Hedging with options

Calculate profit or loss from option contracts and advise on whether to exercise the options for Universal Plastics Ghana Ltd.

Universal Plastics Ghana Ltd imported raw materials from U.S.A. and Europe for the manufacture of plastic products. The company entered into option contracts with ZAA Bank Ghana Ltd to hedge its six months’ currency risk or exposure. The details of the option contracts are as follows:

Details Transaction Amount Strike Price/ Exchange Rate Spot Rate on Maturity Date Option Premium Paid to the Bank
OPTION A Bought Call option to buy USD against GH¢ US$10m USD/GH¢ 4.7 USD/GH¢ 4.5
OPTION B Bought Call option to buy EURO against GH¢ EUR 8m EUR/GH¢ 5.9 EUR/GH¢ 6.3

Required:

  1. Calculate the profit or loss of OPTION A and advise Universal Plastics Ghana Ltd whether to exercise or not. (4 marks)
  2. Calculate the profit or loss of OPTION B and advise Universal Plastics Ghana Ltd whether to exercise or not. (4 marks)
  3. Calculate the overall profit or loss on the decision to hedge based on (i) and (ii) above. (2 marks)

 

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