Part 1: Short objective questions with explanations

Q1. Answered already

Q2. Independent monetary policy and the problems with the structure

Noumi to do

Q3

a. Option position

b. Breakeven of option

This is an example of Call option where Lufthansa will be buying the barrel at the strike (exercise)
price of $82 per barrel. The option will be exercised at this price if it is profitable to do so. However
the exercise price alone does not determine the profitability. Option premium, in this case of $3 per
barrel, needs to be considered. Therefore, Jet Fuel prices have to be trading at $85 ($82 + $3) in
order to arrive at the break-even
 c. Advantages and disadvantages of options in comparison to a future position

Advantages

- Free from market to market

- No requirement to maintain initial and variation margin

Disadvantages

- Tend to be fairly complex

- Option position cannot be sold until maturity or expiration of option
- Less inexpensive in nature

References:

d. During the last decade, the economic situation and indicators of gulf countries has experienced
many swings of declining and growing.

Purchasing Manager of Lufthansa is seeking to manage adverse impact of oil price due to conflict in
Arabian Gulf as it happened very recently in the past. Until 2011, political situation of Arabian Gulf
was almost firm when MENA region faced political conflicts which resulted in Arab Spring and
eventually oil prices collapsed in 2014.

Other risks at play are direct relationships between oil prices and macroeconomic factors such as
GDP, growth and inflation. According to Deloitte's 2020 Oil, Gas, and Chemical Industry Outlook,
other factors such as weaking economic growth in major economies such as US and China would also
have an impact on the price of the barrel. Ongoing, perhaps intensifying, trade tensions, which can
create uncertainty, dampen growth, and lead to modifications in long-established supply chains.

Political risks, including the US election cycle, the outcome of the Brexit process, and tensions in the
Middle East between multiple states and non-state actors with different objectives.

Reference:

International Journal of Energy Economics and Policy | Vol 9 • Issue 4 • 2019

https://www.ogj.com/general-interest/article/14072294/deloitte-oil-gas-firms-face-broad-
macroeconomic-risks
 Part 2 Essay questions

JCB UK Construction company

Q2

a. Doing nothing

Payment of WON 6,300m at current spot rate WON 1,071.95/ GBP (6,300/1,071.95) is valued at
5.877m GBP. However, this amount will be paid in six months’ time, during which time WON may
have strengthened or weakened against the GBP and JCB s exposed to the risk of paying a higher
WON equivalent

If JCB does not hedge against foreign exchange now, this leaves JCB exposed to WON 6,300m paid at
the end of six months when into GBP.

b. Using Futures

Using Futures: The current spot rate is Won 1,071.95/GBP and the six-month forward rate is Won
1.103.28/GBP. The six-month Korean Won interest rate is 12% while the six-month Pound Sterling
rate is 5% per annum.

JCB will have a GBP payment in six months’ time and needs to hedge against WON losing value over
the period of six months.

Based on given interest rates, spot rate at the end of six months is being calculated and exchange
gain or loss on the settlement

Current spot rate = 1,071.95

Forward rate = 1,103.28

Spot @ future date = 1,071.95 x 1.12/1.05 = 1,143.41

Basis risk = (1,071.95 – 1,103.28) = -31.33

Futures price = (1,143.41 + 31.33) = 1,174.74

GBP

Underlying Transaction @ spot: Won 6,300 m / 1,143.41 (5.50)

Gain on futures: (1,174.74 – 1,103.28)/100 0.715

4.785
c. Using call options
Call option gives the holder the right to buy in future. Unlike futures, options are always expensive
due to optional reload/premium future

Current strike price: 1,100 / GBP

Future’s price: 1,174.74/GBP
Calculated as in futures

In this case, Strike price is lower than Future’s price option holder should allow the option to lapse
on the date of exercise. Additional cost of 2.83% of strike price to be paid

d. Using put options

Using Put Options:

A Won 31.13. A six-month Put option at the same strike has a price of 2.48%.

Put Option gives the holder the right to sell the underlying currency. Options are more expensive
than forward contracts and futures.

Spot rate 1,071.95 1,103.26 (Note 1)

Future’s price 1,100.00 1,103.25 (Note 2)

Option will not be exercised as strike price is less than futures price.

(Note 1): Spot price at the end of six months = 1,071.95 + 31. 13 = 1,103.26

(Note 2) Futures’ price at the end of six months = (1,071.95 -1,100) = -28.05
Assuming that basis reduces to zero at maturity in a linear manner.

Underlying transaction at spot rate (WON 6,300 /1,103.26) = GBP (5.7103)

Premium (GBP 5.710 x 2.48%)= GBP (0.1416)

Net cost= GBP (5.8519)

Assessment of alternative strategies

There are various strategies available for JCB in the context of foreign currency risks. In a do nothing
scenario, the actual settlement amount will be determined based on the spot rate at the time of
payment (i.e. 6 months). If at the end of six months, GBP is higher than Won then JCB will limit their
exposure to a foreign exchange loss and hence reduces JCB’s risk of potential cash outflow. However
in the event of GBP losing values against Won, JCB will be exposed to higher risk.
Another strategy to consider would be ‘Futures’: According to ACCA, futures contract are traded
hedging instruments which fixes exchange rate at some future date. In this case, if JCB pursues
futures to settle this transaction, the net cash outflow would be £4.78 m. The advantage of using
such a strategy, JCB’s exposure to foreign currency movement will be limited. On other hand, the
cost of maintaining a treasury department would increase the overheads for JCB.

JCB can also engage in speculation in an organized futures market for the foreign currency. In this
strategy the JCB could make up in profit on its futures market transaction whatever loss it might
have on it foreign trade transaction risk

Gregory J. Millman, The Floating Battlefield: Corporate Strategies in the Currency Wars (New York,
AMACOM, 1990).

Gregory J. Millman, The Vandals' Crown: How Rebel Currency Traders Overthrew the World's Central
Banks (New York, The Free Press, 1995).

Call options provide the holder the right to buy in future, unlike futures, options are always
expensive due to additional premiums embedded in the options price. This extra premium is always
paid up front. The advantage allows the holder, in this case, JCB the right to exercise the option if the
situation is favourable, For example if strike price is less than future’s price. Alternatively, the option
holder has a right to allow the option to lapse in case of unfavourable market conditions. The
additional premium cost of 2.83% is the disadvantage of using such a strategy if JCB decides not to
exercise the option in future

Put options provide the holder the right to sell in future at a fixed exchange rate. The premium cost
feature of Put options makes it similar to a call option.
[ 2.48% ]

Transaction risk: This is the risk that JCB faces when due to acquisition of a foreign company based in
Korea. The cost of acquisition will be denominated in the Korean Won. If Korean Won were to
appreciate versus the GBP then the UK company will have to make a larger payment in its GBP to
meet the contracted price

Translation risk: Translation risk is a foreign exchange risk of translating foreign exchange assets and
liabilities in Statement of Finance Position at the year end. In case of JCB, the cost of acquisition
payable of 6,300 million Won which is due in six months, there is a risk that unpaid foreign exchange
liabilities may result in foreign exchange loss when translating into JCB’s presentational currency
(GBP) at the year end

In order to mitigate the transaction risk associated with the payment of 6,300 million wons, there is
an opportunity to pay the funds now at the spot rate or consider deferring the payment by six
months, investing the funds at 1% over this time period

2. Domestic inflation

Add narrative
 All figures are reported in GBP in million

Defer the payment for 6 months and invest

Pay the funds now   instead
6,300 @ 1 % p.a (pro-rata 6
Interest earning Nil month) -0.2
Payment of funds of 6,300 million
Payment of funds of 6,300 million @ spot rate
5.8 @ forward rate 1.103.28
of 1,017.95
(adjusted for inflation) 5.71
             

Total cost 5.8         5.51

Net savings 0.29

There is a clear indication that JCB will be able to save £0.29 million by deferring the payment and
investing the funds for 6 months.