Basing on the habit of zinc purchasing over many years in the past and the orders for

2012, ABC Inc figured out the volume in need to import monthly; which brought the benefits
to both customers and ABC Inc as well. In the meantime, the company might participate in
the London Metal Exchange to buy zinc futures contract for hedging the risk of price’s
fluctuation. ABC Inc had to base on the demand for zinc from its customers to decide the date
and the quantity of zinc to buy on LME. ABC Inc hedged by using futures to avoid the
increase in zinc price in the next three months, in such case; the loss due to buying zinc at
spot on physical market would be offset by the profit created from buying zinc on the futures
market. Thus, ABC Inc should have determined the expiration date on the futures contract to
be coincidence with the date the company had to buy zinc on cash market, which would close
the company’s position on London Metal Exchange. All the futures contracts traded by ABC
Inc on LME had expiration date of three months. That type of contract was recommended to
be high liquidated on LME when needed. However, to ensure that the company had enough
commodities in stock for customers’ demand, ABC Inc should have bought zinc at spot on
physical market within 15 days before the delivery date stipulated in domestic sale contract.
Basing on data of cash and 3-month price during 6 years, we could make a forecast for
the trend of zinc price in 2012. While with the data of monthly changes in zinc price collected
in 2011, we could suggest a hedge ratio that plays an important role in finding out the optimal
numbers of contract bought on LME by ABC Inc.

Table 1: Zinc price on London Metal Exchange in 2011

ZINC PRICE QUOTED ON LME IN 2011 (USD/MT)
27-Dec-10 2,275.00 27-Dec-10 2,280.00
LME-zinc-cash-official LME-zinc-3-month-official
Date USD/MT Change in % Date USD/MT Change in %
31-Jan-11 2,334.00 2.59% 31-Jan-11 2,360.00 3.51%
28-Feb-11 2,477.50 6.15% 28-Feb-11 2,504.00 6.10%
31-Mar-11 2,318.50 -6.42% 31-Mar-11 2,331.50 -6.89%
28-Apr-11 2,221.50 -4.18% 28-Apr-11 2,235.50 -4.12%
31-May-11 2,250.00 1.28% 31-May-11 2,269.00 1.50%
30-Jun-11 2,315.00 2.89% 30-Jun-11 2,333.00 2.82%
29-Jul-11 2,470.00 6.70% 29-Jul-11 2,490.00 6.73%
31-Aug-11 2,258.50 -8.56% 31-Aug-11 2,286.00 -8.19%
30-Sep-11 1,905.00 -15.65% 30-Sep-11 1,925.00 -15.79%
31-Oct-11 1,918.50 0.71% 31-Oct-11 1,932.50 0.39%
30-Nov-11 1,943.00 1.28% 30-Nov-11 1,940.00 0.39%
30-Dec-11 1,828.00 -5.92% 30-Dec-11 1,845.00 -4.90%

1. What is the hedge ratio for futures contract?

Most of the big-size orders from ABC Inc’s customers had been deposited with the
percentage of 15% of forward contract’s value which has been signed by ABC Inc and its
customers, then it was suggested that ABC Inc should have hedged the position on London
Metal Exchange with the ratio of 100%.
On October 03, 2011, ABC Inc Company and Hoa Phat group signed a purchase contract
in which stated that on January 18, 2012, ABC Inc would deliver to Hoa Phat group 1400
tons of zinc for 1,939.00 USD/MT; Hoa Phat group deposited for ABC Inc 15% of the
contract value. The payment would be made within 15 days before the delivery date, which
was on January 03, 2012. The selling price stipulated in the contract is the forward price of
zinc in the next 3 months. This price was calculated by basing on the value of the current
price of zinc; LIBOR interest rate offered to ABC Inc by Vietnamese bank for USD loan, the
initial basis risk, the storage charges on the physical market and the fees ABC Inc had to pay
for initiating the position on the LME futures market (15 USD) as well.
On October 03, 2011, the borrow rate in USD for companies who possessed the credit
rating as the same as ABC Inc Company was 5% per year. The spot price of zinc quoted on
the LME on October 03, 2011 was 1,847.50 USD/MT, storage charges was 30 USD/MT.
Meanwhile, the 3-month price of zinc on the LME was offered at the time of October 03,
2011 was at 1,871.00 USD/MT, lower than 1900.54USD/MT.

2. What is the strategy of hedging we had proposal to ABC Inc Company on LME?

The futures contract ABC Inc bought on LME had duration of 3 months; it meant that the
expiry date of the contract was on January 03, 2012. To initiate the position on the LME,
ABC Inc was required to follow the terms and conditions as below:
- Initial deposit: 10% of the contract value
- Maintenance margin: 10% of the initial deposit
- Transaction costs for opening and closing account at clearing house of LME per time:
0.016% of one contract value. These fees must be deposited at the time of opening.

After entering into futures contract on LME, all the losses and profit arising from the
fluctuation of zinc price on futures market had been tracked as below:

Table 2: Marking to market profit and loss

GAIN AND LOSS ON TRADING ACCOUNT FOR 01 CONTRACT
Contract Maintenance
25.00 MT USD
size margin
Price Contract Accumula Initial Margin
Date Profit/ Loss Scenario
(USD/MT) value (USD) ted Result Margin call
3-Oct-11 1,871.00 46,775.00
4-Oct-11 1,835.50
5-Oct-11 1,831.00
6-Oct-11 1,843.50
7-Oct-11 1,845.00
10-Oct-11 1,903.50
11-Oct-11 1,880.50
12-Oct-11 1,930.00
13-Oct-11 1,890.00
14-Oct-11 1,901.50
17-Oct-11 1,900.00

18-Oct-11 1,832.00
19-Oct-11 1,832.00
20-Oct-11 1,750.00
21-Oct-11 1,793.00
24-Oct-11 1,840.50

25-Oct-11 1,837.00
26-Oct-11 1,843.00
27-Oct-11 1,880.50
 28-Oct-11 1,908.00
31-Oct-11 1,918.50
1-Nov-11 1,871.00
2-Nov-11 1,916.00
3-Nov-11 1,922.00
4-Nov-11 1,950.50
7-Nov-11 1,912.00
8-Nov-11 1,953.00
9-Nov-11 1,946.00
10-Nov-11 1,883.00
11-Nov-11 1,880.00
14-Nov-11 1,925.50
15-Nov-11 1,905.50
16-Nov-11 1,911.50
17-Nov-11 1,911.50
18-Nov-11 1,926.00
21-Nov-11 1,923.00
22-Nov-11 1,929.00
23-Nov-11 1,903.50
24-Nov-11 1,898.00
25-Nov-11 1,880.50

28-Nov-11 1,928.00
29-Nov-11 1,936.00
30-Nov-11 1,943.00
1-Dec-11 2,033.00
2-Dec-11 2,060.00
5-Dec-11 2,025.00
6-Dec-11 2,008.00
7-Dec-11 2,020.50
8-Dec-11 2,006.00
9-Dec-11 1,985.50
12-Dec-11 1,956.00
13-Dec-11 1,933.00
14-Dec-11 1,874.00
15-Dec-11 1,865.00
16-Dec-11 1,873.00
19-Dec-11 1,851.50
20-Dec-11 1,840.50
21-Dec-11 1,862.50
22-Dec-11 1,850.00
23-Dec-11 1,846.50
28-Dec-11 1,811.50
29-Dec-11 1,798.00
30-Dec-11 1,828.00
3-Jan-12 1,827.00

3. Fill in the above table.

4. Analyze the company outcomes under the following scenarios:

Scenario 1:
On December 29, 2011, the zinc price in the spot market dropped to USD 1,798.00/ MT.
Meanwhile, the futures contract which had the identical characters to the one ABC Inc had
long on October 03, 2011 was offered to be purchased at USD 1,799.00/MT, this price was
referred from the spot price and 3-month price of zinc quoted on December 29, 2011. The
spot price on physical market and the 3-month price of zinc on LME were USD 1,798.00/MT
and USD 1,818.00/MT respectively.

Scenario 2:
Since November 30, 2011, ABC Inc realized that the zinc price had a trend of upward. At
some point of time, the price was even higher than the sale price ABC Inc had offered to Hoa
Phat group. Thus, the company should have closed its position on the futures market to end in
profit and waited until 2 or 3 days later on which there was a signal of price falling, then to
buy zinc on the spot market; which ensured that there would be commodity available in stock
for delivering on January 18, 2012. As could be seen from the price quotation on the LME,
the zinc price from November 30, 2011 onwards increased dramatically and started to
fluctuate erratically. However, up to December 08, 2011, the price tended to move back to
the milestone of under 2,000.00 USD/MT. The bid price for the futures contract was quoted
at 2,010.56 USD/MT-offered by the broker, based on his reference to the spot price and the
3-month price on December 08, 2011. On December 13, 2011, spot price was 1,933.00
USD/MT.

Scenario 3:
Supposed on December 08, 2011, ABC Inc closed the futures contract and bought zinc on
the spot market at the price of 2,006.00 USD/MT simultaneously.