St Barbara Case Solution

The data on the gold options show that the strike price listed for the contract pertains to 100 troy ounces of gold. As Barbara wants to hedge 100 troy ounces, therefore, one contract will be enough. In order to formulate a zero cost collar, Barbara needs to buy a put and sell a call of the same time horizon. Moreover, the cost structure should be such that the money received from the short call should entirely be used to long put. The data on the gold options show that the strike prices range from $1280 to $1400. One has to search for a suitable put and call combination that locks the price for Barbara. Therefore, the premium received from the covered call should be greater than the premium paid for the protective put. In this case, buying a call with the strike price of $1300 and selling a put at the strike price of $1360. The net premium in this case comes out to be almost zero. Therefore, regardless of the actual price of the gold, the price for Barbara is fixed between $1300 and $1360.

Firstly, one needs to distinguish between the mode and functionality of both types of instruments in order to test for their suitability. An option is a financial instrument that gives its holder the right, but not the obligation, the either buy or sell a fixed quantity of desired stock or any other asset for a given strike price at a given time. On the other hand, the futures contracts are standardized contracts in which a party is liable for either sell or buy a stock or an asset, commodities, etc. at a predetermined price (and time). The reason for not choosing the futures contracts is evident from the definition of two instruments. In options, Barbara can not only limit the downside risk but it is also not obligated to buy or sell. It can incur a small loss and escapes from a large one. On the other hand, futures contracts are marked to market daily and Barbara can incur unlimited loss. Moreover, the margin requirement in future contracts also drain a lot of money in the form of possible daily losses. Futures contracts are also regulated and, in any scenario, the obligatory position of the party needs to be terminated with the desired transaction. Therefore, it is not feasible for Barbara to opt for risky and obligatory futures contract when it can hedge from less risky options.

Saint Barbara is a gold producer, hence, it sells this raw gold to the related parties in other countries. Saint Barbara indulges in activities in various currencies. Let’s examine the currency risk and its special link to the gold sales. The gold sales are linked to the currencies of the three countries. Barbara does not buys and sells gold in AUD. Rather, it uses the local currencies in order to carry out the sales. Therefore, the price of gold is related to the prevalent home currency (USD, PGK,SBD). Any appreciation or depreciation in the value of any of the currencies will cause the gold prices to either increase or decrease. If the AUD rises, the relative values of the other currencies depreciate. Therefore, it becomes cheaper to buy the gold in those currencies. On the contrary, any relative decrease in AUD value will cause a relative increase in the gold prices of the foreign countries. In essence, the exchange rate movements and the resulting appreciation or depreciation of the AUD will cause the price of the gold to differ from time to time. Hence, if the currency exchange rate is not hedged, the gold prices are exposed to the movement of the relevant currencies.

Currency risk can be hedged using currency forwards. Let’s consider the given scenario in which Saint Barbara wants to convert PGK to AUD in the future. Currency forward is a contract to buy or sell a predetermined quantity of currency at a fixed exchange rate. Let’s assume that the AUD/PGK exchange rate is currently 2.5 (1 Australian dollar equal to 2.5 PNG Kina) and Barbara wants to withdraw 10000 PGK after six months. Currency forward will allow Saint Barbara to set a future exchange rate for the conversion. Let’s assume that the six month forward quote for AUD/PGK is 2.7. Now six months in the future, Saint Barbara can convert PNG Kina to AUD at this rate. After six months, if the rate stands exactly at 2.7, then it’s detrimental for Barbara as the conversion will yield less Australian dollars (almost 3700 AUD for 10000 PGK withdrawal). However, by entering into a contract, Barbara has ascertained that the possible loss on the conversion cannot exceed this limit (300 AUD). If, after six months, the exchange rate stands at 2.9, then the currency forward contract will save 251 AUD for Barbara. At the same time, this hedging will not allow Barbara to gain any amount in the case the rate decreases from 2.5 exchange mark.

There are various call and put instruments for the prescribed exercise price, 0.8950 USD-AUD. One standard contract of currency options will allow Barbara to convert 100,000 AUD. In the current case, as Barbara wants to convert USD to AUD, therefore, it needs to buy the put options that will give Barbara the right to buy USD and convert it to AUD at the given price. The premium for this call option is $0.0074. Therefore, effectively, for converting 100,000 AUD to PGK at 0.8950 exchange rate, Barbara has paid the stated premium. However, as it is a currency option, therefore, Barbara will not be obligated to carry out the transaction in any circumstance. If the call options comes out to be in the money, then it should cash it, otherwise it better not to exercise the option.