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St Barbara Case Solution

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The zero-cost collar is, in fact, a combination of two different instruments; a short call and a long put. This is clear from the structure that, for one instrument (long put), you pay a premium but for the other (short call) you may receive the exact same premium. The total cost comes out to be zero. The strike prices of the two instruments will be most important as not only they are the boundaries of the collar, but they are also important in equalizing the premiums for both instruments. The resulting graph of the zero-cost collar shows that both the profit and loss potential of the option holder is limited. Moreover, due to the unique combination of the covered call and the protective put, the price range for the gold can be ‘collared’ between X and Y. Therefore, a zero-cost collar does not fully minimize the risk of loss rather it only establishes a price range in which the price of gold is guaranteed. The zero-cost collar will not allow St Barbara to profit from the rising prices. However, it does possess the ability to put a floor on the loss of Barbara.

Following questions are answered in this case study solution

  1. This question deals with hedging gold price volatility.

  • Gold price volatility is hedge by using gold put options and gold call options to create a zero-cost option collar structure. Appraise how the collar is used to hedge the gold price risk so as to fix the price of gold for St Barbara.

  • Use the data on gold options with expiry on June 14 to apply a zero-cost collar. St Barbara would like to settle a minimum price of $1,340 per troy ounce. Assume that it plans to hedge 100 troy ounces.

  • St Barbara plans to use options to hedge the gold price risk even though gold futures contracts are available. Evaluate why St Barbara may not use futures for hedging gold price risk.

  1. This question relates to currency hedging.

  • St Barbara states that currency risk arises due to gold sales. Analyze how the sale of goods results in currency risk for St Barbara based on its operations.

  • St Barbara can easily hedge the currency risk associated with AUD-USD since derivative contracts for USD-AUD are available. However, the currencies of Papua New Guinea and Solomon Islands are non convertible and hence there are no derivative contracts available to hedge the currency risk associated with them. If St Barbara wants to withdraw funds from Papua New Guinea and convert to Australian dollars, apply currency forwards to explain how it can hedge the currency risk associated with AUD-PGK.

  • Assume that St Barbara decides to hedge its USD-AUD volatility through USD-AUD options. Appraise how to hedge USD-AUD volatility when it plans to convert USD into AUD using USD-AUD options with exercise price of 0.8950. Assume that hedging will start on April 1 and maturity is in June.

  • Assume that St Barbara use the option as in part (c). Appraise under what conditions St Barbara would exercise the option.

  • Assume USD-AUD futures is priced at 0.9000 on May 31 and 0.9025 on 30 Jun. Appraise what would be the cash flow associated with the purchase of options if the amount of AUD to be bought is 100,000.

  1. Assume that St Barbara engages in a currency swap with a counterparty in USA. Examine the use of currency swap and calculate the cash flow involved in this swap for St Barbara and the counterparty.

  2. Assume that St Barbara engages in interest rate cap. Apply interest rate options and calculate the cash flow involved in this arrangement for 3 years starting April 1, 2014. The last interest payment will be on March 31, 2017. Assume that the cap premium will have to be paid on April 1 every year.

Case Analysis for St Barbara

  • 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.

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