Describe the Three Arbitrage Alternatives and Compute the Profit or loss Based on 100 ounces of Gold: Deloitte Corporate Financial Risk Management Assignment, SMU, Singapore

Assignment
This assignment comprises two questions, designed to test students’ awareness on topics involving speculative and hedging strategies. In Question 1, students are expected to conduct arbitrage between two derivative markets.

For Question 2. students are required to evaluate a hedging strategy on foreign exchange risk. In both questions, the emphasis is on analytical thinking to assess the effectiveness and implications of the strategies.

Question 1

Today, you obtained the following information on gold derivatives (oz = ounce): 1 -year futures contract @ Bid $1,900 / oz – Offer $1,950 / oz. 2 -year forward contract @ Bid $2,000 / oz – Offer $2,080 / oz. 3 -year forward contract @ Bid $2,140 / oz – Offer $2,200 / oz.

Assume trading of futures contracts is on a full notional value basis and not on margin. Interest rates are 5 percent pa (compound) for the next 3 years. Storage and insurance costs for gold are $5 per oz per annum, payable in advance.

Required: Describe the three arbitrage alternatives and compute the profit or loss based on 100 ounces of gold. Comment on the results.

Question 2

Assume today is the end of March 2021. Rigmast Inc, an American firm, will import an oil rig from a U.K. rig maker in 6 months. The contracted price is GBP50 million. Rigmast, a highly risk-averse firm, is considering the following alternatives to hedge its impending currency risk.

Alternative 1: Borrowing and lending money. The home and the UK interest rates are at 2 percent and 4 percent respectively. The UK bank charges a fee of 0.2 percent on the British pounds’ proceeds. The spot exchange rate today is GBP 1 = USD 1.35. The prediction of the spot rate in 6 months is GBP 1= $1.33.

Alternative 2: Futures contract expiring in September 2021. The futures contract price is GBP1= $1.30 at the moment, and it is predicted to move to GBP1= $1.28 in 6 months. The contract specifications are Tick size 0.01 cent per GBP, Tick value = USD12.50, and size = GBP125,000 Alternative 1 Forward Contract. The 6-month forward rate is at Bid GBP 1 = 1.29 and Offer
GBP 1 = USD1.2950. The result of BREXIT appears to drive the British pound lower over the next 6 months.

Required:

(a) Explain in detail the procedure of the three hedging alternatives, and calculate the cost of the oil rig in local currency terms under each of the alternatives.

(b) What is the net gain/loss on the futures hedge. Comment on this

(c) Evaluate the factors to decide on the optimal hedging alternative and make a reasoned recommendation on the alternative to be adopted.