Finance Assignment (Other (Not Listed) Sample)

Finance Assignment
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Finance Assignment
Part A
Multinational Corporations face many challenges with one of them arising from the many risks associated with foreign exchange markets. These risks come from the numerous external and sometimes uncontrollable factors that influence exchange rates. Examples of factors that can lead to unexpected variations in foreign exchange rates include changes in political environments, economic performance, public debt, inflation, and interest rates. Such unexpected variations in foreign exchange can wipe out significant portions of expected cash flows and leave a corporation in a difficult position (Allayannis 2001). The importance of future cash flows to businesses is that its quantity and stability largely determines a corporation’s value. Therefore, corporations have to implement strategies that offer protection against the volatility found in foreign exchange markets.
The use of currency futures contracts is one of the options that is available to corporations that operate across national borders. If a corporation expects cash flow denominated in another currency on a given date, the corporation can decide to enter into a contract to exchange the currency at a fixed price on the given date. These contracts are standardized and traded on public exchanges, and they allow the corporation to hedge against the risks associated with changes in exchange rates (Graham 2013). One component of currency futures contracts is that the corporation might be required to provide a margin requirement which will act as collateral. In addition, on the day of the exchange, actual payments will be made in the specified currencies. The corporation therefore has a guarantee on the value of the future cash flow.
The use of currency forward contracts is a second option that is available to corporations that want to hedge against variations in foreign exchange markets. Currency forward contracts are different from the currency futures contracts because they are not standardized or traded on public exchanges. They are created to meet unique requirements that the sellers and the buyers of the currency have. Another feature of currency forward contracts is that they do not have margin requirements (Graham 2013). They are similar to currency futures contract since the exchange of currencies takes place on a provided date. However, the use of currency forward contracts might result in a situation where one party might make a profit while the other party loses.
In the case of a US based company seeking to hedge its future cash outflow in foreign currency, the company would be better off if it decides to use a currency futures contract. The justification for this choice is that currency forward contracts are private arrangements that are not recorded or available to public scrutiny. In addition, should the company decide to use a currency forward contract, it will expose itself to manipulation since forward contracts do not fall under the regulation of any regulatory agencies or the federal government. The other reason not use a currency forward contract is exposure to credit risks. Some of the benefits that the US Company will derive from using a currency futures contract include clear terms and conditions, the ability to close out positions before expiry dates, and the presence of honest regulatory bodies. In conclusion, the use of a currency futures contract will guarantee stability owing to the hedging of the known future cash outflow.
Part B
Hedging is a critical component in finance as it provides a means of reducing risk and mitigating losses when it is done in the correct manner. However, it is worth noting that hedging also reduces profits but this is acceptable since capital is preserved. The minimum variance hedge ratio can be defined as the minimum number of futures or options that are required to hedge a position in the cash market so as to prevent the least change in the hedged position (Beninga 1984, p. 155). The challenge with using futures contracts is that it might be difficult to find a futures market for the position being hedged. For instance, a logistics company wishing to limit exposure to rising jet fuel prices might find it difficult to find a jet fuel futures market. However, the financial markets have grown and become sophisticated enough to allow the logistics company to find products such as futures, derivatives, and options that are related to the jet fuel thus allowing the firm to hedge the risks arising from changing fuel prices.
Once a product that is related to the desired hedge is selected, the correlation between that product and futures contract being hedged, which in the above example is the jet fuel, will be examined. This examination will involve selecting a past interval and finding out whether the prices of the two futures move in the same direction. However, it is worth noting that the movements will be imperfect even if they are in the same direction. These imperfections result in minor losses which need to be eliminated. The minimum variance hedge ratio is applied to come up with an optimal number of contracts which will reduce these losses (Beninga 1984, p. 155). This allows for the hedging to be effective. In the given example of a logistics firm, any losses arising from higher jet fuel prices will be offset by the profits from the increased market value of the related futures, derivatives, or options.
The price sensitivity hedge ratio is similar to the minimum variance hedge ratio since it also minimizes risk. However, there are a number of differences between the two hedge ratios. The minimum variance hedge ratio applies to hedging against future price changes while the price sensitivity hedge ratio applies to hedging against changes in interest rates. Examples of assets whose values depend on interest rates are money market securities and bonds. The hedging for these types of assets involves taking positions in a certain number of futures so that minor changes in the interest rates will not have impacts on the hedged value (Kolb 1981, p. 73).
Another difference between the minimum variance hedge ratio and the price sensitivity hedge ratio comes from the type of information that is taken into consideration. As stated, the minimum variance hedge ratio looks at information from the past to determine the correlation between the price movements. When it comes to the price sensitivity hedge ratio, the focus shifts to current information on sensitivity of a spot and futures prices to variations in the interest rate. The price sensitivity hedge ratio calculates the optimum number of futures that need to be bought in order to protect the value of interest dependent assets. In conclusion, it is evident that both the price sensitivity hedge ratio and the minimum variance ratio both offer protection against risks.
Part C
The crude oil futures contract covers 1,000 barrels. The contract was bought ...