Question

1. Draw an exposure diagram to illustrate a firm’s exposure to interest rate risk if the firm is going to borrow $10m six months from today. Assume the loan will be a one-year loan with all interest paid at the end of the year. Graph the relation between the firms interest costs and interest rates. Also graph the relation between the firm’s profit and interest rates (assuming that higher interest costs cannot be passed on the consumers).

2.Draw an exposure diagram to illustrate the relationship between a firm’s costs and the exchange rate between US dollar and Euro dollar if the fir plans to purchase goods from an European firm one year from today. Assume that the transaction is denominated in Euro dollar, but that the firm is concerned about its costs in US dollars. Also draw an exposure diagram to illustrate the relationship between a firm’s profit and the exchange rate between US dollar and Euro dollar.

3. Draw an exposure diagram to illustrate the relationship between a gold mining firm’s profit and the price of gold in three months.

4. Would a call option or a put option hedge the exposure of the firms described in problem 1,2 and 3?

5. Would a long (buy) or a short (sell) forward position hedge the exposure of the firms described in problem 1,2 and 3?

Answer 1

As per policy I can answer only 1st 4 subparts if there are many subparts in a question.

Question 1:

Question 2:

If the pound appreciates relative to the dollar, then it will take more dollars to buy pounds, which implies that the firm’s cost in dollars will be higher, hence if the value of the pound rises, the firm costs associated with purchasing the British products will increase and the firms profit will decrease.

Question 3:

Question 4: How to hedge using call\put options.

For question 1 to hedge the firms exposure: Purchase a call option with an underlying asset being the interest rate in six months

For question 2 to hedge the firms exposure: Purchase a call option with an underlying asset being the value of the pound relative to the dollar

For question 3 to hedge the firms exposure: Purchase a put option with an underlying asset being the price of gold in 3 months.

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