Lock-in with your forward hedge strategy

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Reference no: EM131605982

The spot price of tin is now RM14,000 per ton. The annualized 3-months KLIBOR rate is 8%. While there is no yield from holding tin, there is a storage cost. Currently the storage cost is about RM420 per ton per year. Futures contracts on tin are quoted as follows: 3 month futures = RM14,171.80 (90 days) 6 month futures = RM14,395.73 (180 days) (i)Assuming the contract size of the futures contract is 10 tons per contract; (a)Prove that there is mispricing. (b)Outline the arbitrage strategy and show the profit if you took a position equivalent to 10 contracts. Assume the spot price of tin on day 90 is RM14,300 and on day 180, it is RM14,700. (ii)You work at Datuk Keramat Smelting, Malaysia’s largest tin smelter. Your company will have a large output of 120 tons available for sale in 4 months. Your boss wants you to design a 4-months forward hedge. (a)Outline your hedge strategy using forwards (show the diagram). (b)Given the background information above, what ringgit amount can you lock-in with your forward hedge strategy? (c)If your company’s cost of funds is 12% annualized and the brokerage/transaction costs are similar between forwards and futures, which would you choose, a forward or futures contract? Explain your choice.

Reference no: EM131605982

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