Reference no: EM133065268

Question 1: Hedging the cost

It is January 2013. Warm Woolies Inc is a manufacturer of the latest in Warm fashion made from Australian wool. The manager, Ms Cuddle, purchases wool in October each year in preparation for the following Warm's fashion range. In January, wool is selling for 740c/kg on the cash market, but Ms Cuddle is cautious as she has been caught by rising wool prices in the past. She has contacted your consultancy firm with the aim of managing the risk (hedging) of price rises leading up to October. After a detailed briefing, you have highlighted the following points as relevant: Warm Woolies

Inc wishes to purchase 7500 kilograms of wool in October 2013. October wool futures are quoted at 770 cents per kilogram.

Outline the futures strategy you would put into place on Warm Woolies' behalf. Be specific about the quantity of futures contracts taken up: whether you are buying or selling futures.

Assume that, come October, Ms Cuddle's fears have been realised and the price of wool has risen to 780c/kg in the cash market. At the time (in October), the October maturity wool futures are quoted at 785. Explain what action you would take, given that Warm Woolies now needs to buy the wool. Again, be specific about your strategy, show what profit or loss was made and demonstrate to Ms Cuddle that she has not been significantly hurt by the rise in prices.

Ignore part (b). Assume that in October, wool prices have dropped to 710c/kg. The October maturity wool futures are quoted at 712. Explain what action you will take. Show Ms Cuddle what price she has effectively paid for her wool.

Question 2: A company has just completed (in June) its cash flow budget and identified a need to borrow $1 000 000 in January when it will have to pay for its large Christmas inventory. This loan will only be short-term as the company expects to have recovered the amount by April of the following year The offer price for January 90-day bank bill futures in June is 96.00. The financial manager feels that this quote provides a level of yield that could be afforded by the company. Contrary to popular belief, the company feels interest rates will increase substantially by January.

What is the level of yield provided by the June offer price?

What would be the value of a contract to cover a contract unit of $1 000 000 if the level of yield provided in part (a) were to be earned?

Suppose that in January interest rates have risen so that the rate on 90-day bank bills is 5 45% and January bank bills futures are quoted at 95.00. What strategy should the company follow and what would be its effective borrowing cost on the bonds issued? (Express the borrowing cost as per cent per annum.)

Suppose that in January, interest rates have fallen on 90-day bank bills to 4.45% and January bank bills futures are quoted at 95.5. What is the borrowing cost if the company buys back on the futures market and issues bank bills to provide the funds?