ABC Ltd is a company located in USA and it has a contract to purchase goods from Japan in two months time on 1 September. It is now 30 June and the payment is to be made in yen and will total 140 million yen. The managing director of ABC Ltd wishes to protect the contract against adverse movements in foreign exchange rates and is considering the use of currency futures. The following data are available: Spot foreign exchange rate: Yen/ $ 128.15 Yen currency futures contracts on the Singapore Exchange Ltd (SGX). Contract Size12,500,000 yen. Contract prices are in US$ per yen as follows:

Contract prices: September 0.007985 December 0.008250 Assume futures contracts mature at the end of the month.

(i) Illustrate how ABC Ltd can hedge its foreign exchange risk on the whole amount using currency futures and any other relevant derivative contract. [9 marks]

(ii) Show what basis risk is involved in the proposed hedge. [3 marks]

(iii) Assuming the spot exchange rate is 120 yen/$ on 1 September and that basis risk decreases steadily in a linear manner, calculate what the result of the hedge is expected to be. Briefly, discuss why this result might not occur. [8 marks]

(b) Currency forwards, futures, options, inter alia, are all derivative contracts that can be used to hedge currency risk. However options represent the best instrument to be used. Discuss. [10 marks]