Q1.(10 marks)

An airline company expects to purchase 5 million gallons of Jet fuel in three months and decides to use Heating oil futures for hedging. The standard deviation of monthly changes in the spot price of Jet fuel is S =0.0356, and the standard deviation of monthly changes in the Heating oil futures is F= 0.0451, and the correlation between the two price changes is = 0.924.

a)What is the optimum hedge ratio h*?

b) If each Heating oil futures contract traded on CME is to deliver 45,000 gallons, what is the optimal number of Heating oil contracts to be hedged? Should they be taking long or short position?

c) Explain why such hedging strategy is not a perfect hedge?

Q2. (12 marks)

a)At the end of day one, a clearing house member is long with 100 contracts at a price of $50,000 per contract. The original margin is $2,000 per contract. On the following day the member becomes responsible for clearing an additional 20 long contracts, entered into at a price of $51,000 per contract. The settlement price at the end of this day is $50,200. How much does the member have to add to his/her margin account with the exchange clearing house on the second day?

b)Assuming it is January 2021 now and that there are no storage costs for CPO and the risk free interest rate is 5% per annum continuously compounding. How could you make an arbitrage profit if the June and December forward CPO contracts for that year trade at RM2,000 and RM2,200 per metric ton respectively? (each CPO contract is for 25 metric ton delivery).

Q3. (8 marks)

a)A palm oil producer expects to have 100,000 tons of crude palm oil (CPO) to sell in six months. Each CPO futures contract is for the delivery of 25 tons. How can the palm oil producer use the contract for hedging? From the producer's viewpoint, what are the proponents and contradictions of hedging?

b)It is said that "Speculation in futures markets is pure gambling. Therefore, it is not in the public interest to allow speculators to trade in the futures exchange". Using your own words comment on this statement.

Q4. (40 marks)

Assuming it is 1^st June today, and consider your corporation need to borrow $500,000,000 for 3 months from 1^st September to 30^th November. The prevailing fixed agreement rate is 5.00% p.a. while the Floating Libor rate could be 5.75% on 1^st September. Assuming there are 92 days between September 1 and November 30, and use actual / 360 convention.You are assigned by your CFO to evaluate the cheapest net cost of interest for this 3 month borrowing for each of the following interest rate hedge instrument:

a)FRA contract

b)Eurodollar Futures

c)Which hedge instrument provides the cheapest cost of interest?