Table of Contents

Executive Summary ........................................................................................................................ 1

Introduction ..................................................................................................................................... 2
Part A - Identifying the financial risk exposures faced by SRN ..................................................... 2
Part B - Recommendations made to SRN’s management on whether to hedge the financial risks
......................................................................................................................................................... 4
Part C – Recommendations on Hedging Strategies ........................................................................ 5
Part D – Hedging Strategies for Production of Copper .................................................................. 9
Part E – Option Strategies ............................................................................................................. 10
Conclusion .................................................................................................................................... 13
References ..................................................................................................................................... 14
Executive Summary

The proposed report focus on the area of financial risk management. It involves identifying,
measuring the financial risk exposures and hedging against the financial risks for the Australian
mining company, Salvatore Resources NL (SRN). Interest rate risk, currency rate risk and market
risk are all hedged by SRN using futures. The Eurodollar futures is used to hedge interest rate risk,
where the company sell high and buy low to make profit. For currency rate risk, SRN can lock in
the exchange rate today with a position of long call option. Next, with a position of short futures
for hedging against market risk, SRN can make profit from metals futures. Two options strategies
are set up to implement hedging for SRN’s June production of copper. The possible adverse
outcomes are explained to SRN management in accordance with the strategies recommended.

Felicia Kue Jing Ee (4329848), Sheena Ho Jia Ling (4331656) Page 1

Introduction

Salvatore Resources NL (SRN) is an Australian mining company which mainly focus on extraction
and processing of gold and copper. The purpose of the report is to assist SRN to identify the
financial risks, followed by recommendations of suitable hedges on the related financial risk
exposures. The strategies will be provided along with the explanation in the report.

Part A - Identifying the financial risk exposures faced by SRN

Financial risk management includes identifying financial risk exposures and this helps a company
to improve in development and effectiveness (Blach 2010). The financial risks of SRN with
justifications are shown below.

Type of financial risks involved Justifications

Currency Risk According to Investopedia (2016), the currency risk or

the foreign exchange risk refers to the risk faced by an
investor when they closed out their long position in
foreign currency at a loss due to fluctuation in exchange
rates. SRN is an Australian company that is trading
using US dollar. When the AUS dollar appreciates and
the US dollar depreciates, the company will have a
negative or lower return. Since SRN’s sales of both gold
and copper are denominated in US dollars, appreciation
of the AUS dollar will cause the value received in
exchange for the USD be lower and affect the payoff .

Interest Rate Risk The cash rate charged by the Reserve Bank of Australia
(RBA) will affect the interest rate in the economy as the
selling and buying of the government bonds and other
relevant securities will affect the supply of money by

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 the commercial banks. As SRN is the borrower, hence a
change in the interest rate will affect the firm. When the
interest rate in the domestic market increases, the cost of
borrowing is high. Changes in interest rates can result in
yields less than expected (‘A guide to floating rate bank
loans: an attractive investment for a rising interest rate
environment’ 2013). The floating rate loan at LIBOR
rate of SRN will not show positive returns. The expense
will increase as the interest rate rises (ACCA 2016). As
SRN has a loan of US$600 million, the debt will
become more costly if the AUS dollar weakens (Mohr
2016). This is because the cost of repayment for the loan
becomes higher.

Market Risk The return of the firm will be affected due to

macroeconomic conditions. For example, political
instability, recessions and natural disaster such as
earthquakes may lower the investment value (‘What is
market risk? Definition and meaning’ 2016). The return
of the firm may be affected due to some unanticipated or
unexpected fall in prices and value of share.

Default Risk

Default risk arises due to economic recession. During

recession, the revenues and earnings of the company can
be affected in which the ability to repay the debts can be
influenced. As a result, the company has to generate
sufficient net income and cash flow to reduce default
risk. The default risk is low if it is the Treasury bonds
from the government. In contrast, the default risk will be
higher for corporate bonds.

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Part B - Recommendations made to SRN’s management on whether to
hedge the financial risks

Hedging involves the use of derivative instruments to reduce financial risks (Chen et al. 2015).
The table below shows the decisions on whether to hedge against the financial risks outlined in
Part A

Type of financial risks involved Decisions on whether to hedge

Currency Risk According to Papaioannou (2006), the data analysis of U.S.

shows that the more likely a larger firm will use derivative
instruments to hedge its currency risk. Therefore, all of the
currency risk is required to be hedged in order to prevent the
exchange rate of Australia from appreciating. As a result, the
exchange rate is locked in today by buying call option.
Eventually, the investor from U.S. is able to make less
payment to buy more of the Australian Shares.

Market Risk Hedging of portfolio is necessary to reduce market risks

(Russell 2015). Hence, SRN can hedge by selling metal
futures. The gain on futures will compensate the loss. By
doing this, sale of a specific stock in SRN’s portfolio may be
achieved when it hit the predetermined price.

Interest Rate Risk Eurodollar futures is ideal to be used for hedging purpose to
protect against interest rate risk exposures in loan (J.
Boudreault 2010). Thus, SRN should hedge interest rate risk
by a short of March Eurodollar futures with 99.02 price.
Locking in interest rate ensures high probability in sale of
production.

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 Default Risk

Part C – Recommendations on Hedging Strategies

1) Eurodollar Dollar Futures is used to hedge interest rate risk

Eurodollar Futures Quotes
SRN can hedge against the increase in the interest rate risk using Eurodollar futures. This is
because as a borrower, SRN will short Eurodollar futures to protect themselves against a
decrease in price (100-YTM). SRN will earn a profit as they sell high and buy low.

Source: http://www.cmegroup.com/trading/interest-rates/stir/eurodollar.html

Situation SRN has borrowed US$600million loan.

Risk Interest rate rises
Plan Want to lock in interest rate for 3 months starting April
Action Short 600 contracts of March Eurodollar futures at 99.02(or
yield of 0.98%)
June 3 month LIBOR rate at June is 2.5% (futures settlement price
97.5)
Gain on futures 600 x [$25 (9902-9750)] = -$2,280,000
Interest paid for three months 90
=$1,000,000 x x 0.025 x 600=$3,750,000
360
Total Payoff $3,750,000 - $2,280,000 =$1,470,000

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2) Futures is used to hedge market risk
The mining company is worried about the decrease in price of metals in the future. Hence, they
will short metals futures at the price agreed today. The company will lose money by selling
metals at a lower price, however they will make profit from metals futures. The loss from
metals is compensated by gain on futures. The price of metals is locked in at price today.
Gold Futures

Source: https://www.cmegroup.com/trading/metals/precious/gold.html

Nature of Business SRN expects to have 2,400 ounces (approximately 2188 troy
ounces) of gold ready for sales in April.
Risk The gold price may fall from current spot price
Action Short 24 gold futures contracts at $1290 per ounce.
2188 troy ounces
[ ] ≈ 22 contracts
100 troy ounces per contract
Gain (loss) on futures The gold futures price in June 2017 is $1292.
Loss on futures = ($1290-$1292) x 24 contracts x 110 troy ounces
= -$5,280

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Copper Futures

Source: http://www.cmegroup.com/trading/metals/base/copper.html

Nature of Business SRN expects to have 500,000 pounds of copper ready for sales in
January.
Risk The gold price may fall from current spot price
Action Short 20 gold futures contracts at $2.2965 per ounce.
500,000 pounds
[ ]=20 contracts
25,000 pounds per contract
Gain (loss) on futures The gold futures price in March 2017 is $2.3055.
Gain on futures = ($2.3210-$2.3055) x 20 contracts x 25,000 pounds
= $7,750

3) Call Option is used to hedge currency risk

SRN is an Australian company that trades using US Dollar. SRN will worry about the
appreciation of AUD because the value in exchange will be lower. Hence, the company can
long a call option to lock in the exchange rate today to reduce loss as the company want to
hedge against a rise in the exchange rate that they intend to buy in the future.

Source: http://www.cmegroup.com/trading/fx/g10/australian-
dollar_quotes_settlements_options.html?optionExpiration=38-M17

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 π

Call Option

Positive Payoff

$0.7250
Price
$0.7306
$0.056

Maximum Loss = $0.056

The option is in the money if the exchange rate is above the strike price ($0.7250). If the
exchange rate increases above the strike price ($0.7250), the holder of the call option will
exercise the option in order to reduce the loss. The holder will be having positive payoff if the
exchange rate increase above the breakeven point ($0.7306), which means that the company
can obtain a gain if AUD$1 can be exchanged by more than US$0.7250. However, the option
will not be exercised by the holder if the exchange is below $0.7250 (out of the money) because
the Australian Dollar is appreciating.

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Part D – Hedging Strategies for Production of Copper

Source :
http://www.cmegroup.com/trading/metals/base/copper_quotes_settlements_options.html?option
ProductId=797#optionProductId=797&tradeDate=11/08/2016

Risk that the company Copper price will decrease.

is hedging against
Number of option Hedge 50% in May: 700,000 pounds/2 = 350,000 pounds
contracts Hedge 50% in June: 700,000 pounds/2 = 350,000 pounds
Total Copper production that should be hedged = 350,000 + 350,000
= 700,000 pounds
700,000 pounds
Number of option contracts =
25,000 pounds per contract
= 28 contracts

Contract month used July 2017

Action The company should long put options to hedge against a decrease in
copper price because the holder of put options has the right to sell.
Option strike prices Option strike price = 425 cents x $0.0005 per pound
and premium costs = $0.2125 per pound
Premium cost = $0.0185 per pound

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Part E – Option Strategies

Hedging with Put Bear Spread

The put bear spread means buying one put in order to earn profit from a decline in the underlying
stock, followed by selling another put with the same expiration and a lower strike price to offset
some of the costs (OIC 2016). For example, the lower the short put strike, the higher the potential
maximum profit, which means a smaller amount of premium will be received.

Source:
http://www.cmegroup.com/trading/metals/base/copper_quotes_globex_options.html?optionProd
uctId=797#optionProductId=797

Number of option contracts N=P/A

required to buy and sell 700,000 Pounds
N=
25,000 pounds
=28 contracts
The contract month of the option July 2017
Buy option at strike price (K2) $6.25(with option premium of $0.0410)
Write options at strike price (K1) $5.75(with option premium of $0.0360)

Stock Price Write Put Long Put Total Net Premium Profit
@ $5.75 @ $6.25
ST > $6.25 0 0 0 -$0.005 -$0.005
$5.75 < ST < $6.25 0 $6.25- ST $6.25- ST -$0.005 $6.245- ST
ST < $5.75 ST-$5.75 $6.25- ST $0.50 -$0.005 $0.495
Cost of Spread=$0.005

Maximum Gain = $0.495 x 28 contracts x 25,000 pounds = $346,500

Maximum Loss =-$0.005x 28contracts x25,000 pounds = -$3,500

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Break-even point=$6.245

π
Maximum Profit: $0.495

BEP: $6.245

Price
K1 = $5.75 K2=$6.25

Maximum Loss: - $0.50

Hedging with Call Bull Spread

The call bull spread consists of two calls with the same expiration but different strike price (OIC
2016). The strike price of the short call is higher than the strike price of the long call, in which it
means that an initial outlay will always be required for this strategy. A higher short call strike
creates maximum capacity for the potential profit. The profit or loss payoff profile for the call
bull spread is once adjusted for the net cost to carry (OIC 2016).

Source:
http://www.cmegroup.com/trading/metals/base/copper_quotes_settlements_options.html?option
ProductId=797&optionExpiration=797-K7#optionProductId=797

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 Number of option contracts N=P/A
required to buy and sell 700,000 Pounds
N=
25,000 pounds
=28 contracts
The contract month of the option July 2017
Write option at strike price (K2) $1.25(with option premium of $0.0115)
Buy options at strike price (K1) $1.20(with option premium of $0.0119)

Stock Price Write Put Long Put Total Net Premium Profit
@ $1.20 @ $1.25
ST > $1.25 ST-$1.20 $1.25- ST 0.05 -$0.0004 +$0.0496
$1.20 < ST < $1.25 ST-$1.20 0 ST-$1.20 -$0.0004 ST-$1.2004
ST < $1.20 0 0 0 -$0.0004 -$0.0004
Cost of Spread = $0.0004

Maximum Profit = $0.0496 x 28 contracts x 25,000 pounds = $34,720

Maximum Loss = -$0.0004 x 28 contracts x 25,000 pounds = - $250

Break Even Point = $1.2004

Call Bull
0.0496

Price

-$0.0004
Break Even Point =$1.2004

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Conclusion

In conclusion, SRN can use futures and options to hedge the interest rate risk, market
risk and also the currency risk. Hedging can help the borrowers to minimize their risk of the
underlying assets. Besides, the company can also use options to hedge 50% of May and June
production of coppers to reduce the risk. SRN are recommended to use option strategies such as
call bull spread as well as put bear spread to hedge June production of copper.

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References

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ACCA 2016, Hedging techniques for interest rate risk, ACCA, 29 March, viewed 5 November
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Blach, J 2010, ‘Financial risk identification based on the balance sheet information’, Managing
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Mohr, A 2016, ‘Factors that impact a firm’s interest rate risk’, Houston Chronicle, viewed 4
November 2016, <http://smallbusiness.chron.com/factors-impact-firms-interest-rate-risk-
1088.html>.

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OIC 2016, Bear put spread, The Options Industry Council, viewed 8 November 2016, <
<http://www.optionseducation.org/strategies_advanced_concepts/strategies/bear_put_spread.htm
l?prt=mx>.

OIC 2016, Bull call spread (debit call spread), The Options Industry Council, viewed 8
November 2016,
<http://www.optionseducation.org/strategies_advanced_concepts/strategies/bull_call_spread.htm
l?prt=mx>.

Papaioannou, M 2006, ‘Exchange rate measurement and management: issues and approaches for
firms’, IMF working paper, International Monetary Fund, viewed 8 November 2016,
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Russell, R 2015, ‘Market too risky? Here’s how to hedge your portfolio’, 29 June, viewed 8
November 2016, <http://www.forbes.com/sites/robrussell/2015/06/29/how-to-hedge-risk-in-
your-portfolio/#3b9111d55160>.

Felicia Kue Jing Ee (4329848), Sheena Ho Jia Ling (4331656) Page 15