2. (50 marks) Parts 2(a)-2(d) are based on the following case: Chum Tsum Gold Ltd. (CTG)...

  

Transcribed Image Text:

2. (50 marks) Parts 2(a)-2(d) are based on the following case: Chum Tsum Gold Ltd. (CTG) is a gold mining company in the U.S. In order to expand its market share, CTG is considering offering long-term contracts for gold to customers (including many independent gold jewelers). It believes that such contracts will be attractive to customers because customers can lock in a fixed gold price ($1,900) and stabilize their future profit margins over long periods. CTG has estimated that it can enter into contracts to supply customers with 6 million ounces of gold over a period of 5 years (i.e. 100,000 ounces per month). These commitments are quite large for CTG as they will exceed the firm's mining capacity. To lock in its own profit margin, CTG plans to hedge against the possibility of gold price increases. Ideally it should have entered long-term forward contracts on gold, matching the maturity of the contracts and of the commitments. However, in the absence of a viable market for long-term contracts, CTG will use short-term futures contracts and implement a rolling hedge, where the long-term exposure is hedged through a series of short-term contracts, with maturities around 3 months, that will be rolled over into the next contract as they expire. The spot gold price is $1,800. CTG believes that it will initially enter into the futures contracts (for hedging) at a price of $1,810. It has estimated that the annual expected return and the annual standard deviation of gold are 10% and 17%, respectively. Financial highlights of CTG (from the latest financial statements): • Total cash: $900 million $3.7 billion $12.8 billion • Total current assets: • Total assets: ** Ignore curve risk (backwardation or contango) and basis risk. (a) (20 marks) Scenario 1: Assume CTG has entered into long-term contracts with customers but has not yet hedged these commitments. Requirement: Identify, assess/measure and evaluate the financial risks for CTG associated with the long-term contracts with customers. (Quantify the risks as far as possible. Interpret and discuss your answers.) (b) (5 marks) Based on the framework introduced by Froot, Scharfstein and Stein (1994) on "A Framework for Risk Management", discuss whether CTG should hedge its market risk brought by the long-term contracts with customers. (c) (20 marks) Scenario 2: Assume CTG has entered into long-term contracts with customers and has started implementing the rolling hedge with short-term futures contracts. Requirement: Identify, assess/measure and evaluate the financial risks associated with the long-term contracts with customers. (Quantify the risks as far as possible. Interpret and discuss your answers.) (d) (5 marks) Scenario 3: CTG has not yet started selling the long-term contracts to customers. Requirement: Based on all your analysis above, what recommendation would you make to CTG regarding the plan of selling long-term contracts to customers? 2. (50 marks) Parts 2(a)-2(d) are based on the following case: Chum Tsum Gold Ltd. (CTG) is a gold mining company in the U.S. In order to expand its market share, CTG is considering offering long-term contracts for gold to customers (including many independent gold jewelers). It believes that such contracts will be attractive to customers because customers can lock in a fixed gold price ($1,900) and stabilize their future profit margins over long periods. CTG has estimated that it can enter into contracts to supply customers with 6 million ounces of gold over a period of 5 years (i.e. 100,000 ounces per month). These commitments are quite large for CTG as they will exceed the firm's mining capacity. To lock in its own profit margin, CTG plans to hedge against the possibility of gold price increases. Ideally it should have entered long-term forward contracts on gold, matching the maturity of the contracts and of the commitments. However, in the absence of a viable market for long-term contracts, CTG will use short-term futures contracts and implement a rolling hedge, where the long-term exposure is hedged through a series of short-term contracts, with maturities around 3 months, that will be rolled over into the next contract as they expire. The spot gold price is $1,800. CTG believes that it will initially enter into the futures contracts (for hedging) at a price of $1,810. It has estimated that the annual expected return and the annual standard deviation of gold are 10% and 17%, respectively. Financial highlights of CTG (from the latest financial statements): • Total cash: $900 million $3.7 billion $12.8 billion • Total current assets: • Total assets: ** Ignore curve risk (backwardation or contango) and basis risk. (a) (20 marks) Scenario 1: Assume CTG has entered into long-term contracts with customers but has not yet hedged these commitments. Requirement: Identify, assess/measure and evaluate the financial risks for CTG associated with the long-term contracts with customers. (Quantify the risks as far as possible. Interpret and discuss your answers.) (b) (5 marks) Based on the framework introduced by Froot, Scharfstein and Stein (1994) on "A Framework for Risk Management", discuss whether CTG should hedge its market risk brought by the long-term contracts with customers. (c) (20 marks) Scenario 2: Assume CTG has entered into long-term contracts with customers and has started implementing the rolling hedge with short-term futures contracts. Requirement: Identify, assess/measure and evaluate the financial risks associated with the long-term contracts with customers. (Quantify the risks as far as possible. Interpret and discuss your answers.) (d) (5 marks) Scenario 3: CTG has not yet started selling the long-term contracts to customers. Requirement: Based on all your analysis above, what recommendation would you make to CTG regarding the plan of selling long-term contracts to customers?

Answer rating: 100% (QA)

ANSWER Part 2a The risks associated with longterm contracts with customers include 1 The risk that g... View the full answer