Question 1 (25 marks)

• a.In your own words explain the potential benefits of risk hedging. In your answer explain why it may not always be optimal for a company to hedge out all of its risks. (10 marks)
• b.A forward contract is calling for a delivery of one XYZ stock 6 months from now. The current stock price of XYZ is 50, the forward price is 55, and the risk-free rate is 5% per annum. Design an arbitrage transaction using one contract. Make sure you list all the steps and the associated cash flows. (10 marks)
• c.Imagine you are managing a copper mine and plan to sell 400 tons of copper 3 months from today. Since you do not know the future price of copper, you are considering employing a put protection strategy to manage your price risk. A put option giving you the right to sell 1 ton of copper for $5.50 per kilogram 3 months from now costs $280. This is the option you want to use.

  How much money can be had with and without the put protection, if the spot price of copper in 3 months time turned out to be:

  • i.$4.20
  • ii.$5.80?

  Explain and show your workings. (5 marks)

Your answer to this question should be no more than 550 words