Recommendations on Derivative Instruments for Various Hedges


Added on  2023-03-17

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(C) Recommendations on derivative instruments for various hedges.
Transaction Risk (Forward contracts)
OceanaGold can use forward contracts to hedge its transaction risk. The company is concerned
with the exchange fluctuation in the AUD/USD currency pair as its sales are in USD and it has
loan expenses to be paid in AUD. So, company will be negatively affected if USD gets weaker
relative to the AUD. Therefore it can use forward contract to buy particular amount of AUD in
future for a pre-determined USD amount. The effect of using such forward contract is that if in the
future the AUD strengthens against USD then company will lose in the real transaction terms but
the same will be recovered via the gains on the forward contract as the company can buy AUD at
predetermined lower USD amount. The advantage of using forward contract is that it does not have
any upfront costs and it protects firm against the harmful exchange rate movements. Also these
contracts are over the counter product so the contract expiry date and the total amount of the
underlying can be customised according to the particular requirement. But, the downsides are that
the company will now face additional credit risk if the counter party to these contracts does not
honour its obligations and if the AUD weakens against the USD the company will now have a loss
in the forward contracts that will nullify the advantages of this positive move (Thomas, 2018).
Interest Rate Risk (Interest rate swaps)
OceanaGold can use interest rate swaps to hedge 50% of the total interest bearing on both the US
and AU loans. The company can use two plain vanilla swaps to convert variable rate loans to fixed
rate. The nominal principal for one of the swap will be AUD 25m and OceanaGold will enter into
this contract to pay fixed and receive floating rate. Similarly, the nominal principal for the other
swap will be USD 10m and the company will enter into this contract to pay fixed and receive
floating rate. The interest rate swaps are over the counter contracts between two independent
parties and it can be set in such a way that the swap reset dates will coincide with the loan reset
dates. Here, the reset dates for AUD and USD loans are 30th June and 30th September so the swap
reset dates of the respective contracts will be on the same date. This will help company hedge the
risk arising from higher interest payments one period ahead of the above dates. But, this swap
contract will expose OceanaGold to the credit risk if counterparty fails to meet its obligations and
the company will also not be able to benefit from the falling interest rates in Australia and US as
then the company will lose on the swaps contracts (PIMCO, n.d.).
Commodity Risk (Futures contracts)
It is advised that OceanaGold should hedge its price risk as the uncertainty in commodity prices
can affect the company profits and futures growth. So, it can use futures contracts to hedge against
the commodity price risk. This will allow the company to hedge its cash positions in the futures
markets. OceanaGold is naturally long in cash as it’s a gold mining company so it will take short
positions in future contracts. The company can use strip hedge using series of futures contract,
number and expiry of different futures contract will depend upon the company’s quarterly
production forecast. But the liquidity of the long term futures contract can be low so this can
increase the hedging costs. Therefore, company can use stack hedge by entering in short
term/nearest less costly futures contract equalling total yearly forecasted production at start and
then rolling forward into next-to-nearest contract accordingly. Futures contract are suitable for
hedging such type of risk as the market for gold futures contract is highly liquid and there is no
credit risk involves because exchange acts as counterparty. But there can be some basis risk
involved in futures contracts due to the exchange standardisation of the contracts (Hecht, 2018).

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