Global Fund Managers Ltd (GFML) is an Australian based investment company with investments in the Australian domestic debt and equity markets as well various international investments. The company is enabled to enter into derivatives contracts to manage financial risks and to add value to positions should the management team elect to do so.

GFML had funds under management as at 31 August, 2012, as follows:

 

  Investment Type	  Amount	Portfolio Beta	Representative Index / Price/Security
Australian Shares (equities)	A$240m	1.0	S&P   ASX 200
Hong Kong Shares (equities) including Chinese shares   listed on the Hong Kong Stock Exchange	US$100m	1.3	Hang Seng   Index
Gold (in the form of securities in a Gold Exchange Traded   Fund or ETF)	US$50m	1.0	Gold Price
Short term interest bearing securities  (average maturity 90 days). Mainly used for   short term liquidity needs and to take advantage of investment opportunities   as they emerge.	A$20m US$15m	0	Bank   Accepted Bills Eurodollars

 

Additional information:

(1)     Exchange Rates at 31 August 2012 were:

A$1 = US$1.03     A$1 = HK$8.00

The Hong Kong dollar exchange rate has been pegged at a fixed rate against the United States dollar at a rate of HK$1 = US$7.78 since the early 1980s.

(2)     GFML’s capital structure is as follows:

Shareholders’ Equity         A$260m

Debt

Variable rate debt:

–        Australian dollars   A$100m

–        US dollars             US$  15m

Fixed Rate Debt                 $A 50m

GFML also has other minor assets and obligations not included in the above figures.

GFML’s management has assessed the outlook for the asset portfolio for the remainder of the year to 30 December 31, 2012 in the following broad terms:

Equities

• Volatility in world equity markets is expected to continue through to end of calendar year 2012. This view is based on conflicting views about a return to a more robust rate of economic growth in the Peoples’ Republic of China; uncertainty about the outcome surrounding the European debt crisis (slow recovery or economic chaos?) and uncertainty about the strength of the weak recovery in the USA. These uncertainties are, of course, interrelated and are expected to impact the markets and industry segments in which GFML invests differentially depending on the outcomes.

Interest bearing securities

• In Australia, the continuance of the so called “two-speed” economy coupled with the strong (some say ‘over-valued’) Australian dollar and, more recently, falling commodity prices due to weakened global demand have heightened market expectations that the Reserve Bank of Australia (RBA) will cut interest rates by 25 or even 50 basis points by year end. This is by no means regarded as certain.
• The US Federal Reserve has held interest rates steady at a very low level over the past two years in its efforts to stimulate the US economy. It is expected that the next movement in US rates will be upwards but this is not expected to occur before 2014.

Currency

• The Australian dollar has again risen sharply in recent weeks although it has fallen back to around the US$1.03 level at present. There is little consensus on the outlook for the A$/US$ exchange rate over the next four months and into 2013. Weakening commodity prices are expected to exert downward pressure on the A$ but recent purchases of the Australian currency by a number of central banks around the world has supported the currency and so as long as this continues it may remain above parity with the US dollar.

Gold

• Despite some recent weakness in the gold price (in terms of US dollars) gold continues to be a refuge for those seeking the security of an asset that will hold its value in these troubled economic times. GFML management wishes to retain its current level of investment in gold but recognises that a resurgent in the Chinese and US economies may lead investors to sell gold in favour of  more risky assets such as equities.

Note: The opinions expressed above are exactly that – opinions and not facts. You may use these opinions as a basis for your recommendations but you may also refute them with contrary evidence or opinions sourced from your own independent research.  No correspondence regarding interpretation of the above opinions will be entered into with students for the purpose of completing this assignment.

Required:

Assume that you are a recently appointed hedge strategist with GFML and that you have been requested to prepare a report for presentation to GFML’s  Investment Strategy Committee at its next meeting. You have been specifically requested to address the following issues:

(a)              To identify and list the specific financial risk exposures faced by GFML with respect to the asset categories listed in the above schedule and the way in which these investments are financed. Bear in mind that GFML is an Australian based fund and that most of its shareholders are Australian residents.

(b)             To make firm recommendations on whether or to hedge all, part or none of the financial risk exposures that you identified in part (a) above. You MUST provide some explanation for each of your recommendations. (You are not required to specify the type of derivative to be used to hedge in response to this question).

(c)              To make recommendations on which derivative instruments (for example, options, futures, swaps) to use to implement any hedges that you have recommended in part (b) above. Once again, you MUST explain your recommendations. [In the event that you have recommended in part (b) to not hedge any of GMFL’s risk exposures then the marks available for parts (b) and (c) will be combined and your answer to part (b) assessed on that basis. This means that you will need to provide very well researched and fully explained reasons for your responses to part (b). However, it is advised that you make at least some hedge recommendations to make responses to parts (c) and (d) more meaningful]. You are NOT required to propose details of how to implement your hedge recommendations in this part – this is to be done in part (d).

(d)             To propose, in accordance with each of your recommendations in (c) above, specific hedging strategies which require you to describe the following:

1.                            i.          the exposures to be hedged,
2.                          ii.          what percentage proportion of the exposure is to be hedged,
3.                         iii.          which derivative(s) are to be used to hedge each exposure,
4.                         iv.          the number of derivative contracts for each hedge,
5.                           v.          the delivery months (or duration of swaps) for each derivative,  and
6.                         vi.          the prices at the time of making the recommendation – futures prices, option strike prices (including an explanation of the choice of strike price(s)] and the interest rate for currency swaps (you will need to research this).

For part (d) you may assume that the hedge horizon is mid-December and that you can use futures and options with a December expiration date for hedging.

Also, in part (d) if you recommend option strategies you may also wish to consider strategies that require the ‘purchase and sale’ of  two different options (e.g. an option spread) to reduce the cost of the option strategy.

 

(1 + 3 + 3 + 5 + 1* = 13 marks)

*1 mark for general presentation