Question 1: It is now October 2004. A company anticipates that it will purchase 1 million pounds of copper in each of February 2005, August 2005, February 2006, and August 2006. The company has decided to use the futures contracts traded in the COMEX division of the New York Mercantile Exchange to hedge its risk. One contract is for the delivery of 25,000 pounds of copper. The initial margin is $2,000 per contract and the maintenance margin is $1,500 per contract. The company's policy is to hedge 80% of its exposure. Contracts with maturities up to 13 months into the future are considered to have sufficient liquidity to meet the company's needs. Devise a hedging strategy for the company. Assume the market prices (in cents per pound) today and at future dates are as follows:
a) What is the impact of the strategy you propose on the price the company pays for copper?
b) What is the initial margin requirement in October 2004? Is the company subject to any margin calls?
Question 2: An exchange rate is currently 0.8000. The volatility of the exchange rate is quoted as 12% and interest rates in the two countries are the same. Using the lognormal assumption, estimate the probability that the exchange rate in 3 months will be
a) Less than 0.7000
b) Between 0.7000 and 0.7500
c) Between 0.7500 and 0.8000
d) Between 0.8000 and 0.8500
e) Between 0.8500 and 0.9000
f) Greater than 0.9000
Based on the volatility smile usually observed in the market for exchange rates, which of these estimates would you expect to be too low and which would you expect to be too high?