Metal Mining Limited Company Financial Analysis - Assignment Example

Metal Mining Limited (MML) Company Name Tutor Course 7TH May, 2011 Table of Contents Table of Contents 2 a)FINANCIAL RISK EXPOSURES 3 Interest rate risk 3 Foreign exchange risk 4 b) Recommendations on financial risk exposures 5 “Hedging interest rate risk”: 5 “Hedging foreign exchange risk”: 5 “Hedging Commodity price risk” 6 c) Recommendations on whether to use options and/or futures and/or swaps to implement the hedges 7 Using swap to hedge against the interest rate risk: 7 Using option to hedge foreign exchange risk: 7 Using futures to hedge commodity price risk: 7 e) INTEREST RATE SWAPS 9 f) Options hedging strategies 10 The put option: 10 The calls option: 11 References 12 a)FINANCIAL RISK EXPOSURES Metal Mining Limited (MML) Company is exposed to some financial risks which include; the interest rate risk, the foreign exchange risk, and the commodity price risk (Burghardt, 2003). Interest rate risk The “interest rate risk” simply means the risk exposure that a portfolio or a company is exposed to as a result of the uncertainty in the “future interest rates”. That is, risk that the value of an investment will vary as a result of a variation in the “absolute level of interest rates”, in the stretch between rates (two) in any “interest rate relationship” Metal Mining Limited has a floating loan facility from a syndicated bank of US$600 million. This is a five- year loan facility which attracts an interest rate of 2.5% on top of the 3 month US dollar LIBOR (London Inter-Bank Offered Rate) rate. This kind of a loan usually uses indices or other basis of rates in determining the rate of interest to be charged in a given period. For instance, this loan facility will be valued at “six-month LIBOR + 2.50%”. This means that on 30th June, 2011 during the loan rollover the interest rate will be determined by the LIBOR at 1st 2011 – the reset date, in addition to the spread. Generally, there is uncertainty on the LIBOR and this may cause the overall interest rate to go up. If the interest rate went up then MML will find itself incurring a lot of interest expense which in turn reduces the income of the company. Foreign exchange risk The “foreign exchange risk” is the risk that the value of an investment will change as a result of changes in the exchange rates of the currency. That is, the risk of an investor having to incur a loss in the closing out of a short or long position in foreign currencies as a result of an unfavorable movements in the exchange rates. Generally, a foreign exchange risk is said to exist when there is uncertainty regarding the “spot exchange rate” that will prevail in some future time due to variation in the exchange rate (Herring, 1986). This risk commonly affects the exports and or imports a commodity. The sales MML Company of both copper and gold are dominated in US dollars. MML Company exports its gold and copper to countries like China and India. This means that these countries must convert their currency to the US dollar in order to buy the gold and copper metals. Any variation in the exchange rate of the currency will make the value of the transaction to either increase or decrease when the money is converted into the Australian dollar. That is, MML Company (seller) transactions with overseas business are not expressed in the domestic currency (Australian dollar, AUD) and thus the company is exposed to the exchange risk. Commodity price risk “Commodity price risk” arises in a situation where a company is exposed to variations in the prices of commodity as a part of the operations of the business of the company. Variations in the prices of the commodity can have unfavorable impacts on the profit margin of the company especially if the increases in costs cannot be charged against the final customer. In this case there is uncertainty regarding the future market value of gold and copper and hence the size of income that will be obtained from their sale in the future (Claessens, 1993). This is as a result of frequent fluctuations in the price of copper and the price of gold. In the export of gold and copper to other countries like India and China MML company will face risk at the port and at destination market in relation to export license. The company will also face cost risk on the prices of their input (for example, labor), price risk, and quantity risk. b) Recommendations on financial risk exposures The report recommends that the management of MML Company makes a hedge on the interest rate risk, the foreign exchange risk, and the commodity price risk. Any of these risks if not hedged against can result to heavy loses in the company. This will in turn reduce the expected return from the investment activities of the company. “Hedging interest rate risk”: The interest rate risk should be hedged through the use of fixed loan facility instead of the floating loan facility whose interest rate keeps changing depending on the LIBOR rate. The report further recommends the financing of the construction cash outlay of some of MML’s latest mine developments with loans of shorter duration in order to reduce the interest rate risk. Notice that the higher the duration of the loan the risky it is for the company in that in the spread of the syndicated bank loan period and the US interest rate may rise. “Hedging foreign exchange risk”: MML Company is engaged in transactions with overseas countries and thus the company is exposed to currency fluctuations risk. There is therefore the need for the company to provide a hedge on foreign exchange risk. The report recommends that the sales of the MML Company be dominated in AUD. This will help to counteract the unforeseen changes in the exchange rate that may have negative impacts on the income from the sales of the company to overseas countries like China and India (Hakala and Wystup, 2002). It is recommended that MML Company enter into a contract with a bank in a forward-exchange contract. The company will contract the foreign currencies to the bank at a pre-agreed future date and at a fixed exchange rate. Having entered into such a contract the company will obtain the exact amount it anticipated from the sale of the metals. It is also advantageous in that this service from the bank is available in almost all the major currencies (Prindl, 1976). “Hedging Commodity price risk” MML Company will be anticipating selling copper and gold in the future and therefore it will use a “short futures hedge” as opposed to a “long futures hedge”. For instance, if the company sells copper futures contracts that are equivalent to its size at extraction time, the company will effectively lock in the copper’s price during that time. In this case the contract will be an agreement to bring specified pounds of copper on particular future date for a specified fixed price. The company will have hedged its exposure to copper prices. Notice that the favourable current price of gold has been occasioned merely due to the unrest in the Middle East countries and the uncertainties due to the recent Japan events. This means that the price of gold stands to drop if these unrest and anomalies are addressed. c) Recommendations on whether to use options and/or futures and/or swaps to implement the hedges Using swap to hedge against the interest rate risk: The use of the interest rate swap will help the MML Company in counteracting the risk associated with the uncertainty of increase in the US interest rate. This is because the US Company that it swaps the interest rate with will be obliged to pay the increment and not MML Company. Using option to hedge foreign exchange risk: The AUD is becoming weak due to the improvement in the US dollar. The company should make a put option in order to curtail the expected fall in the Australian currency in comparison to the US dollar. This means that the value of AUD will depreciate and thus affecting the income of the company. Using futures to hedge commodity price risk: The company anticipates making the sale of the copper and the gold. It will make use of the short-futures hedge in order to hedge against the expected fall in the price of these commodities (Chisholm, 2010). d) Futures: Options: No. of future Contracts required 4 No. of copper option contracts used 2 Delivery months used 3 buying puts or calls buying puts Long or short Futures position short Futures position contract months of the options 3 price of copper futures contracts entered into US$ 407.70 strike price of the options 401.70 total option premium cost US$ 1,420,000 e) INTEREST RATE SWAPS Interest rate swaps are agreements between 2 parties whereby a flow of future payments of interests are exchanged with another basing on a particular principal amount. That is, the exchange of a stream of cash inflows or outflows, based on the specifications of interest rate, for another (Garner and Brittain, 2009). Using interest rate swaps to reduce interest rate risk: MML Company has a loan facility of US$ 600 million with a syndicated bank. The MML Company should liaise with another company within the US which has a loan facility with an Australian bank. This company must be paying the same interest rate as the MML Company. These two companies can then make an agreement to swap the obligations of paying the interest each paying the interest to the lending bank in its home country. Recommendation the use of an interest rate swap by the company: It is recommended that the company enters into an interest rate swap for the remaining terms of its US dollar loan facility (Schaeffer and Ludwig, 1993). This is because if there is an increase in the interest rate in the US, the US Company will be obliged to pay the interest and not the MML Company. Therefore, the uncertainty of increase in the rate of interest charged by the syndicated bank will be offset henceforth. This is a sure way of hedging against interest rate risk from a foreign lender. This is prompted by the fact that some analyses have shown the possibility of increase in the US interest rates over the next year. This is because of the improving conditions in the US’s economy and unwillingness by some countries like Japan and China to go on investing in the US treasuries. If this transpires then the AUD will not continue its current increase against the USD. f) Options hedging strategies The company will use options for purposes of hedging the risks. The MML Company September production of copper is 8,000,000 pounds. There are various options hedging strategies that the company can use and also provide an effective hedge while restricting option payment of premium to a reasonable amount at the same time. Some of these option strategies include the put option and the calls option. The reasons for using these option strategies are that the company stands to gain from them irrespective of the movement of prices of the commodities (Bittman, 2001). The put option: The company should protect its sales of gold and copper by buying a put option on the two commodities. This is done when there are expectations that the price of the commodities might drop. If the price of the commodity rose the put option will expire worthless (Beidleman, 1991). The company will however get profit from the original commodity investment. On the other hand, if the prices went down, the company’s sale will be reduced by the put option, which will be more since the price dropped. The put options give the company the right (but not the obligation) to sell its commodities at a future date. In brief put options are for short positions. MML Company expects the price of copper to fall down from US$ 401.70 to US$ 395.10. in future when the price of copper will be US$ 398.65, the company will make a premium of US$ 14,200,000 ((398.65*4000000)-(395.1*4000000))The company will sell 4 million pounds of copper. The calls option: The company will employ calls options hedging strategies when it hopes that the price of the commodities (copper and gold) will rise. This is for long positions. Call options will give the company the right (but not the obligation) to buy the commodity at a future date. The company expects that the price of copper may rise to US$ 407.45 from US $ 401.70. The company will then buy 4,000,000 pounds of copper at a future price of US$ 407.45. When it sells its copper it will get 407.45 * 4,000,000 = 1629800000. Its profit will be 16298000-(401.7*4,000,000)= US$ 1,606,800 References Chisholm, A. (2010) “Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options”. John Wiley and Sons Burghardt, G. (2003) “The Eurodollar futures and options handbook”. New Delhi: McGraw-Hill. Garner, C. and Brittain, P. (2009)“Commodity options: trading and hedging volatility in the world's most lucrative market”. Maharashtra: FT Press Schaeffer, M. S. and Ludwig, S.M. (1993) “Understanding interest rate swaps”. New Delhi: McGraw-Hill. Beidleman, C.R. (1991) “Interest rate swaps”. Michigan: Irwin Publishers. Herring, R.J. (1986) “Managing foreign exchange risk”. Cambridge: Cambridge University press. Hakala, J. and Wystup, U. (2002) “Foreign exchange risk: models, instruments and strategies”. Pretoria: Risk books. Prindl, A.R. (1976) “Foreign exchange risk”. California: Wiley. Claessens, S., Duncan, R.C. and World Bank (1993) “Managing commodity price risk in developing countries”. London: Word Bank Publications. Bittman, J.B. (2001) “Trading and hedging with agricultural futures and options”. Cornell. McGraw-Hill Publisher. Appendix LIBOR (London Inter-Bank Offered Rate) -it is the rate of lending by one large bank to another. MML - Metal Mining Limited Company AUD - Australian dollar USD – The United States Dollar. Long and Short Hedges •A “long futures hedge” is suitable when there is a plan to procure an asset(s) in the future and there is need to lock in its price •A “short futures hedge” is suitable when there is a plan for the sale of an asset or a commodity in a finite future time and there is need to lock in its price. Put Option is bought when there is an expectation that the price of a commodity will go down Read More