Derivatives –

Casasophia Co, based in a European country that uses the Euro (€), constructs and maintains advanced energy efficient commercial properties around the world. It has just completed a major project in the USA and is due to receive the final payment of US$20 million in four months.
Casasophia Co is planning to commence a major construction and maintenance project in Mazabia, a small African country, in six months’ time. This government-owned project is expected to last for three years during which time Casasophia Co will complete the construction of state-of-the-art energy efficient properties and provide training to a local Mazabian company in maintaining the properties. The carbon-neutral status of the building project has attracted some grant funding from the European Union and these funds will be provided to the Mazabian government in
Mazabian Shillings (MShs).
Casasophia Co intends to finance the project using the US$20 million it is due to receive and borrow the rest through a € loan. It is intended that the US$ receipts will be converted into € and invested in short-dated treasury bills until they are required. These funds plus the loan will be converted into MShs on the date required, at the spot rate at that time.
Mazabia’s government requires Casasophia Co to deposit the MShs2•64 billion it needs for the project, with Mazabia’s central bank, at the commencement of the project. In return, Casasophia Co will receive a fixed sum of MShs1•5 billion after tax, at the end of each year for a period of three years. Neither of these amounts is subject to inflationary increases. The relevant risk adjusted discount rate for the project is assumed to be 12%.

Financial Information
Exchange Rates available to Casasophia
Per €1 Per €1
Spot US$1•3585–US$1•3618 MShs116–MShs128
4-month forward US$1•3588–US$1•3623 Not available

Currency Futures (Contract size €125,000, Quotation: US$ per €1)
2-month expiry 1•3633
5-month expiry 1•3698

Currency Options (Contract size €125,000, Exercise price quotation: US$ per €1, cents per Euro)

Calls Puts
Exercise price 2-month expiry 5-month expiry 2-month expiry 5-month expiry
1•36 2•35 2•80 2•47 2•98
1•38 1•88 2•23 4•23 4•64

Casasophia Co Local Government Base Rate 2•20%
Mazabia Government Base Rate 10•80%
Yield on short-dated Euro Treasury Bills 1•80%
(assume 360-day year)

Mazabia’s current annual inflation rate is 9•7% and is expected to remain at this level for the next six months.
However, after that, there is considerable uncertainty about the future and the annual level of inflation could be anywhere between 5% and 15% for the next few years. The country where Casasophia Co is based is expected to have a stable level of inflation at 1•2% per year for the foreseeable future. A local bank in Mazabia has offered Casasophia Co the opportunity to swap the annual income of MShs1.5 billion receivable in each of the next three years for Euros, at the estimated annual MShs/€ forward rates based on the current government base rates.

Task

As a final MBA student in Derivatives prepare a report that;

1. Advises Casasophia Co on, and recommend, an appropriate hedging strategy for the US$ income it is due to receive in four months. Include all relevant calculations. (20 points)

2. Provides a reasoned estimate of the additional amount of loan finance Casasophia Co needs to obtain to undertake the project in Mazabia in six months. (7 points)

3. Given that Casasophia Co agrees to the local bank’s offer of the swap, calculate the net present value of the project, in six months’ time, in € and discuss whether the swap would be beneficial to Casasophia Co. (5 points for calculations and 8 points for the discussion)