Individual Assignment

FINC 6010 Derivative Securities

Name: Kai Zhu

SID: 430557040

Date: 22/10/2014

The University of Sydney

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Table of Contents

Executive Summary ..................................................................................................... 3

1.0 Corporation Overview ........................................................................................... 4

1.0.1 Purpose and Value of corporation ................................................................................. 4

1.0.2 Business Model and Strategy of Corporation ............................................................... 4

1.1 Main Risk of Corporation .................................................................................................. 5

1.1.1 External Risks ............................................................................................................... 5

1.1.2 Business Risks .............................................................................................................. 6

1.1.3 Financial Risks .............................................................................................................. 6

1.1.4 Operational and Sustainable Risks ................................................................................ 6

2.0 Hedge Strategy ....................................................................................................... 7

2.0.1 Commodity Price Risk .................................................................................................... 7

2.0.2 Foreign Exchange Risk ................................................................................................... 9

2.0.3 Interest Rate Risk ........................................................................................................... 11

3.0 Advantages and Limitations of Hedge Strategy ................................................ 12

3.0.1 Advantage of Hedge ...................................................................................................... 12

3.0.2 Limitations of Hedge .................................................................................................... 13

4.0 Conclusion ............................................................................................................ 13

5.0 References ............................................................................................................. 14

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Executive Summary

The report will show the overview of BHP, a global resource corporation around the

world, export and import natural resources between different countries with various

currencies. The main objective of this report is to identify a series of risks that BHP

may be exposed to, and find some appropriate derivative solutions to hedge them.

According to the annual report 2014, BHP is mainly exposed to four risks: external

risks, business risk, financial risks, operational risks and sustainable risks. In this

report we may mainly focus on external risks (commodity price risk, foreign

exchange risk, and interest rate risks), and determine some appropriate derivative

strategies to hedge them

Although BHP could accomplish risk hedging via applying derivative strategies, it

should be emphasized that there still may exist several limitations of hedge strategies

because of some other external factors (tax and transaction costs…), and the risk may

not be hedged perfectly.

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1.0 Corporation Overview

BHP Billiton is a leading global resources corporation in the world, operating under

Dual listed corporation structure (BHP Billiton Limited and BHP Billiton Plc.), which

creates clients’ long-term sustainable value via acquisition, developing and marketing

of natural resources (BHP Billiton annual report 2014). The main business

commodities of BHP contain petroleum and potash, copper, iron ore, coal, aluminum,

manganese, nickel, and group’s diamonds business.

1.0.1 Purpose and value of corporation

The fundamental of BHP strategy is operational capability through achieving

advanced business results by expanding company’s capabilities and simplicity which

means that focusing efforts on business activities that matter most (BHP Billiton

annual report 2014).

1.0.2 Business model and strategy of corporation

BHP operates under advanced business model, which contains mainly four parts:

exploration and evaluation; extraction and transportation; development; marketing

and logistics. This model will allow BHP to operate more efficiently with

multi-commodity nature of its organization.

The strategy of BHP is to operate long-term, low cost, upstream assets diversified by

its geography, commodities and market via evaluating and extracting resources;

distributing supply chain; managing financial risks associated with revenue around

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the world. BHP prefer to aim and deliver long-term value rather than focusing on

short-term returns. This may incur amounts of risks that face this corporation.

1.1 Main risks of corporation

According to the data analysis issued by BHP Billiton annual report, the global

economy mainly grew at a moderate rate these years. Western countries were

underpinned by central bank’s monetary policy such as United States, United

Kingdom. In the contrast, eastern countries continue to grow significantly with

rebalancing such as China (Kharas, 2010). Some external factors may have an impact

on BHP’s following operations. These factors may include the floating in commodity

prices, exchanges rates, changes in product demand and supply, and other operating

costs. Moreover, the risks of BHP may be divided into five sections: external risks;

business risks; financial risks; operational risks and sustainability risks.

1.1.1 External risks

The external risks may arise from in decreasing in demand in major markets and

commodity price or floating in currency exchange rates in different countries (Lane,

& Ferretti, 2000). Even if the policies issued by local governments that impact on the

stability of long-term values.

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1.1.2 Business risks

The Business risks involve in intrinsic uncertainty of identifying and reserves,

operating company assets and managing capital development projects (BHP Billiton

annual report 2014).

1.1.3 Financial risks

The volatility of global market may result in BHP’s financial risks, which cause

negatively impact on future cash flows (Sommers, Easton, & Sommers, 2007) and the

business activities in investing mining, oil and gas projects. Moreover, the continued

volatility may result in failing in meet clients’ contractual obligations (BHP Billiton

annual report 2014).

1.1.4 Operational risks and Sustainability risks

The cost of operating and productivity may decrease the operation margins and

expansion strategy (BHP Billiton annual report 2014), such as unexpected

catastrophes and climate. Some related accidents might potentially affect BHP’s

reputation, which will enhance the expense of public relation management (Spiro,

Cristina and Michael, 2007).

In conclusion, BHP Billiton mainly faces four risks when it operates under superior

business model. In the next part of this report, the description will focus on solving

external and financial risks (such as commodity price risk, foreign exchange risk,

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interest risk and liquidity risk) under financial risk management knowledge, and

discuss the advantage and limitations of hypothetical strategies.

2.0 Hedge Strategy

2.0.1 Commodity price risk

As a resource corporation around the world, BHP is exposed to the price movement of

crude oil, iron ore, metallurgical and energy coal, gas and copper. It shows that BHP

operates its crude oil about 48 US$/unit in 2005 and 125 US$/unit in 2011, and then

the price falls to 80 US$/unit this year.

Thus, the price change of crude oil may have a significant effect on company’s profit.

Moreover, some unexpected politic trends during these years may also affect the price

change that result the potential loss of profit. BHP should hedge its exposure to these

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fluctuations on crude oil in order to avoid this kind of loss in its business operation.

BHP could apply two types of derivatives to hedge the commodity price risk: long

commodities’ future contracts and long commodities’ call options. BHP could use

CME Group website to search for buying a crude oil futures or options to manage its

risks such as WTI Crude Oil product.

Based on the BHP’s petroleum and potash information, BHP purchased about 240

million barrels per year. Therefore, BHP should long 20,000 (1) contracts each month

(the contract unit of WTI is 1000 barrels).

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AEEE =

20,000 (1)

It is assumed that BHP long the futures at the price 100$/barrel. One month later, the

price is supposed to enhance to 120$/barrel, and then BHP may suffer no loss from

the increasing in oil price by 20$, because BHP has already locked the price for

100$/barrel one month ago.

Moreover, BHP could also hedge the risk by applying long WTI call options. It is

assumed that BHP purchased option on April, and the option price is 4$ with the

strike price of 100$ at maturity of June. At the end of June, the price of crude oil

enhances to 120, and the BHP will have the right to comply the option, which could

make a profit about 20$ for BHP. However, BHP may loss about 4$ on purchasing

this option when the strike price drops below 100$, which means the option will not

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be excised. It can be conclude that the income volatility with longing the call option is

less than that without longing the call option (Jansen, 2004), and BHP could apply

this strategy to minimize the commodity risk in its business operation.

2.0.2 Foreign exchange risk

BHP’s assets, cash flow and revenues are influenced by amounts of different

currencies due to its global business. This may result in a significant impact on BHP’s

financial results when foreign exchange rates fluctuate. According to the BHP annul

report; US dollar is the major currency in which denominates BHP’s global business.

However, some other currencies may also influence BHP’s global business, such as

Australia dollar. For instance, US dollar is mainly depreciated during these years,

which cause the decreasing in exchange rate (which is AUD/USD). This situation may

affect the operating cost of BHP significantly.

< The fluctuation of exchange rate AUD/USD from Jan-13 to Sep 14>

Suppose BHP, US dollar based corporation, sells oil and mineral in Australia.

Currently, US dollar is becoming depreciated. As dollar depreciates, the same amount

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of oil and mineral convert into greater amount of sales in dollar term. Therefore, this

situation may cause a gain for BHP.

Nevertheless, there exist a situation that sales will decrease at the end of trading with

floating exchange rate, and BHP could still hedge the risk via shorting AUS dollar

futures in order to avoid the lost (appreciation of US dollar). For instance, BHP

purchases 240 million barrels per year and if the price of oil is 100$/unit. Suppose

that the exchange rate is 0.95 AUD/USD. Thus BHP should purchase about 252631 (2)

contracts per year

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100,000=252631 (2)

BHP could also use natural hedge to reduce the exchange rate risk in business

operation. Suppose BHP manufactures its products in America originally, but BHP

moves its location to Australia. Then, the production cost will be incurred in AUS

dollar. In this case, even if sales increase because of the depreciation in dollar, the

production cost will enhance as well. Natural hedge may be an alternative way to

hedge the change of exchange rate.

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2.0.3 Interest rate risk

The change of interest rate may have an impact on fair value of fixed rate instruments

and cash flows. Currently, BHP is exposed to interest rate risk on it business operation

such as investment and borrowing fields.

Suppose, BHP decides to hedge the interest rate risk with about 1000million, BHP is

recommended to use 3-month future agreement to lock the future interest rate,

because it could assist BHP to determine whether to borrow or payback. Since, the

interest will be paid at certainty amount, BHP could reduce the risk more efficiently.

Alternatively, BHP ma y use interest rate swap (cross currency interest rate swap) to

convert floating rate exposure to fixed rate exposure or vice versa. For instance, BHP

wants to expand its business into Australia, and swap with Caltex. Generally, they will

deal with a financial intermediary which will earns about 3 or 4 basis points on the

pair of offsetting transaction.

BHP Caltex

Australia Dollar (floating

rate)

LIBOR+0.5% LIBOR+1%

US Dollar (fixed rate) 5.0% 6.5%

*Financial institution requires 50 basis spread

According to the hypothetical data above, BHP has a comparative advantage in US

dollar fixed rate market, and Caltex has a comparative advantage in Australia dollar

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floating rate market. Under this swap, both sides will make 25-basis better off. Thus,

swap could provide BHP with Australia dollar at LIBOR+0.25% per annum, and

Caltex with US dollars at 6.25% per annum.

3.0 Advantages and limitations of hedge strategy.

3.0.1 Advantage of hedge strategy

Hedge strategy could benefit BHP in its business operation. First, trading future

contracts and options can be used to reduce the loss of company, and the charge for

trading futures is relatively low compared to others. It is possible to be reversed easily

and lead to high liquidity.

Option is less risky compared to other trading instruments which means that trader

could be avoided huge loss (the amount is the price trader paid to purchase options),

and financial leverage can be employed to traders via options (Wright, 2013).

Interest rate swap allow BHP to take advantage of global business between two

parties when BHP decide to expand different markets. Although, there exists some

risks that other party will not accomplish obligation, BHP still receives from

participating in swap (Sargeant, 2014).

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3.0.2 Limitations of hedge strategy

BHP could use derivatives to manage its risks when it expands the global business

such as future contracts, options and interest rate swap. Nevertheless, some

uncertainty situations may occur during this period when BHP uses derivatives to

hedge risks. First of all, we do not consider any costs in this process such as tax and

transaction cost. This may result in more expenditure in business (even if these costs

can be ignored). Moreover, future contract is standardized product for fixed terms,

and hedge will be subjected to basis risk via using futures. Moreover, future contract

may offer only a partial hedge, which means it take some risk out of the portfolio

(Jamie, 2012). Furthermore, futures may require BHP to pay premium because of the

margin.

4.0 Conclusion

BHP is involved in some uncertain risks when it operates global business around

world. This report shows the strategy that BHP may apply in order to eliminate risks,

such as WTI call options, future contracts, and interest rate swap. However, it is not

possible to diminish all risks because of the external and uncertain factors and some

hedge strategies also have various disadvantages. Nevertheless, this report still

provides some appropriate recommendations that BHP could apply when it is

exposure to business risks.

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5.0 References

Jamie, A. (2012). To hedge or not to hedge. Retrieved from

http://www.adviceiq.com/articles/jamie-upson-hedge-or-not-hedge

Jansen, M. (2004). Income volatility in small and developing economies: export

concentration matters

Kharas, H. (2010). The emerging middle class in developing contries.

Land, P., Ferretti, G. (2000). The external wealth of nations: measures of foreign

assets and liabilities for industrial and developing countries. Journal of International

Economics, 55, 2001, 263-294

Sargeant, N. (2014). How do companies benefit from interest rate and currency swaps.

Retrieved from http://www.investopedia.com/ask/answers/06/benefitsofswaps.asp

Sommers, P., Easton, P., & Sommers, G. (2001). Financial statement analysis and

security valuation

Wright, M. (2013). An investor’s guide to trading options. Lightbulb press.