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Sun Finance Ltd, a subsidiary of Sun Resorts Group incorporated in Mauritius with reporting currency MauritianRupees (MUR) is contracting two foreign currency loans for three months for working capital purposes as thecost of funds is cheaper than in MUR. The details of the two loans are as follows:

Loan 1: USD 40 million with interest and capital payable at maturity.

Loan 2: EUR 50 million with interest and capital payable at maturity.

Both loans have floating rates.

On 1 February, Sun Finance Ltd will draw funds under the EUR and USD loans and decides to fully hedge thecurrency risk of the principal value of the loan for the next three months as the CFO of Sun Finance Ltd expectsMUR to depreciate vis--vis EUR and USD. Data are presented in Exhibit 1.

Exhibit 1

Foreign Exchange Rates - 1 February

Spot rate (MUR/USD) 34.77

Spot rate (MUR/EUR) 40.50

April dollar futures contract (size = USD 100,000) (MUR/USD) 35.10

April Euro futures contract (size = EUR 100,000) (MUR/EUR) 40.95

As the CFO of Sun Finance Ltd, state the futures positions that it should take on 1 February, to hedge the loans`currency risk. Calculate the number of contracts needed to hedge. Show your calculations. [5 marks]

On 30 April, Sun Finance Ltd is informed that loan repayments inclusive of interest are as follows: USD 42million; and EUR 52.5 million. Current foreign exchange data are presented in Exhibit 2.

Exhibit 2

Foreign Exchange Rates - 30 April

Spot rate (MUR/USD) 36.27

Spot rate (MUR/EUR) 42.54

April dollar futures contract (size = USD 100,000) (MUR/USD) 36.63

April Euro futures contract (size = EUR 100,000) (MUR/EUR) 43.08

REQUIRED

What is the cost of fund for the Euro Loan and USD loan in the respective currencies?

What is the cost of fund of the unhedged loan portfolio for Sun Finance Ltd given that the reporting currency is MUR?

What is cost of fund of the hedged loan portfolio?

Critically explain why a futures contract is more enhanced than a forward contract to manage the risk of counterpartydefault?

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