This document is a report analyzing risks faced by BHP Billiton, a global mining corporation, and proposing hedging strategies. It identifies BHP's main risks as commodity price risk, foreign exchange risk, and interest rate risk due to its international operations. To hedge commodity price risk, the report recommends BHP use crude oil futures contracts and call options. For foreign exchange risk, it suggests BHP short Australian dollar futures to hedge U.S. dollar exposure. Finally, it proposes interest rate swaps and futures to hedge interest rate risk when borrowing funds. The report acknowledges limitations of hedging including basis risk and transaction costs.

1. 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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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.