PROFESSIONAL PROGRAM – Page 67

FM – L2 – Q97 – Hedging with options

UK company hedges $2M USD receipt using currency options, calculates outcome at expiry with given spot rate.

Question

A UK company, PrimeCare Plc, will receive US$2 million in six months’ time. It is now 20th March. The company is not sure whether the US dollar will rise or fall in value against sterling over the next few months, and it has decided to hedge its exposure to currency risk using traded currency options.
On the London Stock Exchange, traded currency options are available in a contract size of £31,250. Options are priced in cents per £1. Assume that option contracts expire on 20th of each month.
The following option prices are currently available:

Exercise price	Calls	Puts
	June	September	June	September
1.8500	1.4	1.9	4.0	5.1

The current spot exchange rate (US$/£1) is 1.8325–1.8375.

Required
(a) Explain how the company’s currency exposure could be hedged using traded currency options.
(b) Show what would happen if the options are still held by the company at expiry and the spot exchange rate is $1.9150–1.9200.

Answer

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Tags: Currency Options, Exchange Rates, Financial Risk Management, Foreign Exchange Risk, Hedging, Sterling, Traded options, US Dollar
Level: Level 2

Topic: Hedging with options

L2 – Q96 – Futures and hedging with futures

US company hedges £400,000 sterling receipt using currency futures, calculating effective exchange rate.

Question

MORE CURRENCY FUTURES
The sterling/US dollar currency future is a contract for £62,500. It is priced in US dollars, and the tick size is $0.0001.
Currency futures are not normally used by companies to hedge currency risks. However, assume that a US company, Apex Innovations Ltd, intends to use currency futures to hedge the following currency exposure.
It is now October. Apex Innovations Ltd expects to receive £400,000 in January from a customer in the UK.
The price of March sterling/US dollar futures is currently 1.8600.
The company is concerned that the value of sterling will fall in the next few months, and it therefore decides to use futures to hedge the exposure to currency risk.

Required
(a) How should Apex Innovations Ltd hedge its currency risk with futures?
(b) Suppose that in January when Apex Innovations Ltd receives the sterling payment, the March futures price is 1.8420 and the spot rate (US$/£1) is 1.8450.
Show what will happen when the futures position is closed, and calculate the effective exchange rate that Apex Innovations Ltd has obtained for the £400,000.

Answer

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Tags: Currency futures, Exchange Rates, Financial Risk Management, Foreign Exchange Risk, Futures contracts, Hedging, Risk Mitigation, Sterling, US Dollar
Level: Level 2

Topic: Futures and hedging with futures

FM – L2 – Q95 – Currency Risk Management

UK company hedges €2,110,000 net euro payment using forward contract, money market hedge, and currency futures; compare costs.

Question

It is now the end of July. A UK company, Zenith Enterprises, expects the following receipts and payments in euros at the end of the month in three months’ time (at the end of October):

| Receipts | €540,000 |
| Payments | €2,650,000 |

The company is concerned about the exposure to a risk of a movement in the sterling/euro exchange rate, and it has decided to hedge the exposure.
It is considering three methods of hedging the exposure:
(a) with a forward exchange contract
(b) using a money market hedge
(c) using currency futures.

Relevant data is as follows:

FX rates, €/£1
Spot	1.4537	1.4542
3 months forward	1.4443	1.4448

3-month interest rates	Borrow	Invest
Sterling (UK)	6.2%	5.6%
Euro	3.8%	3.4%

Currency futures: €/£1
Contract size is €100,000 per contract
December futures price: 0.6929

Required:
Demonstrate with relevant calculations how Zenith Enterprises can hedge its exposure to foreign exchange risk using:
(a) a forward exchange contract (3 marks)
(b) a money market hedge (4 marks)
(c) currency futures (3 marks)
Recommend which method of hedging would be preferable in this situation.

Answer

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Tags: Currency futures, Currency hedging, Euro, Financial Risk Management, Foreign Exchange Risk, Forward Contract, Hedging Strategies, Money Market Hedge, Sterling
Level: Level 2

Topic: Futures and hedging with futures

FM – L2 – Q94 – Futures and hedging with futures

Explain how a Canadian company can hedge USD payment using euro/USD futures.

Question

The euro/US dollar currency future is a contract for €125,000. It is priced in US dollars, and the tick size is $0.0001.

Currency futures are not normally used by companies to hedge currency risks. However, assume that a Canadian company intends to use currency futures to hedge the following currency exposure.

It is now February. The Canadian company has to make a payment of US $640,000 in May to a supplier.

The price of June euro/US dollar futures is currently 1.2800.

The company is concerned that the value of the dollar will increase in the next few months, and it therefore decides to use futures to hedge the exposure to currency risk.

Required

(a) How should the company hedge its currency risk with futures?

(b) Suppose that in May when the company must make the payment in dollars, the June futures price is 1.2690 and the spot rate (US$/€1) is 1.2710.

Show what will happen when the futures position is closed, and calculate the effective exchange rate that the company has obtained for the US $640,000

Answer

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Tags: Basis risk, Currency futures, Effective Exchange Rate, Foreign Exchange Risk, Futures contracts, Hedging
Level: Level 2

Topic: Futures and hedging with futures

FM – L2 – Q93 – Futures and hedging with futures

Illustrate how YSL can hedge FX risk using currency futures for a 140M yen payment.

Question

Zest Inc. is a company located in the USA that has a contract to purchase goods from Japan in two months’ time on 1st September. The payment is to be made in YEN and will total 140 million yen.
The managing director of Zest Inc. wishes to protect the contract against adverse movements in foreign exchange rates and is considering the use of currency futures. The following data are available:
Spot foreign exchange rate $1 = 128.15 yen
Yen currency futures contracts on SIMEX (Singapore Monetary Exchange)
Contract size 12,500,000 yen, contract prices are US$ per yen.
Contract prices:
September 0.007985
December 0.008250
Assume that futures contracts mature at the end of the month.

Required:
(a) Illustrate how Zest Inc. might hedge its foreign exchange risk using currency futures.

(b) Assuming spot exchange rate is 120 yen / $1 on 1 September and that basis risk decreases steadily in a linear manner, calculate what the result of the hedge is expected to be. Briefly discuss why this result might not occur.

Answer

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Tags: Basis risk, Currency futures, Foreign Exchange Risk, Hedge efficiency, Hedging, Japan, USA, Yen, YSL
Level: Level 2

Topic: Futures and hedging with futures

FM – L2 – Q92 – Foreign exchange risk and currency risk management

Calculate unhedged ZMW value of $35M receivable with 5% ZMW depreciation and compare to initial value.

Question

Riverfront Plc has just delivered a major export order to a customer in Canada at a price of $35 million payable in six months’ time and as the company’s finance director you are concerned about the potential impact of currency volatility on the profitability of this particular order.
You have obtained the following exchange rate and interest rate data at the close of business today:

Spot rate (ZMW/$)	ZMW 5 – ZMW 6
6-month forward rate (premium)	0.08 – 0.12

Annual interest rates:

	Deposit	Borrowing
Zambia	10%	14%
Canada	5%	6%

Riverfront Plc’s bank has quoted a premium of ZMW 10,000 (payable up-front) for a $35 million six-month over-the-counter currency put option with an exercise price of ZMW 5.6 = $1.
Riverfront Plc has the ZMW 10,000 available on deposit at the current time and would leave it on deposit for the next six months if it was not used to purchase the currency put option.

Required
(a) Calculate the unhedged ZMW value of the $35 million receivable if, in six months’ time, ZMW has depreciated by 5%. Explain how this compares to the ZMW value of the sale when it was made.

(b) Calculate the hedged ZMW value of the $35 million receivable if Riverfront Plc chooses to use a forward exchange contract.

(c) Calculate the hedged ZMW value of the $35 million receivable if Riverfront Plc chooses to use a money market hedge and calculate the effective forward exchange rate achieved.

(d) Calculate the hedged ZMW value of the $35 million receivable if Riverfront Plc chooses to use an over-the-counter currency put option and the spot exchange rate in six months’ time is:

(1) ZMW 5 = $1

(2) ZMW 6 = $1

Answer

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Tags: Currency Options, Currency Risk, Exchange Rates, Hedging, Put Option
Level: Level 2

Topic: Foreign exchange risk and currency risk management

FM – L2 – Q91 – Foreign Exchange Risk Management

Explain how a UK company can hedge USD payment risk using a forward contract and calculate the sterling cost in 3 months.

Question

A UK company, BrightHorizon Ltd, expects to pay $750,000 to a supplier in three months’ time. The following exchange rates are available for the dollar against sterling (GBP/USD):

| Spot | 1.8570 | 1.8580 |
| 3 months forward | 1.8535 | 1.8543 |

The company is concerned about a possible increase in the value of the dollar during the next three months and would like to hedge its FX risk.

Required:
(A) Explain how the exposure to currency risk might be hedged, and the amount that BrightHorizon Ltd will have to pay in sterling in three months’ time to settle its liability.

(B) Calculate EuroTech GmbH’s income in euros from settlement of the forward contract in two months’ time.

Answer

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Tags: Currency Risk, Foreign Exchange, Forward Contract, Hedging, Transaction risk, USD/GBP
Level: Level 2

Topic: Foreign exchange risk and currency risk management

FM – L2 – Q90 – Foreign exchange risk and currency risk management

Compare costs of hedging Eurotrade's $500,000 payment using forward contract vs. money market hedge.

Question

The treasurer of Eurotrade Company wants to hedge an exposure to currency risk. Eurotrade is a company whose domestic currency is the euro, and the company must make a payment of US $500,000 to a US supplier in six months’ time.
The following market rates are available:

Six month interest rates

	Borrowing	Deposits
Euro	4.8%	4.4%
US dollar	2.5%	2.0%

(These interest rates are expressed as an annual rate of interest.)

Required
Compare the cost of hedging the currency risk exposure with:
(a) a forward exchange contract (3 marks)
(b) a money market hedge. (5 marks)
Recommend which method of hedging would be preferable in this situation.

Answer

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Tags: Currency hedging, Euro, Foreign Exchange Risk, Forward Contract, Money Market Hedge, Transaction exposure, US Dollar
Level: Level 2

Topic: Foreign exchange risk and currency risk management

FM – L2 – Q89 – Treasury Management

Explain how NorthStar Enterprises can use an interest rate swap to hedge a variable rate loan and calculate the effective borrowing rate.

Question

A company, NorthStar Enterprises, has an outstanding 10-year variable rate loan of $15 million on which it is paying SOFRA + 2%. It wishes to eliminate its exposure to a rise in variable interest rates. Currently, 10-year US interest rate swaps are quoted at 4.458%.

Required:
Explain how the treasury function could use an interest rate swap to hedge interest rate risk and calculate the effective borrowing rate that would result.

Answer

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Tags: Hedging, Interest Rate Risk, Interest Rate Swap, SOFRA, Treasury management
Level: Level 2

Topic: Treasury Management

FM – L2 – Q88 – Money Market Hedge

Calculate money market hedge for $600,000 USD receipt in 6 months and estimate 6-month forward exchange rate for BritCo Ltd.

Question

BritCo Ltd expects to receive $600,000 in six months’ time from a customer. It intends to convert these dollars into sterling.
The current spot rate for the dollar against sterling (GBP/USD) is 1.8800. The six-month interest rates are 5% per year for sterling and 3.5% per year for the US dollar.

Required
(a) Show how BritCo Ltd can create a money market hedge for its exposure to a fall in the value of the dollar.
(b) Estimate what the exchange rate should be for a six-month forward contract, GBP/USD.

Answer

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Tags: Currency Risk Management, Foreign Exchange Risk, Forward Contract, Hedging, Interest rates, Money Market Hedge, Sterling, US Dollar
Level: Level 2

Topic: Treasury Management

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FM – L2 – Q97 – Hedging with options

UK company hedges $2M USD receipt using currency options, calculates outcome at expiry with given spot rate.

L2 – Q96 – Futures and hedging with futures

US company hedges £400,000 sterling receipt using currency futures, calculating effective exchange rate.

FM – L2 – Q95 – Currency Risk Management

UK company hedges €2,110,000 net euro payment using forward contract, money market hedge, and currency futures; compare costs.

FM – L2 – Q94 – Futures and hedging with futures

Explain how a Canadian company can hedge USD payment using euro/USD futures.

FM – L2 – Q93 – Futures and hedging with futures

Illustrate how YSL can hedge FX risk using currency futures for a 140M yen payment.

FM – L2 – Q92 – Foreign exchange risk and currency risk management

Calculate unhedged ZMW value of $35M receivable with 5% ZMW depreciation and compare to initial value.

FM – L2 – Q91 – Foreign Exchange Risk Management

Explain how a UK company can hedge USD payment risk using a forward contract and calculate the sterling cost in 3 months.

FM – L2 – Q90 – Foreign exchange risk and currency risk management

Compare costs of hedging Eurotrade's $500,000 payment using forward contract vs. money market hedge.

FM – L2 – Q89 – Treasury Management

Explain how NorthStar Enterprises can use an interest rate swap to hedge a variable rate loan and calculate the effective borrowing rate.

FM – L2 – Q88 – Money Market Hedge

Calculate money market hedge for $600,000 USD receipt in 6 months and estimate 6-month forward exchange rate for BritCo Ltd.

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UK company hedges $2M USD receipt using currency options, calculates outcome at expiry with given spot rate.

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UK company hedges €2,110,000 net euro payment using forward contract, money market hedge, and currency futures; compare costs.

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Explain how a Canadian company can hedge USD payment using euro/USD futures.

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Illustrate how YSL can hedge FX risk using currency futures for a 140M yen payment.

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Calculate unhedged ZMW value of $35M receivable with 5% ZMW depreciation and compare to initial value.

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Explain how a UK company can hedge USD payment risk using a forward contract and calculate the sterling cost in 3 months.

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Compare costs of hedging Eurotrade's $500,000 payment using forward contract vs. money market hedge.

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Explain how NorthStar Enterprises can use an interest rate swap to hedge a variable rate loan and calculate the effective borrowing rate.

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