- 15 Marks
AFM – Nov 2016 – L3 – Q5a – Hedging against financial risk: Non-derivative techniques
Demonstrate how YSL can hedge currency risk using futures contracts and calculate the result of the hedge.
Question
YSL 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 YSL 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: $1 = 128.15 yen
- Yen currency futures contracts on SIMEX (Singapore Monetary Exchange)
- Contract size: 12,500,000 yen
- Contract prices (US$ per yen):
- September: 0.007985
- December: 0.008250
Assume that futures contracts mature at the end of the month.
Required:
i) Illustrate how YSL might hedge its foreign exchange risk using currency futures. (5 marks)
ii) Explain the meaning of basis risk and show what basis risk is involved in the proposed hedge. (5 marks)
iii) Assuming the 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. (5 marks)
(Margin requirements and taxation may be ignored.)
Find Related Questions by Tags, levels, etc.
- Tags: Basis risk, Currency Futures, Currency Hedging, Foreign Exchange Risk, Risk Management
- Level: Level 3