- 15 Marks
FM – L2 – Q93 – Futures and hedging with futures
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 / $1 on 1 September and that basis risk decreases steadily in a linear manner, calculate what the result of the hedge is expected to be. Briefly discuss why this result might not occur.
Answer
(A) Zest Inc. can hedge using futures as follows.
Use September futures, since these expire soon after 1 September, price of 1/0.007985 = 125.23 k/$.
Buy futures, since it wishes to acquire yen to pay the supplier, and the futures are in Yen.
Number of contracts 140m / 12.5m = 11.2 contracts – 11 contracts
Tick size 0.000001 × 12.5m = $12.50
(B) Outcome
Futures market
Opening futures price 0.007985
Closing futures price 0.008394
Movement in ticks 0.00409
409 ticks
Futures market profit 409 × 11 × $12.50 = $56,238
Net outcome
Spot market payment (¥140m .120)
Futures market profit
Hedge efficiency 56,238 / 74,197 = 76%
This hedge is not perfect because there is not an exact between the exposure and the number of contracts, and be spot price has moved more than the futures price due to the in basis. The actual outcome is likely to differ since be the ret not decline uniformly in the real world.
- Tags: Basis risk, Currency futures, Foreign Exchange Risk, Hedge efficiency, Hedging, Japan, USA, Yen, YSL
- Level: Level 2
- Uploader: Samuel Duah