- 10 Marks
FM – L2 – Q94 – Futures and hedging with 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
(A) The company must make a payment in US dollars in May. It must therefore buy dollars to make the payment.
Using futures, the company will therefore buy dollars and sell euro, therefore sell euro/US dollar futures, which are for €125,000 each.
At the futures price of 1.2800, the amount of euros to sell in exchange for $640,000 is:
$640,000 / 1.2800 = $500,000.
The number of contracts to sell is therefore: $500,000 / $125,000 per contract = 4.0 contracts.
The company will sell 4 June contracts at 1.2800.
(B). It will close its position in May, when the futures price is 1.2690.
The value of 1 tick for this contract is 125,000 × $0.0001 = $12.50.
| Original selling price | 1.2800 |
|---|---|
| Buying price to close the position | 1.2690 |
| Gain per contract | 0.0110 |
Total gain on futures position = 4 contracts × 0.011 × $125,000 = $5,500.
The Canadian company must pay $640,000 to its supplier. It has $5,500 profit from closing the futures position. It therefore needs an additional ($640,000 – $5,500) = $634,500.
It must buy these dollars at the spot rate of 1.2710. The cost in euros will be $634,500 / 1.2710 = €499,213.
The effective exchange rate for the payment of $640,000 is therefore $640,000 / €499,213 = US$1.2820/€1.
This is close to the price at which the futures were originally sold. However, the hedge is not perfect because the position was closed before the settlement date for the contract.
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