- 15 Marks
L2 – Q96 – Futures and hedging with futures
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
(a) Apex Innovations Ltd must make a payment in sterling in January. Using futures, the company will therefore sell sterling and they therefore sell sterling/US dollar futures, which are for £62,500. The number of contracts to sell is therefore: £400,000 / £62,500 = 6.4. Since fractional contracts are not possible, the company should sell 6 contracts.
The payments are due in January, but the futures contracts are for March delivery. Apex Innovations Ltd should therefore sell 6 March sterling/US dollar futures contracts at the current price of 1.8600. This locks in the exchange rate for £375,000 of the £400,000 exposure, leaving £25,000 unhedged (which can be converted at the spot rate in January).
(b) Futures position
- October: Sell to open 6 contracts @ 1.8600
- January: Buy to close 6 contracts @ 1.8420
- Quote movement: Loss of 0.0180 (1.8600 – 1.8420)
- Tick size is $0.0001, so the loss is 0.0180 / 0.0001 = 180 ticks per contract
- Loss per contract = 180 ticks × £62,500 × $0.0001 = $1,125
- Total loss for 6 contracts = 6 × $1,125 = $6,750
Net position
- Sterling receipt = £400,000
- Convert £375,000 (covered by futures) at the futures rate of 1.8600 = £375,000 × 1.8600 = $697,500
- Convert remaining £25,000 at spot rate of 1.8450 = £25,000 × 1.8450 = $46,125
- Total dollars received before futures loss = $697,500 + $46,125 = $743,625
- Less futures loss = $6,750
- Net dollars received = $743,625 – $6,750 = $736,875
Effective exchange rate
- Effective exchange rate = $736,875 / £400,000 = 1.8422
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