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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.

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 – 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

Tag (SQ): Sterling

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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 – 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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FM – L2 – Q97 – Hedging with options

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

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L2 – Q96 – Futures and hedging with futures

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

You're reporting an error for "L2 – Q96 – 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.

You're reporting an error for "FM – L2 – Q95 – Currency Risk 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.

You're reporting an error for "FM – L2 – Q88 – Money Market Hedge"

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