Fin management materials / 11 P4AFM-Session13_j08

SESSION 13 – FOREIGN EXCHANGE RISK MANAGEMENT

Example 5

Philadelphia SE £/$ options £31,250 (cents per pound). Data on 4 February:

On 4 February a UK exporter sells to a US customer for $300,000 receivable towards the end of April. Current spot rate $1.6119 to £1.

(a)Show how this receipt could be hedged using currency options;

(b)Illustrate the outcomes if the spot exchange rate on the date of receipt is:

(i)1.625

(ii)1.605

Solution

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5.3Delta hedging with currency options

¾Delta is the change in price of an option for a (small) change in the price of the underlying asset i.e. the spot exchange rate.

¾Delta is calculated as N(d1) in the Grabbe variant of the Black Scholes options pricing model.

¾Delta is also known as the “hedge ratio” and can be used to construct delta-neutral portfolios that eliminate FOREX risk by producing gains/losses on options which cancel losses/gains on an underlying currency exposure.

Example 6

A UK based company needs to buy 150m Euro in 3 month’s time

Euro/Sterling spot rate 0.69 (indirect)

Euro/Sterling “at the money” call options are available with a contract size of 100,000 Euro and 3 month’s to expiry. The price of each contract is £3158 and N(d1) = 0.5386

Required:

Construct a delta hedge to eliminate the FOREX risk and demonstrate how the hedge would operate if Euro/Sterling strengthens to 0.7

Solution

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6CURRENCY FUTURES CONTRACTS

6.1The nature of futures

Definition

A futures contract is a standardised contract between buyer and seller, in which the buyer has a binding obligation to buy a fixed amount (the contract size), at a fixed price (the futures price), on a fixed date (the delivery date), of some underlying asset via a recognised exchange.

¾Futures are simply traded forward contracts.

¾The futures market is a market for risk. Speculators use the market to take risk and companies use the market to hedge risk. The focus in the exam is likely to be risk management – not speculation.

¾Currency futures contracts are standardised contracts for the buying or selling of a specified quantity of a specified currency. They are traded on a futures exchange and have various “delivery dates” e.g. March, June, September and December. The exact day during the month is set in the specification of the contract but is usually toward the end of the month.

¾The price of a currency futures contract represents the forward exchange rate for the currencies specified in the contract.

¾When a futures contract is bought or sold, the buyer or seller is required to deposit a sum of money with the exchange, called initial margin. If losses are incurred the buyer or seller may be called on to deposit additional funds with the exchange (variation margin).

¾Any gains are credited to the margin account on a daily basis as the contract is “marked to market”.

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6.2Hedging with futures

¾Although the definition of a futures contract is basically the same as a forward contact, there is a significant practical difference between hedging with forwards and futures:

With forward contracts there is (usually) physical delivery i.e. a company that signs a forward contract will physically buy or sell the underlying currency when the contract reaches its delivery date (the exception being NDF’s).

However most currency futures contracts are “closed out” before their delivery date. The company simply executes the opposite transaction to the initial futures position e.g. if buying currency futures was the initial transaction, it is later closed out by selling currency futures. This technique is referred to as “offset”.

By using offset the participant in the futures market does not physically buy or sell the underlying currency but simply takes gains or losses on the price movement of the contract.

Even if a futures contract is held until its “delivery date” physically delivery may still not occur – many currency futures are “cash settled” i.e. any gains/losses are taken on delivery date rather than exchanging the underlying currency.

In practice it is rare that the company would wish to hold the contract until its delivery date – there are usually only four such dates per year and hence not very likely to perfectly match with the company’s underlying exposure.

Therefore the company will usually use offset before the delivery date and not physically exchange currency using the futures contract. If and when the company needs to exchange currency it will have to use the spot market.

¾When setting up a position on futures the company must answer the following three questions:

Should the company today buy or sell futures i.e. take a “long” or a “short” position?

Which delivery date should be used?

How many contracts should be used?

¾When the company later wishes to close out its position it simply reverses the answer to the buy/sell question.

¾If a futures hedge is correctly performed any gain made on the futures market will balance a loss on the spot market. However the gains/losses are not likely to perfectly cancel each other out as futures prices rarely move the same amount as spot prices.

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Illustration 2

In August a UK company sells a machine to a US customer for an agreed price of $1,216,250 receivable in November.

The UK supplier is exposed to exchange risk on $1,216,250.

Current spot rate is $1.40 to £1 and December sterling futures are trading at $1.39 (contract size £62,500).

The company fears that sterling may appreciate against the dollar, leading to a transaction loss when the dollars are sold in November on the spot market.

The December sterling futures are currently priced at $1.39 (slightly different to the spot rate – the difference is known as basis). If sterling rises on the spot market than the price of sterling futures will also rise – although not by the same amount as basis must fall over the life of the futures contract.

The company needs to set up a position on futures that will produce a gain if sterling rises. The company should therefore buy sterling futures - a long position gives a gain upon a rising price.

December contacts can be used as they allow the company to hedge at least its period of exposure (September contracts could only hedge until the end of September)

Sterling value of the hedge = 1,216, 250/1.39= £875,000

Number of contracts required = 875,000/62,500 = 14

Therefore in August the company buys 14 December sterling futures at 1.39

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In November the company will receive $1, 216, 250 and change into sterling at the prevailing spot rate

It will also close out the sterling futures by selling the contracts.

(i)Suppose that the spot rate in November is $1.45 and the December futures price has moved to $1.445

Note that the gain and loss do not perfectly match; this is due to the fact that the futures price did not move directly in line with the spot rate. In fact the futures price moved by more than the spot rate – creating an overall gain. This occurred due to the fall in the level of basis in the futures contract between August when it was bought and November when it was sold.

Basis always falls over the life of a futures contract because as the contract approaches its delivery date its price must converge to the spot price. Sometimes this creates a net gain from the hedge, sometimes a net loss.

If basis changes unexpectedly this is known as basis risk.

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(ii)Suppose that the spot rate in November is $1.38 and the December futures price is $1.375.

Note that without the hedge our gain would be much larger. However we cannot default on futures contracts – they are legally binding.

6.3The tick system

¾The minimum price movement for a futures contract is known as a tick size. The exchange specifies the size of this minimum price movement for each type of futures contract.

¾For £/$ futures with a contract size of £62,500 the tick size is 0.01c per £. This means that the tick value, expressed in $, is:

£62,500 × 0.0001 = $6.25

¾Therefore for each 0.01 cent movement in the price of the futures contract the company’s account with the market is credited/debited with $6.25 per contract. This would accrue daily using the mark to market system.

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Illustration 2 (continued)

(i)Suppose that the spot rate in November is $1.45 and the December futures price has moved to $1.445

The gain on the futures contract can be expressed in ticks:

Buy 14 contracts @ 1.39

Sell 14 contracts @ 1.445

This is a 5.5 cent increase in futures price which is equivalent to 550 ticks. Therefore the margin to be credited to the account over the period is:

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Example 7

Assume that it is now 30 June. Boozy Inc. is a company located in the US that has a contract to purchase goods from Japan in two months time on 1 September. The payment is to be made in yen and will total 280 million yen.

The CEO wishes to protect the contract against adverse movements in foreign exchange rates, and is considering the use of currency futures. The following data is available.

Spot foreign exchange rate $/Yen (indirect) 128·15

Yen currency futures contracts on SIMEX (Singapore Monetary Exchange)

Contract size 12,500,000 yen, contract prices are in $ 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 KYT might hedge its foreign exchange risk using currency futures.

(b)Show what basis is involved in the proposed hedge.

(c)Assuming the spot exchange rate is $/Yen 120 on 1 September and that basis 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. Margin requirements and taxation may be ignored.

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