finance technical assignment
iamnickok
HedgingCurrencyExposure.pdf
Forward contracts Futures contracts Options on futures contracts Money Market Hedge
June 2017
Four possible strategies to hedge ◦ Forward market ◦ Futures market ◦ Call options on futures contract ◦ Money market hedge
◦ In addition, we have the option to do nothing (Wait and see strategy)
The forward contract is the most common method to hedge ◦ Forwards are quoted by banks to individual
customers. ◦ Websites like investing.com provide live data for
Bid/Ask points for many currencies/maturities ◦ Financial Times (FT.com) has historical data about
the London closing prices for 1-month and 3- month forward contracts
Forward points ◦ When buying currencies we use the ask for the spot
rate and the ask for the forward points Points need to be adjusted by 10,000 (100 if JPY is
used) before adding them to the spot price Forward prices for pairs with indirect quotes (JPY, CHF,
CAD among others) need to be inverted to estimate USD cost of the transaction. Bid rates must be used in such cases.
Investing.com ◦ Since the forward market provides many maturities for the
forward contract, we can assume that if we pick the right maturity of the forward contract, we will automatically cancel the liability when the forward contract expires.
◦ Total cost per unit would be Spot rate (ask) at the agreement date
+ Fwd Points (ask) adjusted to price
If bid and ask quotes are unavailable, We must assume that the bank will keep half of the normal bid-ask spread for the currency pair.
Normal spreads available in the spot market USDJPY and EURUSD 2 pips GBPUSD, AUDUSD, USDCHF 4 pips USDCAD, NZDUSD 5 pips
In this class we assume that you simultaneously observe the spot and the forward quotes.
In real life, spot prices move significantly while you are talking to the bank, so you would need confirmation of the spot rate that will be used in the contract.
Final unit cost would be 1.3539 – 0.000165 For 3 weeks ahead
1.3537 x 1,000,000 units = 1,353,735
Using futures to hedge currency risk on accounts payable requires two transactions. The opening transaction is a purchase of the futures contract and the corresponding closing transaction on the day that the payment will be made.
Note that futures are not used to acquire the currency being hedged, they are used only to expose yourself to currency risk in an opposite direction of the spot market. That is, whatever you lose (win) in the futures market, you will win (lose) in the spot market nullifying the exchange rate movement that occurs in the period and making the total cost equal the initial spot price.
Cost of using futures would be Unit cost = Spot rate the day of the transaction
+ Futures price the day the hedge is initiated – Futures price the day of the transaction.
For the class project we assume that the transaction is made at the settlement price. Total cost = unit cost x # units + total transaction costs
Beginning of hedge
End of hedge
Unit cost = 1.1401 + 1.11875 – 1.14190 = 1.11705
Total cost = 1.11705 x # units + CME transaction costs
Hedging with future call options ◦ The process is similar to using a futures contract when the option
has not expired
Unit cost = Spot rate the day of the transaction + FV of Call option price (premium) the day the hedge is initiated – Call option price (premium) the day of the transaction.
For the class project we assume that the transaction is made at the settlement price.
FV is calculated as Premium * (1+ (X/360) * Int rate), where X is the number of days in the project
◦ However, if the option expires, there may be no price quote in the market. If that is the case, the intrinsic value is calculated as F – X, where X is the strike price and F is the price of the future contract on expiration. When a call option expires out of the money (F<X), then final price is 0.
Total cost = unit cost x # units + total transaction costs If the option expires OTM, no commission is paid. However, if the option expires ITM, you will have to pay the commission to receive the intrinsic value.
When you hedge payables in a foreign currency, you must use today’s prices to secure the total price you’ll pay for the goods.
MM hedge involves getting a loan in the local currency, transferring to the foreign currency and then investing the proceeds in the foreign currency. This investment in foreign currency is used to pay off the AP.
Calculation process: 1. Calculate the PV of the amount of foreign currency “owed” discounting from time t
to time 0 with the interest rate offered for deposits in the foreign currency 2. Calculate the amount of USD using spot rate at the beginning (time 0) that will be
borrowed from a US bank 3. Calculate the FV of the loan (principal + interest) in order to compare with other
alternatives that are paid at time t
The deposit in foreign currency + the interest earned will total the amount owed and will cancel the account payable in foreign currency. Since all prices are known at time 0, this hedging technique eliminates the risk of movements in the spot rate.
To compound/discount interest rates, please assume year has 360 days and if you hold your position for X days, your
interest rate adjustment is X/360
Four possible strategies to hedge ◦ Forward market ◦ Futures market ◦ Put options on futures contract ◦ Money market hedge
◦ In addition, we have the option to do nothing (Wait and see strategy)
The forward contract is the most common method to hedge ◦ Forwards are quoted by banks to individual
customers. ◦ Services like Investing.com provide live data for
Bid/Ask points for many currencies/maturities ◦ Financial Times (FT.com) has historical data about
the London closing for 1-month and 3 month forward contracts
Forward points ◦ When selling currencies we use the bid for the spot
rate and the bid for the forward points Points need to be adjusted by 10,000 (100 if JPY is
used) before adding to the spot price Forward prices for pairs with indirect quotes (JPY, CHF,
CAD among others) will need to be inverted to estimate USD amount of the transaction. Ask rates should be used in these cases.
Investing.com ◦ Since the forward market provides many maturities for the
forward contract, we can assume that if we pick the right maturity of the forward contract, we will automatically receive the dollar amount negotiated when our customer sends us the payment in foreign currency.
◦ Final value received per unit would be Spot rate at the agreement date (start date)
+ Fwd Points (bid) adjusted to price
If bid and ask quotes are unavailable, We must assume that the bank will keep half of the normal bid-ask spread for the currency pair.
Normal bid-ask spread for EUR is 2 pips We assume that the bank’s commission would be 1 pip
In this class we assume that the official NY closing price of the agreement date (reported by the Fed) is the price at which the forward contract is made.
In real life, spot prices move while you are talking to the bank, so you would need confirmation of the spot rate that will be used in the contract.
Final amount received would be 1.3539 – 0.000215 - 0.0001
For 3 weeks ahead, closing on 5/15
1.3536 x 1,000,000 units = 1,353,585
Using futures to hedge currency risk on accounts receivable requires two transactions. The opening transaction is a sale of the futures contract and the corresponding closing transaction on the day that the payment will be made.
Note that futures are not used to sell the currency being hedged, they are used only to expose yourself to currency risk in an opposite direction of the spot market. That is, whatever you lose (win) in the futures market, you will win (lose) in the spot market nullifying the exchange rate movement that occurs in the period and making the value received equal to the initial spot price.
Amount received using futures Unit price = Spot rate the day of the transaction
+ Futures price the day the hedge is initiated - Futures price the day of the transaction.
For the class project we assume that the transaction is made at the settlement price.
Total amount per unit = unit price x # units - total transaction costs Beginning of hedge
End of hedge
Unit price = 1.4056 + 1.4025 - 1.4075 = 1.4006 Total received= 1.4006 x # units - total transaction costs
Hedging with future put options ◦ The process is similar to using a futures contract when
the option has not expired Unit value = Spot rate the day of the transaction
- FV of Put option price (premium) the day the hedge is initiated + Put option price (premium) the day of the transaction.
For the class project we assume that the transaction is made at the settlement price.
FV is calculated as Premium * (1+ (N/360) * Int rate) where N is the number of days in the exercise
However, if the option expires, there may be no price quote in the market. Instead the intrinsic value is calculated as X – F where X is the strike price and F is the future contract price on expiration day. When put option expires out of the money (F>X), then final value is 0.
Total amount received= unit value x # units - total transaction costs If the option expires OTM, no commission is paid. However if the option expires ITM, you
will have to pay the commission to receive the intrinsic value.
When you hedge receivables in a foreign currency, you must use today’s prices to secure the total amount you’ll receive for the goods/services.
MM hedge involves getting a loan in the foreign currency, transferring to USD and then investing the proceeds in a local bank or directly in the business.
The loan denominated in foreign currency is canceled when the customer liquidates the AR
Calculation process: 1. Calculate the PV of the amount of foreign currency that will be received by discounting
from time t to time 0 with the interest rate required for loans in the foreign currency. 2. Calculate the amount of USD using spot rate at the beginning (time 0) that will be
received by the business 3. Calculate the FV of this amount (principal + interest) in order to compare with other
alternatives that are received at time t. If the business is cash rich, they will deposit it in a US bank and earn the deposit interest rate offered at the time. If the business is not flushed with money, then they can use the money and earn the cost of capital of the firm.
The loan in foreign currency + the interest charged will equal the amount received by the customer. This effectively eliminates all the risk of movements in the spot rate.
To compound/discount interest rates, please assume year has 360 days and you hold your position for N days so your
int rate adjustment is N/360
