EXAMPLE OF HEDGING FX RISK WITH FUTURES

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EXAMPLE OF HEDGING FX RISK WITH FUTURES

• Suppose that a bank is faced with the following
  situation
• ? the bank will receive 15 million from a loan
  payment on May 18 (period t)
• ? today, on February 26 (period 0), we know that
  S0 1.609/, F0,t 1.598/, i 4.5 and i
  6.3
• ? the June futures contract expires on June 20
  (period T)

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• If the bank forecasts that interest rates will
  remain stable until May 18, should it follow a
  forward or a futures hedge?
• If the bank forecasts that the rate will
  increase to 5.5 next month, which will cause the
  forecasted spot rate on May 18 to be 1.57/, how
  should it hedge?

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• If the bank forecasts stable interest rates and
  uses the forward market, it will receive on May
  18
• 15,000,000 ? 1.598/ 23,970,000
• If the bank uses futures, it will go with a
  short hedge
• Bank expects to depreciate and no basis risk
• Futures price of June contract on Feb. 26 is
• Fut0,T (1.609/) (1.045/1.063)(112/360) ?
  1.6/

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• Given no change in basis and if forward
  accurately predicts future spot, then futures
  price on May 18 ? 1.6/
• Since the bank is concerned about depreciation,
  it would have gone short on futures on Feb. 26
• In this scenario, bank makes no profit or loss
  from futures given no change in futures price

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• Better to use forward hedge if forward rate
  accurately forecasts future spot
• If rate? and S ?, we need to re-evaluate
  futures hedge
• In this case, there is basis risk
• Based on St 1.57/, bank would receive on spot
  market
• 15,000,000 ? 1.57/ 23,550,000

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• Bank loses 420,000 from spot compared to using a
  forward hedge
• But, on May 18, price of futures is
• Futt,T (1.57/) (1.055/1.063)(32/360) ?
  1.568/
• Price of futures contract on Feb. 26 was
• 62,500 ? 1.6/ 100,000
• Price of futures contract on May 18 is
• 62,500 ? 1.568/ 98,000

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• Since the bank has gone short on futures, bank
  has made a profit of 2,000 per contract
• Bank has 240 contracts
• Total profit from futures on May 18 is 480,000
• The profit from futures more than offsets the
  loss from the change in the spot rate (480,000 -
  420,000 60,000)
• The bank is better off hedging with futures and
  selling spot on May 18

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EXAMPLE OF HEDGING WITH OPTIONS

• A U.S. firm imports goods from Switzerland
• The firm has a payment of SFr 10 million on
  October 25
• Today, the spot rate is 0.595/SFr and the
  forward rate is 0.599/SFr
• The December SFr call options are priced at 1.10
  cents with a strike price of 62
• Each SFr option contract is for SFr 62,500
• Examine the firms hedging strategy in the case
  that the spot rate on October 25 is either
  0.60/SFr or 0.625/SFr

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