1. avatar says

    i am slightly confused on the outcome on the future, since they are POUND contracts, our closing position should be to buy pounds, then we have to sell the pound first, so then when we sell our it’s pounds 1.5045 & when we buy the Pound back it is @ Dollars 1.5120, arent we Making a loss of $ 0.0075 , since we are paying more dollars to buy the POUND back ON the FUTURES contract. I am confused on this. thankyou.

    • Profile photo of John Moffat says

      Why should our closing position be to buy pounds?

      We are not using the futures in order to buy pounds (when we receive the dollars, we exchange them for pounds at whatever the spot rate happens to be).
      We are using the futures to hedge against the risk of exchange rate movements.

      The underlying transaction (selling dollars and buying pounds) will lose if the exchange rate goes up. So we buy futures now and sell them later, so that if the exchange rate does go up then we make a compensating profit.

      If you have not watched the previous lecture then do so, because I go through a more basic example just to explain the principle behind the use of futures.

  2. Profile photo of azshahke says

    Thank you so much OT for this very helpful lecture. It’s cleared a lot of the misunderstandings I initially had.
    I would also want to thank DeepMaharaj for putting up that formulae chart…. its helped ALOT!
    God Bless!

  3. Profile photo of questforknowledge says

    nice lecture indeed. but i didnt quite understand the area on whether to buy or sell futures in september. to me it’s but quite normal that the future price in december is higher than in september thus we buy futures in september. Does it mean that in the exam the future price at a future date is not given

    • Profile photo of John Moffat says

      Sometimes the futures price on the future date is given, but usually it is not given (and of course in real life you will have no idea what will happen to the futures price in the future).

      Remember that the financial manager is not dealing in futures simply to try and make a profit – this would just be gambling.
      They are using futures to make the profit or loss on the futures equal to the gain or loss on the actual transaction, i.e. to ‘cancel’ the risk in the transaction, and in this way to remove the risk.

    • Profile photo of deepmaharaj says

      Whether to buy or sell Futures – BPP has got very good formula Table

      Receive –> Currency other than US $———-> Sell ( Always)
      Pay —> Currency Other than US $—————> Buy ( Always)
      Receive—-> US $————————————–> Buy ( Always)
      Pay—->US $——————————————–> Sell ( Always)
      So Mnemonic is RPRP =SBBS
      ( First TWO RP for Currencies other than US $)
      ( Later TWO RP for US $)

  4. Profile photo of tinashe says

    it then means using the reference point that i would have expected my US$1,200,000 to be equal to pound of 794176, however using 12th Nov spot rate its Pounds of 789993. indicating an assumed loss in pounds of 4183.

    However my futures hedge gives me a profit of US$6093 which since i cant net dollars to pounds i then have to convert to pounds so iam able to see if this hedge helped or iam worse off. now the first thought that comes to me is i have to sell this dollars at todays spot rate and using the rate in which the bank buys dollars by today of 1.5100, this dollars equal pounds of 4035. hence overall i have lost 148 pounds. But hei if i had not hedged i would have lost pounds of 4183!

    I can accepts that. Nice . Iam still following and catching on, still waiting for more challenges to come. going to next lecture.

  5. avatar says

    In June 2011 paper Q2 we are asked to hedge US dollar receipt . We are given currency futures but examiner does not provide neither the spot rate nor the price of the future at the transaction date . In the answers provided, the examiner does not uses mid- market prices when he arrives at the futures price. I am a bit confused with the way examiner presents his answer. Would appreciate some explanations, please.

    • Profile photo of John Moffat says

      The examiner has done it two ways. One way he has done it is simply to apportion between the 2 month and 5 month futures prices.

      The more accurate way is the way that he has put in brackets. What he has done is calculate the basis now (the difference between todays spot and todays futures price), assumed (as we always do) that it falls to zero over the 5 month life of the future, and therefore estimated the basis risk at the date of the transaction (it will be 1/5th of the current basis because at the date of the transaction the future only has one month left to run).

      If the basis risk was to stay unchanged, then using future would lock the transaction at todays spot rate (any gain/loss on the transaction is ‘cancelled’ by the profit or loss on the futures. However, because the basis risk will change (and we have estimated what it will be), using futures will not exactly ‘cancel’ the gain or loss, but will effectively lock the rate on the transaction at the current futures price minus the basis at the date of the transaction (or, alternatively it locks it at the current spot rate plus 4/5 of the current basis (the amount by which the basis will change) – I find this more logical and it gives exactly the same result.)

      He has not used the mid-market spot because he is finding a lock-in rate, but using mid-market spot would still have got full marks (even though the answer would be a little different)

      • Profile photo of John Moffat says

        The current basis is 1.3698 (the 5 months futures price) – 1.3618 (the current spot rate) = 0.0080

        This basis will fall linearly to zero over 5 months, so in 4 months it will have fallen by 4/5 x 0.0080 = 0.0064

        Therefore using the 5 month futures will effectively lock the rate applicable to the contract amount to 1.3618 (the current spot) + 0.0064 (the change in the basis) = 1.3682.
        (which is the same figure that the examiner shows in his alternative answer in brackets).

        The basis has been calculated using the rate for selling dollars. However you could have calculated the basis using the mid-market spot instead, in which case you would get the current basis as 0.0096, and the change (4/5) to be 0.0077
        This would have resulted in a lock-in rate of 1.3618 + 0.0077 = 1.3695

      • avatar says

        @Johnmoffat, so when you want to calculate the profit or loss on futures do you use the 5month futures price as the buying rate and the ‘apportioned'(method 1 of examiner’s answer) futures price as the selling price? And is it ok to use the 4month forward rate as the spot rate at month 4 (stating the assumption ofcourse) to calculate the basis risk? Please help me understand before I fail AGAIN.

      • Profile photo of John Moffat says

        With regard to your first sentence, the profit or loss on the futures is the difference between the current price of the futures and the price of the future on the date of the transaction. (Which is buy and which is sell depends on whether you are hedging against a receipt or a payment of the foreign currency)

        The basis is the difference between the spot rate and the future price. We can estimate it by looking at the current basis (difference between the current spot and the current futures price) and assuming that it falls linearly over the life of the future.
        We do not need the future spot rate to be able to estimate the basis.

  6. Profile photo of John Moffat says

    Of course there is basis risk!
    However it is not necessary to calculate it in this example because the question actually tells you the spot rate and the futures price on the date of the transaction. That is all we need.
    If we are not given the futures price on the date of the transaction then we need to calculate the basis risk. See the next lecture!

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