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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.
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)
can u illustrate your solution ,the examiners solution is not clear cut….
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
i really appreciate the breakdown, thank you so much you have saved me !
Well done Open Tuition! Thank you very much for this wonderful resource!
Im unable to view your lecture today.it gives a error message as 404 Not Found.Please help
You may have to update your flash player or browser
Lectures work same as always
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!
why r the lectures not complete??? they stop after 2 mins?? plz do something!
lectures are fine, you may have slow internet connection, contact your internet provider for help
the profit we have on futures is in dollar currency but we actually receiving pounds.. what we will do with dollars profit as we cant net dollars with ponds??
@jibran89, unless you are in the US, you will convert them into GBP (assuming you are in the UK!)
hi there is aproblem with this video it stops in the middle
why is there no basis risk?
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