November 14, 2013 at 1:32 pm
Greetings sir. My question is, what should we do if the spot rate on the transaction date is not given? Do we assume a spot rate on our own? Or is there a way to estimate the spot rate? I am also confused about the lock in rate. thanksNovember 15, 2013 at 12:38 pm
The explanation of the lock in rate is also the answer to the first part of your question, so let me try and explain
Between now and the date of the transaction, both spot and futures prices are likely to change.
If they were both going to change by the same amount, then the profit or loss on futures would exactly equal the gain or loss on the transaction. It would mean that the net result would be as though we could fix it at today’s spot. (There is a baby example in the course notes showing this)
However, this does not happen because spot and futures prices do not change by exactly the same amount – the difference between the two (the basis) changes over time. So…..the net result will not be fixed at today’s spot.
But we know why this is happening, and we can forecast how the basis will change (we assume it falls linearly over the life of the future), and so we can forecast the net effect at the date of the transaction – it will be fixed as though it was at today’s spot, together with an adjustment for the basis.
So….the lock in rate is our forecast now, of the net effect of what will happen at the date of the transaction. I.e. The net effect of converting at whatever spot happens to be, together with the profit or loss on the futures, will be equivalent to simply converting at the lock in rate.
We can forecast the lock in rate as being the current spot rate +/- the basis at the date of the transaction. (As to whether it is + or -, remember that spot and futures will get closer together, so it whichever makes them closer)
Alternatively you can exactly the same figure by taking the current futures price +/- the change in the basis. It will give exactly the same lock in rate – I find the previous way easier to remember, but it doesn’t matter.
Do let me know if this makes sense to you.November 15, 2013 at 1:29 pm
Thanks sir it does make sense. So, in case the spot rate on the transaction date is not given, we will compute the lock in rate and then use it to calculate the net amountNovember 15, 2013 at 1:47 pm
That’s correctNovember 21, 2013 at 2:39 pm
Sir please permit me to ask you to explain this lock rate and spot rate not give with just a very baby example here, I understand better with doing the sums, if you don’t mind
Many thanksNovember 21, 2013 at 4:37 pm
Suppose that today, the futures price is 1.40 and the spot is 1.20. The basis today is 0.20.
Suppose also, that the futures finish in 4 months time, and our transaction takes place in 3 months time.
Finally, lets suppose that spot in 3 months time has changed to 1.50.
The basis in 3 months time will have fallen to 0.05 (1 month left in the future out of the four currently), and so the futures price will be 1.55.
So…..we will convert the transaction at spot (1.50) and make a profit on the futures of 0.15 – which is a net effect of 1.35.
However, the problem is that of course we have no idea what spot will end up being.
But……we can estimate how the basis will change, and we can predict the net effect as being:
Current spot (1.20) + change in basis (0.15) which is 1.35. This is the lock-in rate and will be the net effect whatever happens to spot (try it with other spots on the date of the transaction).
Alternatively you can get the lock-in rate by taking the current futures price (1.40) – basis at date of transaction (0.05) which again is 1.35. (Whichever way you find easiest to remember )November 21, 2013 at 4:52 pm
Thanks so muchNovember 21, 2013 at 5:31 pm
You are welcomeNovember 25, 2013 at 2:53 pm
“Current spot (1.20) + change in basis (0.15) which is 1.35. This is the lock-in rate and will be the net effect whatever happens to spot (try it with other spots on the date of the transaction).
Alternatively you can get the lock-in rate by taking the current futures price (1.40) – basis at date of transaction (0.05) which again is 1.35. (Whichever way you find easiest to remember )”
Will it always b like this? Like you have to deduct the unexpired basis fromthe opening futures price to determine the closing futures price?? or is there a different method to determine the closing futures Price? Kindly help me. I always get confused in how to determine the CLOSING FUTURES PRICE? Please help.
And if possible, help me through june 2011 attempt question no. 2 !November 25, 2013 at 5:47 pm
The lock in rate is NOT the futures price at the date of the transaction.
It is what the net effect will be of converting the transaction at spot, and closing the futures deal.
If you are given the spot rate at the date of the transaction, then you are able to calculate the futures price on that date (by adjusting spot by the basis that you will have estimated). This is explained step by step in my lecture.
If you are not give spot at the date of the transaction, then you will have to calculate the lock in rate as per my previous answer.
With regard to the June 2011 question, you are not told what spot will be at the date of the transaction, and so the best is to calculate the lock in rate as described in my previous answer. (The examiner show the workings for this in his answer. He also shows another way which is not really correct – lock in rate is the way to answer it)November 25, 2013 at 10:41 pm
Thank you so much for your reply. I really helped me. Sir can you please tell me just two more thing.:
1) As in your answer above, Will the unexpired basis be always deducted from the opening futures price?? And
2) If, for example, Instead of spot price, forward rate is given on transaction date, Then can the closing futures price be calculated? If you have a lecture regarding it, Kindly tell me which one is it!
Thank you So much for you reply!November 26, 2013 at 8:57 am
1) No. The spot and the futures prices will get closer together, and so you add or subtract the unexpired basis depending on which way brings them closer together.
2) The futures prices is not dependent on the forward rate – they are two different things.November 26, 2013 at 12:07 pm
Thank You so Much Sir! It really helped me alot and cleared alot of confusions! Thank you so much again!November 28, 2013 at 9:29 am
You are welcome
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