October 24, 2012 at 11:22 am
sir,i’m doing bpp kit for p4.i was atempting a question “POLYTOT (JUNE-2004)” n when i saw the solution,he used spot rate instead of mid-spot rate to calculate basis risk.then he used this basis in two areas . .one for deriving “lock-in rate” by adding ticks (difference) to the futures price and used it for calculating over-hedge,,,n second for deriving closing future price by subtracting ticks (difference) from predicted spot rate (forward rate).i’ve seen such solution first time n didn’t see elsewhere.
my question is …what is lock-in rate?and why he used two different rates …i mean what’s the difference between closing future price and lock-in rate????plz replyOctober 24, 2012 at 7:23 pm
The closing futures price is the price of the futures at the date of the transaction. However, clearly when you first start the futures deal you have no idea what the final futures price is going to be.
However, because we can estimate what the basis risk will be at the date of the transaction (an estimate – we assume that it will fall linearly, which is not necessarily going to be the case in real life) we can predict what the net effect of it all is going to be (the net effect being the combination of converting at whatever the spot rate it, and closing the futures deal and making a profit or loss).
This prediction of the net effect is the lock-in rate. Effectively by using futures you are fixing the net effective rate at this lockin rate (on the contract amount)October 25, 2012 at 11:04 am
sory sir, i’m still confused about lock-in rate ….in that question i mentioned above,the lock-in rate was diferent from closing futures price and spot rate on the transaction date.can u please elaborate it with small illustration??first deriving lock-in rate and closing futures price using basis risk and then showing the net effect you discussed about n little explanation of that…………..waiting for ur replyOctober 25, 2012 at 7:39 pm
The lockin rate will certainly be different from the futures price and the spot rate on the date of the transaction – they could be anything, When we start the futures deal we have no idea what the prices will be on the date of the transaction.
However, what we do know is that the profit or loss on the futures would compensate exactly for the gain or loss on the transaction, if it was not for the fact the the basis risk will change.
However we can estimate what the basis risk will be (because we assume it will fall linearly over the life of the future) and so we can estimate what the net affect of using the futures will be (the lock in rate) by adjusting whatever the current rate is by the estimated basis risk.
Have you watched my lecture on here about this?October 26, 2012 at 6:03 pm
oh that’s the thing it is ……now i’ve got ur point!thank a lot sir
and i’ve watched your lectures on currency futures only but didn’t see any point about lock-in rate.on the other hand i’m studying kaplan text for p4 but the topics are not in much detail in that text ….October 27, 2012 at 6:55 am
I am please you have got itOctober 21, 2015 at 7:57 am
Can I know in this question,Polytot (6/04) , how did they calculate the lock in rate 1.5353.
In examiner’s answer, it showed 1.5275+78 ticks where the 78 ticks got by 235 ticks divided by 3 (it said it is the 4 months’ time basic).
I don’t get why it was divided by 3 and the logic behind the calculation of lock in rate.
Looking forward to hearing from you.
Thanks in advance!October 21, 2015 at 8:13 am
With regard to the logic of lock-in rates, you really need to watch the free lecture on them – I cannot type out the whole lecture here 🙂
With regard to the 78 ticks (although you do not need to quote it in ticks – the examiners didn’t bother in his own answer) – ‘now’ is 1 July, and December futures expire on 31 December, which is 6 months from now. The payment is a 4 months time, so at the date of the payment there will be 2 months left on the future (6 – 4). So the basis will have fallen to 2/6 (i.e. 1/3) of what it is now.
(The change in the basis and how futures actually work is, again, all covered in our free lectures on foreign exchange risk management.)October 21, 2015 at 8:17 am
Can you explain when they calculate Net Outcome, Overhedge on forward market, where is this 1883 come from and why it is divided by 1.5337 and again where does it come?
Sorry I’m all confused.
Thanks, I will watch you lecture also.
Looking forward!October 21, 2015 at 9:49 am
The examiners answer does not calculate the over hedge – he simply mentions that there is a slight over hedge. However it occurs because futures can only be dealt with in fixed size contracts so they are having to have 43 contracts (when they only really need 42.98 contracts).
Because the over hedge is known in advance, they can use forward rates on it, which is where the 1.5337 comes from.
I am not surprised you are confused if you are attempting questions without having watched the lectures first!! It should be the other way round 🙂October 21, 2015 at 9:50 am
Thanks a lot !October 21, 2015 at 10:25 am
You are welcome 🙂
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