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 reply
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)
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 reply
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?
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 ….
I am please you have got it
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