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I have been following and preparing myself for the exam using the Kaplan study text and when i sat the P4 exam in June 2014 I followed what i learnt in it but now when I see the answers to the questions I’m staring to question the appropriateness of the study text.
Anyhow my question was in the first foreign exchange question, the payment of $5,060,000 was converted using the 3 month futures plus 1 month futures rate and then divided by 125,000 Euros to arrive at the number of contracts, whereas in accordance to the book, we were supposed to convert the $5,060,000 at that days spot rate and then divide by 125,000 Euros to arrive at the number of contracts. Furthermore, the examiner had not calculated the gain or loss on the futures, so how do we know when to find the gains or losses?
The same goes with the options part, the examiner had used the exercise price to arrive at the number of contracts instead of the spot rate.
Could you please clear my confusion out as I am doing self studies and ended up wasting a lot of time trying to figure out where I went wrong.
Thank you very much
RegardsWith regard to calculation the number of contracts, it is arguable which is best. I actually think Kaplan’s way is strictly the better way.
It can result in slightly different answers, but you would still get full marks in the exam.With regard to calculating the eventual outcome, what happens in real life is that we convert the transaction at whatever the spot rate turns out to be. We also calculate the profit or loss on the futures, and then look at the net result.
This is what Kaplan has done (and what I do in my free lectures on here ) and if you had done this in the exam then you would get full marks.However, since we know what will happen to the basis (the difference between spot and futures, that we assume falls linearly over the life of the future) it is possible to calculate what we call a ‘lock-in rate’ which will predict what the net outcome on the date of the transaction will be. This is what the examiner has done in his answer.
At the moment we have no lecture on here on the lock-in rate (we do on the rest of what happens with futures). I am teaching a lot at the moment, but in a few weeks time I will either record a lecture or write a detailed explanation (so look back here in a few weeks time 🙂 )
However the end result will be the same whether you do it the ‘full way’ or whether you use this ‘lock-in’ rate.
Thanks John, will be looking forward to the lock-in-rate lecture or the written explanation 🙂
You are welcome.
I will do it, but you will have to wait for a few weeks when I will have a break from teaching.
Will do John, thanks..
Regarding this same question using the full way you mentioned that the results will be the same, this is what I came across John, could you please let me know whether this is correct:
Payment of $5,060,000 in 4 months
No. of contracts – 38
Spot Rate – $1.0635 per CHF1
125,000 Euros contract size (I assumed the tick value would be 0.01% or it should be)
3 month expiry – 1.0647 ($ per CHF 1)
6 month expiry – 1.0659 ($ per CHF 1)So this is what I did, the question does not mention about the 4 month futures rate so if I used the lock in rate as you mentioned it, it would be 1.0651.
Therefore the gain or loss on the futures would be 38 x (125,000 x 0.01%) x Number of ticks
Number of ticks would be = 1.0659 – 1.0651 = 0.0008
So the loss on futures would be 38 x 12.5 x 8 = $3,800
$5,060,000 -$3,800 = $5,056,200
Due to the unavailability of the spot rate I used the 4 month futures rate to convert it –
$5,056,200 / 1.0651 = CHF 4,747,160
This result is CHF 3,568 less than what the examiner had achieved.
Is this the correct methodology John?Thanks a bunch
Sorry, but what you have done is not quite correct.
The ‘lock-in rate’ is a prediction of the net effect of converting the transaction and whatever spot turns out to be, and the profit/loss on the futures.
If you do it the ‘full’ way. Then the profit/loss on futures is found by taking the difference between the futures price now and the futures price on the date of the transaction.
To get the futures price on the date of the transaction you need to calculate the difference between spot and futures now (the basis), assume it falls linearly and calculate what the difference will be on the date of the transaction, and then the futures price will be the spot at the date of the transaction as adjusted by the basis just calculated.
(Incidentally, although otherwise you were doing the correct thing, I don’t know why you mentioned ticks – you have not really used ticks and there is never any need to use ticks. If they are talking about currency futures then 1 tick is 0.0001. It is only with interest rate futures that 1 tick is 0.01%. However, your calculations are correct apart from the point above)
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