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Sir in part c of this question’s solution it says that MSHs is depreciating against the euro as interest rates r much higher in Mazabia than the european country. Could u pls explain this. Does this mean if in any coyntry the interest rate going up that currency is depreciating.
And in same part whaile calculating the forward rate how do we know its for six months as in solution in bpp they have calculated six months than 1,1.5,2.5,3.5 years respectively. Thanks
You will know from the free lecture on forecasting exchange rates (and from the formulae given with the exam) that when one country has higher interest rates (or inflation) than the other country then the currency of that country will be expected to weaken/depreciate.
Part (b) of the question says that the project will start in 6 months time.
Dear Mr Moffat,
Question Casasophia part a, using future contracts to hedge against the weakness of USD20 mil. received in 4 months. The hedge is as follows:
We need to buy 117 contracts (rounding from 116.8 which indicates there is an overhedged amount).
Spot now = 1.3618
Spot in 4 months = 1.3623This implies a loss due to the adverse change of the exchange rate for the company, and so I expect a gain in the futures market to compensate the loss of the exchange rate movement.
However, the futures market shows a loss:
Buy futures now at 1.3698
Sell futures in 4 months at 1.3639I find it is similar the case for question Polytot-BPP where the futures market shows a gain and the underlying asset also moves favourably.
Please would you let me know where I am wrong in understanding this area? Besides, do we have to calculate the over/underhedged amount ?
Many thanks,
Hanh
Because they are receiving $’s, then if the spot rate falls they will make a gain (not a loss) on the underlying transaction (to convert to euros will mean dividing by a smaller number which will therefore convert to more euros). Conversely, if the spot rate increases (which it will if the dollar weakens) then they will make a loss on the transaction.
I hope that sorts out your problem (the examiners answer does not really explain it very well).
With regard to the over/under hedged amount, although it is less important for the marks you should mention the fact that there is an over/under hedge and that this is still at risk. Also mention that you could use forward rates (if available) to protect against this risk even if you do not have time to actually calculate any numbers for that bit.
Hi sir,
Refer to the suggested answer for futures contract, I wonder what is the rationale for us to use the difference between 2-mth futures and 5-mth futures to calculate the basis, so as to calculate lock-in rate? Bcos what I understand from Kaplan textbook is, basis is the difference btwn spot rate and future rate. Please kindly correct my understanding, thanks.The more sensible way is the way that the examiner has shown in brackets (starting with the word “OR” 🙂 )
That is the normal way and the way that is in our free lectures (and it would have got full marks).
@hanhvn said:
Dear Mr Moffat,Question Casasophia part a, using future contracts to hedge against the weakness of USD20 mil. received in 4 months. The hedge is as follows:
We need to buy 117 contracts (rounding from 116.8 which indicates there is an overhedged amount).
Spot now = 1.3618
Spot in 4 months = 1.3623This implies a loss due to the adverse change of the exchange rate for the company, and so I expect a gain in the futures market to compensate the loss of the exchange rate movement.
However, the futures market shows a loss:
Buy futures now at 1.3698
Sell futures in 4 months at 1.3639I find it is similar the case for question Polytot-BPP where the futures market shows a gain and the underlying asset also moves favourably.
Please would you let me know where I am wrong in understanding this area? Besides, do we have to calculate the over/underhedged amount ?
Many thanks,
Hanh
Having the exact same doubt regarding the Casasophia question.I read your answer but still unclear .
I also assumed the spot rate after 4 months to be the 4month forward rate.
Spot market
Spot now $1.3618
Spot after 4 months $1.3623Dollar has weakened in the spot market , so we are making a loss as we are dividing 20m now by a bigger number (1.3623 vs 1.3618) in the spot market as we are recieving $
Futures Market
I see we are making a loss here as well
We buy @ 1.3698
We sell @ 1.3639 (spot after 4 months + closing basis=1.3623+0.0016)
Loss of 0.0059We are making a loss in both the markets.
Would you please help me with me with this
We always start the futures deal by buying or selling futures in the same way as the transaction is buying or selling futures.
Since the transaction is receiving $’s and therefore selling $’s to convert, and since the contract currency of the futures is $’s, we will start the deal by selling $ futures and then buying them back later. So here, there is a gain on the futures because the buy price in 4 months time is lower than the current price.
(Had the transaction involved buying $’s (because we were having to pay dollars) then the futures deal would have been to buy $ futures now and sell them later)
@johnmoffat said:
We always start the futures deal by buying or selling futures in the same way as the transaction is buying or selling futures.Since the transaction is receiving $’s and therefore selling $’s to convert, and since the contract currency of the futures is $’s, we will start the deal by selling $ futures and then buying them back later. So here, there is a gain on the futures because the buy price in 4 months time is lower than the current price.
(Had the transaction involved buying $’s (because we were having to pay dollars) then the futures deal would have been to buy $ futures now and sell them later)
The contract currency is Euro not $ -which is why I took it as buy now and sell after 4 months.
Not sure where I am going wrong 🙁
Sorry – it is early in the morning here and I looked at the wrong question 🙁
I know it looks odd to make a loss on both, but the purpose of using futures is to ‘fix’ the final net outcome and not to be making an overall loss or gain as against converting at the current spot rate.
If you assume that spot in 4 months time is 1.3623, then the receipt from the transaction itself will be 20M / 1.3623 = 14.681M, which is more than the receipt in the answer where the examiner has assumed a spot of 1.3698.
If you carry on and subtract your loss on the futures, then you will end up with the same net result as in the answer (14.618M). (It will be a bit different because the contracts didn’t divide exactly, but that is irrelevant in the exam). Any assumed spot rate (and the associated futures price) will end up giving the same final net result, subject to a small difference due to the contract size.
yes you are right! I have got the same answer as the examiner (basically same lock-in rate) even though I assumed a different spot rate.
Only thing what confused me was making a loss in both markets as my understanding so far was that we would make a gain in 1 market if we made a loss in the other
Thanks again John 🙂
Just 1 more question
In such cases , how do we calculate the hedge effectiveness? there is no gain in any market..
is it 0 as the hedge has totally gone wrong?
You couldn’t calculate a figure for the effectiveness. (And in fact I am going to remove the bit about effectiveness from the lectures because it hasn’t been mentioned in the exam for about 15 years now 🙂 )
Hello John, am I right to say that, if future spot rate is not given in currency option question, convert the underlying transaction at the exercise price to show the worst that could happen.thanks
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Hi John,i am confused here. On calculating forward rates in part c) why did we use the offer rate of MShs128 when we are depositing the Euros in exchange for the MShs2.64 billion?
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