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Dear John,
Thank you for the valuable lectures – I find them extremely helpful.
However, I have two problems with regard to Exchange Rate Risk Hedging topic.
First problem: I am often not told what the “future spot rate” will be (such are standard exam questions). I get from your lectures the meaning of basis, and you usually provide “future spot rate”, what makes precise calculation of Currency Futures/Currency options hedge outcome easy. (future spot rate +- unexpired basis = future future price used in calculation). How can I approach this?
Secondly, sometimes I do find a calculation of basis tricky as well. Often today’s spot is quoted with ranges, e.g., USD/EUR 1.4500-1.5000, while futures price has only a one quote (e.g., September futures USD/EUR 1.6000). In these cases I am often not sure if I should use a mid rate (1.4500+1.5000)/2-1.600 to calculate a basis, or only one from the quotes (the less favourable to the company). Often it happens to me that then I have a different answer compared to ACCA results, where basis is calculated differently.
Thank you very much.
1. When we are not told what the spot rate is on the date of the transaction (which is most often the case these days), then we use the lock-in rate (which is the net effect of converting at the future spot together with the gain or loss on the futures). I do explain what the lock-in rate is, and how we calculate it, in my lectures.
2. There are arguments for using the mid-market price or just the relevant spot rate, when calculating the basis. Using either will get the marks in the exam, provided (as always) that your workings make it clear to the market what you are doing. Obviously it will result in a different final answer, but in Paper AFM there is rarely just one ‘correct’ answer, which is why it is the workings that get the marks rather than just the final result 🙂
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