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I am under the impression that when using the futures and spot market,
Lock-In Rate = Opening Future Rate less Closing Basis
So for example to hedge a foreign euro receipt against $ home currency we would:
1)Leaving Currency at risk by buying $ at future spot rate
2)Gambling on a $ futures contract by buying $ now @ opening future price and selling $ later at closing
The net effect of the 2 actions are reflected in the lock-in rate.However, when using the futures market to determine a lock-in rate to hedge a foreign euro receipt on 31st May:
A March future and June future is used to determine an effective futures rate on 31st May,
and the final answer uses that rate to convert.
It does not seem like we go through the 2-step process above.
Am I wrong?There are two ways of getting the lock-in rate. They both give the same result and either way gets full marks (and the examiner usually shows both ways in his answers).
One way is the way that you have written in the second lone of your post. However there is just one thing wrong with what you have written. The futures price and spot rate will always get closer over time. So the lock-in rate will always be between the current spot rate and the current future price. That means that if the current futures price is higher than the current spot rate then to get the lock-in rate we will subtract the closing basis, whereas if the current futures price is lower than the current spot rate we will add the closing basis.
The other way is to apportion (in your example) between the March and June futures prices to get a price for May.
Again, both ways gives the same end result. If you come across an exam question and you get a different answer then tell me which question and I will explain where you have gone wrong 🙂
Thank you very much.
Opening Future rate was in reference to the current future price, but duly noted.
As per your last paragraph, I did get it wrong but upon redoing the question, I got the same answer using both methods.
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