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Hi John,
Relevant information:
Transaction type: A foreign currency payment $12,750,000 in May (local currency in EUR)
Spot price at 28-Feb: 1.2311
Futures contract: Mar at 1.2774, Jun at 1.2143, contract size EUR62,500Using the ‘long method’, I found out that when calculating no. of contracts required, Kaplan study text, Kaplan exam kit and BPP workbook gives different approach, mainly:
1) Using predicted futures price at transaction date in May (Kaplan exam kit = past exams)
= [ $12,750,000 / (1.2143 + ((1.2311 – 1.2143) x ¼ x 1 period) ) ] / EUR62,500
= 167.41 or 167 contracts (under-hedged exist)2) Use directly the futures contract rate at maturity in Jun (In study text/workbook)
= [ $12,750,000 / 1.2143 ] / EUR62,500 = 167.998, or 168 contracts (no under-hedged)Though the difference is minimal, it is really confusing (+frustrating) because none of the study material clarify if it is acceptable in the exam to use any one of the two approaches (of course I will choose to follow exam kit as the answer is written by examiner). Please kindly advice.
Furthermore, is it acceptable to ‘round up’ the no. of contracts required (i.e. the 167.41 contracts above to 168 contracts) to save the hassle of going through the amount not hedged?
Looking forward for your reply and thanks in-advance!
Best regards,
KennyIt is acceptable to round the number of contracts either way, and the examiner will always accept (in your example) either 167 or 168 whichever he chooses to show in his answer (his answers are only suggested answers and there is rarely just one ‘perfectly correct’ answer to Paper AFM questions.
Whichever way you choose to round, you should always at least mention the existence of any over or under hedge.
(Have you watched my free lectures on this?)
So both methods would be acceptable (ie both answers are right) and would earn credit…right sir?
As (1) would result in under hedge and (2) would result in a minimal over hedgeYes, what you write is correct and both are acceptable.
(The marks in Paper AFM are not for the final answer – there are often more than one ‘correct’ answers – but for proving you understand how the futures are working.)
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