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Foreign exchange risk management (1) Part 5 – ACCA (AFM) lectures

VIVA

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  1. Hi Sir,

    Thank you once again for the brilliant lecture. You make studying ACCA an enjoyable experience.

    My question is, when do we know whether to buy or sell futures first?

    In BPP workbook, activity 4 – the company was expected to receive xxxx $ so they entered into a contract to buy pounds first.

    This makes me extremely confused at the moment

    Hope to hear from you, thank you for your selfless support

    • It depends on which currency the contract size is quoted in.

      If the transaction itself involves selling $’s, then if the contract size is quoted in $’s we sell futures (and buy back later).
      If the transaction itself involves buying $’s and the contract size is quoted in $’s then we buy futures (and sell later).

      I do explain all of this in my lectures on futures.

      • Thank you for the prompt response. I understand now.

        To clarify further, if a transaction involves selling $, it means that a company based in UK will be receiving USD therefore they sell USD and buy pounds.

        And, if a transaction involves buying $, does that mean that a company based in UK has to make payment in USD therefore they buy $?

        So sorry for the questions. I watched the lectures but was confused with this part

        Thank you kind Sir

    • It depends on what the contract currency is, as explained in the lecture. If the transaction involves being the contract currency then we buy futures. If it involves selling the contract currency then we sell futures.

  4. John in example 8, the final step is 800,000 x change in futures rate to get the ‘profit’ or ‘loss’. You have down that it is $16,000. Why is it not £16,000 as the purchase of futures was £800,000, then convert that £16,000 to $ at spot?

  5. Thank you for the lecture on currency futures. I’m not there yet but working on it.

    Just clarify that the spot and future price increase by 0.02 is added to the September futures £1.5580, making £1.5780.
    However, the previous examples on Forward contracts example 4, the 3 months forward rates were given as 0.62-0.51 which were subtracted to the 4th and 5th digits of the spot rate $/£ 1.5326-1.5385. This confuses me because 0.02 I was referring to the last digit of £1.5580, making £1.5582.

    To round up my undestnading, the currency futures do not completely hedge the amount at risk it’s only fluctuates the market volatility which the exposure of loss have to be absorbed by an investor.
    How does a broker make money on this highly volatile transaction?

    Thank you very much,
    Daiva

    • The adding of 0.02 in the example was just to give a simple illustration of the basic way in which futures work.

      However forward rates are quoted in a special way and differences from spot are quoted in cents (so 0.62c = $0.0062).

      The two reasons that futures do not completely hedge the risk is because of the contract size (which means it is unlikely that the exact amount can be hedged) and because of the basis (the spot and futures price do not in real life move linearly). Depending on the underlying transaction, some people buy futures and others sell futures. So depending on which way the futures price moves, some make a gain and some make a loss (the dealer makes the opposite gain or loss).
      If you have more questions then please ask in the Ask the Tutor Forum.

  8. I don’t quite get why do we need to buy these futures at all in this example. Why can’t we just spend $1,250,480 to buy GBP on 12th of June? Why do we need to go through all these transactions with futures just to arrive to the same result as if we just bought the currency on spot?

    • Where are you going to get the moment from to be able to convert now? Presumably you would need to borrow it and then have to pay interest on it? (And what if you were going to receive money on a future date – again you would have to borrow money in order to convert now).
      Of course you could do that – that is what money market hedging is, as I explain in the earlier lectures. However I also explain what the problems are and why you might prefer using futures, forward rates, or options. Which is the ‘best’ approach depends on the circumstances and the amount involved, as again I explain.

  9. Dear John,

    Thanks for the lecture.

    Example 8 on Currency Futures. Please clarify because I’m still in doubt about what the requirement trying to say (if the spot and future price increase by 0.02)

    The spot rate on Example was 1.5631 (buying GBP) on 12 June Today, but the Answer says 1.5631 was on 10 August. Can you explain what have I missed out?

    If R buy GBP 800,000 furtures now at 1.5580 on 12 June, R will pay $1,246,400
    Compares to the spot rate 1.5831 (1.5631 + 0.02) on 10 August later which R $1,266,480 would have paid.
    Therefore R will pay less $20,080 (net savings) if buy the futures now.

    If R buy GBP 800,000 Spot now at 1.5631, R will pay $1,250,480.
    The Future, value at 1.5780 (1.5580 + 0.02) on 10 August which is $1,262,400 R would have paid. Therefore still a net savings of $11,920.

    So the most viable option will be buying futures now on 12 June at 1.5580. Does this make sense?

    Thank you.
    Bob

    • There is a typing error in the printed answer. If they were to convert the money ‘today’ (i.e. 12 June, then they would pay $1250480.

      However, they are not converted today. Instead they are converting on 10 August when the rate is 1.5831. To hedge against the risk they are buying futures today at 1.5580 and selling them on the 10 August at 1.5780. The net result on 10 August is that the risk has been hedged exactly and they end up paying a net 1250480. (But as you will see in the later examples this is only to illustrate the idea – in practice it will not be a perfect hedge because of basis risk and contract sizes).

      I will have the wording in the printed answer corrected, but I do show it correctly in the lecture.

  10. John, suppose I speculate on the prices of March future. For the future we can have multiple deals until the last day of March, right? and the profit / loss is calculated on each individual deal, right? So by the last day, i could have profit on some and losses on the other, right? And land with a net loss / profit collectively, but i have to pay the dealer individually at the end of each deal i close, right?

      • No we don’t assume that we are the bank at all!!!

        The company needs to buy Pounds. The Dollar is quoted against the Pound. Using the lower rate would mean it would cost the company fewer dollars, which could not possibly be the case – it is always the bank that gains and ‘us’ who lose.

        Have you not watched the earlier lectures, especially the first in this series, because I use several examples to explain which rate we use depending on which way the exchange rate is quoted, and which currently the company is buying or selling. How you learn the ‘rules’ is your choice – I explain what I regard as the easiest way to remember it. But you cannot simply say ‘the bank sells low’ without deciding which currency they are selling and which way round the exchange rate is quoted!!!!

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