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Foreign exchange risk management (1) Part 8 – ACCA (AFM) lectures

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  1. Hi , here you have said that the spot is higher hence we subtract it to find the lock in rate , suppose spot-futures gives us a negative unexpired basis . so do we do futures – unexpired basis ( the negative amount)

  5. Hi John,

    Thank you for your amazing lectures.

    At e.g 11 ,can u please show in figures how can we arrive to the answer £337,178 using the lock-in rate.

    From my understandung, we will convert the contract value of £ 312,500 using the lock-in rate of 1.4843 to be USD 463,843.75, but since the contract value is not equal to the transaction value we have to factor in the under-hedging value of £24,427 in order to reach the final answer

    I have 2 question here:
    a) which rate to be used to convert the $ 463,843.85 into £
    b) how can we factor the under-hedging

    Answering above questions will clarifiy for me how can we arrive to £337,178

    Thank you John

    • The $463,843.75 converts to GBP 312,500. The under-hedge is $24,427 ($’s not GBP) and to remove the risk on this we would use the forward rate if available (but of course we are not given a forward rate in this example and so it would have to be left at risk and converted at the spot rate on the date of the transaction).

      • Hi John. Firstly, thank you for the great notes and lecturers – very much appreciated. I am a little stuck on this too though. Like others, I have tried to use the lock in rate for question 11, and reached what you have described above, that is, the futures value of £312,500 converts to $463,844.

        However, isn’t the under-hedge amount $500,000 – $463,844 = $36,156 ?
        Which must then be converted at spot on the transaction date, so that would be $36,156 / 1.4791 = £24,444, making the total GBP payment £312,500 + £24,444 = £336,944?

        Can you please explain how you got the under-hedged amount of $24,427 (and what I have done wrong!)? Thanking you in advance

      • Sorry, it was my mistake in my previous reply. The under hedged amount is indeed $36,1565.

        However I think the real confusion here is caused by the fact that we are not using the lock-in rate in this question, and so we do know that of the $500,000 that we are receiving, only the risk on the contract amount is ‘protected’ against risk which is why the net receipt using the futures is not the same as the recipe would have been had we been able to convert it at the current spot. Of the $500,000 we know that $463,844 is covered by the futures and the remaining $36,156 is not covered. The $500,000 that has been converted at spot included the $36,156 that is not covered by the futures and so there is nothing else to be done. However, given that we knew in advance that $36,156 was not covered, then had there been forward rates given then what we could have done is used forward rates on the $36,156 so that when we did receive the $500,000 then $36,156 would be converted at the forward rate (and so be protected against risk) and the remaining $463,844 would be converted at spot (and would be ‘protected’ against risk by the futures deal).

  6. Hi John,

    As someone has done above, I am applying the lock-in rate to example 11, but either I am not understanding correctly or something is amiss.

    I am attempting to set out my answer by calculating the lock-in rate, followed by the result of the hedge and finally the under/over hedge.

    Lock-in Rate: The current futures price of 1.4840 plus the unexpired basis of 0.0003 gives a lock-in rate of 1.4843.

    Hedge (as seems to be mentioned in the above lecture): Contract total of £312,500 * Lock-in Rate of 1.4843 = $463,852

    Under/Over Hedge: Payment due of $500k less Contract total at Lock-in Rate of $463,852 = $36,148.

    However, the above does not seem to square with your discussion higher on this page with Hamjath.

    Also, whilst not possible due to the contract size, am I incorrect in thinking that $500k / Lock-In of 1.4843 should result in the same Net Receipt from Example 11? Because the example result is £337,157, but $500k/1.4843 = $336,853.

    Guidance on the above/an example of using the Lock-in Rate for Example 11 would be greatly appreciated.

    Best,

    Kyle

  7. great lecture!
    sir, so does it means that we can actually applied the lock in rate even though the spot rate is available on transaction date in order to calculate the future price on transaction that?

  8. Hi sir!
    Your videos are really really amazing and it just keeps up my interest in learning the subject increasing day by day….. I have a doubt. Could u pls explain when do we exactly add or subtract the expired or unexpired basis?

  10. Hello, John!
    Could you please explain what exactly is the contract amount for using the lock-in rate.

    Applying to Example 11:
    1) I’m not sure if the contract amount is our initial $500,000
    OR
    the contract amount is amount of contract size (62,500) multiplied by 5 hedging contracts?
    2) When i assume that $500,000 is a contract amount (which i’m not sure – see 1 above), and using lock-in rate of 1.4843 I get an answer of 336,859 pounds, which however does not reconciles to the answer we obtained in Example 11.

    Could you please explain what are the reasons for this difference??

    Thank you in advance!
    Nick

    • Although we wish to hedge $500,000, we cannot because the contract size is GBP62,500.

      Therefore because we have to hedge in fixed sized contracts we are actually hedging 5 x 62,500 = GBP312,500.

      The difference is an over or under hedge which is not hedged using futures (although we could use a forward rate on that amount, if forward rates are available).

      • hello John

        If contracted value is GBP 312500 , converting this into USD at current spot 12 September (312500*1.4791)= $462,218.75, that again converting it by lock in rate 1.4843 would be GBP 311,405.

        please confirm is these numbers are correct or not,if not state correct one pls.

      • Your figures are correct. In addition there is 500,000 – 462,219 = $37,781 that is not covered by the futures (an under hedge) and so this payment will have to be converted at the spot rate on 12 September (if forward rates were available then we could have used them on this under hedge).

      • As a reference for John’s answer, he converted the contract value of GBP 312,500 to USD$ 462,219 then convert it by the lock-in rate ($/GBP) of 1.4843 to arrive at GBP 311,405.

        I wonder if it’s ok to actually apply the lock-in rate to the contract value first (GBP312,500 x 1.4843 = $463,844). Then convert this back to GBP using the spot rate $/GBP1.4812 and arrive at GBP 313,154?

  11. Hello John, the lock in rate is a far better and faster method of calculating future hedges. It also prevents being proned to mistakes of using wrong exchange rates. Pls can lock in rate be used in all exam questions?

    Thank you

  12. Sir John, I wanted to ask that in the lecture notes the places for the advantages and disadvantage of futures forward rate contracts ,money market hedge etc are left blank . So can you please tell about them or are there any updated notes. ???

  14. mjibola: If the current spot is lower than the current futures price, then the lock-in rate must be between the two and so it will be higher than the current spot and lower than the current futures price.

    If, on the other hand, the current spot is higher than the current futures price, the the lock-in rate must be lower than the current spot and higher than the current futures price (to be between the two).

  15. Ok. But why would it be incorrect to deduct the unexpired basis from the spot or add the expired basis to the future? After all, both results would still be in between the spot and future?

    I’m not clear of that please

  16. Dear John,

    i have a question on how should candidate treat under-over hedging in an exam question. Say a contract size 5.39 rounding to 5 in previous Example 11 . Will student be expected to treat the remaining 0.39 under-hedging if the exam question did not ask?

    0.39 contract under-hedge = £24,427 ($500,000 / 1.4840 ) – (£5 x 62,500)

    Thank you for the lecture.

    • If you have the time in the exam, then yes. However, it never carries more than 1 or 2 marks, and so if you are short of time just write that they could use forward contracts on the under/over hedge, without spending time on the calculations.

  18. Hello,

    I can’t understand why we don’t add EXPIRED basis to the futures rate or deduct UNEXPIRED basis from the spot rate to arrive at the lock-in rate if the difference between two rates falls in 2 months time by 2/3 (on the transaction date).

    It’s really crucial for me to understand. Thank you in advance!

    • BTW, even the specimen exam (p.15) shows that LOCK-IN RATE = lower rate (no matter futures or spot) + EXPIRED basis OR higher rate – UNEXPIRED (no matter futures or spot) basis:

      [Alternatively, can predict futures rate based on spot rate: 1·0635 + [(1·0659 – 1·0635) x 4/6] = 1·0651]

      • Yes, of course it will say that for that question.

        However, it depends on whether the current spot rate is higher or whether the current futures price is higher.

        Appreciate that the the two rates get closer together (they will be the same on the expiry date of the future) and therefore the ‘lock-in rate’ must be between the two. You add or subtract accordingly.

    • I explain this in the previous lectures.

      The contract amount will be given in the question just as in the earlier examples. The lock-in rate is applied to the contract amount (multiplied by the number of contracts, again calculated as in the previous examples).

      • so are you saying that when the lock in rate is applied to the contract amount and the number of contracts the value i get is the outcome of the hedge?
        i do not need to do any added computation?

      • No extra computation is needed (except for hedging any under or over amount using forward contracts – although doing the calculation is more of a bonus mark, the main thing is to at least mention the possibility)

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