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Hello,
Please could you help me with the following question?
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Problem: A UK company needs to make a payment of 393,265 Euros in 2 months time. What is the cashflow in 3 months time if futures are used? (today is 20 April)
Data:
Futures price in £ per Euro: June: 0.6964 (contact size is 125,000 Euro)
Two months forward in Euros per £: 1.433-1.459Answer:
SET UP TODAY (20 APRIL):
1. Euros of cover needed = 393,265
2. Contract size = 125,000
Number of contracts = 3
3. June future: Buy euros at 0.6964OUTCOME (20 JUNE)
4. Actual transaction at June spot rate
Actual cover (393,265)
Spot rate 1.433 £(274,434.80)
Compare to April spot (1.439)
= £273,290.50 therefore bad news in June
5. Futures – profit or loss [!!! I AM STUCK HERE !!!]
April – to buy 0.6964
June – to sell 0.6978 (w(i))
profit 0.0014 (14 ticks)profit per contract = £12.50 x 14 = £175
Total profit (3 x 175) = £525
6. Net position
Actual £(274,434.80)
Future 525.00
Net position £(273,909.80)WORKING 1:
End of April:
June future: 0.6964
Spot (1/1.433): 0.6978
Basis (0.0014)
(2 months’ timing difference)End of June:
June future: 0.6978
Spot (1/1.433): 0.6978
Basis: NIL
(0 months timing difference)#############################################################################################
Please could you tell me why they are calculating a “profit on the futures”? Why don’t they just calculate the cost of the futures plus the cost of the forwards (for the remainder of the hedge not covered by the futures)?
Thanks,
Stu
When we are using future, there is no cash flow when the deal is started. Only when the deal is ended (closed off) is there a cash flow – we receive any profit or pay in any loss.
The underlying transaction continues as normal (we convert at whatever the spot rate happens to be on the date of the transaction) and the profit or loss on the futures ‘cancel’s’ out what we have lost or gained on the transaction (but not perfectly because of the basis risk and the contract size).Great, thank you John 🙂
Please could you explain why the forwards have a spread whilst the futures contracts are have a single price? I thought futures were exchange based whereas forwards are direct contracts so wouldn’t have a spread?
Thanks,
Stu
Futures do in fact have a spread, but in the exam you are only ever given one price (except for just one question which was set by the previous examiner).
The reason that forward rates have a spread is for the same reason that spot rates have a spread – the difference is effectively the banks profit 🙂
Thank you John 🙂
In Step 5 / Working 1, please could you explain why the future’s sale price is assumed to be 0.6978 (the June forward’s buy price at 1/1.433)? (i.e. why isn’t it still 0.6964 which it was at the end of April?)
Thanks,
Stu
I don’t know where you got the question from, but (assuming you have given all the data in the question) then it is all rather rubbish 🙂
The idea in the answer is correct – convert the transaction at whatever spot happens to be on the date of the transaction, and calculate the compensating profit or loss on the futures deal.
However, we need the current spot rate (in order to calculate the basis risk as of today – the difference between the current spot and the current future price) and then we need to estimate what the basis risk will have fallen to on the date of the transaction (in 2 months time – i.e. 20 June). We would do this by assuming that it falls linearly to zero on 30 June (the end of the future) – that means counting the days.
Also, (but I guess this must be a typing error) the question asks for the cash flow in 3 months time – but the transaction is in 2 months time!! If that is not your typing error, then it is stupid 🙂
Hi John,
It’s from BPP’s revision pack so I think it’s a copyright issue if I put the whole question up?
If I just use ACCA’s publically published past papers and solutions from December 2010 to December 2012 do you think that would be OK? Has the sylubus changed much?
Thanks,
Stu
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