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Hi John,
I am looking at past exam questions like June 11 Q2. Could you please explain a little more about futures. On what amount number of contracts are calculated – on today’s futures price or on estimated futures price? And in text book says if we receive foreign currency then we have to sell contracts today and buy back on receipt day. But in this question contracts are bought . And should not we have to calculate profit/loss made on futures?
With regard to the number of contracts calculation, is is actually arguable. I think it better to calculate on the current futures price, but the current examiner seems to do it on the predicted futures price. It is a small point and does not really matter in the exam which you choose.
The rule about buying or selling futures is that you should look at the contract currency – here the contract size is EUR 125,000 so the contract currency is Euros. You should then buy or sell futures depending on whether the underlying transaction involved buying or selling the contract currency.
In this question we are received $’s, therefore the underlying transaction will involve selling $’s and buying Euros. Since the contract currency is euros, we should buy futures.With regard to calculating the effect of using futures, you have two choices. Either convert the underlying transaction at whatever spot turns out to be, calculate the profit or loss on the futures, then total up the two.
Or alternatively calculate the lock-in rate (as the examiner has done in this answer) and simply convert the transaction at that rate.Thank you for explanation. Just to make sure I understand right. It is not important what currency we are paying and what we are receiving. I just have to look at contract currency. So it means if I am in the UK and contracts are in €’s then I will have to sell contracts (because I do not have €’s). Right? And then just convert actual payment/receipt as normal and add gain/loss on futures to actual transaction on payments/receipts day?
or use lock in rate as you mentioned. But here I have an another question. What is meant by lock-in rate? Are those 2 different? – futures rate and futures lock-in rate?
About those 2 methods. What is the difference between them?
Not quite.
1 Check what the contract currency is.
2 Decide whether the underlying transaction will result in buying or selling that currency.
3 If it is buying that currency, then we need to buy futures. If it is selling that currency, then we need to sell futures.
The lock-in rate is a prediction of what the net effect will be of converting the transaction at whatever spot rate happens to be, and any profit or loss on the futures deal.
We are able to predict what the net effect will be because we can predict how the spot and the futures price will move against each other.At the moment I do not have a lecture on this. However, I will either record one or post up a full article explaining it. I am teaching at the moment, so it will be two or three weeks before I will be able to do this.
I know I am a headache 🙂 but here is another example.
We are in US and contracts are in €’s.
We expecting receipt in €’sEuros will have to be sold. So as we will be selling euros (which is also in euros as contract currency) we will sell futures and then buy back on the receipt day. Is it correct?
I think I finally got it 🙂 Thank you John for your patience and invaluable help 🙂
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