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I will really appreciate any help as I have trouble understanding one of illustrations in the Kaplan book.
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Europe Co is expected to receive $10m in 4 months’ time, which it wants to translate into €.
The spot rate (quoted as €/$1) is 0.7343 – 0.7355.
Futures market information: ($500,000 contracts, prices quoted as €/$1)
2 month expiry 0.7335
5 month expiry 0.7300Required: Estimate the likely financial result of the hedge, assuming that the spot rate in 4 months is expected to be 0.7337 – 0.7366 €/$1, and that basis reduces to zero in a linear manner.
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In the answer the estimated futures price is 0.7328 (basis of 0.0043 time-apportioned by 5 deducted from spot rate 0.7337).
However, I’m wondering if it should have been deducted from that spot rate – shouldn’t it have been 0.7366 instead? To me, it looks like it should be the ‘higher’ rate being used because the futures will be bought back at the transaction rate and thus the price should be higher (according to the “worse price” rule).
Could you explain why I’m getting this wrong?
Thanks a lot!
The answer is correct it should be 0.7337 only because the contract currency is $, hence we have entred futures market to sell $ in future.
Therefore, if we are selling $s then bank is buying $s from us.
The quotation is 1$ = 0.7337 – 0.7366
(Bid Rate) (Ask rate)
(Bank’s $ Buying Rate) (Bank’s $ selling rate)Since bank is buying $s from us and is giving us Euros in return , that is why bid rate i.e. 0.7337 shall be applicable.
More so why would bank give us more Euros in return for $s, it will put the bank in a worse of position.
Pooja: Please do not answer in this forum because it is the Ask the Tutor Forum and you are not the tutor. (But please do help people in the other Paper AFM forum).
Using futures will not mean selling $’s at a fixed rate. The transaction will be converted at whatever the spot rate is at the date of the transaction. On the same day the futures deal will be closed and the gain or loss on the futures will be calculated.Moveone: The best way to know whether to add or subtract is to remember that as the basis falls linearly to zero, then if the current spot rate is higher than the futures price it will always be higher. Similarly, if the current spot rate is lower than the futures price it will always be lower.
Do watch my free lectures on managing exchange rate risk.
Okay, sorry for the inconvenience caused, I didn’t know that, will keep this in mind from now on!
Thanks for the answer, got your point.
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