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Dear John,
After your lecture, i tried attempting some past exam question. Mar/Jun 2016 Q1. My main issue is just the currency future contract. How they arrived at this answer 0·8638 + (2/3 x (0·8656 – 0·8638)) = 0·8650. Can you please explain? Below is the question extract..
It is expected that Lirio Co will receive Euro (€) 20 million in three months’ time from the sale of its investment. The
€ has continued to remain weak, while the $ has continued to remain strong through 2015 and the start of 2016.
The financial press has also reported that there may be a permanent shift in the €/$ exchange rate, with firms facing
economic exposure. Lirio Co has decided to hedge the € receipt using one of currency forward contracts, currency
futures contracts or currency options contracts.
The following exchange contracts and rates are available to Lirio Co.
Per €1
Spot rates $1·1585–$1·1618
Three-month forward rates $1·1559–$1·1601
Currency futures (contract size $125,000, quotation: € per $1)
March futures €0·8638
June futures €0·8656Currency options (contract size $125,000, exercise price quotation € per $1, premium € per $1)
Calls Puts
Exercise price March June March June
0·8600 0·0255 0·0290 0·0267 0·0319
It can be assumed that futures and options contracts expire at the end of their respective months.The answer has apportioned between the March futures price and the June futures price.
So to get a lock-in rate in 3 months time (which is what we need) we can take the March futures price (which is in 1 months time) and for the extra 2 months add 2/3 of the difference between the June futures price and the March futures price.However, the answer makes it clear that calculated the lock-in rate in the more correct way (the way I explain in my lectures) would get full marks.
Hello John
Thank you so much for taking out time to explain further… However, i don’t understand how the 2/3 is arrived at. From 1st March till 30th June seems four months. My emphasis is on the 2/3.
Many thanks
!st March till 30th June is indeed 4 months.
However March futures expire at the end of March and June futures expire at the end of June.
From 1 March until end of March is 1 months, so we need an extra 2 months until the Euros are received.
There are 3 months between the end of March and the end of June, so for an extra 2 months we need to add on 2/3 of the difference between the March and June futures.
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