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KYT inc
Assume that it is 30 jun.kyt is the company located in the usa that has contaract to purchase goods form japan in two months time,on 1sep,payments is made to be in yen and will total 140million yen .
Managing director of KYTINC wishes to protect the contract against adverse movement in foreign rate ,and is considering the use of currency futures.the folling data are available
Spot foreign exchange rate
Yen/$128.15
Yen currency future contract on SIMEX ( Singapore monetary exchange)
Contract size 12,500,000.contract size are in us$ per yen contract price
September 0.007985
December .008250 assume that contract mature at the end of month.
Required
A illustrate how KYT might hedge its foreign exchange risk using currency future 4 marksB show that how basis risk is involved in proposed hedge .2 marks
C assuming spot rate is 120yen/$1 on 1 september and that basis risk decreases steadily in linear manner, calculate what result of hedge is expected to be .briefly discuss why this result might not occur. margin requirement and taxation may be ignored.7 marks
D discuss the problem of using future contracts to hedge exchange rate risk. 7 marks
AnsB The basis risk is the difference between current spot rate and the future price in this case (128.15-125.23)=2.72yen
Basis risk will be zero at he maturity date of the future contract,30 September,if it reduces in linear manner over the 3 month to contract maturity ,the expected basis risk on 1 September is 2.92/3=0.973yen
The expected future price on 1 September is therefore 0.973yen below the spot price of 120yen/$1.this is y119.027/$1 or $.008401/yen
My problem is that why .0973yen is deducted from 120 yen when yen has strengthen in spot market, before 30September yen should be more than 120yen/$1 ,since from in 30 jun spot price is 128.15yen/$1 and on 30 sep it is 120yen/$1,so I think yen/$ on 1 september should be more than 120yen/$1
If the Yen is strengthening, then $1 will buy fewer Yen.
If at the moment $1 buys 120 Yen, then with a stronger Yen, $1 will buy fewer Yen.
my exact question was why .0973 is deducted from spot price120yen/$1 of 1 september to calculate expected future price of 1 september and this is y119.027/$1or $0.008401/yen.?
spot price at 30 jun is yen /$128.15
and at on 1 September is 120yen/$1
and the basis calculated on the difference between spot price and september future, is The basis risk is the difference between current spot rate and the future price in this case (128.15-125.23)=2.72yen
and the expetcted basis on 1 sep is 2.92/3=0.973my question is only why 0.0973 is deducted from spot price of 120yen/$1 to get expected future price in future contract,.
Sorry – I read you original question too quickly 🙁
The reason is that currently the futures price is below the spot price. Over the period until the end of the future they converge until the difference is zero. Since the futures price is lower now, it will remain lower throughout (with the difference getting smaller).
but iam still confused and could not understand totally,my next question is- when there is future price in future contract is below the current spot rate at 30 jun ,and if after 2 months the spot price is lower then of 30 jun ,and at this condition we need to calculate expected future rate then we have to deduct the basis since basis reduces in linear manner ?
I will like to tell u about my understand on this matter -when future price in future contract is lower than in spot market then future price in future price in future contract will remain lower throughout the year.
whether I am right or not please tell me on my understanding of above matter
Just as the spot rate will change from day to day, so too the price of a September future will change from day to day.
If the futures price today is lower than the spot rate, then it will always be lower (although the basis will reduce, because on 30 September the two must be the same). We assume that the basis reduces linearly, althought it practice it does not have to be linear).It is the fact that the spot and the futures price go up and down together that makes it possible to use futures to hedge against the risk of exchange rate movements on the transaction.
The profit or loss that we make on the buying and selling of the futures will ‘cancel’ the gain or loss on the transaction itself.It will be worth you watching my free lectures on here about futures if you have not already done so.
Respected Sir
I would like to boost my confidence my modifying my initial question but only 1 things is changed here and that is spot price at 1 September is assumed to be 135yen/$1 and except this all other remains as it from original question
such as basis is still 0.973yen
as the yen has depreciated in the spot market after 2months,what will be the expected future price in the future contract ?
will it be
A 135-0.973=134.027yen/$1 ( or $0.00746/yen) ?or
B 135+0.973=135 yen/$1 (or $0.00735/yen)
which 1 will be the right answer ? A or B
A is the correct one. Since the futures price is lower than the spot rate at the moment, it will still be lower on 1 September.
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