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Dear John,
Regarding both foreign exchange and interest rate hedging questions, I’m confused when I should minus the unexpired basis from the futures rate or whether I should add it to the future rate (in order to get the expected futures price). Could you please clarify?
Thank you!
It depends on the current spot and the current futures price.
If the current spot is higher than the current futures price, then it will always be higher.
Similarly, if the current spot is lower than the current futures price then it will always be lower.This is how to determine whether to add or subtract the unexpired basis 🙂
For Question Cocoa Mocha Chai, Specimen Exam September 2018, to get the closing futures price, they added the unexpired basis to the 6 month future. But in Lirio March/Jun 16, they have minused the unexpired basis, even though for both questions the future is higher than the spot. The same should’ve been done for both. Why is that?
CMC has not added the unexpired basis to the 6 month future. I assume you are referring to the examiners answer in which case (in italics) he has added the expired basis to the current spot rate, which gives exactly the same result as subtracting the unexpired basis from the current futures price.
1.0659 – 2/6(1.0659 – 1.0635) = 1.0651
Because the spot and futures move linearly towards zero, the lock-in rate must always be between the current spot rate and the current futures price.
Incidentally, you can find lectures working through the whole of CMC linked from the following page:
https://opentuition.com/acca/afm/afm-revision-lectures/
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