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Sir can you clarify these:
1. The spot rate was given as 1.9156-1.9210. Now we know a bank always gains in payment so it will go for the lowest spot rate. Thus we chose 1.9156. Now if the spot rate was given was 1.9210 – 1.9156 we would still choose 1.9156 right ?
2. Basis risk is spot rate minus future price. The future price of December was given then why was the calculation of lock in rate required. I am scratching my head over this for a lot of days.
3. If the hedging was for money being received then we would have chosen the highest spot rate right?.
1. It depends which way we are converting. If the rate you quote in your example were $’s per €, then if the company is buying $’s (and therefore selling €’s) we convert at the lower rate. If the company is selling $’s (and therefore buying €’s) then we convert at the higher rate. I explain all this, with examples, in the first of my free lectures on foreign exchange risk management.
2. The lock-in rate is the net effect on the date of the transaction of converting at whatever spot turns out to be together with the gain or loss that is made on the futures deal. We have no idea as of now what the spot rate will be on the date of the transaction but we do know in advance what the net effect of using futures will be.
3. The spot rate is used to convert money – it is not the spot rate that is used for hedging. Hedging is reducing the risk due to the fact that the spot rate changes.
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