- This topic has 3 replies, 2 voices, and was last updated 5 years ago by
.
- Posts
Dear John,
I believe I have bit confusion in this area. I am not getting the grasp of the concept. Kindly bear with me.
Looking from example 11’s perception,
we had calculated the solution as: we pay £338,403 for transaction and recevie £865 gain on hedge = Net payment of £337,178 – (A)
Now, if we apply concept of lock in rate to the same exmaple: futures rate (today: 20/Jun) = $/£ 1.4840 + unexpired basis 0.0003 = $/£1.4843
contract amount = 5 x £62,500 = £312,500.
Contract amount £312,500 X Lock in rate $/£1.4843 = $463,843.75 – (B)
converting (B) to GBP using spot rate on 12th september = £ 463,843.75 / 1.4812 = £313,154.03 – (C)Thus, if lockin rate gives us the net effect on date of transaction (equivalent to that converting the transaction on the date of transaction at spot and gain/loss made on the futures), then shouldn’t (A) be equal to (C)? And if that should be the case then why isn’t (A) = (C) in this case? Is it due to over/under hedge?
The reason is that you have gone wrong in the last step.
Applying the lock in rate to the contract amount means that the contract amount of GBP 312,500 will convert to $463,844.
So they will get $463,844 at a cost of GBP 312,500.However they need a total of $500,000, which means that they are short by $36156 (500,000 – 463,844) – they have under hedged.
So they will have to buy the $36156 at the spot rate on 12 September, and it will cost them 36156/1.4791 = GBP 24,445.So the total cost in GBP will be 312,500 + 24,445 = GBP 336, 945.
Obviously this is still different from the GBP 337,178 (by GBP 233), but this is irrelevant for the exam (it is due to the fact there is the spread on the exchange rates rather than just the one rate for both buying and selling $’s).
In the exam, if you are told a spot rate on the date of the transaction, then you use the first method (i.e. calculate (A) in your example). However almost always these days, you are not given the spot rate on the date of the transaction and therefore use the second method (as corrected in this reply).
In both cases there is (in this case) an under-hedge and this amount is still at risk (because it has to be converted at whatever the spot rate is on 12 September, and this is uncertain). You should always state that this amount is at risk, and if there are forward rates given in the question then the risk could be eliminated by using the forward rate on the amount of the over or under hedge.
I hope that all makes sense 🙂
- The topic ‘Lock in rate’ is closed to new replies.