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Dear Sir,
It seems lock in rate only works in questions where we are given different future rates but an example of how it can be calculated from spot rate and a future rate is also given in past paper exams but when I try to solve the following question by lock in i get wrong answer but time line approach solves it.
It is 1 April. A US company buys goods worth €745,000 from a German company payable on1 May. The US company wants to hedge against the euro strengthening against the dollar.
Current spot is $0.9212 = €1 and the June futures rate is 0.9245.
The standard size of a 3-month € futures contract is €125,000.
On 1 May the spot is 0.9351.My question is when do we use lock in rate and when timeline approach?
When we are given the spot rate on the date of the transaction, then we are capable of calculating the basis risk and therefore the future price on the date of the transaction. We then convert the transaction at the spot rate on that date and also calculate the profit or loss on the futures.
If, as is much more likely to be the case in the exam, we are not given the spot rate on the date of the transaction, then we have no choice but to use the lock-in rate (which gives the net effect of converting the transaction at spot together with the profit or loss on the futures).
Given that the calculation of the lock-in rate uses the same arithmetic as does the calculation of the futures price on the date of the transaction, both approaches will give the same end result of (in this case) $687,114.
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