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Dear Mr. Moffat
I can’t understand the answer for Polytot from the BPP revision kit. From my understanding I would
– get 43 contracts by using 4,124,236/1.5275
– estimate future spot rate as opening futures price =1.5275
– thus estimate future closing price as 1.5275-0.0078=1.5197
– lose 62,500*43*(1.5197-1.5275)=-20,962Dollars on the futures
– receive 4,124,236/1.5275=2,699,990 Pounds on the spot market from the transaction left at risk
– arrive at the lock in rate of 4,124,236Dollars/(2,699,990Pounds-20,962/1.5275Pounds)=1.5353This I understand in the BPP Answer. But when it comes to over-/underhedging my answer differs. I would
– calculate an underhedged amount of 4,124,236Dollars-43*62,500Pounds*1.5275(opening futures price)=19,079.75Dollars
– hedge this with the forward rate19,079.75Dollars/1.5374=12,410 Pounds
– arrive at a total receipt of 1,686,267+12,410=2,698,677 Pounds
– get an effective rate of 4,124,236/2,698,677=1.5282But in the BPP answer they suddenly jump to the lock-in rate for the calculation of over-/underhedge and spot market transaction. They
– calculate an overhedged amount of 43*62,500*1.5353-4,124,236Dollars=1,883Dollars
– use the interpolated forward rate for hedging 1,883Dollars/1.5337=1,228Pounds
– translate the future loss at the so-called “closing rate” of 1.5275 (20,963/1.5275=13,724Pounds)
– calculate the “spot market receipt” as 43*62,500*1.5353/1.5275=2,701,224Pounds
– get an effective rate of 4,126,119/(2,702,224-13,724-1,228)=1.5360Why do they suddenly switch to the lock-in rate for calculating over-/underhedge? Why is the “spot market receipt” calculated with the lock-in rate over the future spot? There’s a missing link for me.
Thank you.
I am away from home until Sunday night and I do not have the BPP Revision Kit with me. Please ask again on Monday and I will answer immediately 🙂
I am a bit puzzled because the answer in my edition of the BPP Revision Kit does not do any calculations on the over-hedge in relation to the futures (and neither does the examiners own answer).
Before I say more about the over-hedge, the BPP answer (in my edition of the revision kit) is very poor for two reasons. One is that after their calculation on futures they show “alternative calculation of the effective rate (a quick approximate method)”. This is not an approximate method at all – it is calculating the lock-in rate and is the better way of doing it (because it is faster) and is the way the current examiner always does it.
They also show a calculation for the over-hedge when dealing with the options. Again the examiners own answer does not show this and it is not something that you would normally do when using options anyway. By using forward rates on the over-hedge you are committed to the conversion which is fine if the option ends up being exercised, but is certainly not fine is the exchange rate were to move in our favour and therefore the option is not exercised.With regard to the over hedge on the futures, the lock-in rate of 1.5353 is the effective rate at which the contract amount will end up being converted. i.e the net effect of converting at spot together with any gain or loss on the futures. So they know in advance that the contract amount will end up converting at 1.5353.
So we also now know in advance that $1883 will not be covered by the futures (as per the workings you have quoted form the BPP answer) and so it is this amount on which you would use forward rates if we are to eliminate all the risk.Again, neither my edition of the Revision Kit nor (more importantly!) the examiners answer do any calculations on the over hedge. Ideally you should do the calculations in the exam, but that part never carries many marks and because of time constraints more important is to mention the fact that there is an over or under hedge – even if you do not do calculations on it you are then unlikely to lose more than 1 mark.
I assume that you have watched my free lectures on foreign exchange risk management, but if not then you might find them helpful 🙂
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