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There’s this method using the basis to predict the futures rate and to calculate the effective futures rate assuming the basis falls to zero proportionally over time.
However, both methods are often not interchangeable. I believe basis is used as such:
Predicted futures rate = opening futures rate – opening basis (time passed/contract length)
Effective rate = opening futures rate – closing basisGiven that both methods require us to start from the opening basis they should somehow be related to one another but in often past exam questions we would arrive at different answers with the 2 methods above when calculating the outcome of the future hedge.
Why is that? Am I making sense?
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Edited.
If we know either the spot rate or the futures price on the date of the transaction, then we convert the transaction at spot and add or subtract the gain or loss on the futures deal.
However more often these days we are not given the spot or the futures price on the date of the transaction and therefore we use the ‘lock-in rate’ which gives the net effect of converting at spot and calculating the gain or loss on the futures.
I do explain all of this in my free lectures on the management of foreign exchange risk.
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