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Hi. Sorry for yet another question and making you a step closer to becoming my private online tutor.
Say the contract currency is in GBP and company is due to receive $ in dec.
So, we should open the position by buying GBP currency futures now.
In calculating the number of contracts to buy, since the amount receivable is in $, we need to convert it to the GBP equivalent. My question is this – what rate do we use to convert the $? The current spot rate? Or the current futures rate?
Kaplan study text and Bob Ryan’s book uses the current spot rate, but opentuition notes and online lecture uses the current futures rate, while the revision kit uses the estimated lock-in rate!
Thanks.
Most sensible is the current futures price (although there is a good argument for using the lock-in rate).
For the exam do not worry – whichever you use is unlikely to make a difference of more than 1 contract and the marks are more for showing you understand how futures work.
Hi, tutor:
Follwoing your answer to the above question (you say that there is a good argument for using the lock-in rate), can you clarify
1) how can we estimate the lock-in rate?
2) if we are asked to compare future hedging with forward rate and option hedging, can we just use the estimated lock-in rate to make the comparison? (I mean instead of calculating and comparing the total receipts of the company )Thanks a lot, waiting for your clarification.
The lock in rate is the current futures price, plus the estimated basis risk on the date of the transaction.
And yes – use the lock-in rate to compare with other methods.
What does lock-in rate stand for? Why is it a good argument for using it, pls?
If it is a ‘fixed rate’, forward rate is also fixed, what are the differences between them, pls?
Thanks you.The lock-in rate does effectively fix the rate. (Although not perfectly for two reasons – one is that it only fixes it on the contract amount, and because of the fixed size contracts this amount may not be exactly equal to the amount at risk. Also, it assumes that the basis falls linearly, when in real life it may not be linear)
The huge benefit of futures over forward rates, is that they are completely flexible as regards the date – you can finish the futures deal whenever you like. The problem with forward rates is that you are stuck with a fixed date which is a problem if the customer pays you earlier or later than you expect.
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