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Hi John,
Hope you are well.
This is referring to the example you worked out in this video.
With all due respect and I have a lot of respect for you and your work, I think the way in which you did example 9 is wrong.
It doesn’t lead to the wrong answer but I think the principle behind one little part of your methodology is wrong and I am writing because I want to confirm the logic of it.
In the example, T Plc is based in the UK. They will receive $1,200,000 in couple of weeks.
If they converted at current spot, they would get $1,200,000/ 1.5110 = £794176. This is what represents their risk and not the $1,200,000. They are at risk that when they convert their $1,200,000, they won’t get the £794,176 that they would get now.
And thus the contract size has to be for £794,176/ 62500 = 12.7068 and not $1,200,000/1.5045/62500 = 12.7617.
To prove this, we can run a simulation. If we assume that the futures contract could be bought in partial sizes and that the futures price moved exactly as much as the spot prices did (1.5190-1.5110 = 0.008), using 12.7068 contracts would give a perfect hedge whilst using 12.7617 would not.
I hope you have the time to read this comment and to let me know what you think.
Thank you for your work, I am truly grateful for you and your organization.
I agree with what you have written and it would get full marks (although the examiner normally does it as I have done in my example).
It is though not a point to worry about because in the exam the risk will never be completely hedged due partly to the basis risk and partly due to the fact that it is never obviously possible to have partial contracts (and so in exam questions the number of contracts will always need rounding).
The marks in the exam are primarily in the exam for proving that you know how futures ‘work’ to reduce the risk, rather than for one precise final answer. For example, there are arguments for rounding the number of contracts (be it 12.7068 or 12.7617) to either 12 or 13 depending on the circumstances, but using either would get full marks (in this case I would always round up
🙂 )Thank you for the other comments in your post 🙂
(If you have any more questions of me then please ask in the Ask the Tutor Forum and not this one. This forum is for students to help each other.)
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