Hedging Using Currency Derivatives

1
Hedging Using Currency Derivatives

• Foreign currency futures are traded on the
  Chicago Mercantile Exchange
• Examples of the size of certain contracts
  include
• British Pound 62,500BP
• Canadian Dollar 100,000CD
• Euro 125,000Euros
• Japanese Yen 12,500,000Y
• Swiss Franc 125,000CHF
• Australian Dollar 100,000AD
• Mexican Peso 500,000MP

2
Hedging Using Currency Derivatives

• Contract delivery months are
• March
• June
• September
• December
• Prices are normally quoted as USD per unit of
  foreign currency. So, for example
• USD/CHF 0.60053 or 1.66 CHF 1 USD
• USD/Y 0.007592 or 131.72 JPY 1 USD
• USD/BP 1.43160 or .699 BP 1 USD
• USD/Euro 0.9062 or 1.104 Euro 1 USD

3
When Might You Hedge a Foreign Currency
Transaction?

• Anytime your assets and liabilities are in
  different currencies
• Lets say your accounts receivable are in a
  foreign currency, but your accounts payable are
  in the domestic currency
• Consequently, you are expecting receipts in one
  currency, but expect to make your payments in
  another
• Use a Futures contract to lock in a rate.
  Remember you are locking in an effective rate.
  You now have 2 distinct transactions which will
  offset each other to provide the effective rate
  youve locked in!

4
Example of a Foreign Currency Hedge

• Make the following assumptions
• It is December 31 and your company has just
  signed a contract to sell 25 large earthmovers to
  a German mining company with delivery in exactly
  6 months
• Delivery price is EUR 25.0M
• Delivery and payment of the earthmovers will be
  the end of June
• Current USD/EUR exchange rate is 0.87936
• Price of a June contract for EUR is .8767
• In this particular case, You must make an initial
  outlay of USD 21M which you can borrow at
  7.1225
• Should you undertake the project?

5
Example of a Foreign Currency Hedge (cont)

• You borrowed USD 21M to get the project started.
  How much must you repay in 6 months if the annual
  interest rate is 7.1225?
• In order to break even, what must the Spot
  exchange rate be in June?
• If you want to hedge, how do you decide if you
  buy or sell a contract?
• If youll be receiving foreign currency you enter
  into a contract to deliver that currency
• If youll be paying in a foreign currency, you
  enter into a contract to receive that currency

6
Example of a Foreign Currency Hedge (cont)

• How many contracts do you have to sell?
• You will deliver foreign currency in June at an
  exchange rate of .8767
• This will give you an effective exchange rate.
  What is the price you will receive in USD?
• How does the hedge work if the exchange rate at
  maturity
• Falls to .8700
• Rises to .8900
• Remember you have 2 distinct transactions that
  offset each other to achieve the effective rate!

7
Spot Futures Parity

• If Spot Futures parity states that the Futures
  rate is equal to the current price plus a
  carrying cost, how can the futures rate on
  foreign currency exchange be less than the
  current spot rate?
• Although risk free interest rates vary from
  currency to currency, you should not be able to
  make risk free profits simply through foreign
  currency trading
• Interest rates should reflect the differences in
  exchange rates to prohibit arbitrage profits
• So, just how does this work??

8
Interest Rate Parity(cont)