Currency futures

A US exporter is expected to receive ₤ 250,000 in December (₤ sell $ buy)

It is currently August

• The spot rate now is $1.85/₤

• The quote for December futures is: $1.85/₤

The US exporter uses futures to hedge its currency risk. Contract size is ₤ 62,500

In December, the company receives ₤ 250,000

• The spot rate in December moved to $ 1.90

• The futures rate in December was also $ 1.90

Show the outcome of the hedge

Solution

In August

Underlying transaction is to Sell ₤ and Buy $

In the future market we should also Sell ₤ and Buy $ since the contract currency for futures is ₤

No of contracts 250,000 / 62500 = 4

In December

Sell at $1.85/₤
Spot $1.90/₤
Loss $0.05/₤
Amount ($0.05)/₤ x 4 x ₤62,500 = ($ 12,500)
Sell ₤ 250,000 x 1.9 = $475,000
Net outcome = $462,500

Underlying Transaction
Future Rate $1.85/₤
Settlement date $1.90/₤
Gain $0.05/₤ x 250,000 = $ 12,500
Future Market (Loss) ($12,500)

Money market hedging

1. A Bangladeshi Company owes a Danish creditor Kr 3,500,000 in three months’ time. The
spot exchange rate is Kr/Tk 7.5509 – 7.5548. The company can borrow in Taka for three
months at 8.60% per annum and can deposit kroners for three months at 10% per annum.
 What is the cost in Taka with a money market hedge and what effective forward rate would
this represent.

Solution

Underlying transaction: payment of Kr 3,500,000

Deposit in Kr 3 months earlier Kr 3,414,634 (3,500,000 / 1.025)
Buy Kr using Taka Tk 452,215 (3,414,634 / 7.5509
Borrowing after 3 months Tk 461,938 (452,215 x 1.0215)
Effective Exchange Rate 3,500,000 / 461,938 = 7.5768

Using Interest Rate Parity Theory So x 1+ if

1+id
7.5509 x 1.025 / 1.0215 = 7.5768

2. A Bangladeshi Company is owed SFr 2,500,000 to be paid in three months time by a Swiss
company. The spot exchange rate is SFr / Tk 2.2498 - 2.2510. The Company can deposit in
Taka for three months at 8% per annum and can borrow Swiss Francs for three months at
7% per annum. What is the receipt in Taka with a money market hedge and what effective
forward rate would this represent?

Solution

Underlying transaction: receipt of SFR 2,500,000

Borrow in SFR 3 months earlier SFR 2,457,002 (2,500,000 / 1.0175)
Sell SFR buy Taka Tk 1,091,516 (2,457,002 / 2.2510
Deposit after 3 months Tk 1,113,346 (1,091,516 x 1.02)
Effective Exchange Rate 2,500,000 / 1,113,346 = 2.2455

Using Interest Rate Parity Theory So x 1+ if

1+id
2.2510 x 1.0175 / 1.02 = 2.2455

OTC Currency option

Sugar Ltd is expecting to receive 20 million South African Rands ® in one months’ time. The
current spot rate is R/Tk 19.3383 – 19.3582. Compare the results of the following actions.

a) The receipt is hedged using a forward contract at the rate of 19.3048.

b) The receipt is hedged by buying an over-the-counter (OTC) option from the bank, exercise
price R/Tk 19.30, premium cost of Tk 24,000.
c) The receipt is not hedged

In each case, compute the results if, in one month, the exchange rate moves to:

a) R 21.00/Tk
b) R 17.60/Tk
Solution

a) Receipt from forward contract 20,000,000 / 19.3048 = Tk 1,036,012

b) Receipt from OTC hedging

R 21.00/Tk R 17.60/Tk
Exercise price R 19.30/Tk R 19.30/Tk
Exercise option Yes No
(option gives more outlay) (Option gives less outlay)
Amount 1,036,269 1,136,364
Premium ( 24,000) ( 24,000)
Net outlay 1,012,269 1,112,364

c) Receipt is not hedged

20,000,000/ 21 20,000,000 /17.60
952,381 1,136,364

Currency hedging
Trumpton Ltd has bought goods from a US supplier, and must pay $4,000,000 in three months
time. The company’s finance director wishes to hedge against the foreign currency risk, and the
three methods which the company usually considers are:

• Using forward exchange contracts

• Using money market borrowing
• Making lead payments

The following annual interest rates and exchange rates are currently available.

US dollar Taka
Deposit rate Borrowing rate Deposit rate Borrowing rate
% % % %
1 month 7 10.25 10.75 14.00
3 months 7 10.75 11.00 14.25

$/Tk exchange rate ($= Tk)

Spot 1.8625 – 1.8635
1 month forward 0.60c – 0.58c pm
3 month forward 1.80c – 1.75c pm

What is the cheapest method for Trumpton Ltd – forward contract, money market hedge or
lead payment?
Solution:

Using forward exchange contract:

Forward rate: 1.8625 – 0.0180 = 1.8445
Payment amount: $4,000,000 / 1.8445 = Tk 2,168,609

Using money market borrowing:

Underlying transaction: payment of $ 4,000,000

Deposit in $ 3 months earlier $ 3,931,204 (4,000,000 / 1.0175)
Buy $ using Taka Tk 2,110,714(3,931,204 / 1.8625)
Borrowing after 3 months Tk 2,185,908(2,110,714 x 1.035625)
Effective Exchange Rate 4,000,000 / 2,185,908 = 1.8299

Using Interest Rate Parity Theory So x 1+ if

1+id
1.8625 x 1.0175 / 1.035625 = 1.8299

Making lead payment:

-
Immediate Payment to buy $ $ 4,000,000 / 1.8625 = Tk 2,147,651
Borrowing after 3 months Tk 2,224,161 (2,147,651 x 1.035625)

Currency hedging
ACE Ltd is a UK based trading company. It has five branches worldwide: England (Head office),
Ireland, Germany, Canada, Malaysia, Bangladesh and Australia.

ACE currently do not hedge although the new financial controller is keen to do so in order to
address the risks facing the business. He has constructed the following illustration to show how
currency hedging usually works.

Transaction: cash receipt due in December of $ 326,000 (Sell $ Buy ₤)

London Market $/₤ exchange rates

Spot 1.8906 – 1.8945

Three months forward 0.76 – 0.71 cents premium

Annual three-month interest rates

Borrowing Lending
Sterling 6.5% 4.2%
Dollars 6.0% 3.0%

Philadelphia Stock Exchange

Sterling ₤ 31,250 December (cents per ₤1)

Strike Rate Calls Puts

1.88 2.77 0.81
1.89 2.17 1.06
1.90 1.61 1.50
1.91 1.16 2.05

Requirements

(a) Suggest reasons why ACE may not need to undertake any hedging activities
(b) Discuss three forms of hedging that might be beneficial to ACE. You should give an
advantage and disadvantage of each method and comment on whether this would be
an appropriate method for ACE to adopt.
(c) (i) Calculate the net sterling receipts that the company might expect for its transaction if
it hedges its exchange risk on the forward foreign exchange market.
(ii)Explain how the company can use the money market to hedge its exchange risk
exposure on the receipt of $326,000 in three months time and calculate the effective
three months exchange rate it will achieve.
(iii)The company decides to use traded options to hedge its exposure on its three
months receipt. What will be its total net sterling receipts if it buys options at 1.89 but
the actual exchange rate in three months time turns out to be 1.92?
(d) Explain how the treasurer might make use of interest rate hedges.

Solution

(a)

ACE may not need to undertake any hedging activities one or more of the following reasons:

Costs – could be sometimes prohibitive specially when the domestic currency is stable or being
managed. ACE management may not decide to hedge if cost is prohibitive.

Exposure
The degree of exposure is dependent on:
(a) The size of the transaction, is it material?
(b) The hedge period, the time period before the expected cash flows occurs.
(c) The anticipated volatility of the exchange rates during the hedge period.
The corporate risk management policy should state what degree of exposure is acceptable. This
will probably be dependent on whether the Treasury Department is been established as a cost
or profit centre.

Attitude to risk- What is the risk attitude of management – risk averse or risk taker. If ACE
management are risk takers, they may decide not to hedge.

Portfolio effect – for an international business operating in many countries, the strengthening
in some may be compensated by a weakening in others. ACE is operating in many countries and
may decide not to hedge due to the portfolio effect.

Currency of invoice – If ACE if able to invoice its customers in pound sterling, it will not need to
hedge.
(b)

The three forms of hedging under the circumstances are Forward Rate Agreement, Money
Market hedge and Currency Options:

Forward Rate Agreement

Advantages include:

 fixes the future rate, thus eliminating downside risk exposure

 flexibility with regard to the amount and currency to be covered
 relatively straightforward both to comprehend and to organise.
 No premium payment unlike options
 No adverse movement due to margin requirement
 No basis risk unlike Futures or Options

Disadvantages include:

 no opportunity to benefit from favourable movements in exchange rates as in options.

 Cost may be higher because this is OTC market
 Counterparty risk

Money Market Hedge

Advantages include:

 fixes the future rate, thus eliminating downside risk exposure

 flexibility with regard to the amount and currency to be covered
 No premium payment unlike options
 No adverse movement due to margin requirement
 No basis risk unlike Futures or Options
.
Disadvantages include:
 more complicated to organise than a forward contract
 Cost may be higher
 Counterparty risk
 No upside unlike options

Currency Options

Advantages include:

 fixes the future rate, thus eliminating downside risk exposure

 Opportunity to benefit from favourable movements in exchange rates.
 Cost may be lower
 No Counterparty risk unlike FRA or money market hedge
Disadvantages include:

 No flexibility with regard to the amount and currency to be covered

 More complex compared to FRA
 Adverse movement possible due to margin requirement
 Basis risk
 Premium payment

Forward Rate Agreement

Forward Rate: 1.8945 - 0.0071 = 1.8874

Amount: $326,000 / 1.8874 = £172,724

Money Market Hedge

Underlying transaction: receipt of $ 326,000

Borrow in $ 3 months earlier $ 321,182 (326,000/ 1.015)
Sell $ buy £ £ 169,534 (321,182 / 1.8945)
Deposit after 3 months £ 171,314 (169,534 x 1.0105)
Effective Exchange Rate 326,000/ 171,314 = 1.9029

Using Interest Rate Parity Theory So x 1+ if

1+id
1.8945 x 1.015 / 1.0105 = 1.9029

Currency Options

Underlying transaction: Sell $ and Buy £

Since the currency of option contract is £, the company will have a call option in the Option
Market

Buy option at $1.89/£

No of contracts: $326,000 = 5.5 say 6 contracts
£31,250 x 1.89
Premium payment $ 0.0217/ £ x £ 31,250 x 6 = ($ 4,069)

At spot date in December

Buy option at $1.89/£

Spot rate $1.92/£
Gain $0.03/£
Amount $0.03/£ x £31,250 x 6 = $ 5,625
Receipt $ 326,000
Conversion into £

Gain $ 5,625 1.92 2,930

Receipt $ 326,000 1.92 169,792
Premium $ (4,069) 1.8906 (2,152)
Net Receipt 170,570

(d)
The treasurer can use interest rate hedge to eliminate the risk of adverse movement in interest
rate from the date of signing the contract for borrowing/ deposit till the date of actual
drawdown of the loan or deposit of money. Various forms of hedging that can be done are
Forward Rate Agreement, Futures, Options and Swaps.

You are Finance Director of Westgarth Ltd. a UK based importer /exporter which trades
extensively with customers in Europe. You are concerned about recent exchange rate volatility
and are considering different methods of hedging the exchange risk involved.

The following transactions are expected in 3 months.

Sales receipts € 1,080,000
Purchases payable € 600,000 (Sell € Buy £)

The following economic data is available.

- Spot rate of exchange € 1.4540 – 1.4590
- Euro premium on the three month forward rate of exchange 0.72 – 0.54 cents
- Annual interest rates for three months
o UK 5.50% - 5.75%
o Europe 3.75% - 4.00%
- Option prices (cents per £ contract size £12,500)

Calls Puts
Exercise price 3 month 6 month 3 month 6 month
1.40 - 15.20 - -
1.45 2.65 7.75 - 3.45
1.50 1.70 3.60 - 9.32
Assume that the contracts expire three months from now.

Requirements:
(a) Calculate the net Taka receipts that Westgarth can expect from its transactions if the
company hedges the exchange rate risk using each of the following alternatives:
a. The forward foreign exchange market
b. The money market
Include in your calculations a brief explanation of your approach and recommend the
most financially advantageous alternative.
(b) Explain the factors that the company should consider before deciding to hedge the risk
using the foreign currency markets, and identify any alternative actions available to
minimize risk.
 (c) Describe (i) the characteristics of a fixed forward exchange contract and (ii) the relative
advantages and disadvantages of using foreign currency options.
Illustrate your points numerically assuming that the actual spot rate in three months
time is either €1.40 or €1.48, and evaluate whether Westgarth would have been better
advised to hedge using options instead of a fixed forward contract.

Solution

(a)

Net Receipt of € 480,000

Sell € Buy £

Forward Rate Agreement

Forward Rate 1.4590 – 0.0054 = € 1.4536/ £

Net receipt 480,000 / 1.4536 = £ 330,215
Money market

Underlying transaction: receipt of € 480,000

Borrow in Euro 3 months earlier € 475,248 (480,000 / 1.01)
Sell Euro buy £ £ 325,735 (475,248 / 1.4590
Deposit after 3 months £ 330,214 (325,735 x 1.01375)
Effective Exchange Rate 480,000 / 330,214 = 1.4536

Using Interest Rate Parity Theory So x 1+ if

1+id
1.4590 x 1.01 / 1.01375 = 1.4536

(b)
The factors that the company should consider before deciding to hedge the risk using the
foreign currency markets are as follows:

Costs – could be sometimes prohibitive specially when the domestic currency is stable or being
managed. Management may not decide to hedge if cost is prohibitive.

Exposure
The degree of exposure is dependent on:
(a) The size of the transaction, is it material?
(b) The hedge period, the time period before the expected cash flows occurs.
(c) The anticipated volatility of the exchange rates during the hedge period.
The corporate risk management policy should state what degree of exposure is acceptable. This
will probably be dependent on whether the Treasury Department is been established as a cost
or profit centre.

Attitude to risk- What is the risk attitude of management – risk averse or risk taker. If company
management are risk takers, they may decide not to hedge.
Portfolio effect – for an international business operating in many countries, the strengthening
in some may be compensated by a weakening in others. If the company is operating in many
countries, it may decide not to hedge due to the portfolio effect.

Currency of invoice – If the company if able to invoice its customers in pound sterling, it will not
need to hedge.

Any alternative actions available to minimize risk are as follows:

Matching receipts and payments

When a company has receipts and payments in the same foreign currency due at the same
time, it can simply match them against each other.
It is then only necessary to deal on the forex markets for the unmatched portion of the total
transactions.
An extension of the matching idea is setting up a foreign currency bank account.

Matching assets and liabilities

A company which expects o receive a substantial amount of income in a foreign currency will be
concerned that this currency may weaken. It can hedge against this possibility by borrowing in
the foreign currency and using the foreign receipts to repay the loan.
For example, US dollar receivable can be hedged by taking out a US dollar overdraft. In the
same way, US dollar trade payables can be matched against a US dollar bank account which is
used to pay the creditors.

Leading and lagging

If an importer (payment) expects that the currency it is due to pay will depreciate, it may
attempt to delay payment. This may be achieved by agreement or by exceeding credit terms.
If an exporter (receipt) expects that the currency it is due to receive will depreciate over the
next three months it may try to obtain payment immediately. This may be achieved by offering
a discount for immediate payment.
The problem lies in guessing which way the exchange rate will move.

Netting
A company which imports and exports with another counterpart in another country may reach
an agreement to pay or receive the net amount at the end of the month. This will obviate the
need to hedge every transaction by hedging only the net amount.

(c)

In a fixed forward exchange contract, the rate for buying or selling foreign currency from or to a
bank, is determined at the outset. At the spot date, the transaction takes place at the
predetermined rate. Hence, there is no upside or downside risk.
Advantages and disadvantages of foreign currency options are as follows:

Advantages include:

 fixes the future rate, thus eliminating downside risk exposure

 Opportunity to benefit from favourable movements in exchange rates.
 Cost may be lower
 No Counterparty risk unlike FRA or money market hedge

Disadvantages include:

 No flexibility with regard to the amount and currency to be covered

 More complex compared to FRA
 Adverse movement possible due to margin requirement
 Basis risk unlike Futures or Options
 Premium payment

Currency Options

(d) Underlying transaction: Sell € and Buy £

Since the currency of option contract is £, the company will have a call option in the Option
Market

There is no rate quoted for 1.40 so we will use 1.45 or 1.50.

Using 1.45

No of contracts: €480,000/ (£12,500 x 1.45) = 26.48 or 26 contracts

Premium: 0.0265 x£12,500 x 26 = € 8,613 = (£ 5,924) (8,613 /1.454)

At spot date

Spot Currency Rate 1.40 1.48

Buy option at € 1.45/£ € 1.45/£
Spot rate € 1.40/£ € 1.48/£
Gain - € 0.03/£
Amount € 9,750 €0.03/£ x£12,500 x 26
Receipt € 480,000 € 480,000

Conversion into £

Gain € 9,750
Receipt € 480,000 € 480,000
Total € 480,000 € 489,750
£ equivalent £ 342,857 £ 330,912 (converted at closing spot rate)
Premium £ (5,924) £ (5,924)
Net Receipt £ 336,933 £ 324,988
Using 1.50

No of contracts: €480,000/ (£12,500 x 1.50) = 25.60 or 26 contracts

Premium: 0.0170 x12,500 x 26 = € 5,525 = £ 3,800 (5,525 /1.454)

At spot date

Spot Currency Rate 1.40 1.48

Buy option at € 1.50/£ € 1.50/£
Spot rate € 1.40/£ € 1.48/£
Gain - -
Amount -
Receipt € 480,000 € 480,000

Conversion into £

Gain -
Receipt € 480,000 € 480,000
Total € 480,000 € 480,000
£ equivalent £ 342,857 £ 324,324 (converted at closing spot rate)
Premium £ (3,800) £ (3,800)
Net Receipt £ 339,057 £ 320,524
FRA/Money M £ 330,215

Currency Hedging
You work in the finance team at PTE Electronics Company, which is a Bangladesh based
Company. The Company operated exclusively in Bangladesh for more than 10 years; but its
board recently decided to expand its operations by looking overseas for new contracts. PTE is
ready to submit a tender bid for a contract with a Company located at Japan, local currency,
which is ¥. The margin is set very low due to the chance of repeat business and market
penetration. The following summary information has been prepared:

Total costs plus margin BDT 12.420 million

Tender bid on 30 June 2017 at the current spot rate of ¥ 1.2165/BDT ¥ 15.109 million (Sell
¥ Buy BDT)

PTE’s board understands that the successful bidder will be announced on 31 July 2017. If PTE
wins the bid then work would start on that date and the board estimates that it would be
completed on 30 September 2017 when payment would be received from the Japanese
Company.

The board is concerned that the ¥/BDT exchange rate has changed quite significantly over the
past three months and that if this trend continues then it could have an impact on the
profitability of the contract. The board would like, therefore, to consider hedging against
exchange rate risk immediately on 30 June 2017, even though the outcome of the tender bid is
not yet decided.
The spot ¥/BDT exchange rate over the past three months is summarized below:
Exchange rate (¥/BDT) at 31March 2017 1.1150 – 1.1463
at 30April 2017 1.1373 – 1.1692
at 31 May 2017 1.1600 – 1.1926
at 30 June 2017 1.1832 – 1.2165
You have been asked to advise PTE’s board and the following information has been made
available to you at the close of business on 30 June 2017:

BDT interest rate (lending) 3.2% pa

BDT interest rate (borrowing) 4.2% pa
Yen interest rate (lending) 2.6% pa
Yen interest rate (borrowing) 3.4% pa

Three-month over the counter (OTC) put option on BDT, exercise price (¥/BDT) 1.2150
Three-month over the counter (OTC) call option on BDT, exercise price (¥/BDT) 1.1818
Three-month forward contract premium (¥/BDT) 0.0025-0.0020
Forward contract arrangement fee (per Yen converted) BDT 0.002
Relevant OTC option premium (per Yen converted) BDT 0.012

Requirements:
i) Estimate the spot rate on 30 September 2017 on the assumption that the ¥/BDT
exchange rate continues to change at the same rate as for the period 31March to 30
June 2017.
ii) On the assumption that PTE’s tender bid is successful:
Calculate PTE’s BDT receipt on 30 September 2017 using your answer to part (i) above if
it uses
• a forward contract
• a money market hedge
• an OTC currency option
iii) With reference to your calculations in part (ii) above, discuss the issues that should be
taken account of by PTE’s board when considering whether it should hedge the Japan
contract, assuming the tender bid is successful.
iv) Explain the implications for PTE of using each of the hedging instruments in part (ii) (2)
above if its tender bid is unsuccessful.
v) Explain the principle of interest rate parity (IRP) and, given the information provided
above, calculate the forward rate of exchange on 30 September 2017 using IRP,
commenting on your result. You should use the average current spot and
borrowing/lending rates for the purposes of this calculation.

Solution

i) Estimated spot rate on 30 September 2017:

In order to estimate the rate, we will use the trend for the period 31 March to 30 June 2017
using the bank selling rate (right hand side figures)

The growth rate has been 2% per month.

Hence the estimated rate on 30 September will be 1.2165 x 1.023 = 1.2910

Forward Contract

Rate on 30 June 2017 1.2165

Premium (0.0020)
Forward Rate 1.2145
Gross Receipt Tk 12,440,510 (15,109,000 / 1.2145)
Less Fees Tk (30,218) (15,109,000 x 0.002)
Net Receipt Tk 12,410,292

Money market

Underlying transaction: receipt of ¥ 15,109,000

Borrow in ¥ 3 months earlier ¥ 14,981,656 (15,109,000/ 1.0085)
Deposit in Tk Tk12,315,377 (14,981,656 / 1.2165)
Deposit after 3 months Tk12,413,900 (12,315,377 x 1.008)
Effective Exchange Rate 15,109,000/12,413,900 = 1.2171

Using Interest Rate Parity Theory So x 1+ if

1+id
1.2165 x 1.0085 / 1.008 = 1.2171

OTC currency option

Since the underlying transaction is to sell Yen and buy BDT, we will take a put option.

On spot date:
Sell at 1.2150 (option exercise price)
Spot rate 1.2910

By exercising the option, we get a higher receipt in BDT

Receipt Tk 12,435,391 (15,109,000 / 1.215)
Premium Tk (181,308) (15,109,000 x 0.012)
Net Receipt Tk 12,254,083

(iii)
The factors that should be considered by the board are as follows:

Costs – could be sometimes prohibitive specially when the domestic currency is stable or being
managed. Management may not decide to hedge if cost is prohibitive.

Exposure
The degree of exposure is dependent on:
(a) The size of the transaction, is it material?
(b) The hedge period, the time period before the expected cash flows occurs.
(c) The anticipated volatility of the exchange rates during the hedge period.
The corporate risk management policy should state what degree of exposure is acceptable. This
will probably be dependent on whether the Treasury Department is been established as a cost
or profit centre.

Attitude to risk- What is the risk attitude of management – risk averse or risk taker. If company
management are risk takers, they may decide not to hedge.

Portfolio effect – for an international business operating in many countries, the strengthening
in some may be compensated by a weakening in others. If the company is operating in many
countries, it may decide not to hedge due to the portfolio effect.

Currency of invoice – If the company if able to invoice its customers in pound sterling, it will not
need to hedge.

(iv)
Should PTE board be unsuccessful, the implications are as follows:

Forward rate Agreement

The forward rate agreement will have to be closed on 30th June. Since the agreement was to sell
Yen, Bank will sell Yen to PTE at the contracted rate and buy Tk from spot market. Should the
bank end up paying higher in the spot market, it will charge PTE for the excess amount. In
addition, the bank may charge a fee.

Money Market Hedge

Since the bank would have already executed the money market hedge, it will follow the same
principle as an forward rate agreement. In addition, the bank may charge a fee.

OTC option
Since the OTC option premium has to be paid at the outset on 30 June, this amount will be
forfeited by the bank.

(v)
The principle of IRP states that the forward rate between the two countries will be determined
by the interest rate differential between the two countries. The currency of country having a
higher interest rate will depreciate compared to the other currency with the lower interest rate.

Spot rate: 1.2165

Average rate in ¥ 3%
Average rate in Tk 3.7%

Forward rate So x 1+ if
1+id
1.2165 x 1.0075 = 1.2144
1.00925
American Adventures Ltd (AA) is a family owned company based in the UK. AA organises walking,
cycling and climbing holidays in the United States of America for both British and American
customers. AA has the following receipts and payments due in four months’ time:

Receipts due from American customers on 31 March 2015 $2.25 million

Payments due to American suppliers on 31 March 2015 $3.50 million (Buy $ Sell
£)

You work for Zeta Corporate Finance which has been asked to give advice to AA on hedging its
exchange rate risk. You have available the following data on 30 November 2014:

Exchange rates:

Spot rate ($/£) 1.5154 - 1.5157

4-month forward contract premium ($/£) 0.0012 - 0.0011

March currency futures price (standard contract size £62,500): $1.5148/£

March traded sterling currency options (standard contract size £10,000):

The premiums are quoted in cents per £ and are payable up front.

Strike price Call premium Put premium

$1.56 1.04 6.15

Annual borrowing and depositing interest rates:

Sterling 4.70% - 3.50%

Dollar 3.51% - 2.25%

Requirement:

Assuming the spot exchange rate on 31 March 2015 will be $1.5150 – 1.5156/£ and that the
sterling currency futures price will be $1.5153/£, calculate AA’s net sterling payment if it uses the
following to hedge its foreign exchange risk:

• a forward contract
• currency futures
• a money market hedge
• currency options
Solution

Net payment $ 1.25 million

Underlying transaction: Buy $ and sell £

Forward contract

Spot rate 1.5154

Premium (0.0012)
Forward rate 1.5142
Amount of payment £ 825,518 (1,250,000 / 1.5142)

Currency futures

November

Since the currency of future contract is £, the company will sell in the Future Market
No of contracts 1,250,000 / (62,500 x 1.5148) = 13 contracts

At spot date in March

Sell at $1.5148/£
Spot rate $1.5153/£
Loss $0.0005/£
Amount $0.0005/£ x £62,500 x 13 = $ (406)
Payment ($ 1,250,000)

Conversion into £

Loss $ 406 1.5150 (268)

Payment $ 1,250,000 1.5150 (825,083)
Net Payment (825,351)

Money Market Hedge

Underlying transaction: payment of $ 1,250,000

Deposit in $ 4 months earlier $ 1,240,695 (1,250,000/ 1.0075)
Buy $ Sell £ £ 818,724 (1,240,695 / 1.5154)
Borrowing after 4 months £ 831,553 (818,724 x 1.01567)
Effective Exchange Rate 1,250,000 /831,553 = 1.5032

Using Interest Rate Parity Theory So x 1+ if

1+id
1.5154 x 1.0075/ 1.01567 = 1.5032
Currency options

Since the currency of option contract is £, the company will have a put option in the Options
Market

No of contracts 1,250,000 / (10,000 x 1.56) = 80 contracts

Premium payment $0.0615 x 10,000 x 80 = $ 49,200 = £ 32,466 (49,200/ 1.5154)

At spot date in March

Sell at $1.5600/£
Spot rate $1.5153/£
Gain $0.0447/£
Amount $0.0447/£ x £10,000 x 80 = $ 35,760
Payment ($ 1,250,000)

Conversion into £

Gain $ 35,760 1.5156 23,595

Payment $ 1,250,000 1.5150 (825,083)
Premium ( 32,466)
Net Payment (833,954)

E Inc is a US-based business that is a major computer software provider to the defense industry.

In order to expand its business, the company has recently agreed, in principle, to buy a small
computer software business based in France for €10·54 (Buy € Sell $) million from a French
conglomerate. However, E Inc is concerned over certain legal and technical aspects of the
software business. The two parties to the transaction have therefore agreed that the deal will be
finalised and the purchase price will be paid in three months’ time, subject to the satisfactory
outcome of a due diligence investigation by an independent firm of accountants.
In order to deal with foreign exchange risk associated with the purchase of the French business,
the Corporate Treasurer of E Inc is considering the following choices:
1. The purchase of futures contracts, which will be sold in three months’ time in order
to close the company’s position. The relevant euro futures contracts are currently
priced at €1 = $0·9750. The futures contract size is €125,000 (and should be rounded
to the nearest whole number of contracts). The tick value is $12·50 and one tick is 0·01
cents per €.
2. The purchase of an over-the-counter option at an exercise price of €1 = $0·9900
with a premium cost of $2 per €100.
The current spot rate is €1 = $0·9812.
The Corporate Treasurer of E Inc believes that one of two future scenarios may occur and is
concerned with the effect of each scenario on the choices described above.
The two scenarios are:
• in three months’ time, the spot rate moves to €1 = $0·9998 and the futures price
moves to €1 = $0·9860
• in three months’ time, the spot rate moves to €1 = $0·9660 and the futures price
moves to €1 = $0·9580
Required:

(a) Calculate the cost of the futures contract and the hedge efficiency under each scenario.
(b) Calculate the final outcome of the over-the-counter option under each scenario.
Comment on your findings in (a) and (b) above.
Comment on the appropriateness of each hedging instrument for E Inc.

Solution

Futures contract

Underlying transaction is payment of € 10.54 million

Buy € Sell $
Since the currency of future contract is €, the company will buy in the Future Market
No of contracts 10,540,000 / 125,000 = 84.32 or 84 contracts

At spot date

Currency Spot Rate $0.9998/€ $0.9660/€

Buy at $0.9750/€ $0.9750/€
Future Spot rate $0.9860/€ $0.9580/€
(Loss) / Gain $0.0110/€ ($0.0170/€)
Amount $ 115,500 ($ 178,500)
Payment (€10,540,000) (€10,540,000)
Conversion into $ ($10,537,892) ($10,181,640)
Net payment ($10,422,392) ($10,360,140)

Tick Calculation
0.0110 x 125,000 x 84 = 115,500
0.0110 x 125,000 x 1 = 1,375
110 x (0.0001 x 125,000 x 1) 0.01% of contract value = 1 Tick
110 x 12.50 x 84

Hedge efficiency

Future rate $0.9750/€ $0.9750/€

Spot date at expiry $0.9998/€ $0.9660/€
(Loss)/Gain ($0.0248/€) $0.0090/€
Amount (A) ($261,392) $ 94,860
Hedging (Loss)/Gain (B) $115,500 ($ 178,500)
Hedge Efficiency B / A% 44.18% 188.17%
OTC Options

Since the underlying transaction is to buy Euro, we will take a call option at $0.9900/€

On spot date:

Currency Spot Rate $0.9998/€ $0.9660/€

Buy at $0.9900/€ $0.9900/€
Exercise Yes No (whichever is lower)
Payment ($10,434,600 ) ($10,181,640)
Premium ($ 210,800) ($ 210,800) (€10,540,000 x .02)
Net Payment ($10,645,400 ) ($10,392,440 )

(b)
Appropriateness of hedging instruments are given below:

Currency Futures

Advantages include:

 fixes the future rate, thus eliminating downside risk exposure

 Cost may be lower
 No Counterparty risk unlike FRA or money market hedge
 No premium payment unlike options

Disadvantages include:

 No flexibility with regard to the amount and currency to be covered

 No opportunity to benefit from favourable movements in exchange rates.
 More complex compared to FRA
 Adverse movement possible due to margin requirement
 Basis risk

Currency Options

Advantages include:

 fixes the future rate, thus eliminating downside risk exposure

 Opportunity to benefit from favourable movements in exchange rates.
 Cost may be lower
 No Counterparty risk unlike FRA or money market hedge

Disadvantages include:

 No flexibility with regard to the amount and currency to be covered

 More complex compared to FRA
 Adverse movement possible due to margin requirement
 Basis risk
 Premium payment

Padma Limited imports raw materials from USA and Europe. In order to hedge for next 6
months, it enters into 2 option contracts with New Bank Limited.
The details of the option contracts are as follows:

Details Amount Strike Price/ Spot Rate on Option

Transaction Exchange Maturity Date Premium
Rate
OPTION Bought call US$ 75m BDT 107/ BDT 105/ USD 3.00%
A option to USD
buy USD
against BDT
OPTION Bought call EUR 65m BDT 110/ BDT 112/ EUR 3.5%
B option to EUR
buy Euro
against BDT

Requirements:

i) Advice Padma Limited on whether to exercise Option A or Option B on the basis of its
profit/loss.
ii) Calculate overall gain/ loss of the hedge.

Option A : Call option

Strike Price BDT 107/USD BDT 8,025.00 m

Spot Rate BDT 105/USD BDT 7,875.00 m
Gain by not exercising BDT 150.00 m
Premium BDT (240.75) (3% of 75 x 107)
Net Loss BDT 90.75

Option should not be exercised as Spot Rate yields lower cost

Option B : Call option

Strike Price BDT 110/ EUR BDT 7,150

Spot Rate BDT 112/ EUR BDT 7,280
Gain by exercising BDT 130
Premium BDT (250.75) (3.5% of 65 x 110)
Net Loss BDT 120.75

Option should be exercised as Spot Rate yields higher cost

Premium cost is not relevant for decision making
Your client J Limited expects to win a tender for a contract to supply tables for South African
schools. The tender will be for the supply of 40,000 tables in three months time and a further
60,000 tables in nine months time. The tender price was quoted at 750 South African Rand
(ZAR) per table. If J Limited wins the tender, the South African schools department will pay for
the tables in South African Rand three months after the receipt of each batch of tables.

J Limited has sourced the tables in Australia. If they are successful in winning the tender their
Australian supplier will charge $100 (Australian) per table. All tables will be dispatched directly
to South Africa. The Australian supplier has agreed that full payment (for all tables) will be
made by J Limited in 12 months’ time.

You have researched the relevant exchange rate information which is summarised in the
following table:

Exchange Rates ZAR/€ Aus $/€

Spot 12.5 13 1.9 1.95

3 Month 30 cent 32 cent 10 cent 15 cent
Forward premium premium premium premium
6 Month 40 cent 44 cent 12 cent 16 cent
Forward premium premium premium premium
9 Month 60 cent 68 cent 14 cent 18 cent
Forward premium premium premium premium
12 Month 80 cent 90 cent 18 cent 20 cent
Forward premium premium premium premium

Your bank has quoted the following standardised currency options rates;

Option Type Exercise 6 month 9 Month 12 Month Contract Size

Price Premium Premium Premium
ZAR Put 12 0.25 0.4 0.55 500,000 ZAR
Aus $ Call 2 0.4 0.6 0.8 100,000 Aus
$

Each premium is quoted in €s per 100 units of the relevant foreign currency.

Requirements:
i) If J Limited is successful in winning the tender, advise on the profit it will secure if the
foreign exchange risk is hedged using the forward exchange market.

ii) Determine the profit on the contract if the foreign currency transaction risk relating to all
potential transactions is hedged using standardised currency options.
Underlying transaction: Sell 30,000,000 ZAR in 6 months
Sell 45,000,000 ZAR in 12 months
Buy 10,000,000 AUD in 12 months

Using Forward Rate:

Receipt after 6 months: Euro 30,000,000 / 12.56 = 2,388,535
Receipt after 12 months: Euro 45,000,000 / 12.1 = 3,719,008
Payment after 12 months: Euro 10,000,000 / 1.72 = 5,813,953
Profit 293,590

Using Options:
Put Option in ZAR for 6 months:
No of contracts 30,000,000 / 500,000 = 60 contracts
Premium: Euro 30,000,000/ 100 * 0.25 = 75,000

Put Option in ZAR for 12 months:

No of contracts 45,000,000 / 500,000 = 90 contracts
Premium: Euro 45,000,000/ 100 * 0.55 = 247,500

Call Option in AUD in 12 months:

No of contracts 10,000,000 / 100,000 = 100 contracts
Premium: Euro 10,000,000/ 100 * 0.8 = 80,000

Upon Expiry:
Put Option in ZAR for 6 months:
Sale at 12.00
Spot* 12.56
Option not exercised
Underlying transaction receipt Euro 30,000,000 / 12.56 = 2,388,535
Put Option in ZAR for 12 months:
Sale at 12.00
Spot* 12.10
Option not exercised
Underlying transaction receipt Euro 45,000,000 / 12.10 = 3,719,008
Call Option in AUD for 12 months:
Buy at 2.00
Spot* 1.72
Option not exercised
Underlying transaction payment Euro 10,000,000 / 1.72 = 5,813,953
* Spot rate assumed at Forward Cover rate

Profit:
Receipt 6,107,543
Payment 5,813,953
Premium 402,500
Loss (108,910)0
Attire Ltd., a UK multinational Company operating in Bangladesh, started trading in 2016. Its
functional currency is GBP (£). The company makes industrial filters and of late has been
expanding its trading links (both in terms of imports and exports) in Europe. To date it has not
been concerned with managing its foreign exchange risk. However, Attire's board of directors
now wishes to investigate the implications of a change in that policy. You are a member of the
company's finance team and have been sent the memorandum set out below by Nayeem
Ahmed, Attire's Finance Director.

MEMORANDUM
To: Finance Team Member
From: Nayeem Ahmed
Date: 21 March 2022

I'd like you to finish off a piece of work I've been doing for the board which wants to establish if
it's worth trying to hedge our exposure to foreign exchange risk. We have three fairly large
transactions to deal with in the next six months, all of which involve buying/selling euros.

The details are as follows.

• We are due to receive €632,000 from a German customer on 20 June 2022. (Sell € Buy £)
• We are due to receive €560,000 from a Belgian customer on 22 September 2022 and to pay
€1,347,500 to one of our Spanish suppliers on the following day. (Buy € Sell £) 787,500

I have researched the relevant foreign exchange rates and interest rates and they're listed
below:
Exchange rates Euro (€)/GBP (£)
Spot rates 1.412 – 1.445
Three months forward rates 0.85 – 0.81 cents premium
Six months forward rates 1.43 – 1.38 cents premium
Interest rates Lending Borrowing
Euro 3.9% pa 5.2% pa
GBP 4.8% pa 6.1% pa

Could you write a memorandum for the board which:

a) Recommends whether we should use (i) a forward contract or (ii) a money market
hedge. It would also be advisable to show the board what the outcome would be if we
didn't hedge at all (you can assume here there would be no change in the spot rate as at
21 March 2022 in the next six months).
b) Explain the implications of using futures contracts or currency options instead.
Solution
Underlying transactions €632,000 receivable on 20 June 2022
€787,500 payable on 22/23 Sept 2022

Forward Contract
€632,000 receivable on 20 June 2022

Spot Rate 1.4450

3 month premium 0.0081
Forward Rate 1.4369
Amount receivable on 20 June 2022 632,000 /1.4369 = £ 439,836

€787,500 payable on 22/23 Sept 2022

Spot Rate 1.4120

3 month premium 0.0143
Forward Rate 1.3977
Amount payable on 20 June 2022 787,500 /1.3977 = £ 563,426

Money Market Hedge

€632,000 receivable on 20 June 2022
Borrow 3 months earlier 623,889 (632,000 / 1.013)
Deposit in £ 431,757 (623,889 /1.445)
Deposit after 3 months 436,938 (431,757 * 1.012)

€787,500 payable on 22/23 Sept 2022

Deposit 6 months earlier 772,437 (787,500 / 1.0195)
Borrow in £ 547,052 (772,437/1.412)
Borrowing after 6 months 563,737 (547,052* 1.0305)

Conclusion: Forward cover is a better option since receipts are higher after 3 months and
payments are lower in six-month’s time under this option

No hedge
Receipts in 3 months €632,000/1.445 = 434,370
Payments in 6 months €787,500/1.412 = 557,720
The answer to the theory question can be found in my lecture notes. Compare the
advantages and disadvantages of the four methods of hedging
Assume that the current date is 31 December 2021. You are a Financial Analyst working for Soft
Apparels (SA), which is a Bangladeshi Company that exports apparels to Sri Lanka. The
Chairman of Risk Management Committee of SA is wary of its exposure to foreign exchange
rate risk (‘forex risk’) and the need to hedge it.

The Chairman asked you to advise the board on how to hedge the forex risk associated with its
trading activities in Sri Lanka. You have the following information available to you at the close
of business on 31 December 2021:

One of SA’s client owes to SA LKR 35,000,000, which will become due on March 31, 2022. (Sell
LKR Buy BDT)
Exchange rates Spot rate (LKR/BDT) 2.36 – 2.38
Three-month forward contract discount (LKR/BDT) 0.0031 - 0.0034
March currency futures price (standard contract size BDT 1,000,000): LKR 2.41/BDT

Annual borrowing and depositing interest rates

BDT 9.00% - 6.00%
LKR 10.5% - 5.50%

Three-month over-the-counter currency options

Call options to buy BDT have an exercise price of LKR/BDT 2.42 and premium of BDT 0.03 per
LKR converted.
Put options to sell LKR have an exercise price of LKR/BDT 2.41 and a premium of BDT 0.02 per
LKR converted.

Requirements:
(a) Assuming that the spot exchange rate on 31 March 2022 will be LKR/BDT 2.425 – 2.445
and that the BDT currency futures price will be LKR 2.443/BDT, calculate SA’s BDT
receipt if it uses the following to hedge its forex risk:
• a forward contract
• a money market hedge
• currency futures contracts
• an over-the-counter currency option
(b) Describe the relative advantages and disadvantages of each of the hedging techniques
in (a) above and advise SA on which would be most beneficial for hedging its forex risk.
(c) Identify and explain overseas trading risks (other than forex risk) that SA is exposed to
and discuss how they might be mitigated.
Solution
Underlying transaction Receipt of LKR 35,000,000 in March 31,2022

Forward contract
Spot rate 2.3800
Discount 0.0034
Forward rate 2.3834
Amount receivable on March 31,2022 35,000,000 / 2.3834 = BDT 14,684,904

Money market hedge

Borrow 3 months earlier LKR 34,104,750 (35,000,000 / 1.02625)
Deposit in BDT 14,329,727 (34,104,750 /2.38)
Deposit after 3 months 14,544,673 (14,329,727* 1.015)

Currency futures contract

As the futures contract currency is BDT and we will buy BDT in the underlying transaction, we
will sell in the future market at LKR 2.41/BDT.
No of contracts 35,000,000 /(1,000,000 x 2.41) = 14.52 contracts or 15 contracts

March 31,2022
Buy at LKR 2.41/BDT
Spot rate LKR 2.443/BDT
Gain LKR 0.033/BDT
Amount LKR 495,000 (0.033 x 15 x 1,000,000)
Receipt LKR 35,000,000
Total LKR 35,495,000
In BDT BDT 14,517,382 35,495,000 /2.445

OTC options
As we will sell LKR in the underlying transaction, we will have a put option at LKR 2.41/BDT.
Premium BDT 700,000 35,000,000 x 0.02

March 31,2022
Sell at LKR 2.41/BDT
Spot rate LKR 2.445/BDT
Receipt BDT 14,522,822 35,000,000 /2.41
Premium BDT 700,000
Net BDT 13,822,822

The answer to the theory question can be found in my lecture notes.

JBL Limited took a 5-year loan of US$ 20 million in January 2020 at a fixed interest rate of 12%
per annum from an investment bank to finance a plant expansion project. At the time of taking
loan, JBL was exporting a significant proportion of its output to a foreign market. Thus, it was
sure that it would be able to earn U.S. dollars to make dollar payments on the loan. For about a
year now, JBL has not been able to export its output to its foreign market due to trade
restrictions. It sells only to buyers in Bangladesh for the Bangladesh Taka. The company now
prefers to have its interest obligation in Bangladesh Taka rather than U.S. dollar.
On the advice of the Treasury Manager, JBL has entered a currency swap arrangement with a
bank to manage the underlying risk exposure. Per the terms of the swap, JBL will continue to
honour its obligations under the actual loan. Under the swap, JBL and the bank will exchange
interests and principals in the appropriate currencies. With a pre-arranged exchange rate of
Tk.86.50/USD1, the notional principals under the swap arrangement are agreed at US$20
million and TK.130 million. The 12% interest rate on the existing dollar loan will continue to
apply to both the original dollar loan and the dollar interest payments under the swap
arrangement. The interest rate that will apply to the Taka notional principal is set to 15%.

Requirement: Evaluate how JBL Limited can use the currency swap to manage the underlying
risk exposure

The currency swap will permit JBL Limited to pay the obligations relating to the outstanding
loan in its preferred currency. Thus, whenever interest payment is due, JBL gets to pay interest
to the swap counterparty in Takas while it receives interest in dollars from the swap
counterparty under the swap arrangement. JBL then forwards the dollar interest to the lender.
At maturity, JBL gets to pay the principal in Takas to the swap counterparty while it receives the
dollar principal from the swap counterparty. JBL then forwards the dollar principal received to
the lender.

The details of the cash flows are presented in the table below:
Notional principal (USD) USD 20,000,000
Exchange rate TAKA 96.5 / USD1
Notional principal (TAKA) TAKA 1,930,000,000
Dollar interest rate 12%
Taka interest rate 15%

Whenever interest payment is due:

JBL pays to the lender USD (2,400,000)
JBL receives from the counterparty USD 2,400,000
JBL pays to the counterparty TAKA (289,500,000)
-----------------------------
Net interest TAKA (289,500,000)
=================
When principal payment is due:
JBL pays to the lender USD (20,000,000)
JBL receives from the counterparty USD 10,000,000
JBL pays to the counterparty TAKA (1,930,000,000)
-------------------
Net principal repayment TAKA (1,930,000,000)
===========