Transcript Chapter 11 - Blackwell Publishing

CHAPTER 11
Foreign Exchange Futures
In this chapter, we discuss foreign exchange futures. This
chapter is organized as follows:
1. Price Quotations
2. Geographical and Cross-Rate Arbitrage
3. Forward and Futures Market Characteristics
4. Determinants of Foreign Exchange Rates
5. Futures Price Parity Relationships
6. Speculation in Foreign Exchange Futures
7. Hedging with Foreign Exchange Futures
Chapter 11
1
Price Quotation
In the foreign exchange market, every price is a relative
price. That is, there is a reciprocal rate.
Example:
To say that $1 = € 2.5 (2.5 euros) implies that € 2.5 will buy
$1
Or
€ 1 = $0.40
Figure 11.1 shows foreign exchange rate quotations as
they appear in the Wall Street Journal.
Chapter 11
2
Price Quotation
Insert Figure 11.1 here
Chapter 11
3
Price Quotation
Forward rates are the rates that you can contract today for
the currency.
If you buy a forward rate, you agree to pay the forward
rate in 30 days to receive the currency in question.
If you sell a forward rate, you agree to deliver the currency
in question in receipt of the forward rate.
The transactions are in the interbank market. The
transactions are for $1,000,000 or more.
One rate is the inverse of the other (e.g., $/€ reverse of
€/$).
Using the previous example $1 = €2.5
U .S .$ / € rate 
1
€ rate / U .S .$rate
U .S .$ / € rate 
1
2.5
U .S .$ / € rate  0.40
€ rate / US $rate 
€ rate / US $rate 
1
US$rate / € rate
1
0.40
€ rate / US $rate  2.50
Chapter 11
4
CME’s Euro FX Futures
Product Profile
Product Profile: The CME=s Euro FX Futures
Contract Size: 125,000 Euro
Deliverable Grades: N/A
Tick Size: 0.0001=$12.50
Price Quote: U.S dollars per Euro.
Contract Months: Six months in the March, June, September, and December cycle
Expiration and final Settlement: Eurodollar futures cease trading at 9:16 a.m. Chicago Time
on the second business day immediately preceding the third Wednesday of the contract month.
The contract is physically settled.
Trading Hours: Floor: 7:20 a.m.-2:00 p.m; Globex: Mon/Thurs 5:00 p.m.-4:00 p.m.; Shutdown
period from 4:00 p.m. to 5:00 p.m. nightly; Sunday & holidays 5:00 p.m.-4:00 p.m.
Daily Price Limit: None
Chapter 11
5
Geographical and Cross-Rate Arbitrage
Pricing relationships exist in the foreign exchange market.
This sections explores two of these relationships and
associated arbitrage opportunities:
1. Geographical Arbitrage
2. Cross-Rate Arbitrage
Chapter 11
6
Geographical Arbitrage
Geographical arbitrage occurs when one currency sells for
a different prices in two different markets.
Example
Suppose that the following exchange rates exist between
German marks and U.S. dollars as quoted in New York and
Frankfurt for 90-day forward rates:
New York
$/€
0.42
Frankfurt
€/$
2.35
To identify the opportunity for an arbitrage we can compute
the inverse. From the price in New York, we can compute
the appropriate exchange rate in Frankfurt.
1
 € / $  2.381
0.42
Chapter 11
7
Geographical Arbitrage
If the transpose is equal to the price of the currency in
another market, there is no opportunity for a geographic
arbitrage.
If the transpose is not equal to the price of the currency in
another market, the opportunity for a geographic arbitrage
exists. In this case:
1
 € / $  2.381
0.42
In New York, the €/$ rate is 2.381, but in Frankfurt it is
2.35. Thus, an arbitrage opportunity exists.
Table 11.1 shows how to exploit this pricing discrepancy.
Chapter 11
8
Geographical Arbitrage
Table 11.1
Geographical Arbitrage
This is an arbitrage transaction since it has a certain profit with no investment.
Notice that the arbitrage is not complete until the transactions at t = 90 are
completed.
t = 0 (the present)
Buy 1 in New York 90 days forward for $.42
Sell 1 in Frankfurt 90 days forward for $.4255.
t = 90
Deliver 1 in Frankfurt; collect $.4255.
Pay $.42; collect 1.
Profit:
$.4255
B .4200
$.0055
Chapter 11
9
Cross-Rate Arbitrage
Cross-rate arbitrage, if present, allows you to exploit
misalignments in cross rates. A cross-rate is the exchange
rate between two currencies that is implied by the
exchange on other currencies.
Example
In New York, there is a rate quoted for the U.S. dollar
versus the euro. There is also a rate quoted for the U.S.
dollar versus the British pound. Together these two rates
imply a rate that should exist between the euro and the
British pound that do not involve the dollar. This implied
exchange rate is called the cross rate. Cross rates are
reported in the Wall Street Journal.
Cross-Rate Arbitrage
US$
€ (Euro)
US$
₤ (B. Pound)
Figure 11.2 shows quotations for cross rates from the
Wall Street Journal.
Chapter 11
10
Cross-Rate Arbitrage
Insert Figure 11.2 here
Chapter 11
11
Cross-Rate Arbitrage
If the direct rate quoted somewhere does not match the
cross rate, an arbitrage opportunity exists.
Suppose that we have the following 90-day forward rates.
FS indicates the Swiss franc (FS):
New York
Frankfurt
$/€
0.42
$/SF
0.49
€/SF
1.20
The exchange rates quoted in New York imply the following
cross rate in New York for the €/SF:
€ / SF 
€ / SF 
($ 1/ € )$ / SF
(0.142)0.49
€ / SF  1.167
Chapter 11
12
Cross-Rate Arbitrage
Because the rate directly quoted in Frankfurt differs from
the cross rate in New York, an arbitrage opportunity is
present.
Table 11.2 shows the transactions required to conduct the
arbitrage.
Table 11.2
CrossBRate Arbitrage Transactions
t = 0 (the present)
Sell SF 1 90 days forward in Frankfurt for 1.2.
Sell 1.2 90 days forward in New York for $.504.
Sell $.504 90 days forward in New York for SF 1.0286.
t = 90 (delivery)
Deliver SF 1 in Frankfurt; collect 1.2.
Deliver 1.2 in New York; collect $.504.
Deliver $.504 in New York; collect SF 1.0286.
Profit: SF 1.0286
B 1.0000
SF .0286
Chapter 11
13
Forward and Futures Market
Characteristics
The institutional structure of the foreign exchange futures
market resembles that of the forward market, with a
number of notable exceptions as shown in Table 11.3.
Table 11.3
Futures vs. Forward Markets
Forward
Futures
Size of Contract
Tailored to individual needs.
Standardized.
Delivery Date
Tailored to individual needs.
Standardized.
Method of
Transaction
Established by the bank or
broker via telephone contract
with limited number of buyers
and sellers.
Determined by open auction
among many buyers and
sellers on the exchange floor.
Participants
Banks, brokers, and multiB
national companies. Public
speculation not encouraged.
Banks, brokers, and multinational companies. Qualified
public speculation encouraged.
Commissions
Set by Aspread@between
bank's buy and sell price.
Not easily determined by
customer.
Published small brokerage fee
and negotiated rates on block
trades.
Security Deposit
None as such, but compensating bank balances required.
Published small security
deposit required.
Clearing Operation
(Financial Integrity)
Varies across individual
banks and brokers. No separate clearinghouse function.
Handled by exchange clearinghouse. Daily settlements to
the market.
Marketplace
Over the telephone worldwide.
Central exchange floor with
worldwide communications.
Economic
Justification
Facilitate world trade by providing hedge mechanism.
Same as forward market. In
addition, it provides a broader
market and an alternative
hedging mechanism via public
participation.
Accessibility
Limited to very large customers who deal in foreign trade.
Open to anyone who needs
hedge facilities, or has risk
capital with which to speculate.
Regulation
SelfBregulating.
April 1975CRegulated under
the Commodity Futures
Trading Commission.
Frequency
of Delivery
More than 90% settled by
actual delivery.
Less than 1% settled by
actual delivery.
Price Fluctuations
No daily limit.
No daily limit.
Market Liquidity
Offsetting with other banks.
Public offset. Arbitrage offset.
Source: IMM, AUnderstanding Futures in Foreign Exchange Futures,@pp. 6B7.
Chapter 11
14
Determinants of Foreign Exchange
Rates
This section explores the following determinants of foreign
exchange rates:
1. Balance of Payments
2. Fixed Exchange Rates
3. Other Exchange Rate Systems
– Freely Floating
– Managed Float or Dirty Float Policy
– Pegged Exchange Rate System
– Joint Float
Chapter 11
15
Balance of Payments
Balance of payments is the flow of payments between
residents of one country and the rest of the world. This flow
of payments affects exchange rates.
The balance of payments encompasses all kinds of flows
of goods and services among nations, including:
– The movement of real goods
– Services
– International investment
– All types of financial flows
Deficit Balance of Payment
Expenditures by a particular country exceed receipts. A
constant balance of payments deficit will cause the value
of the country’s currency to fall.
Surplus Balance of Payment
Receipts by particular country exceed expenditures.
Chapter 11
16
Fixed Exchange Rates
Fixed Exchange Rates
A fixed exchange rate is a stated exchange rate between
two currencies at which anyone may transact.
For a particular country, a continual excess of imports over
exports puts pressure on the value of its currency as its
world supply continues to grow.
Eventually, the fixed exchange rate between the country’s
currency and that of other nations must be adjusted either
by devaluating or revaluating.
– Devaluation: the value of the currency will fall relative to
other countries.
– Revaluation: the value of the currencies will increase
relative to other countries.
Exchange Risk
The risk that the value of a currency will change relative to
other currencies.
Today a free market system of exchange rates prevails.
Daily fluctuations exists in the exchange rates market.
Chapter 11
17
Other Exchange Rates Systems
Freely Floating
A currency has no system of fixed exchange rates. The
country's central bank does not influence the value of the
currency by trading in the foreign exchange market.
Managed Float or Dirty Float Policy
The central bank of a country influences the exchange
value of its currency, but the rate is basically a floating rate.
Pegged Exchange Rate System
The value of one currency might be pegged to the value of
another currency, that itself floats.
Joint Float
In a joint float, currencies participating in the joint float
have fixed exchange values relative to other currencies in
the joint float, but the group of currencies floats relative to
other currencies that do not participate in the joint float.
This is particularly important for the foreign exchange
futures market.
Chapter 11
18
Future Price Parity Relationships
In this section, other price relationships will be examined,
including:
1. Interest Rate Parity Theorem (IRP)
2. Purchasing Power Parity Theorem (PPP)
Chapter 11
19
Interest Rate Parity Theorem
The Interest Rate Parity Theorem states that interest rates
and exchange rates form one system.
Foreign exchange rates will adjust to ensure that a trader
earns the same return by investing in risk-free instruments
of any currency, assuming that the proceeds from
investment are converted into the home currency by a
forward contract initiated at the beginning of the holding
period.
To illustrate the interest rate parity, consider Table 11.4.
Table 11.4
Interest Rates and Exchange Rates to
Illustrate Interest Rate Parity
Interest Rates
Exchange Rates
$/
U.S.
B
Germany
B
Spot
.42
30Bday
.41
.18
.576
90Bday
.405
.19
.33
180Bday
.40
.20
.323
Chapter 11
20
Interest Rate Parity Theorem
If interest rate parity holds, you should earn exactly the
same return by following either of two strategies:
Strategy 1:
Invest in the U.S. for 180 days with a current rate of 20%
Strategy 2:
a) Sell $ for euros (€) at the current rate (spot rate) of
0.42.
b) Invest € proceeds for 180 days in Germany with a
current rate of 32.3 percent.
c) Receive the proceeds of the German investment
receiving (€ 2.7386 in 180 days).
d) Sell the proceeds of the German Investment for dollars
through a 180-day forward contract initiated at the
outset of the investment horizon for a rate of 0.40.
Chapter 11
21
Interest Rate Parity Theorem
Strategy 1
Invest in the U.S. for 180 days. You will have the following
in 6 months:
FV = PV(1+i)N
Alternative notation:
FV = DC (1+RDC)
FV = $1(1+.20)0.5
FV = $1.095
Chapter 11
22
Interest Rate Parity Theorem
Strategy 2:
a) Sell $ for euros (€) at the current rate (spot rate) or
0.42. You will receive:
1
 €2.381
0.42
b)
Invest euro proceeds for 180 days in Germany with a
current rate of 32.3 percent.
FV = PV(1+i)N or FV = DC (1+RDC)
= 2.381(1+.323)0.5
= €2.7386
c) Receive the proceeds of the German Investment
(receiving € 2.7386 in 180 days). Take your euros out
of bank.
Chapter 11
23
Interest Rate Parity Theorem
Strategy 2:
d) Sell the proceeds of the German investment for dollars
through a 180-day forward contract initiated at the
outset of the investment horizon for a rate of 0.40.
$U.S. = €($/€)
$U.S. = 2.7386 (0.40) or $U.S. = $1.09544
This amount can be stated as:
FV  ( DC / FC)(1  rFC ) F0,t
DC/FC = the rate at which the domestic currency can
be converted to the foreign currency today.
rFC
= the rate that can be earned over the time
period of interest on the foreign currency.
F0,t
= the forward or futures contract rate for
conversion of the foreign currency into the
domestic currency.
Chapter 11
24
Interest Rate Parity Theorem
FV  ( DC / FC)(1  rFC) F 0, t
FV  (
1
)(1  0.323) 0.5 0.40
0.42
FV  $1.0954
The two strategies produce the same return, so there is no
arbitrage opportunity available. If the two produced
different returns, an arbitrage strategy would be present.
Chapter 11
25
Interest Rates Parity Theorem
The equality between the two strategies can also be stated
as:
DC(1 + rDC) = (DC/FC)(1 + rFC)F0,t
Where
DC
= the dollar amount of the domestic currency
rDC
= the rate that can be earned over the time period
of interest on the domestic currency
DC/FC = the rate at which the domestic currency can be
converted to the foreign currency today
rFC
= the rate that can be earned over the time period
of interest on the foreign currency
Fo,t
= the forward or futures contract rate for
conversion of the foreign currency into the
domestic currency
Chapter 11
26
Interest Rates Parity Theorem
Using the previous example:
DC(1  rDC )  ( DC / FC)(1  rFC) F 0, t
$1.0954  $1.0954
We can manipulate the equality to solve for other
variables:
F 0, t 
DC(1  rDC )
1  rDC
 FC
( DC / FC)(1  rFC )
1  rFC
(
)
The above equation says that, for a unit of foreign
currency, the futures price equals the spot price of the
foreign currency times the quantity:
 1+ r

 1+ r
DC
FC



This quantity is the ratio of the interest factor for the
domestic currency to the interest factor for the foreign
currency.
Chapter 11
27
Interest Rates Parity Theorem
We can compare the last equation to the Cost-of-Carry
Model in perfect markets with unrestricted short selling, we
obtain:
1+

1 + Cost-of-Carry =  r DC   1 + (r
 1 + r FC 
DC
-r
FC
)
The cost of carry approximately equals the difference
between the domestic and foreign interest rates for the
period from t = 0 to the futures expiration.
Applying this equation for the 180-day horizon using
the rates from Table 11.4.
F0,t
S0
rDC
rFC
=
=
=
=
.40
.42
.095445 for the half-year
.150217 for the half-year
The result is:
 1.095445
.40 = .42 

 1.150217
Chapter 11
28
Exploiting Deviations from Interest Rate
Parity
In the event that the two rates are not equal, the arbitrage
that would be undertaken is referred to as covered interest
arbitrage. Where we would borrow the $1 needed to
undertake Strategy 2 above. If the rate earned on the
investment is higher than the cost of borrowing the $1, an
arbitrage profit can be earned. This is equivalent to cashand-carry arbitrage.
This cash-and-carry strategy is known as the covered
interest arbitrage in the foreign exchange market.
Chapter 11
29
Exploiting Deviations from Interest Rate
Parity
Covered Interest Arbitrage
0
1
1. Borrow DC @ RDC
2. Sell FC forward/futures
3. Exchange &
receive DC/FC
4. Invest FC @ RFC
DC
FC
RDC
RFC
5. Receive DC/FC
plus accrued RFC
6. Deliver FC at RFC
7. Receive DC
8. Pay loan (DC +RDC)
= Domestic fund/currency
= Foreign currency/funds
= Domestic interest rate
= Foreign interest rate
If Interest Rate Parity (IRP), the exchange rate equivalent of
the Cost-of-Carry Model, holds the trader must be left with
zero funds. Otherwise an arbitrage opportunity exists.
Chapter 11
30
Exploiting Deviations from Interest Rate
Parity
Using the data from our previous example, Table 11.5
shows the transactions that will exploit this discrepancy.
Table 11.5
Covered Interest Arbitrage
t = 0 (present)
Borrow 2.3810 in Germany for 90 days at 33%.
Sell 2.3810 spot for $1.00.
Invest $1.00 in the U.S. for 90 days at 19%.
Sell $1.0355 90 days forward for DM 2.5570.
t = 90 (delivery)
Collect $1.0444 on investment in U.S.
Deliver $1.0355 on forward contract; collect 2.5570.
Pay 2.5570 on 2.3810 that was borrowed.
Profit:
$1.0444
B 1.0355
.0089
Chapter 11
31
Purchasing Power Parity Theorem
The Purchasing Power Parity Theorem (PPP) asserts that
the exchange rates between two currencies must be
proportional to the price level of traded goods in the two
currencies. Violations of PPP can lead to arbitrage
opportunities, such as the example of “Tortilla Arbitrage”
shown in Table 11.6.
Assume that transportation and transaction costs are zero
and that there are no trade barriers. The spot value of
Mexican Peso (MP) is $.10.
Table 11.6
Tortilla Arbitrage
Mexico City
New York
MP/$
Cost of One Tortilla
10
10
MP 1
$.15
Arbitrage Transactions:
Sell $1 for MP 10 in the spot market.
Buy 10 tortillas in Mexico City.
Ship the tortillas to New York.
Sell 10 tortillas in New York at .15 for $1.50.
Profit:
$1.50
B 1.00
.50
Chapter 11
32
Purchasing Power Parity Theorem
Over time, exchange rates must conform to PPP. Table
11.7 presents prices and exchange rates at two different
times (PPP at t = 0, PPP at t = 1).
Table 11.7
Purchasing Power Parity Over Time
Expected Inflation Rates from t = 0 to t = 1:
Exchange Rates MP/$
Tortilla Prices
Mexico City
New York
$
MP
.10
.20
t=0
10.00
t=1
10.91
MP 1.00
$ .10
MP 1.20
$ .11
Chapter 11
33
Speculation in Foreign Exchange
Speculating with an Outright Position
Assume that today, April 7, a speculator has the following
information about the exchange rates between the U.S.
and the euro. Table 11.10 shows the exchange rates.
Based on the exchange rate information, the market
believes the euro will rise relative to the dollar. The
speculator disagrees. The speculator believes that the
price of the euro, in terms of dollars, will actually fall over
the rest of the year.
Table 11.10
Foreign Exchange PricesCSpot and Futures, April 7
$/
Spot
JUN Futures
SEP Futures
DEC Futures
.4140
.4183
.4211
.4286
Chapter 11
34
Speculation in Foreign Exchange
Speculating with an Outright Position
Table 11.11 shows the speculative transactions that the
speculator enters to take advantage of her/his belief.
Table 11.11
Speculation in Foreign Exchange
Cash Market
April 7
Anticipates a fall in the value
of the euro over the next 8
months.
December 10
Spot Price $/= .4211
Futures
Market
Sell one DEC
euro futures
contract at
.4286.
Buy one DEC
euro futures
contract at
.4218.
Profit:
$ .4286
B .4218
Profit per euro
$ .0068
Times euro per contract 125,000
Total Profit
$ 850
The speculator’s hunch was correct, and thus made a
profit.
Chapter 11
35
Speculation in Foreign Exchange
Speculating with Spreads
Spread strategies include intra-commodity and intercommodity. Assume that a speculator believes that the
Swiss franc will gain in value relative to the euro but is also
uncertain about the future value of the dollar relative to
either of these currencies.
The speculator gathers market prices for June 24 $/C and
$/SF spot and future exchange rates. Table 11.12
summarizes the information.
Table 11.12
Spot and Futures Exchange Rates, June 24
Implied DM/SF
CrossBRate
$/SF
$/
Spot
.3853
.4580
1.1887
SEP
.3915
.4616
1.1791
DEC
.4115
.4635
1.1264
MAR
.4163
.4815
1.1566
JUN
.4180
.5100
1.2201
Chapter 11
36
Speculation in Foreign Exchange
Speculating with Spreads
Table 11.13 shows the transactions that the speculator
enters to exploit his/her belief that the December cross rate
is too low.
Table 11.13
A Speculative CrossBRate Futures Spread
Date
Futures Market
June 24
Sell one DEC euro futures contract at .4115.
Buy one DEC SF futures contract at .4635.
Buy one DEC euro futures contract at .3907.
Sell one DEC SF futures contract at .4475.
December 11
Futures Trading Results:
Sold
Bought
 125,000
euro
.4115
B .3907
$.0208
SF
.4475
B .4635
B$.0160
= $2,600
B $2,000
Total Profit: $600
Chapter 11
37
Speculation in Foreign Exchange
Speculating with Spreads
Assume that a speculator observes the spot and futures
prices as shown in Table 11.14. The speculator observes
that the prices are relatively constant, but believes that the
British economy is even worse than generally appreciated.
She anticipates that the British inflation rate will exceed the
U.S. rate. Therefore, the trader expects the pound to fall
relative to the dollar.
Table 11.14
Spot and Futures Prices, August 12
$/British Pound
1.4485
1.4480
1.4460
1.4460
1.4470
Spot
SEP
DEC
MAR
JUN
Because the speculator is risk averse, she decides to trade
a spread instead of an outright position.
Chapter 11
38
Speculation in Foreign Exchange
Speculating with Spreads
Table 11.15 shows the transactions that the speculator
enters to exploit her belief.
Table 11.15
Time Spread Speculation in the British Pound
Date
Futures Market
August 12
Buy one DEC BP futures contract at 1.4460.
Sell one MAR BP futures contract at 1.4460.
Sell one DEC BP futures contract at 1.4313.
Buy one MAR BP futures contract at 1.4253.
December
March
December 5
Sold
Bought
 25,000
1.4313
B 1.4460
B $.0147
1.4460
B 1.4253
$.0207
= B $367.50
+ $517.50
Total Profit: $150
As a result of her conservatism, the profit is only $150. Had
the trader taken an outright position by selling the MAR
contract, the profit would have been $517.50.
Chapter 11
39
Hedging with Foreign Exchange Futures
Hedging Transaction Exposure
You are planning a six-month trip to Switzerland. You plan
to spend a considerable sum during this trip. You gather
the information in Table 11.6.
Table 11.16
Swiss Exchange Rates, January 12
Spot
MAR
JUN
SEP
DEC
.4935
.5034
.5134
.5237
.5342
After analyzing the data, you fear that spot rates may
rise even higher, so you decide to lock-in the existing
rates by buying Swiss franc futures.
Chapter 11
40
Hedging with Foreign Exchange Futures
Hedging Transaction Exposure
Table 11.17 shows that transaction that you enter in order
to lock in your exchange rate.
Table 11.17
Moncrief's Swiss Franc Hedge
Cash Market
Futures Market
January 12 Moncrief plans to take a sixB
Moncrief buys 2 JUN SF futures
month vacation in Switzerland, contracts at .5134 for a total
cost of $128,350.
to begin in June; the trip will
cost about SF 250,000.
June 6
The $/SF spot rate is now .5211, Moncrief delivers $128,350 and
giving a dollar cost of $130,275 collects SF 250,000.
for SF 250,000.
Savings on the Hedge = $130,275 B 128,350 = $1,925
In this example, you had a pre-existing risk in the
foreign exchange market, since it was already
determined that you would acquire the Swiss francs.
By trading futures, you guaranteed a price of $.5134
per franc.
Chapter 11
41
Hedging with Foreign Exchange Futures
Hedging Import/Export Transaction
You, the owner of a import/export business, just finished
negotiating a large purchase of 15,000 Japanese watches
from a firm in Japan. The Japanese company requires your
payment in yens upon delivery. Delivery will take place in
6 months. The price of the watches is set to Yen 2850 per
watch (today’s yen exchange rate). Thus, you will have to
pay Yen 42,750,000 in about seven months.
You gather the information shown in Table 11.18. After
analyzing the information, you fear that dollar may lose
ground against the yen.
Table 11.18
$/Yen Foreign Exchange Rates, April 11
Spot
JUN Futures
SEP Futures
DEC Futures
.004173
.004200
.004237
.004265
Chapter 11
42
Hedging with Foreign Exchange Futures
Hedging Import/Export Transaction
To avoid any worsening of your exchange position, you
decide to hedge the transaction by trading foreign
exchange futures. Table 11.19 shows the transactions.
Table 11.19
The Importer's Hedge
April 11
November 1
Cash Market
Futures Market
The importer anticipates a
need for Yen 42,750,000 in
November, the current value
of which is $178,396, and
which have an expected value in November of $182,329.
Receives watches; buys Yen
42,750,000 at the spot market
rate of .004273 for a total of
$182.671.
Spot Market Results:
The importer buys 3 DEC yen
futures contracts at .004265
for a total commitment of
$159,938.
Anticipated Cost $182,329
B Actual Cost
B 182,671
B$ 342
Profit = $187
Sells 3 DEC yen futures contracts at .004270 for a total
value of $160,125.
Futures Market Results:
Net Loss: B $155
Notice that because you were not able to fully hedge
your position, you still had a loss.
Chapter 11
43
Hedging with Foreign Exchange Futures
Hedging Translation Exposure
Many global corporations have subsidiaries that earn
revenue in foreign currencies and remit their profits to a
U.S. parent company. The U.S. parent reports its income in
dollars, so the parent's reported earnings fluctuate with the
exchange rate between the dollar and the currency of the
foreign country in which the subsidiary operates. This
necessity to restate foreign currency earnings in the
domestic currency is called translation exposure.
Chapter 11
44
Hedging with Foreign Exchange Futures
Hedging Translation Exposure
The Schropp Trading Company of Neckarsulm, a
subsidiary of an American firm, expects to earn 4.3 million
this year and plans to remit those funds to its American
parent. The company gathers information about the euro
exchange rates for January 2 and December 15 as shown
in Table 11.20.
With the DEC futures trading at .4211 dollars per euro on
January 2, the expected dollar value of those earnings is
$1,810,730. If the euro falls, however, the actual dollar
contribution to the earnings of the parent will be lower.
Table 11.20
Exchange Rates for the Euro
Spot
DEC Futures
January 2
December 15
.4233
.4211
.4017
.4017
Chapter 11
45
Hedging with Foreign Exchange Futures
Hedging Translation Exposure
The firm can either hedge or leave unhedged the value of
the earnings in euros, as Table 11.21 shows.
Table 11.21
Schropp Trading Company of Neckarsulm
January 2
Expected earnings in Germany for the year:4.3 million
Anticipated value in U.S. dollars: $1,810,730
(computed @ .4211 $/)
Schropp Trading Company's Contribution to Its Parent's Income:
Contribution to parent's income in U.S. Dollars from 4.3 million earnings (Assumes
spot rate of .4017)
Futures profit or loss
(Closed at the spot rate of .4017)
Total
Chapter 11
Unhedged
Hedged
$1,727,310
$1,727,310
0
$ 84,875
$1,727,310
$1,812,185
46