Discussion of the types of hedging strategies in the foreign exchange markets along with a case study on " Currency Futures"

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INTERNATIONAL FINANCE
CURRENCY FUTURES
[9/12/2014]
PREPARED BY:
AANCHALSAXENA 12032303
AVANTI MUKUL 12032274
CHARMI DUTIA 12032275
KISHAN SHINGADIYA 11030077
VAISHAKH SASIKUMAR 12032273

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Table of Contents
The Foreign Exchange Market ................................................................................................................3
Types of Foreign Exchange Transactions ............................................................................................3
Importance of the Foreign Exchange Market .....................................................................................3
Future Contracts and Hedging Strategies...............................................................................................4
Short Hedge using futures ..................................................................................................................4
Long Hedge using futures ...................................................................................................................5
Forward Contracts ..................................................................................................................................6
Hedging using Forward Contracts.......................................................................................................6
CASE 1 (payables)................................................................................................................................6
Case 2 (receivables) ............................................................................................................................7
Options....................................................................................................................................................8
Call option:-.........................................................................................................................................8
Put option:- .........................................................................................................................................8
Advantages and Disadvantages of Various Hedging Tools .....................................................................9
Case Study.............................................................................................................................................10
Key Terms..........................................................................................................................................10
Margin Account of the US Exporter..................................................................................................11
References: ...........................................................................................................................................14
Appendix 1 ............................................................................................................................................15
Calculation of Gain/Loss: ..................................................................................................................15

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The Foreign Exchange Market
The foreign exchange market is a market that spreads across the entire globe, with currencies
being exchanged every hour and prices constantly fluctuating every day. The foreign
exchange market comprises of a physical and institutional structure which builds the
foundations through which the money of one country can be traded with another. It facilitates
international trade transactions by providing and attaining credit and minimizes foreign
exchange risk by reducing financial exposure. It settles the rate of exchange between
currencies leading to the physical completion of transactions. Here, foreign exchange is the
funds of a foreign country and a foreign exchange transaction is the contract between the
buyer and the seller where the given sum of one currency is to be delivered at a particular rate
for another currency. (CME Group, 2013)
Types of Foreign Exchange Transactions
There are mainly three different types of transactions implemented in the foreign exchange
market. These include transactions on a spot basis, forward basis and a swap basis.
Transactions on a spot basis call for an immediate deliverance of foreign exchange. A
forward transaction involves the delivery of foreign exchange at a future date, either through
a ‘future’ contract or through an ‘outright’ basis. A swap transaction involves exchanging one
foreign currency for another, simultaneously. (Moffet, Stonehill and Eiteman, 2014)
Importance of the Foreign Exchange Market
Since international trade involves participants living in countries that do not share the same
home currencies, transfer of purchasing power is necessary. Normally, each country prefers
to deal in their home currency but given that transactions and trade can be carried out in only
one currency one out of the two participants has to work with foreign currency.
Stock in transit needs to be funded as transporting goods between countries can be time
consuming. Here, the foreign exchange market works as a source of capital by regularly
financing the moving inventories.
Lastly, one of the most important uses of the foreign exchange market is that it provides
hedging facilities for transferring risk during transactions to someone more eager to bear the
risk. This has been further discussed in this essay in detail.

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Future Contracts and Hedging Strategies
A future contract also referred to as futures is an agreement between two parties involving the
buying or selling of a particular asset for a price decided between the parties today (futures
price) with the delivery and payment ensuing at a pre-decided future date (delivery date).
However since future prices are constantly changing the price paid on the delivery date is not
the same as the price decided by the parties when they first entered into the contract (spot
price).
Although the main aim of a futures contract is to assist international trade, it also ensures risk
reduction associated with the prospect of defaulting by the parties involved. This is known as
hedging the risk. Shareholders hedge risk to make outcomes more certain and reduce the risk.
Hedging future contracts can increase or decrease a firm’s profits as opposed to firms that do
not hedge leading to constant or stagnant profits. (Colorado, 2014 and Deptfin, 2014)
Short Hedge using futures
In futures a short hedge refers to a short position taken up by the party that sells the asset in
the future. Instead, it can also be used by a speculator who expects the price of the asset to
decrease in the future.
For example,
A shepherd wants to sell a flock of sheep in February based upon the spot rate at that time; he
can hedge using the subsequent approach:
A future contract is agreed upon, with delivery and purchase in February for $150. Let us
assume, the Shepherd anticipates selling £50,000. At present, the Spot price is $155. Suppose
the spot price decreases to $140 in February. This will cause a loss of $10 per £100 on
making the sale due to the reduced price. He will gain $10 by buying it immediately at $140
after selling it for $150.
Consequently, suppose the price increases to $160 in February. This will cause a gain of $10
per £100 on making the sale due to the increased price. He will lose $10 by selling it
immediately at $160 after buying it for $150. In both cases the effective price of the sale is
$150.
Hence the shepherd (seller) was able to lock in the price by balancing any gains/losses.

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Long Hedge using futures
In futures a long hedge refers to a long position taken up by the party that buys the asset in
the future. Instead, it can also be used by a speculator who expects the price of an asset to
increase in the future. ( Montana, 2014)
For example,
A shoemaker wants to buy 2,000 rolls of leather in July based upon the spot rate at that time;
he can hedge using the subsequent approach:
A future contract is agreed upon, with delivery and purchase in July for $59 per roll. At
present the spot price is $60. Suppose the spot price decreases to $55 in July. This will cause
a gain of $4 per roll on making the purchase due to the reduced price. The shoemaker will
lose $4 by immediately selling at $55 after buying it for $59.
Consequently, suppose the price increases to $65 per roll in July. This will cause a loss of $6
per roll on the purchase due to the increased price. The shoemaker will gain $6 by
immediately buying for $65 after selling it for $59. In both cases the effective price of the
sale is $59
Hence the shoemaker was able to lock in the prices by balancing any gains/losses.

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Forward Contracts
A forward contract (or simply forward) is defined as,
“An agreement between 2 parties to trade a specific asset, for example a stock, at a future
time T, at and at a certain price K.” (Blythe and Stephen, 2013)
Here K indicates Delivery time and T marks Maturity. These underlying assets of the
contract (K, T) remain fixed whereas the value of the contract fluctuates over time.
Forex forward contracts are highly liquid and widely traded with nearly $60 trillion
outstanding contracts as of December 2013. Various institutions employ forward contract to
manage foreign exchange exposure of future cash flows.
Hedging using Forward Contracts
Forward hedge functions with foreign exchange forwards. It is parallel to the future hedge
except the fact that, future gains/losses is settled on a daily basis but forward gains/losses is
settled at the termination of the contract. In order to hedge future foreign currency cash
outflows, the business is likely to enter into a short position forward contract to procure the
appropriate amount of foreign currency at a fixed exchange rate. To hedge future currency
cash inflows, firm enters into a long position forward contract to sell the entitled amount at
the fixed exchange rate.
For example;
CASE 1 (payables)
A British car dealer specialized in importing Italian cars has made orders for the next year
where he is liable to pay €30 million in 12 months. Concurrently, he is worried about the
sterling-euro exchange rate fluctuations on accounts payable. For instance, if the exchange
rate is €1.48/£ then the cash outflow in pounds will be £20.27 million. But the payment in
pounds will be £21.73 million if the exchange rate dropped to €1.38/£. Hence, with the
current exchange rate being €1.4423/£ the importer enters into a forward contract, whereby
the he fixed the cash outflows to £20.80 regardless of the exchange rate in 12 months.
The importer makes a forward gain if the forward contract matures falls below the forward
exchange rate of €1.4423/£. Importer makes a loss if the forward contract matures rises
above forward exchange rate €1.4423/£.

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Case 2 (receivables)
Suppose a German company doing business in US will receive $100 million in US dollars in
6 months and intends to convert the payment into euros when the payment is made; Current
exchange rate between German euros and US dollars is €110.355/100$. The firm decides to
enter into a forward contract to hedge the exchange rate risk by selling the US dollars at
€109/100$. Forward exchange rate is less than the existing exchange rate, but the firm
accepts it because the future exchange rates will be even lower.
Source ( Wang and Pejje, 2005)

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Options
“Option is an agreement between two parties (buyer & seller) although, the buyer of the
option has the right but not the obligation to buy a specified currency at a specified rate, on or
before specified expiry date from the seller”
The two types of option are; the put option and the call option.
Call option:- The buyer has the right to buy specific currency, at a specific exchange rate
on or before the expiry date.
For example;
A trader buys an October £1 call option for £0.10, which means he can buy using this option
on or before the expiry date in October from the seller. £0.10 is the premium paid by the
buyer and £1 is the exercise price or strike price. Trader will use his right and buy the option
if the pound appreciates more than £1, but will allow the contract to expire if the pound
depreciates below £1.
Put option:- The seller has the right to sell a specific currency, at a specific exchange rate
on or before the expiry date.
For example;
Brandroot Co is a US based exporting company which is expected to receive Canadian
dollars in six months. Brandroot is concerned whether the Canadian dollar will depreciate in
the future. Brandroot buys Canadian dollars put option which gives the company the right to
sell the Canadian dollars at a specified strike rate. The company locks the minimum rate at
which it can convert Canadian dollars to US dollars.
However, if Canadian dollar depreciates, then the company can let the option to expire and
sell the Canadian dollars it receives at the spot rate.
( Mandura and Jeff, 2011)

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Advantages and Disadvantages of Various Hedging
Tools
Financial Instruments Advantages Disadvantages
Forward Contracts :
Can be used for any amount
Currency risk can be hedged
completely
Challenging to look for a
counter party (lacks
flexibility and liquidity)
Tied up capital is required
Presence of default risk
Futures Contracts:
Has high liquidity
Positions could be reversed
without difficulty
Does not require much tied
up capital
Can be used only for fixed
amounts
Currency risk is hedged only
partially
Presence of basis risk
Options :
Maximum loss is the
premium paid.
Does not require much tied
up capital
Positions could be reversed
without difficulty
Can be used only for fixed
amounts
Lacks liquidity
Presence of basis risk
Currency risk is hedged only
partially

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Case Study
Key Terms
Margin Account :
It is account created with the broker to make a deposit as a security for financial transactions
otherwise financed on credit. It is used to reduce counterparty risk. In the given case , the US
exporter opens a long position for hedging @ £ 1.5666/$ .
Initial Margin:
When the margin account is created, the broker requires the investor to deposit a certain
amount of money. This initial amount is called as the initial margin. In the given case the
initial margin is taken as : $683 X 93 contracts = $63519, Thus converting it on day 0's ( 19th
Nov 2014 ) spot rate i.e £1.5666/$ = £ 99508.86
Marking to Market :
at the end of each day the margin account is adjust to reflect the final gain and loss using the
settlement prices of futures for the day which is termed as marking to market.
Maintenance Margin :
The margin account is required to maintain a balance up to a certain amount at all times .
This is known as the maintenance margin. In our given case, the US exporter is required to
keep the maintenance margin @ 75% of the initial margin which is £ 74631.65 .
Margin Call :
Should the margin account value fall below the level of maintenance margin level, the
investor is called upon to top up the value of the margin account until the margin account
balance is equal to the initial margin amount. This is known as margin call.

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In the given case, The US exporter is expected to receive £925000 in 3 months time. Since
the US exporter is concerned over exchange rate movements in these months and thus
decides to hedge his exposure by taking a position on the NYSE Euronext Market. He opens
up a margin account through futures to hedge his risk.
The below account shows the number of days for which the margin account has been
prepared. It reflects spot rates, future prices and gains or losses made through the changes in
the rates. Future prices used to calculate gain or loss is done through using British Pound/ US
Dollar future. This account is prepared using the actual spot rates and future prices on NYSE
Liffe market.
On 19th
November 2014, he opens a short position @ £1.5666/$ and hence deposits
£99,508.86 into his margin account as his initial margin.
Margin Account of the US Exporter
(NYSE Euronext)
(Refer appendix for Gain/Loss calculations)
In the above table, the basis is the difference between spot rate and the future rate. This is to
prove the convergence theory of future and spot rates. Convergence theory illustrates that the
basis decreases as the future contract nears its expiry date and becomes nil when the future
contract reaches its maturity.
Days: Spot Rate
(£/$)
Future
Price (£/$)
Basis Gain/(loss) Margin A/c
(£)
Margin
Call
19th
1.5666 1.5666 - - 99,508.86 -
20th
1.5702 1.5688 0.0014 (2046) 97,462.86 -
21st
1.5678 1.5674 0.0004 1302 98,764.86 -
24th
1.5698 1.5707 0.0009 (3069) 95,695.86 -
25th
1.5725 1.5721 0.0004 (1302) 94,393.86 -
26th
1.5794 1.5784 0.0010 (5859) 88,534.86 -
27th
1.5725 1.5715 0.0010 6417 94,951.86 -

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The US exporter would prefer to go for a short hedge in the futures market. This is because
he suppose to receive British Pounds from the UK importer in the coming three months and
would prefer to sell it and buy back his domestic currency.
As seen in the calculations in Appendix 1 , the exporter made a loss of £4557 in the margin
account . Now let us further calculate the total loss or gain that he incurs due to his
transaction with the British Importer.
Amount to be received £925,000
Discount of 2% allowed to the Importer for early payment (£18,500)
Margin account loss (£4,557)
Net results in Pounds £ 901,943
Since the Amount of the net result be converted into the US Exporter's home currency, we
take the spot rate on the 7th day i.e £1.5725/$ = $573,572.65 , which is the final amount that
the exporter will be left with after carrying out the entire transaction with the UK importer.
Now let us look at this situation from another perspective, Assume the UK importer had
decided to pay the US importer the entire amount i.e £925,000 after 3 months , and the
exporter had not hedged his risk, then his net gain or loss from the transaction would have
been the following:
Using interest rate parity ,Expected spot rate in 3 months time =
Spot Rate Today * (1+ interest rate of UK) / ( 1+interest rate of US)
given ,
Interest rate in the Uk is 0.5% Interest rate in the USA is 0.25%
source: (Tradingeconomics.com, 2014)
£ 1.5666/$ * ( 1+ 0.05) / (1 + 0.25)
= £1.3159/$
Now if we calculate the net amount at this expected spot rate, the exporter would have
expected to received
£925000 @ £1.3159/$ = $ 702,940.95 .

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Thus , we can observe that even though the US exporter decided to hedge his risk and had to
close his position in the margin account in 7 days due to early payment on which he had to
allow a 2% discount, his net amount received is $573,572.65 . Whereas , if the payment was
made after 3 months without the exporter hedging his risk , he would have expected to
receive $ 702,940.95
This occurred due to the fall in the future expected spot rate in the next 3 months. Thus the
exporter lost on $129,368.3 due to his decision of hedging against the risk.

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References:
 Colorado (2014), The Foreign Exchange Market [online]. Available from:
http://www.colorado.edu/Economics/courses/boileau/4999/sec3.PDF [Accessed 4th
Dec 2014]
 Deptin (2014), Hedging Strategy using Futures[online]. Available from:
http://140.123.5.6/deptfin/course_data/Data/Lecture04.pdf [Accessed 4th Dec 2014]
 H. Moffett, M., I. Stonehill, A. and K. Eiteman, D. (2014). Fundamentals of
Multinational Finance. 4th ed. Harrlow: Pearson Education Limited 2014, pp.172-
173.
 CME Group (2013), Understanding FX Futures [online]. Available from:
http://www.cmegroup.com/education/files/understanding-fx-futures.pdf [Accessed
4th Dec 2014]
 Montana (2014), Hedging Strategies Using Futures and Options [online]. Available
from: http://www.montana.edu/ebelasco/agec421/classnotes/strategies.pdf [Accessed
4th Dec 2014]
 Blythe, Stephen 2013, An Introduction to Quantitative Finance, Oxford University
press, UK
 Wang, Peijie 2005, Economics of Foreign Exchange & Global Finance, Springer
Publishing Company, N.Y
 Madura, Jeff 2011, International Financial Management,11th
edn,Cengage
learning,Boston,US
 Tradingeconomics.com,(2014). United States Fed Funds Rate/1971-
2014/data/chart/calendar. [online] Available at:
http://www.tradingeconomics.com/united-states/interest-rate [Accessed 4th Dec 2014]

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Appendix 1
Shown below is the calculation of his gain/ loss :
Calculation of Gain/Loss:
20th
November 2014:
Opening short @ 1.5666
Closing long @ 1.5688
Gain/(Loss) per contract (0.0022)
Total gain/(loss) on the transaction = Gain/Loss per contract X number of contracts X
contract size
= 0.0022 × 93 × 10,000
= (£2046)
21st
November 2014:
Opening short @ 1.5688
Closing long @ 1.5674
Gain/(Loss) per contract 0.0014
Total gain/(loss) on the transaction = 0.0014 × 93 × 10,000
= (£1302)
24th November 2014:
Opening short @ 1.5674
Closing long @ 1.5707

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Gain/(Loss) per contract (0.0033)
Total gain/(loss) on the transaction = 0.0033 × 93 × 10,000
= (£3069)
25th
November 2014:
Opening short @ 1.5707
Closing long @ 1.5721
Gain/(Loss) per contract (0.0014)
Total gain/(loss) on the transaction = 0.0014 × 93 × 10,000
= (£1302)
26th
November 2014:
Opening short @ 1.5721
Closing long @ 1.5784
Gain/(Loss) per contract (0.0063)
Total gain/(loss) on the transaction = 0.0063 × 93 × 10,000
=(£5859)
27th
November 2014:
Opening short @ 1.5784
Closing long @ 1.5715
Gain/(Loss) per contract 0.0069
Total gain/(loss) on the transaction = 0.0069 × 93 × 10,000
= £6417
thus, net gain / (loss) incurred by the US exporter on the margin account :

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initial deposit = £ 99508.86
Less: margin call = £ 0
Less: bal on final day in the margin a/c = (£ 94951.86)
___________
Therefore, loss incurred = (£ 4557)

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Contribution Graph (%) :
0
5
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