Hedging

Hedging with Derivatives and
Money Market Hedge
Now that we’re familiar with options, let’s
look at using forward rates, futures rates
and call and put options to hedge a long
(Account Receivable or Note Receivable)
or short (Account Payable or Note
Payable) position in a currency. First, let’s
assume that we sold merchandise to a
British firm for 1 million pounds payable in
6 months.
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Hedging with a Forward Contract
with a Bank
One alternative is to go to our bank who,
deals in foreign exchange, and simply
lock-in the value of the 1 million pounds
sterling that we will receive in six months
with a forward contract with the bank.
Assume that the forward rate that the bank
offers to us is USD 1.5179 per pound.
Then, we are guaranteed that the amount
we will receive will be the following:
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Hedging with a Forward Contract
with a Bank
Value of 1 million pound receivable
= 1,000,000 pounds * USD 1.5179 per
pound
= USD 1,517,900
What should be apparent, however, is that
whether the pound appreciates or
depreciates, we’ve locked-in the amount
that we will receive: USD 1,517,900
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Hedging with a Futures Contract
An alternative to contracting privately with
a bank is to contract for 1,000,000 pounds
with futures contracts. Assuming that the
futures rate of exchange is USD 1.5204
per pound, but will include transactions
costs (commissions) of 0.2%, we will net
the following amount when we receive the
one million pounds in six months:
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= 1,000,000 pounds * USD 1.5204 per
pound
= USD 1,520,400 pounds
- USD 3,041 pounds
($1,520,400*.002)
= USD 1,517,359
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Given the difference between the bank’s
forward contract and the futures contract,
it would be slightly more advantageous to
use the forward contract (USD 1,517,900
– USD 1,517,359 = USD 541). The
market effect is that there will be a slight
increase in supply of pounds in the
forward market (driving the rate down, with
less demand in the futures market (driving
the rate up). They should be the same.
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Money Market Hedge
Another alternative is to utilize the money
markets to hedge the 1 million pound
receivable. This relies upon borrowing
and investing funds via the money
markets and using the spot rate to lock-in
the amount we will receive from the
receivable.
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Money Market Hedge
Assume the following:
We can invest in British t-bills at a rate of
8% and we can borrow in Britain at a rate
of 11%.
Also, assume that we can invest in US t-
bills at a rate of 5% or borrow in the US at
an 8% rate of interest.
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Money Market Hedge
Now, think about what we are trying to do.
We will receive one million pounds in six
months, so we want to move the pounds
to the United States. The following slide
shows how we can accomplish this
through the money markets:
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Money Market Hedge
Britain
Today 6 months
Borrow/Lend
Spot Rate Forward/Future
United States
Today 6 months
Borrow/Lend
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Money Market Hedge
Since we are going to receive one million
pounds in six months, we want to move
the funds using the money markets as the
following arrows indicate:
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Money Market Hedge
As the arrows indicate, we want to borrow
against the 1 million pounds in Britain,
convert to US dollars at the spot rate of
exchange, and invest in U.S. t-bills. The
reason we want to invest in t-bills is so we
can compare the amount of dollars we will
receive today by borrowing against the
receivable with the amount of dollars we
will receive in six months using a forward
contract or a futures contract.
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Money Market Hedge
Borrowing against the 1 million pound
receivable:
= 1,000,000 pounds/(1+.055)
= 947,867 pounds
Converting to US dollars at the spot
exchange rate of USD 1.5385 per pound:
= 947,867 pounds * USE 1.5385 / pound
= USD 1,458,294
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Money Market Hedge
Investing the dollars at 5% in US t-bills for six
months
= USD 1,458,294 * 1.025
= USD 1,494,751
As is obvious, in this case the forward or futures
contract approaches will yield more funds for the
receivable than using a money market hedge.
This is due to the fact that our borrowing rate in
Britain is higher than British t-bill rates (a
transactions cost).
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Using a Put Hedge
One way of perfectly hedging our long position in
pounds by using options is to sell a call option
on the pounds and buy a put option. By selling a
call, we’ve locked-in what we will receive (the
buyer will force us to sell at the strike price) if the
pound goes up in value. By buying a put option,
we’ve locked-in what we will receive if the pound
depreciates (we can force the seller of the option
to buy pounds from us at the strike price).
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Using a Put Hedge
Assume that we can buy a put option with a
strike price of USD 1.53 per pound by paying
USD 0.015 per pound (one and one-half cents
per pound is the cost of the put option). Also,
assume that at maturity in six months that the
exchange rate is USD 1.5243 per pound. Since
the market rate of exchange is less than the
strike price, we will want to exercise our put
option and sell at the strike price of USD 1.53
per pound.
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Using a Put Hedge
= 1,000,000 pounds * USD 1.53 / pound
= USD 1,530,000
Subtracting the cost of the put option of
USD 15,000 (1,000,000 pounds * USD
0.015 per pound = USD 15,000), we will
net USD 1,515,000.
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Using a Put Hedge
= USD 1,530,000
- USD 15,000
= USD 1,515,000
Why might we be willing to buy a put option that
only nets us USD 1,515,000 when a forward
hedge or a futures hedge will net us between
USD 1,517,359 and USD 1,517,900? Because
with the put option, we still have the potential for
realizing the upside potential of an appreciation
of the pound.
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Hedging

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