A U.S. FI has a long position in 75,500,000 assets funded with U.S. dollar denominated liabilities. The

Question:

A U.S. FI has a long position in £75,500,000 assets funded with U.S. dollar denominated liabilities. The FI manager is concerned about the £ appreciating relative to the dollar and is considering a hedge of this FX risk using £ futures contracts. The manager has regressed recent changes in spot £ exchange rates on changes in £ futures contracts. The resulting regression equation is: ΔSt = 0.09 + 1.5ΔFt. Further, the Cov(ΔSt, ΔFt) was found to be 0.06844, σΔSt = 0.3234, and σΔft = 0.2279. Pound futures contracts are sold in standardized units of £62,500. Calculate the number of futures contracts needed to hedge the risk of the £75,500,000 asset. Calculate the hedging effectiveness of these futures contracts. To what extent can the manager have confidence that the correct hedge ratio is being used to hedge the FI’s FX risk position?