QUESTION 11 ANSWER ALL PARTS OF THIS QUESTION a. Imagine that your company is going to receive certain amount of foreign currency (FC) in 6 months (this is, T1) from one of your foreign clients. You are going to use a future contract to hedge this exposure. The features of this contract are the following: 1) you do not have a future for the currency that you are exposed to, therefore you use another FC as a hedge; 2) the maturity of this future contract is one year (this is, T2); 3) the size of the future contract is one unit of the FC that you use as a hedge. Assume that the spot rate in 6 months can take any of the following three values in home currency (HC) units: 4, 5, or 6. In addition, assume that the cashflows that you can obtain from one future contract in 6 months can take any of the following three values in HC units: 5, 6, or 8. Assume that the three scenarios for the spot rate and for the future contract cashflows are equally likely. Note: Remember from the course slides that the cashflows of a future sale are defined as x Ce 12 Fr 1,72), where is the number of FC we short of the hedge in T2. Therefore, the cashflows from each future contract is free - fron,m2) REQUIRED: i. Define the concept of hedging in the context of currency markets. [5 marks] ii. Describe the main differences between future contracts and forward contracts. [8 marks] iii. Determine the expected value of the spot sale in 6 months, the expected cashflow in 6 months from shorting B = 2 units of the FC in one year, and the expected cashflows of the combination of the spot sale and the future contract. [15 marks] iv. Describe the statistical rule to hedge FC exposure using future contracts. [5 marks] QUESTION 11 ANSWER ALL PARTS OF THIS QUESTION a. Imagine that your company is going to receive certain amount of foreign currency (FC) in 6 months (this is, T1) from one of your foreign clients. You are going to use a future contract to hedge this exposure. The features of this contract are the following: 1) you do not have a future for the currency that you are exposed to, therefore you use another FC as a hedge; 2) the maturity of this future contract is one year (this is, T2); 3) the size of the future contract is one unit of the FC that you use as a hedge. Assume that the spot rate in 6 months can take any of the following three values in home currency (HC) units: 4, 5, or 6. In addition, assume that the cashflows that you can obtain from one future contract in 6 months can take any of the following three values in HC units: 5, 6, or 8. Assume that the three scenarios for the spot rate and for the future contract cashflows are equally likely. Note: Remember from the course slides that the cashflows of a future sale are defined as x Ce 12 Fr 1,72), where is the number of FC we short of the hedge in T2. Therefore, the cashflows from each future contract is free - fron,m2) REQUIRED: i. Define the concept of hedging in the context of currency markets. [5 marks] ii. Describe the main differences between future contracts and forward contracts. [8 marks] iii. Determine the expected value of the spot sale in 6 months, the expected cashflow in 6 months from shorting B = 2 units of the FC in one year, and the expected cashflows of the combination of the spot sale and the future contract. [15 marks] iv. Describe the statistical rule to hedge FC exposure using future contracts. [5 marks]
