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Analytical Application: The Use of Currency Future Contracts as a Hedging Strategy to Mitigate the Likelihood f Adverse Foreign Exchange Movements - Case Study Example

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This analysis focuses on the use of currency futures contracts as a hedging strategy to mitigate the likelihood of adverse foreign exchange movements. There are three scenarios in this discussion: Hedging against Payables, Hedging against Receivables, and Speculation, Options, and PIPs…
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Analytical Application: The Use of Currency Future Contracts as a Hedging Strategy to Mitigate the Likelihood f Adverse Foreign Exchange Movements
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Download file to see previous pages Hedging against Payables Currency future contracts allows organizations to trade in the respective currencies in which payments and receipts are to be made. These currencies are traded in the form of contracts such that each contract is composed of certain units of a particular currency. In this scenario, the currency is the Euro and the reference currency is assumed to be US Dollars. Therefore, one contract of Euro consists of €125,000. So in order to hedge the payment of around €500,000, the number of Euro contracts required for hedging are 4 i.e. (€500,000/€125,000). In case of payment, the standard hedging strategy would be to buy four Euro futures contracts expiring in June as the conventional period of contracts is three months such that March, June, September and December futures contracts are available for trading. As the payment is to be made in three months from now, therefore, June future contract would be the most suitable contract in this regard. The current spot price is €1=$1.3167 and the Future June Contract price is €1=$1.3114. Therefore, the organization will be facing the danger of Euro currency to be more expensive in the future against the US Dollars such that it will have to pay more US Dollars for the payment of €500,000. In this case, the appropriate hedging strategy would be to buy four Euro currency futures contracts and sell them at the time of actual payment. Assuming that if the spot price after three months increases, it will result in again for the future contracts that the organization has bought earlier but simultaneously, the increasing spot rate would result in the loss in the actual cash transactions of buying €500,000 at a higher price. In this way, the gain realized from the future market will offset the loss that would be incurred in the actual purchase of Euro currency. If the situation turns the other way round and the spot rate of Euro decreases, then there would be a loss in the future contracts that organizations had bought three months earlier, but simultaneously the organization will have to pay less US Dollars to purchase €500,000. ...Download file to see next pagesRead More
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