A Redetermination of Hedging Strategies Using Foreign Currency Futures Contracts - Case Study Example

?Analytical Application In case of imports and exports, the biggest danger that organizations generally face is that of adverse movement of the exchange rates. Since the payments and receipts are normally due in the near future, therefore, organizations do not have any control over the foreign exchange rates. There are various tactics, which are used by the organizations in order to mitigate the foreign exchange risk (Lien & Tse, 2002). These hedging strategies may have various different forms among which open market operations, currency forward contract, currency future contracts and currency options are quite popular (De Jong et al, 1997). Each hedging strategy has its own pros and cons. This analysis explicitly focuses on the use of currency future contracts as a hedging strategy to mitigate the likelihood of adverse foreign exchange movements. There are three scenarios that are highlighted in the following discussion. 1. Hedging against Payables Currency future contracts allow 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 future contracts expiring in June as the conventional period of contracts is three months such that March, June, September and December future 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 a gain 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. In this case, the loss suffered in the currency future market will be offset against the gain that organization experienced as a result of decrease in the Euro spot rate after three months. Hence, in this way, the organization will be safeguarding itself for any volatility in the foreign exchange rates (Herbst et al 1992). 2. Hedging against Receivables A similar strategy would also be applied in the case of receivables such that the number of contracts to be traded is now eight as the total amount to be hedged is €1,000,000 and the size of the contract is €125,000. Since the case demands that the amount is going to be received, therefore, the biggest danger in terms of Euro currency fluctuation would be that the Euro might become cheaper such that it would earn less US Dollars if the spot price of Euro slips in three month’s time. Therefore, as part of the hedging strategy for the currency future contracts, 8 June future contracts should be sold short and then buy them back after three months. Assuming that the spot price of Euro increases, then there would be a loss in the June future contracts because those contracts are sold short at the lower price and when the time of expiry approached, the price of Euro increased, therefore, the currency futures suffer a loss by selling short at a lower price and buying back at a higher price. However, simultaneously, when receipts of €1,000,000 would be remitted, they will earn more US Dollars as the Euro price will going to be increased. As a result, the loss incurred in the future contracts will be offset by the gains in the actual selling of Euros. On the contrary, if the spot price of Euro is decreased, then there would be a gain in the June future contracts such that the future contracts were sold short at a higher spot price three months ago whereas the current spot price is decreased now, so at the expiry the future contracts will be bought at a lower price resulting in a gain. However, at the same time when that receipt of €1,000,000 will be remitted, they would fetch lesser US Dollars as the spot price after three months will be decreased. Therefore, the resulting gain in the June future contracts would be offset against the loss incurred as a result of selling the Euros at a lower price. Hence, the likelihood of Euro prices slipping can be effectively hedged by using currency future contracts in the case of receipts (Herbst et al 1992). 3. Speculation, Options and PIPs Another tactic for hedging against the adverse movements of foreign exchange rates is the use of options. The use of options can also be exercised such that options provide an opportunity to buy or sell the foreign currency at a currently specified and predetermined price. In case, if the price moves in an adverse direction, the option can be exercised, however, in case if the prices move in a favorable direction, then options can be left unexercised (Hsln et al, 1994). The biggest disadvantage of using options is the incurrence of the upfront cost, which is known as premium on options. This premium is paid irrespective of whether the option is exercised or not. In case of buying a currency for the payment case, the name of the option is referred to as “call option” and in case of selling a currency for the remittance purpose, the name of the option is referred to as the “put option”. In the case of call option, if the spot price is increased, then call option can be exercised by purchasing the foreign currency at a price specified by the call option. However, if the spot price is decreased, then it would be beneficial to lapse the call option and purchase the foreign currency from the open market at a lower cost as compared to the price set out in call option. In case of selling a foreign currency, if the spot price of the foreign currency is decreased, then the put option would be exercised and the foreign currency would be sold at the price specified in the put option. However, if the price is increased, then the put option would be left unexercised such that the foreign currency would be sold in the open market price at a higher rate as compared to the price specified in the put option. Assuming that a future contract is bought, if the price is increased by 1 percent, then it will be known as 100 PIPs i.e. 1/100 (Points in Percentage). In such case, there would be a gain of 1 percent if the price increases by 100 PIPs. If the price is reduced by 100 PIPs, it will result in a loss of 1 percent. References De Jong, A., De Roon, F. and Veld, C. (1997), Out-of-sample hedging effectiveness of currency futures for alternative models and hedging strategies. Journal of Futures Markets., 17: 817–837.  Herbst, A. F., Swanson, P. E. and Caples, S. C. (1992), A redetermination of hedging strategies using foreign currency futures contracts and forward markets. Journal of Futures Markets., 12: 93–104.  Hsln, C.-W., Kuo, J. and Lee, C.-F. (1994), A new measure to compare the hedging effectiveness of foreign currency futures versus options. Journal of Futures Markets., 14: 685–707. Lien, D. and Tse, Y. K. (2002), Some Recent Developments in Futures Hedging. Journal of Economic Surveys, 16: 357–396. Read More