International Finance : Forward Contrats, Currency Futures - Coursework Example

In the current scenario, a UK-based corporation namely as Mega Company is exporting a machine to the US-based corporation, Bestway Enterprises for a sum of $500,000. This receipt is going to be received by Mega Corporation after around 3 months. So, Mega Corporation here faces a risk of strengthening the domestic currency which is Pound Sterling against US Dollars. If Pound Sterling appreciates, then there will be less amount of money would be converted in to Pound Sterling from US Dollars. So in order to combat with the exchange rate fluctuations, there are different sorts of strategies available, called as hedging strategies which are used by the corporations to reduce the element of exchange rate volatilities.

Some of these strategies are listed as under: Money Market Operations Lead Payments Netting Forward Contracts Future Contracts Options In the following discussion, only Forward Contracts and Future Contracts are discussed in detail: Forwards Contracts Forward Contracts are the ones in which an agreement is made between the parties regarding the future exchange rate. The future exchange rate is set now and the parties to contract will deliver the currencies at the rate determined at the time of contract.

This is purely a private contract such that any of the party can terminate this contract which means that it is legally binding. This contract is also called as tailor-made or customized contract such that the contract features can be designed by the parties with their consent. Future Contracts Future Contracts are also used as a hedging device to protect the corporations from the volatility of exchange rate movements. These contracts are traded in mercantile exchanges such that these are legally binding to both the parties and the local exchange market plays a role of an intermediary in respect of execution of the contracts.

The future contracts works on the principle that the party which faces an exchange rate risk can take an appropriate long or short position in future market. So if the part is going to have a loss in the open spot market, if will be overlapped by a corresponding gain in the future market and vice versa. However, it is important to note that since the future contracts are standardized contracts and are available only specific contract of currency units, therefore, it might be possible that amount of money cannot be hedged such that some amount of money can remain over or under-hedged.

Question 2 Construction of hedge through Forward Contract and Future Contracts October 20, 2011 Spot Rate ($/?) 1.5685 3 Month Forward Rate 1.5670 March Futures 1.5764 January 20,201 Spot Rate ($/?) 1.5527 March Futures 1.5518 Contract Size ?62,500 Forward Contract Setup Amount need to be hedged on October 20, 2001 for 3 Month Forward rate ($500,000/1.5670) = ?319,081 Actual Spot Rate on January 20, 2011 = $500,000/1.5527 = ?322,020 Future Contract Setup Which Contract = Future March Hedging Strategy = Buy Now, Sell Later (Because amount to be hedged and contract size are not denominated in same currency) No.

of Contracts = $500,000 / (62,500 x 1.5764) = 5.07 or 5 Contracts Mega Company needs to implement the policy of slightly under-hedge Question 3 Critical Appraisal of Forward Contracts and Future Contracts Following are the important differences among the Forwards and Futures which also act as their