How Forward Contracts and Currency Futures could be Used by TIR Plc - Assignment Example

Question a) Explain how forward contracts and currency futures could be used by TIR Plc. Your explanation should include the construction of appropriate hedges using the above data. (20 marks) Forward contract is an agreement between two parties to buy or sell a foreign currency at a particular future time period with agreeing to a particular price. It provides the ability to lock the purchase price without any direct cost and it is used by corporate treasurers to lock in cash planning, profit margin and to ensure the continuous supply of scarce resources (Barker, & Hui, 2003). Thus many business corporations and banks have been using forward contracts to ignoring future uncertainty about prices. But nonetheless speculators depend on forward contracts to bet on price changes of the underlying asset. Thus forward contracts have differed from other currency deals with reference to the size, time period and settlement procedures. Essentially forward contracts are executed over-the-counter (OTC) basically because those contracts are more conveniently executed through telephone and online trading activities in worldwide without any trading place or transactions. The asset in this instance is the currency of a country. In the same manner currency futures involve agreements by two parties to deliver and accept a financial asset on a future specified date. The difference between the two is based on the fact that Forward contracts are traded over the counter, i.e. they are fixed contracts which are not subject to any exchange. On the other hand currency futures are subject to exchange trading. Therefore they are standardized and need to be carried out through a party that would accept the exchange. Currency futures thus involve a margin while forward contracts have no such margins. Since currency futures are based on exchange the degree of risk is mitigated while forward contracts carry a greater degree of risk. The following formula is often used by hedging companies in order to determine the relative value of the contract in the future as against the current value (Hull, 2000). Future Value of Currency (FV) FV=P(1+r)n FV = Future Value of Currency P = Principal r = interest rate per year n = number of years Source: http://thismattter.com For example, if the interest rate in the United States is 7%, then the future value of a dollar in 1 year would be $1.07. Thus Futures are highly standardized, being exchange-traded, whereas forwards can be unique, being over-the-counter. Therefore in the case of physical delivery by the subsidiaries of the TIR Plc, the forward contract specifies to whom to make the delivery. The counterparty for delivery on a futures contract is chosen by the clearing house. The parent company in the UK is expecting $1.4 million by 1st of December, i.e. after three months from its US subsidiary. Thus according to the interest rate futures the sum of US dollars received by the parent company would be: $1.4m X 1.6280 = $2.2792 because at the end of the three month period the US dollar would be worth 1.6280. Question 2 (b) Discuss the merits of using forward contracts and financial futures to hedge currency risk. (20 marks) As in the investment related practices in the money market, currency hedging involves both benefits and drawbacks and those differ with reference to some factors including trading style, investment preferences, market changes, other risk-minimizing practices and trading goals (Hsin, Kuo, & Lee, 1994). Thus the benefits that are obtainable from managing the currency risk by adopting hedging practices would not be similar to all investors. However there can be identified some benefits and drawbacks of currency hedging strategy as pointed below. The main benefit of currency hedging is to minimize loss and risks to the investor. It is a great method to deal with international investment opportunities (Black, 1989). Even though such good risk protection methods are incorporated the investor still has the opportunity to make substantial profits. Currency hedging gives a certain amount of assurance to investors to carry out investments that would be otherwise considered too risky. Therefore currency hedging strategies and techniques can be regarded as the better alternatives available for long term investors and traders as for minimizing short term risk. Further it is more appropriate for long term investors who cannot spare the time to be constantly monitoring their investment portfolios for variations in the market (Levy, & Lim, 1994). Currency hedging protects investors against such developments like inflation, changes in interest rates and exchange rate volatility and more. It also helps traders survive through hard markets and economy crisis situations. Thus hedging vehicles can also be used for locking the profit and further it provides investors to survive in the difficult times in the market. In fact successful currency hedging strategies provides the assurance against the fluctuations of the commodity prices, inflation rates, exchange rates and interest rates and so on (Cusatis, 2005). It must be noted that hedging practices provides the opportunity to practice different strategies and techniques in order to maximizing the returns while with minimizing the exposure related risk. Indeed there are a few situations in which currency hedging is useful such as in international equity or/and bond investments, investing in currency and trading in currencies as retailers do and inflation limiting hedging. The latter alternative typically involves using commodities and/or metals to hedge against inflation, which is typically aided by the US Dollar. In other words, inflation wary investors might tend to buy gold and/or oil to hedge against a weakening US Dollar. This scenario is often seen in markets for commodities such as coffee, oil and gold, where speculative currency deals are more likely to increase the sensitivity of a commodity to Dollar movements For example if the dollar were to firm up, there would be higher prices. Despite the attractiveness of this type of hedging strategy there are doubts about the degree of certainty in using such commodities as oil and coffee because they fluctuate in value very widely at times. Therefore the above benefits can be negative when the drawbacks are factored in. While practicing those hedging strategies it could involve more cost and related expenditure. As stated the above high risk would lead to a high return and bearing low risk means reducing returns. Investment decisions have to be taken more wisely with considering the external factors which could lead to returns or otherwise losses (Neal, 1993) Thus this would be a difficult strategy to follow for most of the short term investors or traders. For instance currency hedging practices would lead to fewer benefits whenever the money market is performing better in its activities with fewer movements. It must be noticed that in order to succeed in the currency hedging strategy, it requires both the trading skills and experience in the relevant field. Question 3 If on 1st December exchange rates and currency futures have moved to Spot rate $1.7324 - $1.7328 Currency Futures December $/ Contract $1.7305 = 2.4227 Evaluate the forward and the futures hedges constructed in part (a). (Your evaluation should include both numerical and a written evaluation.) (25 marks) For instance if the spot price is USD/EUR = 0.0004 ($1.7324 - $1.7328), then this means that 1 USD = 0.0004 EUR. According to the spot rate $1.4 million would be worth $2.42536 ($1.4m X $1.1324) and $2.42592 ($1.4m X $1.7328) respectively when it is received by the parent company in the UK. Thus the spot rate differential of 0.0004 would bring about $0.00056 million (1.4 X $0.0004). On the other hand the currency futures for December show a value of $2.4227 million ($1.4m X $1.7305). This is quite clear on the calculations based on the given currency futures. Assuming that the following scenarios develop then the outcomes would be completely different. (b). If the treasurer had forecast that. I. Interest rates in the UK relative to US were expected to rise, or Foreign exchange rates and interest rates are positively related because when interest rates fall the exchange rates also fall. Thus in the US the exchange rate would fall because American investors would find it relatively profitable to invest in the UK. So the demand for Sterling denominated assets would rise. This is because potential foreign investors do not buy the domestic currency concerned for investment when the domestic interest rates fall and as a result the demand for the domestic currency abroad falls thus leading to an unfavorable exchange rate. These are financial contracts in which the potential buyer and the seller agree to swap exposure to risk in interest rate related volatility during the period under contract (Staff, & Marshall, 2005). Usually many such contracts are based on what is known in money market jargon as "fixed-to-float' swaps in which the seller of the swap ends up with a fixed rate from the buyer and gives a floating rate to the latter. Indeed there are fixed-to-fixed swaps and float-to-float ones as well. In fact commercial investors are keenly interested in these swaps because they allow them (the investors) to re-allocate the degree of exposure in interest rate movements. II. Inflation in the UK was expected to fall. How would this information affect the decision to hedge (Your discussion should make reference to the underlying theory on exchange rate movements) (25 marks) A fall in inflation in the UK means that US dollars coming into the UK parent company would be able to buy more goods and services. In other words the value of the Sterling would fall against the US Dollar. The US Dollar would be attractive from the view point of the parent company in the UK. Thus the company would benefit from higher margins when the Dollar is exchanged against the Sterling. However it must be noted that other major currencies like the Euro and the Yen might have a countervailing impact on this positive movement if the company makes a lot of material purchases from these other countries. Currency hedging is a practice that has been adopted by financial investors in order to reduce exposure to unwanted risk and minimize price fluctuations associated with such developments like inflation, changes in interest rates and exchange rate volatility (Gregory, & Arvanitis, 2001). Thus majority of institutional portfolios are based internationally and investors are involved in some currency hedging strategies due to the currency risk in the global market. In fact investors may adopt different currency hedging strategies to bear the risk and to gain positive returns from the money market operations. There can be identified different foreign currency hedging vehicles to reduce the currency risk and to achieve investing outcomes including spot contracts, forward contracts, foreign currency options, swaps, swap options, OTC and other derivatives. Currency hedging facilitates an assurance to investors to make investments under minimum risk related circumstances. Thus financial investors do not make use of all those above currency hedging vehicles and techniques due to some variable factors - relative significance in non-currency investment opportunities and net returns; high investment risk due to the government policies on foreign exchange rates; anti-inflationary measures by the government; positive relationship between foreign exchange rates and the inflation rates. However risk control managers are more concentrating in managing risk through hedging related vehicles and techniques as a measure of saving their own risk. Finally it must be noted that international commerce has increased rapidly with the internet and it has facilitated more transparent marketplace where individuals and firms will have to face significant changes and uncertainty in the money market. In fact this uncertainty leads to volatility in the market and arise a need for an efficient foreign currency hedging vehicles to ensure the stability of the future financial status of the firm level (Graham, 2001). Therefore firms need to survive against the currency risk with trying to minimize their involvement with volatile currencies such as Japanese Yen. Even though it is not a totally reliable solution that firms could trust all the time. REFERNCES 1. Black, F 1989, 'Universal hedging: optimizing currency risk and reward in international equity portfolios', Financial Analysts Journal, vol.8, pp.16-22. Top of Form 2. Barker, B & Hui, B 2003, Hedge funds - the way forward, Balance Sheet, vol. 11, no. 1, pp. 32 - 36. 3. Cusatis, P 2005, Hedging Instruments and Risk Management: How to Use Derivatives to Control Financial Risk in Any Market (McGraw-Hill Library of Investment and Finance), McGraw-Hill, New York. 4. Gregory, J & Arvanitis, A 2001, Credit: The Complete Guide to Pricing, Hedging and Risk, Management Risk Books, London. 5. Graham, A 2001, Hedging Currency Exposure (Glenlake Series in Currency Risk Management), Routledge, London. 6. Hull, JC 2000, Options, Futures and other Derivatives, Prentice-Hall, New York. 7. Hsin, CW, Kuo, J & Lee, CF 1994, 'A new measure to compare the hedging effectiveness of foreign currency futures versus options', The Journal of Futures Markets, vol.14, PP.685-707. 8. Levy, H & Lim, KC 1994, 'forward exchange bias, hedging and the gains from international diversification of investment portfolios,' Journal of International Money and Finance, vol.13 pp.159-70. 9. Neal, L. 1993, The Rise of Financial Capitalism: International Capital Markets in the Age of Reason (Studies in Macroeconomic History), Cambridge University Press, Cambridge. 10. Staff, J & Marshall, A 2005, 'International Cash Management and Hedging: A Comparison of UK and French Companies,' Journal of Managerial Finance, vol.31, no.10, pp.18-34. 11. Future value of currency retrieved from http://thismattter.com on 20th Dec. 2010. Read More