ACCA P4 Advanced Financial Management - 2010 - Study text

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Chapter 14: Futures and hedging with futures

 The holder of a long position can close the position by selling an equal number

of the futures, for the same settlement date, before the settlement date. For

example, a long position in 30 June Eurodollar futures can be closed at any time

before settlement in June by selling 30 June Eurodollar futures.

 The holder of a short position can close the position by buying an equal quantity

of the futures, at any time before settlement. For example, a short position of 25

September FTSE100 futures can be closed at any time before settlement in

September by buying 25 September FTSE100 futures.

When a long position is closed, the original buying price and the selling price to

close the position will be different, and there will be an overall gain or loss from the

difference between the buying and selling prices. Similarly, when a short position is

closed, the original selling price and the buying price to close the position will be

different, and there will be an overall gain or loss from the difference between the

selling and buying prices.

Dealing in futures therefore results in gains or losses on the futures position, which

arise because of movements in the market price of the futures.

Example

A company wants to hedge a currency transaction exposure. The exposure relates to

a transaction that will occur in November, and the company needs to sell 20 euro

currency futures. There are futures with settlement dates in September and

December, but not November.

It should therefore sell futures for the next settlement date after the expected

transaction, which in this example is December. Suppose the company sells 20

futures at a rate of 1.3500 ($1.3500 = €1).

In November when the transaction occurs, the company should close its position. It

opened the position by selling 20 December futures, and it should close the position

by buying 20 December futures. There will be a cash profit or loss on closing the

position.

The company will use the spot market for the transaction in euros. The gain or loss

on the futures position, taken with the spot price, will result in a net exchange rate

close to (but probably not equal to) the rate of 1.3500 that was obtained in the

futures contract.

This will be illustrated in more detail later.

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Ticks and tick values

 Ticks

 The value of a tick

4 Ticks and tick values

4.1 Ticks

A tick is the minimum price movement for a futures contract. For example:

 US dollar-euro currency futures are contracts for €125,000 in exchange for US

dollars. They are priced at the EUR/USD rate ($ per €1), and the size of a tick is

US$0.0001.

 Short-term interest futures are priced up to a theoretical maximum of 99.9999

and each tick is 0.0001 in price. A tick represents an interest rate of 0.01% per

annum.

 Stock index futures are priced in terms of the stock index itself. For example,

DAX Index futures might be priced at 8200 or the Hang Seng Index futures at

21750. Price movements are in units of the index itself.

4.2 The value of a tick

Since every futures contract is for a standard quantity of the underlying item, each

movement in price of one tick has the same value, representing a gain or loss to a

buyer and a corresponding loss or gain to a seller. For example:

 The value of one tick for a US dollar-euro currency future (€125,000 in exchange

for US dollars) is: 125,000 euros × $0.0001 per euro = $12.50.

This can be proved easily. If the price of the contract is $1.2000, the cost of

125,000 would be $150,000. If the exchange rate rises by one tick to $1.2001, the

cost of €125,000 would be $150,012.50. This upward price movement would

represent a gain of $12.50 to someone with a short position in the futures and a

loss to the holder of a long position.

 A Eurodollar future is a short-term interest future representing a three-month

deposit of US$1,000,000. The value of one tick for a Eurodollar future is therefore:

$1,000,000 × 3/12 × 0.0001 = $25.

 For stock index futures, each one tick of price has a fixed value. The value of a

tick for FTSE100 futures, for example, is £10.

Example

Tick values can be used to calculate the gain or loss on a futures position. For

example, suppose that a company buys 20 June Eurodollar futures at 9650 and sells

20 June futures later at 9672 to close the position. There is a gain of 0.0022 ticks on

each contract, the value of each tick is $25, and the total gain is therefore:

20 contracts × 22 ticks × $25 per tick = $11,000.

Chapter 14: Futures and hedging with futures

Basis and basis risk

 Basis

 Basis risk

5 Basis and basis risk

5.1 Basis

The futures price for an item is never the same as the spot market price or current

market price, except at settlement date for the contract. For example, a company

might sell September sterling/US dollar futures in April at a price of 1.9800 when

the current spot exchange rate is 1.9600. The difference of 0.0200 or 200 points is

called ‘basis’.

As a futures contract moves towards settlement, the basis should gradually reduce

in size, until it is 0 at settlement date. If the basis is not 0 at settlement, dealers in the

market would be able to make an instant guaranteed profit by:

 buying or selling in the futures market, and simultaneously

 selling or buying in the cash market (spot market).

However, most futures positions are closed before settlement. When a futures

position is closed, there will still be some basis, and the futures price and the current

spot market price will be different.

For your examination, you might be required to estimate what the basis should be

when a position is closed. To do this, we have to make the simplified assumption

that the basis will reduce in a straight line from the time the futures position is

opened to 0 at settlement date. Using this assumption, we can estimate the expected

basis at the intended date for closing the position.

Example

A company sells September sterling/US dollar futures at the end of April at a price

of 1.9800 when the current spot exchange rate is 1.9600. There are exactly five

months to settlement date, assuming the settlement date for the September futures

contract is at the end of that month. The company expects to close the position at the

end of July, after three months.

The basis is 200 at the end of April. Assuming that basis falls to zero at a steady rate,

it should be expected to fall by 200 between the end of April and the end of

September, which is by 40 each month. (This is the total basis of 200 points divided

by 5 months.) At the end of July, after three months, basis should have fallen by 120,

and the expected basis when the position is closed in July would therefore be 80 (200

– 120). We would therefore estimate that the futures price will be higher than the

spot rate by 80.

(The futures price will be higher than the spot rate because it was higher when the

futures were originally sold and the short position in the futures was established.)

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5.2 Basis risk

In practice, basis does not fall at an even rate.

Basis risk is the risk that when a futures position is closed, the size of the actual

basis will be different from the expectation of what the basis should be. In the

example above, when the position in September currency futures is closed in July,

the futures price might be 1.9790 and the current spot price might be 1.9740, giving a

basis of 50. This is less than the expected basis of 80 that was estimated when the

futures position was opened, by a difference of 30.

The significance of basis is explained later.

Chapter 14: Futures and hedging with futures

Hedging risk exposures with futures

 Creating a hedge with futures

 Imperfect hedges

 Basis and imperfect hedging

6 Hedging risk exposures with futures

6.1 Creating a hedge with futures

Futures can be used to hedge a short-term exposure to currency risk, interest rate

risk or market risk for share prices. They can hedge short-term exposures only,

because virtually all futures trading is in contracts with a settlement date within the

next 12 months.

The concept of hedging with futures is to create a position in futures that is the opposite

of the exposure that is being hedged. By creating an opposite position in futures:

 any loss on the position that is being hedged will be matched by a gain on the

futures position

 however, any gain on the position that is being hedged will be matched by a loss

on the futures position.

A useful rule to remember is that:

 a long position in futures will gain from an increase in the futures price and

lose from a fall in the price

 a short position in futures will gain from a fall in the futures price and lose from

a rise in the price.

The settlement date for the futures must be later than the date of the transaction

that is being hedged. For example, if a company is hedging a position in interest

rates for the euro, and intends to close the position in August, it should open a

position in September futures. If it opened a position in June futures, the futures

would reach settlement in June, and the position would no longer be hedged.

Example

A US company expects to receive 2,000,000 euros from a customer in April, in four

months’ time, and it wishes to hedge the exposure with currency futures. On receipt

of the euros in April, the company will exchange them into US dollars. The

company’s exposure is to a fall in the value of the euro.

Each US dollar/euro currency future is for €125,000. The US company will want to

sell euros in exchange for US dollars, therefore it will sell June futures to hedge its

position. It will sell 16 contracts (which is €2,000,000/€125,000 per contract).

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If the euro falls in value against the US dollar, the value of the €2,000,000 receivable

will fall. However, the price of the futures will also fall and since the company has a

short position in the futures, it will gain from the fall in price. The gain on the

futures position will offset the fall in value in the dollars.

6.2 Imperfect hedges

With futures, it is not usually possible to hedge a position exactly. Futures are contracts

for a standard quantity of an underlying item, whereas the position for which the hedge

is required might not be an exact multiple of the value of a futures contract.

Example

A French company expects to receive US$1,200,000 in July, in three months’ time,

and it wants to hedge its exposure with currency futures. It will exchange the dollar

income in July for euros, and so will be selling dollars and buying euros. Its

exposure is therefore to a fall in the value of the dollar.

A futures contract is for 125,000 euros. It will create a hedge with futures by

purchasing September futures. We need to calculate the equivalent value of

$1,200,000 in euros. Suppose the company can buy September futures at 1.2350

($1.2350 per €1).

 This represents 971,660 euros (US$1,200,000/1.2350).

 971,660 euros is equivalent to 7.8 contracts (€971,660/€125,000 per contract).

The company cannot buy a fraction of a future, and so must buy 7 or 8 contracts. If it

buys 7 contracts, it will be hedging €875,000 and if it buys 8 contracts, it will be

hedging €1,000,000. In both cases, the hedge is imperfect.

In this example, the company will probably buy 8 contracts, because 7.8 is nearer 8

than 7.

Having bought futures to create a long position, the company will gain from a rise

in the futures price (a rise in the exchange rate, which means a weaker dollar). This

will offset the fall in the value of the future dollar income of $1,200,000 due to a fall

in the value of the dollar.

Note on buying or selling futures as a hedge

You need to understand how a hedge is created, by buying or by selling futures.

The basic principle is that the futures position that provides a hedge against the risk

must be the ‘opposite’ of the underlying position, so that a loss on the underlying

position will be offset by a gain on the futures position (and a gain on the

underlying position results in a loss on the futures position).

In this example, the company will receive US dollars. This is the underlying

position. The risk is that dollars will fall in value against the euro. The hedge is

created by paying US dollars in the futures contracts, which is the opposite of the

underlying position. Paying US dollars means receiving/buying euros, so the hedge

is constructed by purchasing dollar/euro futures.

Chapter 14: Futures and hedging with futures

6.3 Basis and imperfect hedging

A hedge with futures is also imperfect because of basis and basis risk. When a hedge

is created with futures, the current spot price will differ from the futures price by

the basis. Over time, since basis falls towards 0, changes in the futures price will be

larger than changes in the current spot market price. This means that the hedge

created by the futures position will not provide a gain or loss that matches exactly

the loss or gain on the transaction or position that is being hedged.

The effect of basis on hedging is described in more detail later.

Hedging with currency futures: the approach summarised

You might find the following guidelines useful in deciding how to create a hedge

with currency futures:

Step Comment

Identify the underlying transaction

that you are trying to hedge.

Does the company need to buy a quantity of a

currency at the future date or sell a quantity of a

currency? Which currency will the company need to

buy or sell?

What is the currency risk in the

underlying transaction?

Will the company have to pay more if a currency

goes up in value, or if it goes down in value? Or will it

receive less if a currency goes up in value or down in

value?

It is useful to think of the currency in which the

futures are denominated.

Work out a futures position that

creates a profit if there is a ‘loss’ on

the underlying transaction.

What futures position is needed so that if a loss is

incurred on the underlying transaction because of an

adverse exchange rate movement, a profit will be

made on the futures position?

Or what futures position is needed so that if less

income is obtained from the underlying transaction

because of an adverse exchange rate movement, a

profit will be made on the futures position?

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Currency futures

 Features of currency futures

 Hedging currency exposures with futures

7 Currency futures

7.1 Features of currency futures

Currency futures are contracts for the purchase/sale of a standard quantity of one

currency in exchange for a second currency. Futures contracts are priced at the

exchange rate for the transaction.

Most currency futures are contracts for the major international currencies. For

example:

Currency future (CME) Amount

US dollar – euro EUR 125,000

US dollar – yen 12.5 million yen

US dollar – British pound £62,500

US dollar – Swiss franc SFr125,000

US dollar – Canadian dollar C$100,000

An examination question on currency futures should tell you the size of each

futures contract.

7.2 Hedging currency exposures with futures

The principles of hedging with futures have been explained already. However,

several examples will be used to illustrate how hedging works. Study each example

carefully: they get progressively more difficult.

Example: perfect hedge, no basis

It is July. A US company must pay 750,000 euros to a Spanish supplier in November,

and wishes to hedge its currency exposure with currency futures. In this example, it

is assumed that there is no basis, and the futures price and the current spot market

exchange rate are always equal. The price of December futures in July is 1.2100

($1.2100 per €1). The value of a tick is $12.50. (This is €125,000 × $0.0001 per $1.)

The exposure is to the risk of a rise in the value or cost of the euro between July and

November. The underlying position is that the US company will pay euros in

November. So to create a futures hedge against the risk of a rise in the cost of the

euro, it should buy euro currency futures. If the cost of the euro goes up, the

company will have to pay more to obtain the 750,000 euros, but this higher cost will

be offset by a gain on the futures position.

Chapter 14: Futures and hedging with futures

This logic can be set out in the three-step approach described earlier, as follows:

Step Comment

Identify the underlying transaction

that you are trying to hedge.

The US company will be paying 750,000 euros

What is the currency risk in the

underlying transaction?

The cost of obtaining the euros will go up. The

cost/value of the euro will rise against the dollar.

Work out a futures position that

creates a profit if there is a ‘loss’ on

the underlying transaction.

If a loss will be incurred on the underlying transaction

if the value of the euro goes up, the futures position

should create a profit if the value of the euro goes up.

So buy euro currency futures, since a profit will be

made if the value of the euro goes up and the futures

can be sold at a higher price.

The US company should therefore buy 6 December contracts (€750,000/€125,000 per

contract) at a price of 1.2100. The company is therefore ‘long’ 6 December contracts.

Suppose the spot exchange rate in November when the US company must make the

payment in euros is 1.2240. The cost of buying the euros has gone up.

The long’ futures position is closed by selling 6 December contracts at 1.2240, because

in this example the futures price is also 1.2240. The position is closed at a profit, as

follows:

Open futures position: buy at 1.2100

Close position: sell at 1.2240

Gain 0.0140

Gain = 140 ticks per contract at $12.50 per tick.

Total gain on futures position = 6 contracts × 140 ticks × $12.50 = $10,500.

The US company has to pay US1.2240 to obtain the euros to make the payment in

November, but the net cost is calculated by taking the cost of the spot transaction

and the gain or loss on the futures position.

Spot market: buy €750,000 at 1.2240 918,000

Less gain on futures position (10,500)

Net cost of €750,000 907,500

The net cost is $907,500, so the effective exchange rate secured by futures hedge =

US$907,500/€750,000

= US$1.2100/€1.

This is the spot rate and the futures price at the time the position was opened.

Conclusion

With a perfect hedge and no basis, futures can therefore fix the effective exchange

rate at the spot rate when the hedge was created. However, in practice, the hedge is

likely to be imperfect and there is basis.

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Example: imperfect hedge but no basis

It is June. A UK company expects to receive US$1,000,000 from a customer in

August, and wishes to hedge its currency exposure with currency futures. In this

example, it is assumed that there is no basis, and the futures price and the current

spot market exchange rate are always equal. The price of September futures in June

is 1.8200. The value of one tick is $6.25.

The exposure is to the risk of a fall in the value of the US dollar between June and

August. The company will receive US dollars. It can create a hedge with futures by

selling dollars and buying British pounds. The UK company should therefore buy

the currency futures, which are denominated in British pounds.

This logic can be set out in the three-step approach described earlier, as follows:

Step Comment

Identify the underlying transaction

that you are trying to hedge.

The UK company will be receiving $1 million.

What is the currency risk in the

underlying transaction?

The value of the dollar will fall and the income will be

worth less in sterling. Futures are denominated in

sterling, so it is better to state that the risk is that the

value of sterling will increase.

Work out a futures position that

creates a profit if there is a ‘loss’ on

the underlying transaction.

If a loss will be incurred on the underlying transaction

if the value of sterling goes up, the futures position

should create a profit if the value of sterling goes up.

So buy sterling currency futures, since a profit will be

made if the value of sterling goes up and the futures

can be sold at a higher price.

At a rate of 1.8200, the sterling equivalent of $1,000,000 is £549,451. Each futures

contract is for £62,500, therefore the company would want to buy 8.79 contracts. The

company will probably decide to buy 9 contracts, although the hedge is imperfect.

Suppose that in August when the dollars are received, the dollar has actually

strengthened in value and the exchange rate is 1.7800 (and the futures price is also

1.7800). The company will sell the $1,000,000 and close its futures position. The

position for the company is as follows:

Open futures position: buy at 1.8200

Close position: sell at 1.7800

Loss 0.0400

Loss = 400 ticks per contract at $6.25 per tick.

Total loss on futures position = 9 contracts × 400 ticks × $6.25 = $22,500.

Received from customer 1,000,000

Loss on futures

(22,500)

Net receipt in dollars 977,500

Sell dollars at 1.7800 (spot rate)

Income in British pounds £549,157

Effective exchange rate secured by futures hedge = US$1,000,000/£549,157 =

$1.8210/£1.

ACCA P4 Advanced Financial Management - 2010 - Study text - Emile Woolf Publishing

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