Question

An American Financial Institution has made a loan commitment of €10,000,000 to a client which is likely to be taken down in 6 months. The current spot exchange rate is $1.50/€. • Is the FI exposed to a dollar depreciation or appreciation? • If the spot rate six months from today is $1.6/€, what amount of dollars is needed if the loan is taken down and the FI is not hedged? • If it decides to hedge using € futures, should the FI buy or sell € futures? • A six month € futures contract is available for $1.53/€. What net amount would be needed to fund the loan at the end of six months if the FI had hedged using the €10 million futures contract? Assume that the futures prices are equal to the spot prices at the time of payment. Please include the calculation. Thank you

Answer 1

FI is exposed to a dollar depreciation. as per the current spot exchange rate €10,000,000 is equal to €10,000,000*$1.50/€ = $15,000,000. lat's say if dollar depreciates in 6 months to $1.55/€ then same €10,000,000 will be equal to $15,500,000 and loss for FI of $15,500,000 - $15,000,000 = $500,000. dollar depreciation means 1 euro will get more no. of dollars and appreciation means opposite of that.

If the spot rate six months from today is $1.6/€ then amount of dollars needed is: €10,000,000*$1.60/€ = $16,000,000  if the loan is taken down and the FI is not hedged.

If it decides to hedge using € futures, the FI should buy € futures because this way FI will lock in the exchange rate now to get euros after 6-months.

net amount needed to fund the loan at the end of six months if the FI had hedged = €10,000,000*$1.53/€ - $15,000,000 = $15,300,000 - $15,000,000 = $300,000.

$15,000,000 is at the current spot exchange rate of $1.50/€. so by hedging only $300,000 extra fund needed.