Question

Explain how currency futures could be used to hedge your business in Mexico. Explain how currency options could be used to hedge your business in Mexico.(500 words)

Answer 1

CURRENCY FTURES FOR HEDGING

If a US company needs to pay to Mexican company , say 1 million Pesos after 90 days:

The US company should go long on Peso. Say current exchange rate 0.054 US dollar per Mexican Peso and 90days future rate is 0.055 S dollar per Mexican Peso.

The US Company should BUY 1million Peso Futures at 0.055 dollar per Peso and lock the rate.

If the Value of Peso goes up , the company makes profit in the futures contract which helps in the payment at higher rate.

For example ,if the spot exchange rate after 90days is o.056US dollar per peso, the company makes profit of (0.056-0.055)*1million US dollar=$1000

But it will need to pay its obligation at higher rate of USD 0.056 per peso ,making a loss of $1000.This loss will be offset from the gain in futures contract.

Reverse will be true if the spot exchange rate is les than 0.055 after 90days.There will be loss on future contract and gain in the actual payment .In effect, the exchange rate will be locked at USD 0.055 per Mexican Peso.

CURRENCY OPTIONS FOR HEDGING

If a US company needs to pay to Mexican company , say 1 million Pesos after 90 days:

Say current exchange rate 0.054 US dollar per Mexican Peso

The US company can buy 90 days call option on 1 million Mexican peso at strike price of o.054 US dollar

This will give the company right but no obligation to buy 1 million Pesos at 0.054 dollar per peso after 90 days . The company will need to pay a small premium for the option which will be the cost of hedging.

If the rate goes up to say 0.056 USD per Peso after 90 days , there will be gain of (0.056-0.054)*1 million=$2000 in the Call option

For the payment, the company will buy at higher rate which will be offset by the Option gain. Thus, the exchange rate of USD 0.054 /Peso will be locked.

If the spot rate falls below 0.054 USD per Peso, there will be no obligation on the part of the company to buy at the higher price of 0.054. Hence , there will be no loss on option.

The company will buy I million Peso at lower spot rate from the market for the payment