Question

In: Finance

You work in the treasury department of a global consulting company that typically invoices its customer...

You work in the treasury department of a global consulting company that typically invoices its customer bills in local currency. One of your company’s consulting teams has been working on a project in Australia that you expect will be completed within six months, at which time you expect to bill your client AUD1,160,000.

It is now May, 2020, and you are concerned that the Australian dollar will depreciate over the next six months. You decide to consider using currency futures contracts as a hedge. You collect the following data:

S[USD/AUD] = .7742

AUD futures contract prices: .7736 Open interest (# of contracts:) 62,000

June ‘20

Sept. ‘20

.7707 7,300

Contract notional amount: AUD 100,000
Minimum tick size: .0001 per Australian dollar increment

(a) Using the September contract, calculate the amount of contracts you would use if you employed (i) a naive hedge and (ii) a delta hedge approach to minimize the difference in the change in the value of this hedge with the change in the value of the AUD1,160,000 receivable. Specify if you would buy or sell these contracts.

(b) Assume the six month period described above extends at least one month beyond the maturity date of the September 2020 contract. Give two reasons why you might still choose to use the June contract instead of the September contract and describe what transactions you would execute in early June assuming you still wanted to maintain the hedge.

Solutions

Expert Solution

a) Since, AUD is receivable, to hedge AUD must be sold via futures. Thus, you would sell Futures contracts in both cases

i) Naive hedge completely hedges the position. Hence, number of contracts = 1,160,000/100,000 = 11.6

ii) Delta Hedge would try to hedge USD proceeds of current position with future rate. Thus, number of contracts =

1,160,000*(0.7742/0.7707)/100,000 = 11.65

b) Reasons for using June contracts -
i) Cost of carry is negative for AUD futures (Spot > June Fut> Sep Fut). Using June futures instead of September reduces the same
ii) Open interest of June contracts is much higher than September contracts, implying higher liquidity and potentially lower transaction costs for entering/exiting the position

To maintain similar hedge at end of June, contracts would be rolled over such than June position is closed and September is instated. This implies selling buying June futures and selling September futures


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