Question

1. Suppose that you will have to pay €2,000,000 on May 15 to your partner in France. The current exchange rate implied by the futures is $1.35/€. How can you lock in this exchange rate regardless of the spot rate at $1.25/€ or $1.45/€ on the delivery day?

Answer 1

Ans : Currency Futures are future contracts where the underlying commodity is currency exchange. These are used to fix the rate for buy/sell for a defined period of time.

Situration : Euro 2,000,000 are required to be paid on May 15. The current Exchange rate implied by the Futures is $1.35/Euro.

Solution : To lock in this exchange rate i.e. $1.35/Euro will need to buy Futures Contract today with the expiry of May 15 and the contracted price at $1.35/Euro. This will fix the obligation i.e. Liability to $2,700,000 for buying Euro 2,000,000 on May 15. Currecny Futures requires margin payable per contract which will be required to be paid while buying Currency Futures Contract.

On the Day of Delivery if spot rate is $1.25/Euro

In this case will buy the 2,000,000 Euros at $2,700,000 whereas if bought in spot market at $1.25/Euro  it would have cost $2,500,000. The hedge i.e buying Futures contract @ $1.35/ Euro resulted in loss of $200,000

On the Day of Delivery if spot rate is $1.45/Euro

In this case will buy the 2,000,000 Euros at $2,700,000 whereas if bought in spot market at $1.45/Euro  it would have cost $2,900,000. The hedge i.e buying Futures contract @ $1.35/ Euro resulted in savings of $200,000.

Ans : Thus in order to lock in the exchange rate of $1.35/euro will need to buy currency futures contract. This will save from the risk of non-hedging.