Question

A U. S. company expects to pay its supplier 1 million British pounds in 3 months and is considering whether to hedge the resulting foreign exchange risk with a futures contract or a forward contract on British pounds with 3 months to the delivery date. The correlation between changes in the spot price of British pounds in terms of U. S. dollars and changes in the U. S. interest rate is 0.85. Taking into account the daily settlement process associated with the use of futures contracts, which of the following is the correct hedging strategy?

Select one:

Buy a futures contract on British pounds

Buy a forward contract on British pounds

Sell a futures contract on British pounds

Answer 1

Answer :

Expectation of Importer Who will pay Foreign Currency :

Since Importer is going to pay Foreign Currency so, he will want that Foreign Currency to fall / depreciate.

Because When Foreign Currency depreciates in terms of Home Currency then he will end up paying lower home currency to bank in excj=hange of Foreign Currency .

In the Given Question , Foreign Currency is British Pounds and dollar is the Home Currency .

Now, RISK TO Importer ,

Risk to Importer is that he is going to pay the amount to the supplier in British Pounds after 3 months from now, so what if the British Pound appreciate , he will incurr loss by paying more dollar to purchase the British Pounds to foreign supplier.

So, the Risk of Foreign Currency Appreication will be There after 3 month from Now.

Foreign Exchange risk of involved , thus Hedging is required in order to absorb the loss situation .

Amount of payment to be made to supplier after 3 months = 1 million british pounds

1 million = 10,00,000

Correlation between Spot price of British Pound and US dollar is 0.85, which indicates the Positive relation about the fluctuation of British pounds in terms of US dollar.

Meaning , 0.85 reflects that the British Pounds will increase in terms of US dollar which is bad news for the Investor.

So, Now Investor Shoukd Hedge its Position

US Company who is importer is expecting that the Price of British Pounds in terms of US Dollar is going to rise/ appreciate then it will take short position in British Pounds .

If US Company expects that the Price of British Pounds in terms of US Dollar is going to depreciate then it will take Long position in British Pounds .

Now, Since Positive correlation is maintained betwee the British Pound and the Dollar so, it is expecting that the British Pound Price will rise against US dollar . Therefore, Short Position will be taken in British Pound.

Sell a futures contract on British pounds

So, US company should enter into future contract of sell of British Pound after 3 months .

Beacuse when today US company Enters into sell future contract of 3 months, it will book Sale contract rate of future date at the end of 3 months so, today buy rate will be booked and later on at high price of sale it will be squared off . Since british Pound price is expecting to rise in Future so, that is the reason Short/ Sell future contract is entered today.

No, US Company will not enter to Buy a futures contract on British pounds because it is expecting that the British Pound Price will rise against US dollar at the end of 3 months from now.

US company should not enter into Buyof forward contract on British pounds because under forward contract Rate is already fixed along with the time .

So, it is not beneficial as comapred to future contract because under future contract contract can be closed even before the date of maturity and also the rate is not fixed .

SO, US COMPANY SHOULD SELL a futures contract on British pounds