Question

Given the following data, detail the hedging strategy using Futures Contracts Contract:

Net Exposure = €50,873,878

September 2018 Euro Futures Contract @ $1.2496

Size of Contract: 125,000 Euros

Answer 1

Futures contracts are one of the most common derivatives used to hedge risk. A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price. The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price. The ultimate goal of an investor using futures contracts to hedge is to perfectly offset their risk. In real life, however, this is often impossible and, therefore, individuals attempt to neutralize risk as much as possible instead. For example, if a commodity to be hedged is not available as a futures contract, an investor will buy a futures contract in something that closely follows the movements of that commodity.

When a company knows that it will be making a purchase in the future for a particular item, it should take a long position in a futures contract to hedge its position. For example, here, our Company knows that in September, 2018, it will get €50,873,878. By buying the futures contract, Company can lock in a certain price in $. This reduces the company's risk because it will be able close its futures position and sell €50,873,878 for the price fixed in $ at September, 2018.

Here, number of contracts = €50,873,878 / €125,000 = 407

Cost of contract = 407*@ $1.2496 = $508.58