Question

A company expects to receive the following two payments from their client in China.
January 6,2021                               ¥1,000,000.00
April 6, 2021                                   ¥1,000,000.00                                                           

Given the follow data, answer the following questions.
Spot rate today (October 6, 2020)            $0.1455              Spot rate on Expiration
Jan 6, 2021 Futures                                     $0.1440              Spot rate on Jan 6, 2021= $0.1550
Apr 6, 2021 Futures                                     $0.1430              Spot rate on Apr 6, 2021= $0.1425

a) Should the company be worried of the dollar depreciating or appreciating?
b) How should the company hedge the two receivables using futures?
c) What will be the outcome of the hedges if the spot rate on expiration is as shown above? Show all work.
d) Explain margin requirements and maintenance margin when trading futures contracts.

Answer 1

Answer (a):

~ The company should be worried of the dollar appreciating.

~ The company expects to receive two payments from China in the Chinese Yuan currency, hence the company will benefit if the receivable currency Chinese Yuan appreciates and the US Dollar depreciates. Hence, the risk of the company is dollar appreciating.

Answer (b):

~ The risk of the company is Dollar appreciating and Yuan depreciating.

~ Hence, to hedge its receivables in Yuan currency, the company should Sell the future contracts as follows :

1. Sell the Jan 6, 2021 futures at the exchange rate of 1¥ =  $0.1440 with total contract value of ¥1,000,000

2. Sell the Apr 6, 2021 futures at the exchange rate of 1¥ =  $0.1430 with total contract value of ¥1,000,000

Answer (c):

1. Profit/Loss on the Payment Received on Jan 6, 2021:

~ Selling price fixed in the futures contract = $0.1440

~ To square off the futures transaction on expiry, spot rate on expiration = $0.1550

~ Profit/Loss on futures contract sold = (Futures Price - Spot Price) * Contract Value

= ($0.1440 - $0.1550) * ¥1,000,000

= -$11,000 (Loss of $11,000)

2. Profit/Loss on the Payment Received on April 6, 2021:

~ Selling price fixed in the futures contract = $0.1430

~ To square off the futures transaction on expiry, spot rate on expiration = $0.1425

~ Profit/Loss on futures contract sold = (Futures Price - Spot Price) * Contract Value

= ($0.1430 - $0.1425) * ¥1,000,000

= $500 (Profit of $500)

Answer (d):

~ A margin requirement is the percentage of securities transaction amount that an investor must pay for with his/her own cash, when trading in futures.

~ There are two type of margin requirements - Initial Margin Requirement and Maintenance Margin.

~ Initial margin is the percentage of the purchase price that must be covered by the investor's own money. That means, suppose an investor wants to initiate a purchase transaction of $10,000, and the initial margin requirement is 50%, then $5000 should be initially paid by the investor as the initial margin.

~ Maintenance margin is the amount of equity that the investor must maintain in the account on a regular basis. If once a purchase position on stock is taken, then the % maintenance margin of the total position value will be kept in the account, and the remaining value will be considered investor's equity.

~ For example, in the above $10,000 purchase transaction, if the stock price falls and the total value now falls to $8000, and tif he maintenance requirement is 30%, then investor's equity will only be 70% of $8000 i.e. $5600, because the remaining $2400 will be maintenance margin.