Question

Q5 A U.S. firm is receiving 185m JPY in 3 months’ time. JPY Futures are available on the Chicago Mercantile Exchange (CME) with a contract size of 12,500,000 JPY and currently trade at 0.009502 JPY/USD. The contract maintenance margin is 3600 USD with an initial margin of 110% of the maintenance margin. a) Describe the firm’s FX spot market currency exposure (long/short, size of exposure) before hedging. b) Describe how this firm would hedge its position using futures contracts. c) How many contract positions on the CME should be taken if the goal is to minimise the firm’s exposure to risk? d) What will be the initial futures cash flow required (amount and currency)? e) Assuming that the exposure and contract maturity dates are the same, what is the expected total (Physical + Hedge) net USD cashflow? (You may ignore the time value of money and you may assume that the Unbiased Expectations Hypothesis holds)

Answer 1

(a) Firm's spot market currency exposure:

US firm has a receivable of ¥ 185 million in 3 month's time.

Firm has an exposure of ¥ 185 million

Exposure for US firm in spot market in terms of $ is 185 million × spot rate in spot market

(b) How firm would hedge it's position using futures contract:

As firm has a receivable of ¥ 185 million in 3 month's time,

It is afraid of ¥ depreciating and $ appreciating,

Therefore in order to hedge it's position, firm shall take short position on ¥ futures.

(c) How many contract positions has to be taken in order to minimise the firm's exposure:

Given, Contract size = 12.5 million

Therefore No. of contracts

= Exposure÷Contract size

= 185 million÷12.5 million

=14.8 contracts

No. of short contracts on ¥ futures

= 14.8 contracts

(d) Initial future cash flows required:

Initial Margin = Maintenance margin ×110%

Initial Margin = $3,600×110%

Initial Margin = $3,960

(e) If exposure and contract maturity dates are same, Net USD cash flows:

Physical USD will be ¥185 millions converted into $ at spot rate after 3 month's in Spot Market i.e.,

Physical USD

= ¥185 million × spot rate after 3 month's in spot market

Hedge USD will be profit or loss on futures which will be converted into $ at spot rate after 3 month's in spot market i.e.,

Hedge USD

Profit/ Loss = [(0.009502 - spot rate after 3 month's in currency market) × no.of contracts × contract size]×spot rate in spot market

Net USD

= Physical USD + Hedge USD ( in case of profit)

Net USD

= Physical USD - Hedge USD ( in case of loss)

In case if futures spot rate in currency market after 3 months has the effect of ¥ getting depreciated, then it results in profit on contract and Net USD will be Physical USD + profit on contract converted into $

In case if futures spot rate in currency market after 3 months has the effect of ¥ getting appreciated, then it results in loss of contract and Net USD will be Physical USD - Loss on contract converted into $