Question

In: Finance

Suppose that you intend to hedge a CHF cash flow that is expected to materialize sometime...

Suppose that you intend to hedge a CHF cash flow that is expected to materialize sometime within the next three months. You are contemplating whether you should:
a. use a forward hedge by contacting a bank and setting up a forward contract on CHF that expires in 3 months, or
b. use a futures hedge by trading CHF futures on the futures exchange in Chicago.
What are the factors that will lead you to prefer one versus the other alternative?

Solutions

Expert Solution

There are a few things to consider before deciding which option to opt. Now first is the certainity of the time in which CHF cash flow is received. Another is certainity that the cash flow is actually received or not. The counter party risk or default risk is also an important factor. The margin to be paid in case of Futures Contract

Now lets weigh both the options on this factors

Factors Forward Hedge Futures Hedge
Time certainity if time is not certain then it would be difficult to set a predefined date in advance when the CHF is received. In this case we face the risk of unavailability of the fund if the CHF Cash Flow is not received Even if it is uncertain the futures transactions can be extended for a longer time period
Cashflow certainity If the Cashflow is certain then Forward Hedge is best but if it is not then the there is a chance default risk on our side Even if the payment is not received then we can just square off the position and take up loss or profit in the transaction
Counter Party Risk In this case Bank might default In this case clearing houses are the intermediary so it would be very less risky
Cost The Cost of Forward Hedge is the cost incurred in executing the contract In this case a marked to market system is in place where you have to pay a margin amount and with movement of the price you have to add margin. Thus this can be a costly affair if the amount is too big as capital would be required to buy futures
Regulation The price will vary and negotiated and unregulated The price will fixed and regulated
Gaurantee None Yes due to mark to market
Size The contract size is customised The Contract size is fixed thus we may not be able to hedge properly
Transaction Over the counter On exchange

Related Solutions

Suppose a venture's first cash flow is expected in Year 6, and the cash flow is...
Suppose a venture's first cash flow is expected in Year 6, and the cash flow is expected to be 3,891,326. A comparable firm has earnings of 31,104,064 and a market cap of 412,501,981. Assuming a discount rate of 15%, find the present value (at Year 0) of the firm in do
What is a cash flow hedge of a foreign currency receivable?
What is a cash flow hedge of a foreign currency receivable?
Define and differentiate the differences between a cash flow hedge and a fair value hedge, including...
Define and differentiate the differences between a cash flow hedge and a fair value hedge, including when (in or under which particular or specific circumstances) a U.S.-based firm would consider using one hedge vs. the other type of hedge. Be specific. Summarize the differences that exist, if any, between the US GAAP and IFRS on the accounting for derivatives designated as hedges at the current date you are answering this question. Prepare an example of a U.S.-based firm managing an...
1. Suppose that you are long in the cash market and hedge with a put option....
1. Suppose that you are long in the cash market and hedge with a put option. As the price of the commodity rises above the strike price what does the hedging position cost you? 2. An ethanol producer would purchase a put option to hedge against potential increases in the price of corn. True or False 3. What is the strike price of an option? The intrinsic value of the option. The price you paid to purchase the option. The...
A ________ hedge refers to an offsetting operating cash flow such as a receivable arising from...
A ________ hedge refers to an offsetting operating cash flow such as a receivable arising from the conduct of business.   A) natural B) financial C) contractual D) futures
Suppose SMG considers an acquisition that is expected to increase SMG’s free cash flow by $6...
Suppose SMG considers an acquisition that is expected to increase SMG’s free cash flow by $6 million the first year, and its contribution is expected to grow at 2.5% per year from then on. SMG has negotiated a purchase price of $66.25 million. SMG always adjusts its capital structure to maintain a constant debt-equity ratio of one. The acquisition has the same risk as SMG’s divisions, its corporate tax is 40%, its cost of debt is 5%, and its unlevered...
. You are considering the following project. What is the expected cash flow for the last...
. You are considering the following project. What is the expected cash flow for the last year (year 3)? This cash flow includes operating cash flow and terminal cash flow. Project life: 3 years Equipment: Cost: $20,000 Economic life: 3 years Salvage value: $4,000 Initial investment in net working capital: $2,000 Revenue: $13,000 in year 1, with a nominal growth rate of 6% per year Fixed cost: $3,000 in year 1 Variable cost: 30% of revenue Corporate tax rate (T):...
Accounting for cash flow hedge of the forecasted sale of a commodity inventory Assume that our...
Accounting for cash flow hedge of the forecasted sale of a commodity inventory Assume that our company decides to hedge the risk of changes in its cash flows relating to a forecasted sale of 100,000 bushels of wheat by entering into a derivative instrument. We expect to sell the 100,000 bushels of wheat on the last day of the period. On the first day of the period, we enter into derivative contract and designate it as a cash flow hedge...
A company's most recent annual Free Cash Flow is $180,000,000. Free cash flow is expected to...
A company's most recent annual Free Cash Flow is $180,000,000. Free cash flow is expected to grow by 15% per year for the next 10 years and then grow by 3% per year thereafter. Investors required rate of return is 11%. What is the current value of the stock? a. $11,300,755,080 b. $2,250,000,000 c. $5,404,011,121 d. $1,636,363,636
You own factory A and factory B. The next cash flow for eachfactory is expected...
You own factory A and factory B. The next cash flow for each factory is expected in 1 year. Factory A has a cost of capital of 3.5 percent and is expected to produce annual cash flows of $19,300 forever. Factory B is worth $545,000 and is expected to produce annual cash flows of $19,900 forever. Which assertion is true?a.Factory A is more valuable than factory B and factory A is more risky than factory Bb.Factory A is more valuable...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT