Question

You are the treasurer for ABC corporation.  You just received a bill from your Italian supplier of Genoa salami for Eur 500,000. The Euros are due in three months.

1- What would you do to hedge this exposure? ( What hedge would you put on)

2- If you hedged the underlying position properly, what would you expect the net gain or loss to be when you combine the underlying position with the hedge mark-to-market?

Answer 1

(1)

• To hedge the risk of currency fluctuations, as the treasurer of ABC Corporation we should buy Euro futures.
• Futures are derivative instruments that involve 2 parties to buy and sell an underlying asset at a fixed price (Exercise price), for some time in the future.
• Thus, by going long/ buying the futures, we have fixed our payment amount and have effectively hedged our position to pay Eur 5,00,000 to the Italian supplier from Genoa Salami after 3 months.

(2)

On the day of expiry of the futures contract, the day the long part has to buy and the short party has to sell, the

Net Gain for the long party = Spot - Exercise price

If the spot exchange rate is higher than the exercised price/ rate (if Exercise price < Spot price), then the long party gains as it has to effectively pay a lower amount.

However, in case the Exercise price > Sport price, the long party has a loss as it is effectively paying more than the price it could've been bought (spot price).