YSL is a company located in the USA that has a contract to purchase goods from Japan in two months’ time on 1st September. The payment is to be made in YEN and will total 140million yen.
The managing director of YSL wishes to protect the contract against adverse movements in foreign exchange rates and is considering the use of currency futures. The following data are available;
Spot foreign exchange rate
$1=128.15yen
Yen currency futures contracts on SIMEX (Singapore Monetary Exchange)
Contract size 12,500,000 yen, contract prices are US$ per yen.
Contract prices:
September 0.007985
December 0.008250
Assume that futures contracts mature at the end of the month.
Required: (Margin requirements and taxation may be ignored).
i) Illustrate how YSL might hedge its foreign exchange risk using currency futures. (5 marks)
View Solution
YSL can hedge using futures as follows.
• Use September futures, since these expire soon after 1 September, price of 1/0.007985 = 125.23 ¥/$.
• Buy futures, since it wishes to acquire yen to pay the supplier, and the futures are in Yen.
• Number of contracts 140m/12.5m = 11.2 contracts (11 contracts)
• Tick size: 0.000001 x 12.5m = $12.50
ii) Explain the meaning of basis risk and show what basis risk is involved in the proposed hedge. (5 marks)
View Solution
Basis risk arises from the fact the price of a futures contract may not move as expected in relation to the value of the instrument being hedged. Basis changes do occur and thus represent potential profits/losses to investors. Typically, this risk is much smaller than the risk of remaining unhedged.
Basis risk is the difference between the spot and futures prices.
Spot price = 1/128.15
. = 0.007803
Basis = 0.007803 – 0.007985 = 182 ticks with 3 months to expiry
Basis with one month to expiry, assuming uniform reduction = 1/3 X 182 = 61 ticks
Spot price on 1 Sept = 1/120 = 0.008333
Therefore predicted futures price = 0.008333+0.000061= 0.008394
iii) Assuming spot exchange rate is 120 yen/$1 on 1 September and that basis risk decreases steadily in a linear manner, calculate what the result of the hedge is expected to be. Briefly discuss why this result might not occur. (5 marks)
View Solution
Outcome:
Futures market
Opening futures price 0.007985
Closing futures price 0.008394
Movement in ticks 409 ticks
Page 22 of 23
Futures market profit 409 x 11 x $12.50 = $56,238
Net outcome
. $
Spot market payment (¥140m. 120) 1,166,667
Futures market profit 56,238
. 1,110,429
Hedge efficiency
56,238/74,197 = 76%
This hedge is not perfect because there is not an exact match between the exposure and the number of contracts, and because the spot price has moved more than the futures price due to the reduction in basis. The actual outcome is likely to differ since basis risk does not decline uniformly in the real world.