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Problem Set of Session 4:: K K T K K

This document contains solutions to problems from a session on foreign exchange and currency futures. Problem 1 discusses why currency futures contracts are generally closed through reversing trades rather than held to delivery, with only 1% resulting in delivery due to standardized delivery dates not matching actual transaction dates. Problem 2 calculates the total profit for two traders, one with a futures contract and one with a forward contract on euros, finding they have the same profit but the forward trader likely did better due to daily settlement of futures contracts. Problem 3 explains how to calculate the new delivery price K2 when rolling a forward contract forward to a new time T2 rather than settling at the initial time T1.

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Pauline Cavé
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46 views

Problem Set of Session 4:: K K T K K

This document contains solutions to problems from a session on foreign exchange and currency futures. Problem 1 discusses why currency futures contracts are generally closed through reversing trades rather than held to delivery, with only 1% resulting in delivery due to standardized delivery dates not matching actual transaction dates. Problem 2 calculates the total profit for two traders, one with a futures contract and one with a forward contract on euros, finding they have the same profit but the forward trader likely did better due to daily settlement of futures contracts. Problem 3 explains how to calculate the new delivery price K2 when rolling a forward contract forward to a new time T2 rather than settling at the initial time T1.

Uploaded by

Pauline Cavé
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Problem Set of Session 4:

1. Why are most futures positions closed out through a reversing trade rather
than held to delivery?

Answer:
In forward markets, approximately 90 percent of all contracts that are initially
established result in the short making delivery to the long of the asset
underlying the contract. This is natural because the terms of forward
contracts are tailor-made between the long and short.
By contrast, only about one percent of currency futures contracts result in
delivery. While futures contracts are useful for speculation and hedging, their
standardized delivery dates make them unlikely to correspond to the actual
future dates when foreign exchange transactions will occur. Thus, they are
generally closed out in a reversing trade. In fact, the commission that buyers
and sellers pay to transact in the futures market is a single amount that
covers the round-trip transactions of initiating and closing out the position.

2. Trader A enters into futures contracts to buy 1 million euros for 1.3 million
dollars in three months. Trader B enters in a forward contract to do the
same thing. The exchange rate (dollars per euro) declines sharply during
the first two months and then increases for the third month to close at
1.3300. Ignoring daily settlement, what is the total profit of each trader?
When the impact of daily settlement is taken into account, which trader
does better?

Solution:
The total profit of each trader in dollars is 0.03×1,000,000 = 30,000. Trader
B’s profit is realized at the end of the three months. Trader A’s profit is
realized day-by-day during the three months. Substantial losses are made
during the first two months and profits are made during the final month. It
is likely that Trader B has done better because Trader A had to finance its
losses during the first two months.

3. A company enters into a forward contract with a bank to sell a foreign


currency for K1 at time T1 . The exchange rate at time T1 proves to be S1
( > K1 ). The company asks the bank if it can roll the contract forward until
time T2 ( > T1 ) rather than settle at time T1 . The bank agrees to a new
delivery price, K 2 . Explain how K 2 should be calculated.

Solution:

1
The value of the contract to the bank at time T1 is S1 - K1 . The bank will
choose K 2 so that the new (rolled forward) contract has a value of S1 - K1 .
This means that
- rf (T2 -T1 )
S1e - K2e-r (T2 -T1 ) = S1 - K1
where r and rf are continuously compounded domestic and foreign risk-
free rate observed at time T1 and applicable to the period between time T1
and T2 . This means that
( r -rf )(T2 -T1 )
K2 = S1e - (S1 - K1 )er (T2 -T1 )
This equation shows that there are two components to K 2 . The first is the
forward price at time T1 . The second is an adjustment to the forward price
equal to the bank’s gain on the first part of the contract compounded
forward at the domestic risk-free rate.

5. Cray Research, a US company, sold a super computer to the Max Planck


Institute in Germany on credit and invoiced €10 million payable in six
months. Currently, the six-month forward exchange rate is $1.10/€ and the
foreign exchange advisor for Cray Research predicts that the spot rate is
likely to be $1.05/€ in six months.
(a) What is the expected gain/loss from the forward hedging?
(b) If you were the financial manager of Cray Research, would you
recommend hedging this euro receivable? Why or why not?
(c) Suppose the foreign exchange advisor predicts that the future spot rate
will be the same as the forward exchange rate quoted today. Would you
recommend hedging in this case? Why or why not?
(d) Suppose now that the future spot exchange rate is forecast to be
$1.17/€. Would you recommend hedging? Why or why not?

Solution:
(a) Expected gain($) = 10,000,000(1.10 – 1.05)
= 10,000,000(.05)
= $500,000.

(b) I would recommend hedging because Cray Research can increase the
expected dollar receipt by $500,000 and also eliminate the exchange risk.

2
(c) Since Cray Research can eliminate risk without sacrificing dollar receipt,
I still would recommend hedging.

(d) Now, hedging via forward contract involves an expected loss: -


$700,000 = 10,000,000 (1.10 -1.17). Hedging thus becomes much less
attractive. But if Cray Research is highly risk averse, it may still decide to
hedge. The decision to hedge then critically depends on the firm’s degree
of risk aversion.

6. Banks find it necessary to accommodate their clients’ needs to buy or sell


FX forward, in many instances for hedging purposes. How can the bank
eliminate the currency exposure it has created for itself by accommodating
a client’s forward transaction?

Answer:
To illustrate, suppose a bank customer wants to short British pound
sterling three months forward against dollars.
The bank can handle this trade for its customer (by taking a long position
in pound forwards) and simultaneously neutralize the exchange rate risk in
the trade by replicating a short position in pound forwards using money
market instruments.
This is done by selling (borrowed) British pound sterling spot against
dollars. The bank will lend the dollars for three months until they are
needed to deliver against the dollars it has sold forward. The British
pounds received will be used to liquidate the sterling loan.

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