Page 197 - AFM Integrated Workbook STUDENT S18-J19

Hedging foreign exchange risk

Question 1

The financial manager of Tomtom Co, a UK based company, has identified
that the company needs to make a payment of 2.1 million Clearland dollars
(C$) in five months’ time on 31 August.

To hedge against possible fluctuations in the exchange rate, the financial
manager has decided to use futures contracts.

Futures prices (£... to C$1), contract size C$100,000:

June contracts 0.6134

September contracts 0.6268

The spot rate of exchange is £0.5955 to C$1.

Required:

Calculate the result of the relevant futures hedge, assuming that the spot
rate of exchange is £0.5850 to C$1, and the futures price has moved to
£0.5820 to C$1 by 31 August.

Solution

Set up hedge

Buy or sell futures? CC is C$. We are buying C$. So buy futures.

Number of contracts = C$2,100,000/C$100,000 = 21

Which expiry date? September, since it expires soonest after the transaction
date of 31 August.

Contact the exchange: We need to buy 21 September contracts at a price of
£0.6268 to C$1.

Result of hedge

On 31 August – assume spot rate is £0.5850 to C$1 and futures price is
£0.5820 to C$1:

185