Steps in a Future Hedge

Illustration 3:

Today is 31 December. Spandau plc anticipates that in two months' time it will need to pay for purchases of $11 million. The exchange rates on 31 December are:

Spot rate:　　1.9615 $ per ￡.

Futures rates:

Required

Calculate the outcome of using a futures hedge in two months' time if the spot rate is 1.9900 $ per ￡ and the futures rate is 1.9880 $ per ￡.

Step 1: Now (31 December)

Type of contract:

The contract currency is ￡s and Spandau will need to sell ￡s (to obtain the $s needed), so contracts to sell are needed.

Date of contract:

The earliest futures expiry date after the transaction is March so this will be chosen.

Number of contracts:

The standard contract size is ￡125,000. At the March futures rate of 1.9556, the number of contracts needed is $11m÷1.9556 = ￡5,624,872. So the number of contracts needed is ￡5,624,872/￡125,000 = 45 contracts (rounding to the nearest whole contract)

So Spandau will need to enter into 45 March contracts to sell @ 1.9556

Step 2: End February

Complete the actual transaction on the spot market.

So $11m invoice will cost @ Feb spot rate 1.9900 = ￡5,527,638

This cost is lower because the ￡ has strengthened. This means that a loss is likely to be made on the futures contract.

Step 3: At the same time as Step 2

Close out the futures contract by buying ￡s back from the futures market.

A loss has been made as the buying price is above the selling price.

The loss can be quantified in one of two ways (either can be used):

1　0.0324 × 125,000 × 45 contracts = $182,250, or

2　$12.50 × 324 ticks × 45 contracts = $182,250

Converting $182,250 into ￡s at February's spot rate = $182,250/1.9900 = ￡91,583 loss

So the net outcome from the futures hedge = ￡5,527,638 cost (Step 2) + ￡91,583 (Step 3) loss = ￡5,619,221.