The Advanced Financial Management syllabus states that there will be at least one question with a focus on syllabus section E, Treasury and advanced risk management techniques. Within Section E, foreign exchange risk management is frequently examined. This article will explain the significance of the information you’ll be given in foreign exchange risk management questions and show you what you’ll be asked to do.
The scenario is adapted from Nutourne Co, Question 2 in the December 2018 exam, which ACCA published. Some of the numbers have been changed. In this question, the closing futures price and spot rate are not given and so the predicted futures rate has to be calculated. (See the article 'Exchange traded foreign exchange derivatives' for an example of when the spot rate and futures price on the day of settlement are given). There is also a spreadsheet provided showing how the calculations could be set out in the spreadsheet tool in the exam.
Nutourne Co is a company based in the USA, supplying medical equipment to the USA and Europe. Nutourne Co’s treasury department hedges foreign exchange risk on transactions using forward contracts, the money market, traded futures or traded options.
It is currently 30 November 20X8.
Nutourne Co’s treasury department is currently dealing with a sale to a Swiss customer of CHF12.3 million which has just been agreed, where the customer will pay for the equipment on 31 May 20X9.
Exchange rates (quoted as US$/CHF 1) |
|
Spot |
1.0292 – 1.0309 |
Three months forward |
1.0322 – 1.0341 |
Six months forward |
1.0356 – 1.0378 |
Annual interest rates available to Nutourne Co
|
Investing rate |
Borrowing rate |
Switzerland |
3.2% |
4.4% |
USA |
4.6% |
5.8% |
Currency futures (contract size CHF125,000, futures price quoted as US$ per $1)
|
Futures price |
December |
1.0306 |
March |
1.0336 |
June |
1.0369 |
Currency options (contract size CHF125,000, exercise price quotation US$ per CHF1, premium: US cents per CHF1)
|
Calls |
Puts |
||||
Exercise price |
December |
March |
June |
December |
March |
June |
1.0375 |
0.47 |
0.50 |
0.53 |
0.74 |
0.79 |
0.86 |
If futures or options are chosen, any amount not hedged by a futures or options contract will be hedged on the forward market.
Futures and options contracts mature at the month’s end. Basis can be assumed to diminish to zero at contract maturity at a constant rate, based on monthly time intervals.
Required:
Evaluate which of the possible methods of hedging being considered would give Nutourne Co the highest receipt, assuming the options are exercised.
Read the requirements carefully
You must read the requirements before reading the scenario in detail. Knowing what you have to do will help you analyse the scenario and ensure that you answer the question fully.
Breaking down the requirements for Nutourne Co:
Evaluate which of the possible methods of hedging being considered would give Nutourne Co the highest receipt | The answer needs to state which method gives the highest receipt, but it does not ask you to recommend a method. However, if there are uncertainties relating to the amounts received for any of the methods, it would be legitimate to discuss them. |
Assuming the options are exercised | This means that the amount hedged by the options contracts will be translated at the exercise price. |
Identify the important data in the scenario
Hedging methods to be used
The scenario states that the following methods should be considered:
Transaction to be hedged
Nutourne Co is a company based in the USA … currently dealing with a sale to a Swiss customer of CHF12.3 million which has just been agreed.
Nutourne Co needs to hedge against the USD strengthening (the CHF weakening).
Implications for hedging methods
Forward contract | Money market | Futures contracts | Options contracts |
SELL CHF to bank at forward rate when money received from customer. | BORROW in CHF – the amount borrowed will be repaid by the CHF receipt from Swiss customer.
| SELL CHF futures now to hedge against sale of CHF when money received from Swiss customer. | BUY CHF PUT options now to hedge against sale of CHF when money received from Swiss customer. |
Time period
It is currently 30 November 20X8… the customer will pay for the equipment on 31 May 20X9.
Two things to note:
Implications for hedging methods
Forward contract | Money market | Futures contracts | Options contracts |
6 month forward rate will need to be used. | Annual interest rates will have to be divided by 2. | Date of futures will have to be after May. | Date of options will have to be after May. |
Spot rate
1.0292 – 1.0309 (quoted as US$/CHF 1)
Remember that the bank ‘always wins’ – so if there is a choice of two exchange rates, choose the one that gives the lowest receipt.
Implications for hedging methods
Forward contract | Money market | Futures contracts | Options contracts |
Not relevant. | Determines USD received when translating CHF amount borrowed.
| Could be used in basis calculation.
Use lower of two rates (1.0292), as multiplying CHF receipt to obtain USD, and use of lower rate will mean fewer USD are received.
| Could be used in basis calculation.
Use lower of two rates (1.0292), as multiplying CHF receipt to obtain USD, and use of lower rate will mean fewer USD are received. Note that premium is quoted in US$, so it will not be translated. |
6 month forward rate
1.0356 – 1.0378 (quoted as US$/CHF 1)
6 month rate is used, as it is 6 months between today‘s date (30 November) and date of settlement (31 May).
Remember again that the bank ‘always wins’.
Implications for hedging methods
Forward contract | Money market | Futures contracts | Options contracts |
Use lower of two rates (1.0356) as multiplying CHF receipt to obtain USD, and use of lower rate will mean fewer USD are received. | Not relevant
| Could be used if there is an amount not hedged. If there is a under -hedge, use lower of two rates (1.0356) as multiplying CHF receipt to obtain USD, and use of lower rate will mean fewer USD are received.
| Could be used if there is an amount not hedged. If there is a under -hedge, use lower of two rates (1.0356) as multiplying CHF receipt to obtain USD, and use of lower rate will mean fewer USD are received.
|
ANSWER
Let’s now review the answer:
Forward contract
Receipt = CHF12,300,000 × 1.0356 = $12,737,880
Three months 1.0322 – 1.0341
| Use six months rate and lower of two rates (1.0356), as multiplying CHF receipt to obtain USD, and use of lower rate will mean fewer USD are received. |
Money market hedging
Amount borrowed = CHF12,300,000/(1 + [0.044/2]) = CHF12,035,225
CHF Investing 3.2% Borrowing 4.4% | Borrow in CHF at 4.4%, as CHF receipt from Swiss customer will pay back borrowing. Adjust rate as borrowing is for 6 months. |
Receipt = CHF12,035,225 × 1.0292 = US$12,386,654
Spot 1.0292 – 1.0309 | Use lower of two rates (1.0292), as multiplying CHF receipt to obtain USD, and use of lower rate will mean fewer USD are received. |
Receipt = US$12,386,654 × (1 + [0.046/2]) = US$12,671,547
US$ Investing 4.6% Borrowing 5.8% | Invest translated receipt at 4.6%. Adjust rate as investment is for 6 months. |
Futures
Sell CHF futures now to hedge against sale of CHF when money received from Swiss customer. |
December 1.0306 March 1.0336 June 1.0369 | Must be June (1.0369) as only date after 31 May. |
Number of contracts = CHF12,300,000/125,000 = 98.4, say 98, hedging 98 × CHF 125,000 = CHF12,250,000
Contract size is $125,000 | Number of contracts = Receipt/$125,000, rounded to the nearest contract |
Remainder to be hedged on the forward market = CHF12,300,000 – CHF12,250,000 = CHF 50,000
Receipt = CHF50,000 × 1.0356 = $51,780
Number of contracts does not cover full amount of transaction, so need to hedge residual receipt of CHF. Underhedge = Amount of transaction – Amount hedged Use same rate as for forward contract above of 1.0356 |
Estimate from March and June futures rates
Predicted futures rate at the end of May = 1.0336 + ([1.0369 – 1.0336] × 2/3) = 1.0358
Expected receipt = CHF12,250,000 × 1.0358 = $12,688,550
Futures and options contracts mature at the month’s end. Basis can be assumed to diminish to zero at contract maturity at a constant rate, based on monthly time intervals.
| 31 May is 2/3 of time between 31 March and 30 June, so use 2/3 of the difference between March futures price of 1.0336 and June futures price of 1.0369. This method is a shortcut, used to work out a ‘lock-in’ rate that will be the net result of the underlying transaction and the hedge gains or losses. |
Or
Estimate from spot rate and June futures rate
Predicted futures rate at the end of May = 1.0292 + ([1.0369 – 1.0292] × 6/7) = 1.0358
Expected receipt = CHF12,250,000 × 1.0358 = $12,688,550
Futures and options contracts mature at the month’s end. Basis can be assumed to diminish to zero at contract maturity at a constant rate, based on monthly time intervals.
| 31 May is 6/7 of time between 30 November and 30 June, so use 6/7 of the difference between spot rate of 1.0292 and June futures rate of 1.0369. This method is a shortcut, used to work out a ‘lock-in’ rate that will be the net result of the underlying transaction and the hedge gains or losses. |
| $ | |
|---|---|
Futures | 12,688,550 |
Remainder on forward market | 51,780 |
| 12,740,330 |
Options
Buy CHF put options to hedge against sale of CHF when money received from Swiss customer. |
Put: December March June | Must be June as only date after May. |
Number of contracts = CHF12,300,000/125,000 = 98.4, say 98, hedging 98 × CHF 125,000 = CHF12,250,000 (as for futures)
Receipt = CHF125,000 × 98 × 1.0375 = $12,709,375
Contract size is $125,000 | Number of contracts = Receipt/$125,000, rounded to the nearest contract |
Remainder to be hedged on the forward market = CHF12,300,000 – CHF12,250,000 = CHF 50,000
Receipt = CHF50,000 × 1.0356 = $51,780 (as for futures)
Number of contracts does not cover full amount of transaction, so need to hedge residual receipt of CHF. Underhedge = Amount of transaction – Amount hedged Use same rate as for forward contract above of 1.0356. |
1.0375 options = 98 × 125,000 × 0.0086 = $105,350
Put June 0.86 US cents per CHF
| Multiply number of contracts × size of one contract × 0.0086, as premium is quoted in US cents (not US dollars) per CHF. |
| $ |
|---|---|
Receipt | 12,709,375 |
Forward contract | 51,780 |
Premium | (105,350) |
| 12,655,805 |
If the options are exercised, the futures would give the higher receipt. The options give a lower receipt because of the premium that Nutourne Co has to pay. The futures will be subject to the risk that basis (the difference between the futures price and the spot price) may not decrease linearly as the futures approach maturity, as assumed in the above calculations. This will mean that the hedge of the CHF12,250,000 is imperfect, and the receipt may be unpredictable despite a futures hedge being taken out.
This question has demonstrated how to use the data given in the question in foreign exchange hedging calculations. Hopefully, it will help you tackle this type of question systematically.
View an example of how the question could be attempted in the exam software
Written by a member of the AFM examining team