Hedging Strategies in Foreign Exchange

This assignment delves into the concept of hedging in foreign exchange markets, focusing on forward and future contracts. It uses a scenario involving Mr. X, an investor who wins a contract in Australia, to illustrate how these instruments can mitigate currency risk. The document also examines valuation models for options and their role in managing risk during trading.

Answer - 1
Hedging can be defined as a way to manage the risk to an extent that can be endured. Variations
in the foreign exchange rate tend to have significant implication and hence, it is essential to use
forward and future. Forward rates are agreement that is customized between two parties so that
the exchange rate can be fixed for a future transaction (Deegan, 2011).
An investor Mr. X (contractor) won a bid to develop a roach in Australia and for that, the
contract was signed in July that amounted to $10,000 that would be paid in September. This
amount is in tune with the minimum revenue of Mr. X that is $10,000 at the exchange rate of
0.10. Moreover, exchange rates can lead to a depreciation of the dollar and hence the project
unworthy. Mr. X enters into a forward contract with the bank to fix the exchange rate at 0.10 and
the forward contract constitutes an obligation on both the sides. The bank needs to counter party
for the transaction either a party that needs to hedge against the appreciation of $10,000 that
expires at the same time or a party that desires to speculate on the trend that will go update. If the
bank play plays the role of the counter party then the risk needs to be borne by the bank. By
entering into a forward contract Mr. X is sure of having an exchange rate of 0.10 per $ in the
future and is not concerned about what will happen to the spot rupee exchange rate. If the dollar
will depreciate then the investor Mr. X will be protected (Deegan, 2011).
Mr.X can enter into currency future contract that is an agreement between two parties to
purchase or sell a specific currency at a future date at a specified exchange rate that is fixed or
agreed upon. A future contract is a contract that is standardized in nature and going by the above
example suppose the investor entered into forward then Mr. X would have sold rupee future to
hedge against the depreciation of the rupee. The dollar future is sold by Mr. X at the rate of .0.10
per dollar. Thereby, a contract size appears to be $10,0000. If the dollar depreciates to 0.07 then
Mr. X is sure to buy the contract at the new rate. It needs to be noted that Mr. X purchased the
contract for 0.07 and sold for 0.10. This reaps a profit of $3000 [($0.10-$0.07) x 10,0000. In the
spot market, Mr. X will get $7000 at 0.07 and the cash flow will appear at 10000. Therefore,
future hedging will provide Mr. X the advantage with the obligation to buy back the contract at
any point of time.
1

Answer - 2
It is not only the interest rate that affects the future prices there are other factors like interest
income, an underlying price that influences the future and forward prices. In the above case, Mr.
X sells futures as the cash flow was not certain in nature, the investor needs to discount at the
risk-free rate to know the present value of the asset (Guerard, 2013). In this scenario, no
arbitrage situation exists and nowhere specified that the result must match the assets spot price
(Parrish , 2013). Hence, the trader or the investor above needs to borrow, as well as lend at the
risk-free rate and in the absence of no arbitrage condition the future price will be as follows
F0,T=S0*er*T
F0,T = price of the contract
S0 = underlying asset spot price
2

T = time until maturity
Hence, the future price of the underlying can be determined.
Answer - 3
Option functions on the concept of leverage and have less risk as compared to the stock position.
Option contract can be used in an effective manner that helps to lessen the risk and is an effective
mechanism that paves the way for a better exposure. For example, if the stock price of the
consumer goods stock is riding at $60 and it has a gap down opening at $20 when the consumer's
goods products are found to be defective and killed four patients the stop order of the investor
will be executed at $20. This will provide a huge loss of $40 and protection is less in this
scenario. However, instead of purchasing the stock, the call option is purchased at $12 every
share. Now the risk situation is changed completely when an option is purchased because the risk
is only the amount that is paid for the option (Graham & Smart, 2012). Hence, if the stock opens
at $20, anyone who purchased it at $40 will be out while the investor will just forgo $11.50.
Hence, utilizing the options in this manner makes options less risky in nature.
Answer - 4
Various valuation models are being used by the options trader so as to compute the theoretical
option values (Libby et. al, 2011). Such mathematical options can be used to compute the value
of other underlying assets like stock indexes. Since the underlying behaves in the same manner
and have strike price, underlying price and days till expiration together with the concept of
forecast, therefore, assumption and implies volatility can be utilized to compute the prices of the
underlying. It needs to be noted that the variables fluctuate over the life span of the option and
the theoretical value of the option projects such changes (Brealey et. al, 2014). In a similar
manner, the underlying contains a value which can be used to compute the value with ease and
flexibility. Further, the models of the stock options consider the stock price and in a similar
manner the stress in provided on the stock indexes.
3

When undergoing a big volume of trade, the major reliance needs to be done on the updates of
the theoretical value as it helps in ascertaining the risk and helps in the process of trading.
4

References
Brealey, R, Myers, S. & Allen, F. (2014). Principles of corporate finance. New York: McGraw-
Hill/Irwin.
Deegan, C. M., (2011). In Financial accounting theory. North Ryde, N.S.W: McGraw-Hill
Graham, J & Smart, S. (2012) Introduction to corporate finance. Australia: South-Western
Cengage Learning.
Guerard, J. (2013). Introduction to financial forecasting in investment analysis. New York, NY:
Libby, R., Libby, P. & Short, D. (2011). Financial accounting. New York: McGraw-
Hill/Irwin.
Parrish , S. (2013). What Happens If Interest Rates Go Up. Accessed August 31, 2017 from
https://www.forbes.com/sites/steveparrish/2013/08/20/what-happens-if-interest-rates-go-
up/#366560b35aaf
5