Answer - 1Hedging 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 andthe 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 thebank 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 acontract 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 - 2It 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 followsF0,T=S0*er*TF0,T = price of the contractS0 = underlying asset spot price2
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