Report on Hedging and Performance of Foreign Transaction Hedge

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Contents
Question 2..................................................................................................................................1
Report on 20th October 2017...................................................................................................1
Introduction.........................................................................................................................1
Need For hedging the upcoming transaction and details of the appropriate hedging
strategy................................................................................................................................2
Conclusion..........................................................................................................................3
Report on 10th March 2018....................................................................................................3
Introduction.........................................................................................................................3
Performance of the foreign transaction hedge....................................................................4
Margin Account..................................................................................................................4
Conclusion..........................................................................................................................8
Question 3..................................................................................................................................9
Report to the advisory board................................................................................................10
Risks faced by the portfolio and VAR analysis................................................................10
Portfolio Risk:...................................................................................................................10
Portfolio VAR:..................................................................................................................11
Different VAR estimates..................................................................................................12
Back-testing......................................................................................................................14
Use of derivatives to improve the VAR estimates............................................................15
References................................................................................................................................16
Appendix..................................................................................................................................17
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Question 2
Report on 20th October 2017
Introduction
This report discusses the need for hedging the upcoming transaction where the company will
receive £ 9m on the 9th of March 2018. The report also explains the hedging strategy that
should be used to hedge this transaction using the currency futures contracts. After explaining
the need for hedging this transaction, the report chooses the appropriate futures contract on
CME and then it calculates the required number of futures contracts.
Need For hedging the upcoming transaction and details of the appropriate
hedging strategy
The company is expecting to receive a payment of £ 9m on the 9th of March 2018. The
company is based in US, so this transaction will introduce foreign exchange risk from the
depreciation of £. If £ depreciates in future in comparison to today then the company will
receive less dollar amount on 9th March 2018. Therefore, it is advised to hedge such risk from
foreign exchange fluctuation using derivatives (Golden, 2019). Futures and forward contracts
can be used for such type of hedging: Forward contracts are over the counter contract
between two parties that can be customised according to the need of the individual parties but
they involve credit risk; Futures contracts are exchange traded contracts and they have pre-
defined specification but they do not have any credit risk involved as exchange acts as a
counterparty (Hull, 2017). So, futures contracts can be used to reduce the volatility in the
cash-flows arising due to the fluctuations in the foreign exchange rate.
In this future transaction the company will receive £ 9m on the 9th of March 2018. It means
the company is long on £ 9m. In order to hedge this transaction risk the company needs to
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take short position in £ futures contract expiring near the transaction date. This will allow the
company to sell £ 9m for fixed dollars amount on contract expiry date.
Out of the available contracts, CME-STERLING COMP. MAR 2018 - IBC0318 is a suitable
contract. This futures contract has expiry near but later than the transaction date so it will
reduce the basis risk.
To calculate the required number of futures contracts, total transaction value is divided by the
value of single futures contract (Hull, 2017).
This contract is based on £ 62,500.00.
No. of £ futures contracts the company needs to short: 9000000/62500 = 144.
Conclusion
The report discussed the need for hedging the foreign transaction risk due to the fluctuations
in the foreign exchange. The company will receive £ 9m on the 9th of March 2018 so it faces
risk from the devaluation of £ as this will reduce the dollar amount it will receive after
conversion to the home currency. So, the company can short 144 CME-STERLING COMP.
MAR 2018 - IBC0318 contracts to receive a fixed amount on 9th March 2018 by selling £ 9m
at the contract rate.
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