Financial Derivatives: Currency Hedging and Investment Strategies

This assignment solution addresses two key problems in international finance. The first problem involves a British firm hedging its USD exposure using CME futures contracts. The solution details the firm's strategy of selling GBP/USD futures, calculates the number of contracts needed, and determines the initial margin required. The second problem focuses on a U.S. firm, ETT Consulting, and its EUR receivables. The solution analyzes the use of a money market hedge, determining the appropriate currencies for borrowing and investment, and calculating the investment amount. The solution incorporates interest rate differentials, exchange rate predictions, and the effective rate of exchange including hedging, to provide a comprehensive understanding of the hedging strategies and the financial calculations involved. References to relevant sources are also included.

Ans 1:
A)
In the given case, a British firm has sold goods to US firm, for a consideration of $ 5,670,000. The
consideration for the transaction would be paid in December.
The firm wants to hedge the exposure using CME future contracts, since the British firm is expecting
to received USD, the firm should sell GBP/USD future.
As in the month of December the firm would receive $ 5,670,000 from the sale transaction and it can
settle the future using the amount so received.
B)
Since, the December expiry, GBP/USD future is trading at 1.6491, this implies that 1.6491 USD would
fetch 1 GBP in December, on the expiry of future. Each contract has 62,500 GBP as the underlying.
And the firm is expected to receive $ 5,670,000, thus it should sell, GBP (5,670,000/1.6491)/62500
GBP per contract, i.e. 55 contracts of GBP/EUR, with each contract having 62,500 GBP.
C)
As given in the problem, The initial margin required for dealing in futures contract is 110% of
maintenance margin.
The initial margin in this case is 110% of maintenance margin.
Maintenance margin normally is the difference between spot exchange rate and future rate of the
contract. Thus, in this case, the maintenance margin is GBP (1/1.6491-1/1.6524)*62500*55, i.e. GBP
(0.6064-0.6052)*62,500*55, i.e. GBP 4,095 (Approx)
Since, initial margin is 110% of maintenance margin, thus, initial margin, which the company requires
to keep with the broker is 110% of 4,095, i.e. GBP 4,504.
Ques 2:
A)
Though the nominal rate of borrowing is lesser in U.S. as compared to Europe, since the difference in
the currency exchange rate is higher than the difference in nominal exchange rate hence, the real
interest rate on borrowing is lower in Europe firm should borrow in EUR.
And similarly, though the nominal rate of return on investment in Europe is higher than rate of
return in USA, since the difference in the currency exchange rate is higher than the difference in
nominal exchange rate hence, the real interest rate on investment is higher in USA and hence the
firm should be investing in USD.
B)
The firm should invest the USD equivalent amount that would be sufficient enough to match the
250,000 EUR to be received in six month.

Predicted rate of EUR in six month period is 1.2911(1.02)=1.2866(1.03), i.e. 1 USD = 0.998562 EUR.
Thus, the amount that firm should receive in terms of EUR is 250000/0.998562 = 250,360 EUR and
the present value of EUR 250,360 considering the rate of return on investments of 0.5%, shall be
250,360*1/1.0025, i.e. $ 249,735
C)
The firm should borrow the amount equivalent to the investment amount, i.e. EUR
249735*0.998562, i.e. EUR 249,376.
D)
From the investment made of @ 249,725, the future asset would be equal to $ 250,360.
E)
Effective rate of exchange including hedging is 1.290533/1.292391 EUR/USD
References:
Interest rate and exchange rate.
https://www.economicshelp.org/blog/5394/interest-rates/interest-rates-and-exchange-
rate/. Accessed on 26.09.2019
The relationship between exchange rates, interest rates. Retrieved from
https://msu.edu/course/ec/340/Kilic/lecture9.pdf. Accessed 26.09.2019