The principles of hedging with futures have been explained already. However, several examples will be used to illustrate how hedging works. Study each example carefully: they get progressively more difficult.
Example: perfect hedge, no basis
It is July. A US company must pay 750,000 euros to a Spanish supplier in November, and wishes to hedge its currency exposure with currency futures. In this example, it is assumed that there is no basis, and the futures price and the current spot market exchange rate are always equal. The price of December futures in July is 1.2100 ($1.2100 per €1). The value of a tick is $12.50. (This is €125,000 × $0.0001 per $1.) The exposure is to the risk of a rise in the value or cost of the euro between July and November. The underlying position is that the US company will pay euros in November. So to create a futures hedge against the risk of a rise in the cost of the euro, it should buy euro currency futures. If the cost of the euro goes up, the company will have to pay more to obtain the 750,000 euros, but this higher cost will be offset by a gain on the futures position.
This logic can be set out in the three-step approach described earlier, as follows:
Step Comment
1 Identify the underlying transaction that you are trying to hedge.
The US company will be paying 750,000 euros 2 What is the currency risk in the
underlying transaction?
The cost of obtaining the euros will go up. The cost/value of the euro will rise against the dollar.
3 Work out a futures position that creates a profit if there is a ‘loss’ on the underlying transaction.
If a loss will be incurred on the underlying transaction if the value of the euro goes up, the futures position should create a profit if the value of the euro goes up.
So buy euro currency futures, since a profit will be made if the value of the euro goes up and the futures can be sold at a higher price.
The US company should therefore buy 6 December contracts (€750,000/€125,000 per contract) at a price of 1.2100. The company is therefore ‘long’ 6 December contracts.
Suppose the spot exchange rate in November when the US company must make the payment in euros is 1.2240. The cost of buying the euros has gone up.
The long’ futures position is closed by selling 6 December contracts at 1.2240, because in this example the futures price is also 1.2240. The position is closed at a profit, as follows:
Open futures position: buy at 1.2100 Close position: sell at 1.2240 Gain 0.0140 Gain = 140 ticks per contract at $12.50 per tick.
Total gain on futures position = 6 contracts × 140 ticks × $12.50 = $10,500.
The US company has to pay US1.2240 to obtain the euros to make the payment in November, but the net cost is calculated by taking the cost of the spot transaction and the gain or loss on the futures position.
$ Spot market: buy €750,000 at 1.2240 918,000 Less gain on futures position (10,500) Net cost of €750,000 907,500
The net cost is $907,500, so the effective exchange rate secured by futures hedge = US$907,500/€750,000
= US$1.2100/€1.
This is the spot rate and the futures price at the time the position was opened.
Conclusion
With a perfect hedge and no basis, futures can therefore fix the effective exchange rate at the spot rate when the hedge was created. However, in practice, the hedge is likely to be imperfect and there is basis.
Example: imperfect hedge but no basis
It is June. A UK company expects to receive US$1,000,000 from a customer in August, and wishes to hedge its currency exposure with currency futures. In this example, it is assumed that there is no basis, and the futures price and the current spot market exchange rate are always equal. The price of September futures in June is 1.8200. The value of one tick is $6.25.
The exposure is to the risk of a fall in the value of the US dollar between June and August. The company will receive US dollars. It can create a hedge with futures by selling dollars and buying British pounds. The UK company should therefore buy the currency futures, which are denominated in British pounds.
This logic can be set out in the three-step approach described earlier, as follows:
Step Comment
1 Identify the underlying transaction that you are trying to hedge.
The UK company will be receiving $1 million.
2 What is the currency risk in the
underlying transaction? The value of the dollar will fall and the income will be worth less in sterling. Futures are denominated in sterling, so it is better to state that the risk is that the value of sterling will increase.
3 Work out a futures position that creates a profit if there is a ‘loss’ on the underlying transaction.
If a loss will be incurred on the underlying transaction if the value of sterling goes up, the futures position should create a profit if the value of sterling goes up.
So buy sterling currency futures, since a profit will be made if the value of sterling goes up and the futures can be sold at a higher price.
At a rate of 1.8200, the sterling equivalent of $1,000,000 is £549,451. Each futures contract is for £62,500, therefore the company would want to buy 8.79 contracts. The company will probably decide to buy 9 contracts, although the hedge is imperfect.
Suppose that in August when the dollars are received, the dollar has actually strengthened in value and the exchange rate is 1.7800 (and the futures price is also 1.7800). The company will sell the $1,000,000 and close its futures position. The position for the company is as follows:
Open futures position: buy at 1.8200 Close position: sell at 1.7800 Loss 0.0400 Loss = 400 ticks per contract at $6.25 per tick.
Total loss on futures position = 9 contracts × 400 ticks × $6.25 = $22,500.
$ Received from customer 1,000,000 Loss on futures (22,500) Net receipt in dollars 977,500 Sell dollars at 1.7800 (spot rate)
Income in British pounds £549,157
Effective exchange rate secured by futures hedge = US$1,000,000/£549,157 =
This is close to the spot rate and futures price at the time the position was opened.
Ignoring basis, the futures hedge has therefore fixed the effective exchange rate close to the spot rate and futures price when the hedge was created. However, in this example, the exchange rate moved favourably, and the gain from the increase in value of the dollar income was offset by a loss on the futures position.
Example: imperfect hedge and basis
A Netherlands company expects to pay US$1,200,000 to a US supplier in late November. It is now late July, and the current spot exchange rate is €1 = $1.2200.
The current spot price for December dollar-euro currency futures is $1.2170. The company wants to hedge its exposure with currency futures.
The logic of establishing a hedge with currency futures can be set out in the three- step approach described earlier, as follows.
Step Comment
1 Identify the underlying transaction that you are trying to hedge.
The European company will be paying $1.2 million.
2 What is the currency risk in the
underlying transaction? The cost/value of the dollar will increase and the cost in euros will rise. Futures are denominated in euros, so it is better to state that the risk is that the value of the euro will fall.
3 Work out a futures position that creates a profit if there is a ‘loss’ on the underlying transaction.
If a loss will be incurred on the underlying transaction if the euro falls in value, the futures position should create a profit if the value of the euro falls.
So sell euro currency futures, since a profit will be made if the value of the euro falls and the futures position can be closed by buying euro futures at a lower price than the futures were originally sold.
The company will sell futures to create a ‘short position’ to hedge the currency risk.
The equivalent value of $1,200,000 at the current futures price is 986,031 euros ($1,200,000/1.2170).
The number of contracts required is therefore 7.9 contracts (€986,031/€125,000 per contract).
The company will probably create the hedge with 8 contracts (by selling 8 December futures).
In this example, the basis is 30 points in July (1.2200 – 1.2170). The December futures contract reaches settlement in five months’ time, therefore basis should fall by 6 points each month (30 basis points/5 months). By the end of November, four months later, the basis should therefore have fallen by 24 points, from 30 to 6.
Suppose that in November when the dollars are paid, the spot rate has moved to 1.2040 and the futures price is 1.2030. (The actual basis is 10.) The company will close its futures position.
Open futures position: sell at 1.2170 Close position: buy at 1.2030
Loss 0.0140
Gain = 140 ticks per contract at $12.50 per tick.
Total gain on futures position = 8 contracts × 140 ticks × $12.50 = $14,000.
$ Payment to customer 1,200,000 Gain on futures (14,000) Dollars to be purchased spot 1,186,000 Buy dollars at 1.2040 spot
Cost in euros €985,050
Effective exchange rate secured by futures hedge = US$1,200,000/€985,050 = US$1.2182/€1.
This is fairly close to the spot rate and futures price at the time the position was opened. In this example, the expected basis in November was 6 points and the actual basis was 10 points, and the gain on the futures position was therefore 4 points or ticks per contract more than expected. This has affected the value of the hedge by 8 contracts × 4 ticks × $12.50 = $400.
Short-term interest rate futures (STIRs)
Features of short-term interest rate futures
Hedging short-term interest rate exposures with STIRs
Hedging examples
8 Short-term interest rate futures (STIRs)