Learning Objective: Apply Currency Futures to Hedge Exchange Rate Risk
Directions:
On 10/25/2021, your company receives 3.75 million Euros for selling products in Germany. Currently, the EUR/USD exchange rate is 1.1613. So if you convert this 3.75 mil Euros to USD today, it will be worth $4,354,931. You are extremely happy with the current exchange rate and would take this US dollar value. However, if you convert now, you may have to pay tax today.
Instead, you decide to convert Euros to USD at the end of next month and delay paying the tax. However, this delayed conversion comes with a risk. Since EUR/USD exchange rate fluctuates every day, the US dollar value of your Euros next month will no longer be the same dollar amount. This risk is called currency risk, aka foreign exchange rate (FOREX) risk.
The objective of this project is to design/execute a strategy today such that the USD value stays close to $4.35 mil throughout the whole sample period. The financial instrument for this project is Euro FX futures contract expiring in Dec 2021 (ticker: /6EZ21 or E6Z21).
10 Questions (each is worth 1 point, consider each as a rubric):
1. When you convert 3.75 mil Euros into USD next month, are you “buying” or “selling” Euros? To lock the future exchange rate in this case, should you “long” or “short” Euro FX futures today? Explain.
2. What is the contract size (aka. contract unit) of 1 Euro FX futures contract? Is the British Pound futures contract size the same as Euro FX futures? How many Euro FX futures contracts do you need to long/short today?
The rest of this project will confirm whether your actions taken on 10/25/2021 (=answers to Q1/Q2) are indeed the correct hedging strategy at the end. If you don’t find sufficient evidence of lowering risk in Q3-Q10, it’s likely that your answers to Q1/Q2 are incorrect so revise your answers and solve them again, as necessary.
3. For every trading day (skip holiday/weekends) during the sample period, collect the EUR/USD exchange rate (from either Bloomberg, Google, Yahoo, Fed, etc) and the Euro FX futures price (from CME or other sites).
The above screenshot is what the Euro FX futures quotes looks like at cmegroup.com.
The price you need to collect is “Last” price (not Open, High, Low).
Prepare a spreadsheet and create 3 columns for:
⦁ Date (exclude non-trading days)
⦁ EUR/USD exchange rate
⦁ Euro FX futures price
4. In columns E and F, calculate “Daily Gains” and “Cumulative Gains” for your Euro FX futures position from Q1 and Q2. Calculate these values in Excel. Do not manually enter the values. If I don’t see Excel calculation behind your answers, I’ll assume you copied someone else’s answers, which is not acceptable for an individual project.
5. Assume the initial margin requirement is $2,420 per contract and the maintenance margin requirement is $2,200 per contract. In column G, calculate the “Margin Account Balance” for each trading day. Is there a margin call at any time? If yes, add the required cash to the margin account to avoid liquidation.
6. In column H, convert 3.75 mil Euros into USD using the exchange rates in column B for each day. In column I, calculate the values of your “Hedged Value”. At this point, your spreadsheet should have the columns (A – I) in the screenshot above.
7. Plot the unhedged values and hedged values in Q6 over time. Discuss whether your strategy was successful. Specifically, did your futures position lower the currency risk?
8. Calculate the standard deviations of the unhedged values in H. In addition, calculate the standard deviation of hedged values in I. Discuss whether your strategy was successful.
9. If EUR/USD exchange rate increases in the future, the USD value of your Euros will become higher, which will benefit you. Suppose you want to benefit from this positive opportunity but still want to limit the loss against FOREX drop.
For this objective, Euro FX futures is a wrong instrument. Instead, which investment strategy should you use? In addition, which specific financial derivative will this strategy involve?
10. Euro FX futures is an example of FX (or currency) derivatives. In Module 3, we learned Eurodollar futures. Eurodollar futures may sound similar to Euro FX futures but they are fundamentally different. What is Eurodollar futures?
Why and when will a company use Eurodollar futures? Using a specific example from Module 3 and discuss how a company would use Eurodollar futures.
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