Fin 5545 Project Currency Exchange Rate Risk Due Date 4

Fin 5545 Project Currency Exchange Rate Risk Hedgedue Date 4292018

Read the notes section at the end. It will answer questions you may have. The sample period for this project is from 3/19/2018 to 4/20/2018. You will need to collect real-time data starting from today. At 4pm, your company receives 12,500,000 Euros. If you convert 12.5 million Euros now, it will be USD 15,370,625. You are happy with this rate but prefer to delay conversion to avoid a high tax today, risking exchange rate fluctuations. The objective is to design a strategy to keep the USD value of your Euros as close to $15,370,625 as possible over this period, using Euro FX futures contracts expiring in June 2018. The project involves answering ten questions based on data collection, calculations, and analysis.

Paper For Above instruction

In this project, the primary goal is to hedge the currency risk associated with delaying the conversion of 12.5 million Euros into USD. Given the volatility of the EUR/USD exchange rate, the company aims to implement a hedge using Euro FX futures to stabilize the USD equivalent of its Euro holdings over five weeks, from March 19 to April 20, 2018. This analysis involves understanding the distinctions between different futures contracts, calculating appropriate hedge positions, tracking daily market data, computing gains and margins, and analyzing the effectiveness of the hedge.

Understanding Futures Instruments and Market Mechanics

The first step is to differentiate between Euro FX futures and Eurodollar futures. Euro FX futures are standardized contracts traded on the CME that facilitate exchange rate hedging or speculation involving the Euro and USD. These futures are settled based on the EUR/USD exchange rate at contract expiration, and they are designed explicitly for currency rate hedging. Conversely, Eurodollar futures are contracts that involve U.S. dollar deposits held outside the United States, primarily used to hedge interest rate risk rather than FX rate fluctuations (Hull, 2017). The main difference lies in their underlying assets and their purpose: Euro FX futures directly hedge currency exposure, while Eurodollar futures primarily hedge interest rate movements on dollar deposits.

Contract Sizes and Similarities

The contract size of a Euro FX futures contract, as specified by CME, is 125,000 Euros per contract. This standardization enables traders and hedgers to easily quantify and manage currency exposure. The British Pound futures contract size differs, typically being 62,500 GBP per contract (CME, 2018). Thus, while both are currency futures, they do not share the same contract size, reflecting differences in the currencies’ denominations and trading conventions.

Positioning for Hedging

To hedge the Euro currency position effectively, the company should take a short position in Euro FX futures. This is because the exposure to Euro appreciation (which would decrease USD value) necessitates an inverse position to offset potential losses. The number of contracts needed is calculated by comparing the Euro amount with the futures contract size, adjusted by the current EUR/USD rate:

Number of contracts = (Euro amount) / (contract size in Euros) × (current EUR/USD exchange rate) = 12,500,000 / 125,000 × 1.2276 ≈ 122.76 contracts.

Since fractional contracts are not traded, the firm should round to 123 contracts short to hedge its currency risk. This position ensures that gains or losses in futures offsets fluctuations in the USD value of the Euro holdings.

Data Collection and Calculation of Daily Prices

During the sample period, daily closing prices for EUR/USD exchange rates and Euro FX futures (specifically CME's June 2018 contracts) must be collected. Data can be retrieved from financial data providers such as Bloomberg, Yahoo Finance, or CME's official website. The collected data should include date, exchange rate, and futures price. This data forms the basis for subsequent calculations of daily gains and cumulative gains, enabling an effective hedge analysis.

Daily Gains, Margin Calls, and Hedging Effectiveness

Using the collected prices, the daily gains or losses of the futures position are calculated based on the daily change in futures prices times the contract size and position size. These daily gains accumulate over the period to evaluate the total hedge performance. The margin account balance changes daily, reflecting gains or losses, initial margins ($10,000 per contract), and maintenance margins ($8,000). If the balance falls below the maintenance margin, a margin call is issued, requiring additional funds to maintain the position.

Calculating USD Values and Assessing Hedge Performance

The unhedged USD value is straightforward: 12.5 million Euros multiplied by the actual EUR/USD exchange rate for each day. The hedged value adds the cumulative gains/losses from futures to this unhedged value, providing a better measure of the hedge effectiveness. Plotting these values over time visually demonstrates how well the hedge stabilizes the USD amount. Calculating the standard deviation of these series quantifies the risk reduction achieved through hedging.

Evaluating Hedge Success

The hedge is considered successful if the standard deviation of the hedged USD value is significantly lower than that of the unhedged USD value. This indicates reduced volatility and risk exposure. Alternatively, comparing the range or tracking error of the two series can also serve as performance metrics. If the hedge effectively minimizes daily fluctuations around the target value of approximately $15,370,625, it fulfills the strategic purpose.

Hedging Strategies for Upside Benefit

If management wants to benefit from potential currency appreciation (i.e., higher USD value if EUR/USD increases), the existing short futures position would limit gains. Instead, a different instrument such as a currency call option on EUR/USD would better serve this purpose, allowing upside participation while providing downside protection. This asymmetric hedge is ideal for firms desiring to hedge against declines but participate in gains, aligning with the concept of cost-effective risk management (Madura, 2018).

Conclusion

In conclusion, implementing a hedge via Euro FX futures involves careful calculation of the position size, daily data monitoring, margin management, and performance evaluation. The hedge aims to mitigate currency risk and stabilize USD influx from Euro assets. The practical steps include identifying the correct futures contracts, executing the appropriate short position, continuously tracking market data, and adjusting margins. Properly executed, this strategy effectively reduces exchange rate volatility's impact, enabling the company to plan finances with greater certainty.

References

  • CME Group. (2018). Euro FX futures product specifications. CME.
  • Hull, J. C. (2017). Options, Futures, and Other Derivatives (10th Edition). Pearson.
  • Madura, J. (2018). International Financial Management (13th Edition). Cengage Learning.
  • CME Group. (2018). FX Futures Contract Specifications. CME.
  • Investopedia. (2021). Difference Between Euro Forex and Eurodollar Futures. https://www.investopedia.com/
  • Bloomberg. (2018). Historical EUR/USD exchange data. Bloomberg Terminal.
  • Yahoo Finance. (2018). EUR/USD historical data. https://finance.yahoo.com/
  • Bank of International Settlements. (2018). Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets.
  • International Monetary Fund. (2018). Currency Composition of Official Foreign Exchange Reserves (COFER). IMF Publications.
  • Choudhry, M. (2010). The Principles of Financial Derivatives. Wiley Finance.

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