Currency Futures- Hedging

Example – Hedging (Futures)

– Company A must Pay £1 Million in September for imports from Britain.
– Company B will receive £3 Million in September from exports to Britain

• Current Exchange Rate Rs/ £ = 70.2039

• September Futures Price Rs/ £ = 69.9147
• in September at expiration spot price is 71
• Size of Futures Contract £ 62500

• Company A’s Hedging Strategy

– (pay means Short in SPOT)
– Buy (Long) Position in 16 Futures Contracts. This locks in the exchange rate of
69.9147 for the £1 Million it will pay

• Company B’s Hedging Strategy

– Receive means (Long in SPOT)
– Sell (Short) Position in 48 Futures Contracts. This locks in an exchange rate of
69.9147 for the £3 Million it will receive.
 Company A

Short position in Long Position in Futures

Cash Market market

Time Spot Futures Basis Profit/Loss

Right now 70.2039 69.9147 0.289  

At maturity 71 71 0  

Pay off -0.7961 1.0853   0.2892

 Company B

Long position in Short Position in Futures

Cash Market market
Time Spot Futures Basis Profit/Loss
Right now 70.2039 69.9147 0.2892  
At maturity 71 71 0  
Pay off 0.7961 -1.0853   -0.2892
• Total profit in spot = .7961*3,000,000
=2,388,300

• Total Loss in futures = -1.0853* 48*62500

=-3,255,900

• Net Loss =867,600

 Hedge Ratio
Can I hedge the loss due to basis Risk ?
 Company B

Long position in Short Position in Futures

Cash Market market
Time Spot Futures Basis Profit/Loss
Right now 70.2039 69.9147 0.2892  
At maturity 71 71 0  
Pay off 0.7961 -1.0853   -0.2892
• Instead of 48 futures contracts If Company
B had sold 35.20943 contracts then it
would have resulted in perfect hedge.

Loss in futures =35.20943*62500* (-1.0853)

=-2,388,300
Which is exactly equal to the profit in spot.
• Hedge Ratio = Futures position/Underlying

Asset Position

• Hedge Ratio =35.20944/48

=0.73353 (.7961/1.0853)
 How to estimate Hedge ratio
Change (St)= alpha + beta *change (Ft) + error term

Change (St) = change in cash price on day t

Change (Ft) = change in futures price on day t

Beta gives the hedge ratio.

Beta = Covariance (S,F) /variance (F) or

Beta = correlation coefficient (S,F)* standard deviation (S)/
Std. dev of (F)