1. Intermediate Investments F3031 Hedging Using Currency Derivatives Foreign currency futures are traded on the Chicago Mercantile Exchange Examples of the size of certain contracts include: –British Pound: 62,500BP –Canadian Dollar:100,000CD –Euro125,000Euros –Japanese Yen 12,500,000Y –Swiss Franc125,000CHF –Australian Dollar100,000AD –Mexican Peso500,000MP

2. Intermediate Investments F3032 Hedging Using Currency Derivatives Contract delivery months are: –March –June –September –December Prices are normally quoted as USD per unit of foreign currency. So, for example: –USD/CHF = 0.60053or 1.66 CHF = 1 USD –USD/Y = 0.007592or 131.72 JPY = 1 USD –USD/BP = 1.43160or.699 BP = 1 USD –USD/Euro 0.9062or 1.104 Euro = 1 USD

3. Intermediate Investments F3033 When Might You Hedge a Foreign Currency Transaction? Anytime your assets and liabilities are in different currencies –Let’s say your accounts receivable are in a foreign currency, but your accounts payable are in the domestic currency –Consequently, you are expecting receipts in one currency, but expect to make your payments in another –Use a Futures contract to lock in a rate. Remember: you are locking in an effective rate. You now have 2 distinct transactions which will offset each other to provide the effective rate you’ve locked in!

4. Intermediate Investments F3034 Example of a Foreign Currency Hedge Make the following assumptions: –It is December 31 and your company has just signed a contract to sell 25 large earthmovers to a German mining company with delivery in exactly 6 months –Delivery price is EUR 25.0M –Delivery and payment of the earthmovers will be the end of June –Current USD/EUR exchange rate is 0.87936 –Price of a June contract for EUR is.8767 –In this particular case, You must make an initial outlay of USD $21M which you can borrow at 7.1225% Should you undertake the project?

5. Intermediate Investments F3035 Example of a Foreign Currency Hedge (cont) You borrowed USD $21M to get the project started. How much must you repay in 6 months if the annual interest rate is 7.1225%? In order to break even, what must the Spot exchange rate be in June? If you want to hedge, how do you decide if you buy or sell a contract? –If you’ll be receiving foreign currency you enter into a contract to deliver that currency –If you’ll be paying in a foreign currency, you enter into a contract to receive that currency

6. Intermediate Investments F3036 Example of a Foreign Currency Hedge (cont) How many contracts do you have to sell? You will deliver foreign currency in June at an exchange rate of.8767 This will give you an “effective” exchange rate. What is the price you will receive in USD? How does the hedge work if the exchange rate at maturity: –Falls to.8700 –Rises to.8900 –Remember: you have 2 distinct transactions that offset each other to achieve the effective rate!

7. Intermediate Investments F3037 Spot Futures Parity If Spot Futures parity states that the Futures rate is equal to the current price plus a carrying cost, how can the futures rate on foreign currency exchange be less than the current spot rate? Although risk free interest rates vary from currency to currency, you should not be able to make risk free profits simply through foreign currency trading Interest rates should reflect the differences in exchange rates to prohibit arbitrage profits So, just how does this work??

8. Intermediate Investments F3038 Interest Rate Parity (cont)