1. A Pak company exports US$ 1 million goods to a customer in united states with a payment to be received after 3 months. A Pak company exports US$ 1 million goods to a customer in united states with a payment to be received after 3 months. Current spot rate is US $/PKR = 60.1234 – 60.1599 Current spot rate is US $/PKR = 60.1234 – 60.1599 3 Months Interest Rates DepositLoan 3 Months Interest Rates DepositLoan (Per Annum) (Per Annum) PKR Rs3.55%4.45% PKR Rs3.55%4.45% US $3.15%4.52% US $3.15%4.52% How can a firm establish a Money Market Hedge? How can a firm establish a Money Market Hedge? Example: Money Market Hedge Future Receipt in FCY

2. Firm will receive 1 million dollars in 3 months and therefore, to create hedge it needs to borrow US$ now. Firm will receive 1 million dollars in 3 months and therefore, to create hedge it needs to borrow US$ now. The borrowed amount plus interest after 3 months should be equal to US$ 1 million (liability) which will be set off against the future income. The borrowed amount plus interest after 3 months should be equal to US$ 1 million (liability) which will be set off against the future income. In this way the income after 3 months (asset) will be equal to the liability. In this way the income after 3 months (asset) will be equal to the liability. Firm would borrow us $ now for 3 months @ interest rate of 4.52% pa. Firm would borrow us $ now for 3 months @ interest rate of 4.52% pa. Solution

3. 4.52% pa needs to be converted to 3 month rate. 4.52% pa needs to be converted to 3 month rate. =4.52 / 4 = 1.1300 =4.52 / 4 = 1.1300 We must express this interest rate as (1+r) We must express this interest rate as (1+r) 1.1300 will be 1.0113 1.1300 will be 1.0113 Borrow Loan= US $ 1 million/1.0113 = $ 988,826.00 Loan Borrow Loan= US $ 1 million/1.0113 = $ 988,826.00 Loan After 3 months loan + principal will be exactly US $ 1 million. After 3 months loan + principal will be exactly US $ 1 million. Solution

4. In second phase of Hedging: In second phase of Hedging: Assuming that the borrowed amount is utilized in business. Assuming that the borrowed amount is utilized in business. Borrowed us $ are converted to PKR at spot rate PKR 60.1599 Borrowed us $ are converted to PKR at spot rate PKR 60.1599 Then PKR will be: Then PKR will be: = 988,826 x 60.1599 = PKR 59,487,689.00 = 988,826 x 60.1599 = PKR 59,487,689.00 Assuming that the borrowed amount is not utilized in business. Assuming that the borrowed amount is not utilized in business. This amount can be put to a PKR deposit @ interest rate of 3.55% pa. This amount can be put to a PKR deposit @ interest rate of 3.55% pa. PKR deposit rate 3.55% for 3 months can be stated as 0.8875 per quarter. PKR deposit rate 3.55% for 3 months can be stated as 0.8875 per quarter. Solution

5. Using (1+r) equation, quarterly interest rate of 0.8875 will be 1.008875. Using (1+r) equation, quarterly interest rate of 0.8875 will be 1.008875. PKR deposit will earn after 3 months: PKR deposit will earn after 3 months: = 59,487,689 x 1.008875 = 60,353,229 In this example, Rs. 60,353,229 is certain cash flow and has locked/Fixed exchange rate of PKR In this example, Rs. 60,353,229 is certain cash flow and has locked/Fixed exchange rate of PKR = 60.3532 (60,353,229 / 1,000,000) = 60.3532 (60,353,229 / 1,000,000) Solution

6. When a Future Payment in FCY is required: When a Future Payment in FCY is required: A hedge can be created by exchanging domestic currency for foreign currency now and putting the fcy under a deposit. A hedge can be created by exchanging domestic currency for foreign currency now and putting the fcy under a deposit. The term of deposit should end on the date fcy payment will be made. The term of deposit should end on the date fcy payment will be made. Secondly, the deposit plus interest thereof should equal to the fcy payment. Secondly, the deposit plus interest thereof should equal to the fcy payment. In this way we can fix the cash flow in local currency. In this way we can fix the cash flow in local currency.

7. A currency future is a standard contract between Buyer and seller in which the buyer has a binding obligation to buy a fixed amount, at a fixed price and on a fixed date of some underlying securities. A currency future is a standard contract between Buyer and seller in which the buyer has a binding obligation to buy a fixed amount, at a fixed price and on a fixed date of some underlying securities. Fixed amount = Contract size Fixed amount = Contract size Fixed price = Future price Fixed price = Future price Fixed date = Delivery date Fixed date = Delivery date 6) Currency Futures

8. Futures are the forward contracts traded on futures and options exchanges. They can only be bought and sold through future exchanges. Futures are the forward contracts traded on futures and options exchanges. They can only be bought and sold through future exchanges. They are standardized contracts – having identical specification. For example, every sterling contract has same terms and conditions. They are standardized contracts – having identical specification. For example, every sterling contract has same terms and conditions. Futures contracts are traded for settlement at a predetermined Time during a year. Futures contracts are traded for settlement at a predetermined Time during a year. These contracts are normally available in major currencies only Like Dollar, Pound Sterling, Yen, Euro etc. These contracts are normally available in major currencies only Like Dollar, Pound Sterling, Yen, Euro etc. Currency Futures Features

9. Future are traded at a price agreed between buyer and seller. Future are traded at a price agreed between buyer and seller. Most of contracts do not run till agreed settlement date (They are closed out before that time). Most of contracts do not run till agreed settlement date (They are closed out before that time). Contracts that close before the agreed date are settled in two ways: Contracts that close before the agreed date are settled in two ways: Cash settlement Cash settlement – With cash settlement cash is paid by one to other party. Physical delivery Physical delivery – With physical settlement, The agreed item is delivered by the seller to the buyer. Bonds futures are physical traded, whereas currency futures are cash settled. Currency Futures Features

10. All future contracts have fixed settlement date but can be closed out at any time before the agreed final date. All future contracts have fixed settlement date but can be closed out at any time before the agreed final date. When a company buys a future contract Buyer in long position, for example, December, it represents long position. When a company buys a future contract Buyer in long position, for example, December, it represents long position. It can close out the respective position by indulging in opposite direction transaction, before the date in December by selling the future. It can close out the respective position by indulging in opposite direction transaction, before the date in December by selling the future. When a position is closed, there will be resultant gain or loss (The difference between the selling and buying price). When a position is closed, there will be resultant gain or loss (The difference between the selling and buying price). Currency Futures Features

11. You can also sell something that you don’t have. Selling futures mean taking short position. You can also sell something that you don’t have. Selling futures mean taking short position. A short position can be closed by buying the same item (short sold) before the final date. Again there will be a gain or loss. A short position can be closed by buying the same item (short sold) before the final date. Again there will be a gain or loss. Currency Futures Features

12. Mechanism Ticks: Ticks: A tick is the minimum price movement of a contract. A tick is the minimum price movement of a contract. For example, the movement in US$ / PKR rate from 60.1599 to 60.1600, means the rate has risen 1 ticks. For example, the movement in US$ / PKR rate from 60.1599 to 60.1600, means the rate has risen 1 ticks. For example, the movement in US$ / PKR rate from 60.1501 to 60.1505, means the rate has risen 4 ticks. For example, the movement in US$ / PKR rate from 60.1501 to 60.1505, means the rate has risen 4 ticks.

13. Ticks: Ticks: Every tick movement in price has same money value. Every tick movement in price has same money value. For example, sterling/us$ contract standard size is sterling 62,500/-. the price is in us$ and tick size is $ 0.0001, which means each tick value is $ 6.25. For example, sterling/us$ contract standard size is sterling 62,500/-. the price is in us$ and tick size is $ 0.0001, which means each tick value is $ 6.25. If a trader is holding a long position and price of future increases, then there’s profit and fall in value represents loss. If a trader is holding a long position and price of future increases, then there’s profit and fall in value represents loss. If trader is holding is short position, rise in future value represent a loss, fall in price profit. If trader is holding is short position, rise in future value represent a loss, fall in price profit.

14. A Pak company bought goods for $ 900,000 in December and needs to settle in May. Due to the sensitivity of exchange rate of $/PKR the company intends to hedge this transaction exposure with currency futures. A Pak company bought goods for $ 900,000 in December and needs to settle in May. Due to the sensitivity of exchange rate of $/PKR the company intends to hedge this transaction exposure with currency futures. The spot rate when the goods were purchased was US$ 1 = PKR 60.1559. The $/PKR may futures contract is currently priced at US $ 1 = PKR 60.1585. The spot rate when the goods were purchased was US$ 1 = PKR 60.1559. The $/PKR may futures contract is currently priced at US $ 1 = PKR 60.1585. Assuming that the spot rate when goods are paid is US$ 1 = PKR 60. 2171 and June futures is priced at US$ 60.2201. Assuming that the spot rate when goods are paid is US$ 1 = PKR 60. 2171 and June futures is priced at US$ 60.2201. How can company Hedge this transaction with currency future? How can company Hedge this transaction with currency future? Example: Currency Futures Scenario: Future Payment in Fcy

15. Exposure US $ 900,000.00 900,000.00 Spot Rate December PKR60.1559 Fcy Future December PKR60.1585 Spot Rate (June) PKR60.2171 Fcy Future (June) PKR60.2201

16. PKR/$US$ PKR PKR In December and will sell in June In December and will sell in June December - fcy Futures purchased 60.1585 900,000.00 900,000.00 54,142,650.00 54,142,650.00 In May - When payment will be made in US $ 60.2201 900,000.00 900,000.00 54,198,090.00 54,198,090.00 Gain on sale of Fcy Contracts 55,440.00 55,440.00

17. MayPKR/$US$ PKR PKR Need to buy US $ at Spot rates to make payment 60.2171 900,000.00 900,000.00 54,195,390.00 54,195,390.00 Less: Profit / gain on Fcy Futures (55,440.00) (55,440.00) Net cost 54,139,950.00 54,139,950.00 Effective Exchange Rate 54,139,950.00 / 900,000.00 54,139,950.00 / 900,000.00 60.1555 60.1555

18. Standardized Futures Contracts: Standardized Futures Contracts: On some commodity exchanges, Currency Futures are available in the following denominations. On some commodity exchanges, Currency Futures are available in the following denominations. Future Standard Qty/Contract Price Quotation Tick Size Value of 1 Tick GBP/US$ GBP 62,500 US$ Per 1 GBP $0.0001$6.25 EURO/US $ Euro 125,000 US$ Per 1 Euro $0.0001$12.50 YEN/US$ Yen 12.50 Million US$ Per 1 Yen $0.000001$12.50 Euro/GBP Euro 100,000 GBP Per 1 Euro GBP 0.0001 GBP 10