Hedging with Derivatives and Money Market Hedge

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Hedging with Derivatives and Money Market Hedge.

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Hedging with Derivatives and Money Market Hedge

Now that we’re familiar with options, let’s look at using forward rates, futures rates and call and put options to hedge a long (Account Receivable or Note Receivable) or short (Account Payable or Note Payable) position in a currency. First, let’s assume that we sold merchandise to a British firm for 1 million pounds payable in 6 months.

Hedging with a Forward Contract with a Bank

One alternative is to go to our bank who, deals in foreign exchange, and simply lock-in the value of the 1 million pounds sterling that we will receive in six months with a forward contract with the bank. Assume that the forward rate that the bank offers to us is USD 1.5179 per pound. Then, we are guaranteed that the amount we will receive will be the following:

Hedging with a Forward Contract with a Bank

Value of 1 million pound receivable

= 1,000,000 pounds * USD 1.5179 per

pound

= USD 1,517,900

What should be apparent, however, is that whether the pound appreciates or depreciates, we’ve locked-in the amount that we will receive: USD 1,517,900

Hedging with a Futures Contract

An alternative to contracting privately with a bank is to contract for 1,000,000 pounds with futures contracts. Assuming that the futures rate of exchange is USD 1.5204 per pound, but will include transactions costs (commissions) of 0.2%, we will net the following amount when we receive the one million pounds in six months:

Hedging with a Futures Contract

= 1,000,000 pounds * USD 1.5204 per

pound

= USD 1,520,400 pounds

- USD 3,041 pounds

(\$1,520,400*.002)

= USD 1,517,359

Hedging with a Futures Contract

Given the difference between the bank’s forward contract and the futures contract, it would be slightly more advantageous to use the forward contract (USD 1,517,900 – USD 1,517,359 = USD 541). The market effect is that there will be a slight increase in supply of pounds in the forward market (driving the rate down, with less demand in the futures market (driving the rate up). They should be the same.

Money Market Hedge

Another alternative is to utilize the money markets to hedge the 1 million pound receivable. This relies upon borrowing and investing funds via the money markets and using the spot rate to lock-in the amount we will receive from the receivable.

Money Market Hedge

Assume the following:

We can invest in British t-bills at a rate of 8% and we can borrow in Britain at a rate of 11%.

Also, assume that we can invest in US t-bills at a rate of 5% or borrow in the US at an 8% rate of interest.

Money Market Hedge

Now, think about what we are trying to do. We will receive one million pounds in six months, so we want to move the pounds to the United States. The following slide shows how we can accomplish this through the money markets:

Money Market Hedge

Since we are going to receive one million pounds in six months, we want to move the funds using the money markets as the following arrows indicate:

Money Market Hedge

As the arrows indicate, we want to borrow against the 1 million pounds in Britain, convert to US dollars at the spot rate of exchange, and invest in U.S. t-bills. The reason we want to invest in t-bills is so we can compare the amount of dollars we will receive today by borrowing against the receivable with the amount of dollars we will receive in six months using a forward contract or a futures contract.

Money Market Hedge

Borrowing against the 1 million pound receivable:

= 1,000,000 pounds/(1+.055)

= 947,867 pounds

Converting to US dollars at the spot exchange rate of USD 1.5385 per pound:

= 947,867 pounds * USE 1.5385 / pound

= USD 1,458,294

Money Market Hedge

Investing the dollars at 5% in US t-bills for six months

= USD 1,458,294 * 1.025

= USD 1,494,751

As is obvious, in this case the forward or futures contract approaches will yield more funds for the receivable than using a money market hedge. This is due to the fact that our borrowing rate in Britain is higher than British t-bill rates (a transactions cost).

Using a Put Hedge

One way of perfectly hedging our long position in pounds by using options is to sell a call option on the pounds and buy a put option. By selling a call, we’ve locked-in what we will receive (the buyer will force us to sell at the strike price) if the pound goes up in value. By buying a put option, we’ve locked-in what we will receive if the pound depreciates (we can force the seller of the option to buy pounds from us at the strike price).

Using a Put Hedge

Assume that we can buy a put option with a strike price of USD 1.53 per pound by paying USD 0.015 per pound (one and one-half cents per pound is the cost of the put option). Also, assume that at maturity in six months that the exchange rate is USD 1.5243 per pound. Since the market rate of exchange is less than the strike price, we will want to exercise our put option and sell at the strike price of USD 1.53 per pound.

Using a Put Hedge

= 1,000,000 pounds * USD 1.53 / pound

= USD 1,530,000

Subtracting the cost of the put option of USD 15,000 (1,000,000 pounds * USD 0.015 per pound = USD 15,000), we will net USD 1,515,000.

Using a Put Hedge

= USD 1,530,000

- USD 15,000

= USD 1,515,000

Why might we be willing to buy a put option that only nets us USD 1,515,000 when a forward hedge or a futures hedge will net us between USD 1,517,359 and USD 1,517,900? Because with the put option, we still have the potential for realizing the upside potential of an appreciation of the pound.