You have decided to use December futures to hedge the risk of a sale of British
ID: 2730418 • Letter: Y
Question
You have decided to use December futures to hedge the risk of a sale of British Pound (BP). The sale will be for 250,000 BP and will take place on November 1. The current spot price for BP $1.55 per BP and the current December futures BP price is $1.61 per BP. To hedge your risk, should you take a long position in December futures If the spot rate prevailing on November 1 is $1.49 per BP and the December futures price on November 1 is $1.54 per BP, what is the effective U.S. Dollar revenue to you from selling 250,000 BP? Include any costs or benefits from hedging. If the spot rate prevailing on November 1 is $1.63 per BP and the December futures price on November 1 is $1.71 per BP, what is the effective U.S. Dollar revenue to you from selling 250,000 BP? Include any costs or benefits from hedging. Will you need to undertake a reversing trade? Why or why not?Explanation / Answer
Requirement a:
The original contract entered is sale of British Pound i.e., Short Position.
To hedge the contract, the position to be taken is long position in December Futures.
Requirement b:
Short Position:
Revenue from Short Position = ($1.61 - $1.55) *250000
= $0.06 * 250000
= $15000
Long Position:
Revenue from Long Position = ($1.49 - $1.54) * 250000
= -$0.05 * 250000
= -$12500
Effective US Dollar Revenue
= Revenue from short position + Revenue from long position
= $15000 - $12500
= $2500
Requirement c:
Short Position:
Revenue from Short Position = ($1.61 - $1.55) *250000
= $0.06 * 250000
= $15000
Long Position:
Revenue from Long Position = ($1.63 - $1.71) * 250000
= -$0.08 * 250000
= -$20000
Effective US Dollar Revenue
= Revenue from short position + Revenue from long position
= $15000 - $20000
= -$5000
Requirement d:
In the case of (b), reversing trade can be undertaken as there exists positive revenue.
In the case of (c), it is better not to undertake reversing trade as there exists negative revenue.
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