Hedging Tools

Review and Practice Problems with Answers (Teaching Guide)

1. Forward Contract

Textbook Definition: Contracts committing the issuer to sell a financial instrument at a

given [interest] rate as of a specific date.
Translation: You agree to either buy or sell an amount of currency (or whatever else it
is) in the future at a price decided upon today. This "price" could be anything...an
exchange rate, an interest rate, etc...

Other Notable Vocabulary:

Long Position: looking to buy
Short Position: looking to sell

Example
The Cat Empire, Australia's hottest new band, is on its first world tour. They are playing
in Mongolia for 100,000 Tugriks (MNT), in Kazakhstan for 100,000 Tenges (KZT), in
Botswana for 100,000 Pulas (BWP), and in Suriname for 100,000 SRD over the next
three months. The band wants to get the most out of its earnings and is planning to use
forward contracts to do so.

3-month Forward 3-month Forward

Current Spot Rate
Contract Rate Forecasted Rate
1 AUD = 1050 MNT 1 AUD = 1000 MNT 1 AUD = 1100 MNT
1 AUD = 110 KZT 1 AUD = 105 KZT 1 AUD = 100 KZT
1 AUD = 5 BWP 1 AUD = 5 BWP 1 AUD = 5 BWP
1 AUD = 2 SRD 1 AUD = 4 SRD 1 AUD = 6 SRD

1) What forward contracts should Cat Empire use to get the most out of the above
posted exchange rates?

Answer: Anytime the 3-month contract rate yields more AUD than the 3-month
forecasted rates, get a forward contract. In this case, Cat Empire will want to be in the
short position for Forward Contracts for the MNT and the SRD. To be safe, the Cat
Empire may also want to use a Forward Contract for the BWP as well.

2) How many AUD will the Cat Empire have at the end of their three-month tour?

Answer: 46,100 AUD (assuming the Forward contracts were used as stated in question 1)

(100,000 MNT x 1 AUD/1000 MNT) + (100,000 KZT x 1AUD/100 KZT) + (100,000

BWP x 1 AUD/5 BWP) + (100,000S RD x 1 AUD/4 SRD) =
= 100 AUD + 1000 AUD + 20,000 AUD + 25,000 AUD = 46,100 AUD

1
2. Foreign Currency Futures

Textbook Definition: An agreement to deliver to another a given amount of a

standardized commodity or financial instrument at a designated future date.
Translation: This is the same thing as a forward contract, but a futures contract can only
be in a set increment (kind of like a bank note), such as $100,000 (which is the most
common denomination). So you can buy, say, 5 futures contracts worth $500,000.

Other Notable Vocabulary:

• Futures Price: the price (exchange rate) that you'll get
• Round Turn Cost: the administrative cost on each futures contract
• Marked to Market: market price to current market value instead of book value

Example
Henry Avery, a pirate that has spent his life pillaging and plundering the western
hemisphere, wants to retire and buy a condominium in Bangalore in I year. The
anticipated price on the condominium is expected to be INR 3 million. The 1 year future
price is IUSD = INR 40. The cost of a round turn per contract is USD 75. Each Indian
Rupee future contract represents INR 500,000.

1) How many USD will Henry need if he were to secure this position?

Answer: $75,450

Step One. How much is condo worth in USD?

INR 3,000,000 / 40 (spot) = $75,000

Step Two. How much do round cost?

INR 3,000,000/500,000 = 6 x $75 = $450

Step Three. What is the total price in USD?

$75,000 + $450 = $75,450.

2) If the 1 year spot rate ends up to be 1 USD = INR 30, how many USD will Henry
gain/loose?

Answer: -$24.550 loss (if he didn’t hedge)

Step One. How much is condo worth in USD in the future?

INR 3,000,000/3 0 (spot) = $100,000.

Step Two. How much do round turns cost?

$ 0 (It's not applicable here).

Step Three. What is the total loss?

$75,450 - $100,000 = -$24,550 loss

2
 3. Foreign Currency Options

Textbook Definition: The right, but not the obligation to buy or sell an underlying
security.
Translation: You pay money to be guaranteed the right to buy something at a certain
price in the future. You don't have to buy it, but you could if you wanted to.

Other Notable Vocabulary:

• Exercise price: price at which you can buy the underlying security
• Call Option: Right to buy a financial instrument at t a specific price. (Call me the
money!)
• Put Option: Right to sell a financial instrument at a specific price. (Put the
money away!)
• American Option: May exercise at anytime (but you usually don't).
• European Option: Exercise only at a specific date
• Long position: You have the currency you need to do something with. You got
money.
• Short position: You don't have the currency you need to do something with. You
don’t got money.
• Writer: Must stand behind obligation bound if buyer demands.

Examples
90-DAY
CALL PUT
SPOT RATE FORWARD STRIKE PRICE
PREMIUM PREMIUM
RATE

1 DZD = 0.05 AED 1 DZD = 0.10 AED 1 DZD = 0.075 AED 0.05 AED/DZD 0.025 AED/DZD

Omar has decided to take a three-month contract in Algeria that will render 500,000
Algerian dinars (DZD) for services rendered. Omar resides in the United Arab Emirates
and will need to convert his earnings into dirhams (AED), so his friend Jay recommends
he look into options.

1) Which is better for Omar - buying a call or writing a call?

Answer: It depends, but for the sake of argument we'll say “Buying a call".

Since Omar needs AED, he needs the option to buy AED at the set price in the future,
which he gets from buying a call option. However, if he wrote a call option, he would be
giving someone else the option the purchase DZD at some point in the future – there’s no
guarantee that Omar will get his needed DZD.

3
2) Which is better for Omar - buying a put or writing a put?

Answer: It depends, but for the sake of argument we'll say “Buying a put".

Since Omar needs AED, he needs the option to sell DZD at a set price in the future,
which he gets from buying a put option. However, if he wrote a put option, he would be
giving someone else the option to sell their AED at some point in the future – there’s no
guarantee that Omar will get his needed DZD.

3) Of the four options - buying a call, writing a call, buying a put, and writing a put -
which is the best bet for Omar?

Answer: Write a Call

Step One: Calculate Buying a Call.

Exchange: 500,000 DZD x 0.075 AED/1 DZD = 37,500 AED

Less Premium: 500,000 DZD x 0.05 AED/1 DZD = 25,000 AED
Remainder: 12,500 AED

Step Two: Calculate Writing a Call (losses are unlimited).

Exchange: 500,000 DZD x 0.075 AED/1 DZD = 37,500 AED

Gain of Premium: 500,000 DZD x 0.05 AED/1 DZD = 25,000 AED
Total: 37,500 AED + 25,000 AED = 62,500 AED

Step Three: Calculate Buying a Put.

Exchange: 500,000 DZD x 0.075 AED/1 DZD = 37,500 AED

Less Premium: 500,000 DZD x 0.025 AED/1 DZD = 12,500 AED
Remainder: 37,500 AED – 12,500 AED = 25,000 AED

Step Four: Calculate Writing a Put (losses are limited).

Exchange: 500,000 DZD x 0.075 AED/1 DZD = 37,500 AED

Gain of Premium: 500,000 DZD x 0.025 AED/1 DZD = 12,500 AED
Total: 37,500 AED + 12,500 AED = 50,000 AED

4
4. Tunnel Forwards

Textbook Definition: Guess what... it's not in the textbook.

Translation: This is essentially a forward contract, but instead of negotiating a set
exchange rate, you negotiate a range of where your exchange rate could fall.

Other Notable Vocabulary:

• Zero cost range forward: where there is no premium paid.
• Strike price on a put set: exchange rate when you are selling currency.
• Strike price on a call set: exchange rate when you are buying currency.

Example
Charlie's rich, world-traveling uncle died and willed Charlie 10 million South African
Rand. Charlie will receive his inheritance in 120 days, after all the paperwork and
necessary documents are completed. Charlie wants to profit from a predicted devaluation
of the USD, but wants to limit his losses in case the dollar rebounds. The current strike
prices on a zero cost range forward is a strike on the Rand put set at USD 0.15 and the
strike on the Rand call set at USD 0.2. What is the maximum and minimum that Charlie
could receive?

Answer: minimum: $1,500,000 m; maximum: $2,000,000 m

Step One: Calculate minimum: ZAR 10,000,000 x 0.15= $1,500,000

Step Two: Calculate maximum: ZAR 10,000,000 x 0.2 = $2,000,000

5
5. Foreign Currency Loan

Textbook Definition: Foreign Currency Loans are not discussed in the textbook. (Aren't
you glad you came to the TA session?)
Translation: You take out a loan in a foreign currency and convert it to your currency
today. You have to pay the loan back with interest in the future.

Other Notable Vocabulary:

• Prime Rate: Same idea as LIBOR - the best possible interest rate available.
• Spread or Premium: Depending on your credit rating, what interest rate you pay
along with (in addition to) the prime rate.
• Arrangement Fee: Essentially the fee that the bank charges you for their
administration costs.

Example
Kumar Sangakkaraa, cricket player from Sri Lanka, has been offered a new job during
the off-season as a little-league cricket coach in India. The job lasts for three months, but
he won't get paid his 500,000 INR until the end of his contract. To pay for his living
expenses during those three months, Kumar is considering taking out a foreign currency
loan. The loan could be made at 3% above the present Indian prime rate of 8% plus an
arrangement fee of 0.2%. The Sri Lankan prime rate is currently 10%, and Kumar will
not pay a spread above that or an arrangement fee because he is a super star in Sri Lanka.
If the spot rate is currently 1 Sri Lankan Rupee (SLR) = 0.35 Indian Rupees (INR) and
the 3-month forward rate is 1 Sri Lankan Rupee = 0.30 Indian Rupees, should Kumar
take the foreign currency loan?

Answer: No! Kumar's best choice would be to convert enough SLR to bring 500,000
INR with him to India - when he gets paid in 3 months, his contract will be worth more
than he paid for the 500,000 INR, thanks to depreciation of the INR against the SLR. His
second best choice would be to take out a loan in Sri Lanka for enough SLR to bring
500,000 INR and then pay back the interest when he returns to Sri Lanka - again,
depreciation of the INR against the SLR makes the 500,000 INR contract worth a lot
more in three months. It would be better not to pay a loan back in INR.

Step One. How much is the 500,000 INR worth to Kumar today?
500,000 x 1/0.35 = 1,428,571 SLR

Step Two. How much will the 500,000 INR be worth in 3 months?
500,000 * 1/0.30 = 1,666,666 SLR

Step Three. What are the costs associated with the foreign currency loan?

• Total Interest Paid: 500,000 x (0.08 + 0.03) = 55,000 INR

• Total Arrangement Fee: 500,000 x 0.002 = 1,000 INR
• Amount that Kumar would receive today: 500,000- (55,000+ 1,000) = 444,000
INR

6
 • What is this worth in SLR: 444,000 x 1/0.35 = 1,268,571 SLR

Step Four. Explore other options…local currency loan!?!

Total Paid in 3 Months: 1,428,517 x 1. 1 = 1,571,428 SLR,
where 1.1 was derived from (1 + (0.1/4)) – annual rate is adjusted to 3 months.

Calculate the opportunity cost (interest rates are adjusted for the 3 months).

Step One. Calculate what Kumar will receive after paying the 11% interest.
500,000 / (1+(0.11/4)) = 486,618

Step Two. Calculate the arrangement fee.

500,000 x 0.002 = 1,000

Step Three. Calculate the amount received today using the loan.
486,618 – 1,000 = 485,618

Step Four. Convert into SLR.

485,618 / 0.35 = 1,387,480

Step Five. Calculate the opportunity cost.

1,387,480 x (1 + (0.1/4)) = 1,422,167

7
6. Pre-sale of a Foreign Contract

Textbook Definition: Again, this isn't in the textbook. It's nice to know this is an option
though.
Translation: You're expecting to collect on a contract in the future. Instead of waiting
for your money, you sell your contract to a third party and get your money today.

Example
Miss Universe Riyo Mori has been offered a 6-month contract worth 5 million USD to
star on an American cable television show. Riyo doesn't want to wait for 6 months to
collect on her contract as the Yen is depreciating against the USD. The spot rate is 1 YEN
= 5 USD, the 6-month forward rate is 1 YEN = 10 USD, and LIBOR is currently 4%.
Riyo could pre-sell her contract for an interest rate of 1.5%+ LIBOR and a flat up-front
fee of 1%. Should she take the deal?

Answer: Yes!!! She would receive a lot more yen now than she would six months from
now.

Step One: How much is the contract worth today?

5,000,000 x 1/5 = 1,000,000 YEN

Step Two: How much is the contract worth in 6 months?

5,000,000 x 1/10 = 500,000 YEN

Step Three: What are the costs associated with the pre-sale of her contract?

• Interest Paid: 5,000,000 x (0.04 + 0.015) = 275,000 USD

• Flat up-front Fee: 5,000,000 x 0.01 = 50,000 USD
• Amount received today: 5,000,000 - (275,000 - 50,000) = 4,775,000 USD
• Converted today: 4,775,000 x 1/5 = 955,000 YEN

Calculate opportunity costs (interest rates are adjusted for the 6 months).

Step One. Calculate what Riyo will receive after paying the 5.5% interest.
5,000,000 / (1 + (0.055/2)) = 4,866,180

Step Two. Calculate the arrangement fee.

5,000,000 x 0.01 = 50,000

Step Three. Calculate the amount received today through the pre-sale.
4,816,180 / 5 = 963,236

Step Four. Calculate the opportunity cost.

963,236 x (1 + (Rus/2)) = …..