In October, a U.S. Company is expecting to receive funds in Euros in December from its European customers of 1,250,000 Euros, and wants to hedge against a fall in the value of the Euro relative to the U.S. dollar in December. At this time the spot exchange rate Euro is worth $1.114 USD. The CME Group currency future settle rate for a December Euro FX futures contacts is 1 Euro = $1.1231 USD, with each futures contract for 125,000 Euros per contract.
a. What position and how many contracts should the financial manager take to hedge against a rise in the Euro? Explain why. (Hint: # contracts = Amount of Euros Hedging / 125,000 Euros per contract; always take a position that will give you a futures gain to offset your spot loss in the event of what you want to hedge.)
b. Suppose later in December the spot rate for the Euro falls to $1.003 USD and the futures settle rate has falls to $ 1.011 USD. Calculate the spot opportunity loss or gain for the company and the futures gain or loss. What is the net hedging result?
c. What are the advantages and disadvantages of hedging with FX options on futures contracts instead?

Question

Quizplus · Accepted Answer

The Answer is A. Take a short position, so you'll make a futures gain if the value of the Euro falls to offset a Spot Loss if the Euro falls.
Number of Contracts___10 contracts___________
# Contracts = 1,250,000 Euros / 125,000 = 10 contracts
B. Spot Gain or Loss _($138,750)_
Futures Gain or Loss __$140,125_______
Net Hedging Result __$1,375___ (Futures Gain or Loss - Spot Gain or Loss)
Calculations:
Spot Loss = 1,250,000 Euros [$1.114 - $1.003] = Loss of $138,750
Futures Gain = 125,000 x 10 [$1.1231 - 1.011] = $140,125
C. Options if the FX rate goes the opposite way expected, you don't have to take the futures loss against the spot gain. Disadvantage: high premium cost at times.