Question

A U.S. firm is receiving 185m JPY in 3 months’ time. JPY Futures are available on the Chicago Mercantile Exchange (CME) with a contract size of 12,500,000 JPY and currently trade at 0.009502 JPY/USD. The contract maintenance margin is 3600 USD with an initial margin of 110% of the maintenance margin.

a) Describe the firm’s FX spot market currency exposure (long/short, size of exposure) before hedging.

b) Describe how this firm would hedge its position using futures contracts.

c) How many contract positions on the CME should be taken if the goal is to minimize the firm’s exposure to risk?

d) What will be the initial futures cash flow required (amount and currency)?

e) Assuming that the exposure and contract maturity dates are the same, what is the expected total (Physical + Hedge) net USD cashflow? (You may ignore the time value of money and you may assume that the Unbiased Expectations Hypothesis holds)

Answer 1

Answer to a).

Describe the firm’s FX spot market currency exposure (long/short, size of exposure) before hedging ?

Since It is a U.S firm and about to receive 185 million JPY in 3 Month's Time , Therefore the U.S Firm is exposed to foreign Currency risk that is JPY Because in 3 months time the JPY may depreciate .

So, If we do not opt for Hedging , Firm's Spot Market Currency Exposure is :

JPY contract size = 12,500,000 JPY

Spot Rate , 1 JPY = 0.009502 USD

So, The Exposure at Spot Rate = 185 million JPY * 0.009502

The Exposure at Spot Rate = 1,850,00,000 * 0.009502

The Exposure at Spot Rate = 17,57,870 USD

So, 1850,00,000 JPY is exposed to 17,57,870 USD, if taken at Spot Rate .

Contract Size of JPY = 12,500,000 JPY

So, If one opts for Hedging JPY ,

No. Of contracts of JPY to be entered = 1850,00,000 / 125,00,000

No. Of contracts of JPY to be entered = 14.8

So, Either 14 or 15 contracts size would be entered to cover/ hedge the amount of 185 million JPY.

Answer to b).

Describe how this firm would hedge its position using futures contracts?

As Calculated in Answer a), No. of Contracts to be entered to hedge 185 miilion to be received in 3 month's period is 14 or 15 contracts .(since it cannot be 14.8 Contracts ).

So, If the Firm is Expecting that The JPY against USD is going to appreciate in 3 month's time , It will Go LONG on JPY Future Contract .

If the Firm is Expecting that The JPY against USD is going to depreciate in 3 month's time , It will Take SHORT Position in JPY Future Contract .

Initial Margin = 3600 USD * 110%

= 7560 USD

So, Firm has to deposit 7560 USD as Intial Market in order to Hedge JPY of 185 millions on Foreign Exchange market and have to maintan the Margin upto 3600 USD during The contarct period that is at any point the Intial Margin deposited should not fall below 3600 USD.

Answer to c).

How many contract positions on the CME should be taken if the goal is to minimize the firm’s exposure to risk?

Firm is receiving 185m JPY in 3 months’ time

JPY Futures are available on the Chicago Mercantile Exchange (CME) with a contract size of 12,500,000 JPY

= 185,000,000 (total ) / 12,500,000 (Per contract Size)

= 14.8 contracts

So, Either 14 or 15 contracts positions could be entered into by the Firm in order to minimize the firm’s exposure to risk.

At 14 Contract Positions , Risk of 175 million JPY  (14 * 125,00,000 ) will only be hedged that is it will be partially hedged.

Even at 15 Contracts Positions , Risk of 187.5 million will be hedged which is more than 185 million JPY so, it will also be partially hedged.

Answer to d).

What will be the initial futures cash flow required (amount and currency)?

Intial Future Cash Flow will be Intial Margin to be paid ,

Initial Margin = 3600 USD * 110%

= 7560 USD

So, 7560 USD will Initially be paid to Exvhamge or Broker in order to Hedge the Foreign Currency Fluctuation risk of 185 Miilion JPY.