Question

Suppose that a real estate business headquartered in the US plans to invest in a property in Italy. The property will cost 3,000,000 euros, payable on December 1st. The currency exchange rate on October 1st is currently 0.9 dollars per euro. The real estate business is concerned that the euro may appreciate in the near future, thus making the Italian property more expensive in dollar terms. A euro currency futures contract is for 125,000 euros. A December 15th euro currency futures contract is priced at 118,750 dollars. What is the hedge ratio? Should the business buy or sell euro currency futures contracts?

Answer 1

hedge ratio = value of hedge position / value of total exposure

where value of hedge position means amount invested in hedged position that is future contract worth 125000 euro

where value of total exposure means amount invested on underlying asset that is property in italy worth 3000000 euro

=125000/3000000

=0.0416

the company will sell the euro currency futures because the value of euro has been appreciated by december 15 from .90 to .95 so its better for the company to sell than buy.

the exchange rate of euro was .90 in october which means 125000*.90=112500

now the amount is 118750(125000*.95)