Nutourne Co is a company based in the USA, supplying medical equipment to the USA and Europe.
It is 30 November 20X8. Nutourne Co’s treasury department is currently dealing with a sale to a Swiss customer of CHF12·3 million which has just been agreed, where the customer will pay for the equipment on 31 May 20X9. The treasury department intends to hedge the foreign exchange risk on this transaction using traded futures or options as far as possible. Any amount not hedged by a futures or option contract will be hedged on the forward market.
Exchange rates (quoted as US$/CHF 1)
Spot 1·0292–1·0309
Three months forward 1·0327–1·0347
Six months forward 1·0358–1·0380
Currency futures (contract size CHF125,000, futures price quoted as US$ per CHF1)
Futures price
December 1·0318
March 1·0345
June 1·0369
Currency options (contract size CHF125,000, exercise price quotation US$ per CHF1, premium: US cents per CHF1)
Calls Puts
Exercise price December March June December March June
1·0375 0·47 0·50 0·53 0·74 0·79 0·86
Futures and options contracts mature at the month end.
Non-executive director’s comments
A new non-executive director has recently been briefed about the work of the treasury department and has a number of questions about hedging activities. He wants to understand the significance of basis risk in relation to futures. He also wants to know the significant features of over-the-counter forward contracts and options, and why Nutourne Co prefers to use exchange-traded derivatives for hedging.
The non-executive director has also heard about the mark-to-market process and wants to understand the terminology involved, and how the process works, using the transaction with the Swiss customer as an example. The treasury department has supplied relevant information to answer his query. The contract specification for the CHF futures contract states that an initial margin of US$1,450 per contract will be required and a maintenance margin of US$1,360 per contract will also be required. The tick size on the contract is US$0·0001 and the tick value is US$12·50. You can assume that on the first day when Nutourne Co holds the futures contracts, the loss per contract is US$0·0011.
Required:
Evaluate which of the exchange-traded derivatives would give Nutourne Co the higher receipt, considering scenarios when the options are and are not exercised.
Nutourne Co will have a Swiss Franc receipt in six months’ time and needs to hedge against the dollar strengthening.
Futures
Sell Swiss futures and use June futures contracts.
No. of contracts = CHF12,300,000/125,000 = 98·4, say 98, hedging CHF12,250,000
Remainder to be hedged on the forward market is CHF12,300,000 – CHF12,250,000 = CHF 50,000
Receipt = CHF50,000 x 1·0358= $51,790
Calculation of futures price
Assume that basis reduces to zero at contract maturity in a linear fashion.
Estimate from March and June futures contract rates.
Predicted futures rate at the end of May = 1·0345 + ([1·0369 – 1·0345] x 2/3) = 1·0361
Expected receipt = CHF12,250,000 x 1·0361 = $12,692,225
Outcome
Or
Calculation of futures price
Alternatively, use spot rate = 1·0292
Predicted futures rate at the end of May = 1·0292 + (6/7 x (1·0369 – 1·0292)) = 1·0358 (when the June futures contract is closed out in May).
Expected receipt = CHF12,250,000 x 1·0358 = $12,688,550
Outcome
Options contract
Nutourne Co would purchase CHF June put options.
Number of contracts 98, as before.
Amount not hedged, hedged by forward contract CHF translated as $51,790 as before.
Assuming the options are exercised:
Discuss the benefits and drawbacks for Nutourne Co in using forward contracts compared with using over-the-counter currency options, and explain why Nutourne Co may prefer to use exchange-traded derivatives rather than over-the-counter derivatives to hedge foreign currency risk.
Benefits of a forward contract
A forward contract would not involve payment of a large premium upfront to the counterparty.
A forward contract is a simple arrangement to understand, whereas the basis of calculation of the premium for an over-the-counter (OTC) option may be unclear.
A forward contract gives a certain receipt for the purposes of budgeting.
Drawbacks of a forward contract
A forward contract has to be fulfilled, even if the transaction which led to the forward contract being purchased is cancelled. Exchange rate movements may mean that the contract has to be fulfilled at an unfavourable rate. An OTC option can be allowed to lapse if it is not needed.
A forward contract does not allow the holder to take advantage of favourable exchange rate movements. An OTC option need not be exercised if the exchange rate moves in the holder’s favour.
A forward contract may only be available for a short time period, depending on what currencies are involved. An OTC option may be purchased for a longer time period, over a year.
The rate offered on a forward contract will be determined by a prediction based on expected interest rates. The rate offered on an OTC option may be more flexible. This may suit a holder who is prepared to tolerate the risk of some loss in order to have the opportunity to take advantage of favourable exchange rate movements, but who wishes to use the option to set a limit to possible losses.
Reasons why exchange-traded derivatives are used
One of the main reasons why the treasury function uses exchange-traded derivatives is that the contracts can be bought and sold as required. Also, because the markets are regulated by an exchange, counterparty risk (the risk of the other party to the transaction defaulting) should be minimised.
Explain to the non-executive director how the mark-to-market process would work for the CHF futures, including the significance of the data supplied by the treasury department. Illustrate your explanation with calculations showing what would happen on the first day, using the data supplied by the treasury department.
The mark-to-market process begins with Nutourne Co having to deposit an amount (the initial margin) in a margin account with the futures exchange when it takes out the futures. The margin account will remain open as long as the futures are open. The profit or loss on the futures is calculated daily and the margin account is adjusted for the profit or loss.
The maintenance margin is the minimum balance which has to be maintained on the margin account.
If the losses on the futures are so large that the balance on the margin account is less than the maintenance margin, then the futures exchange will make a demand (a margin call) for an extra payment (the variation margin) to increase the balance on the account back to the maintenance margin.
In the example, initial margin = $1,450 x 98 = $142,100
Maintenance margin = $1,360 x 98 = $133,280
Loss in ticks = 0·0011/0·0001= 11
Total loss = 11 ticks x $12·50 x 98 = $13,475
Balance on margin account = $142,100 – $13,475 = $128,625
This is less than the maintenance margin, so Nutourne Co would have to deposit an extra ($133,280 – $128,625) = $4,655 (the variation margin) to bring the balance on the margin account up to the maintenance margin.
Alternative solution
In some exchanges, a variation margin may be required to increase the balance on the account back to its initial margin level. Therefore, in this case, the variation margin amount would be $13,475 (i.e. $142,100 – $128,625).