ESTIMATION OF THE £/ EXCHANGE RATE IN 6 MONTHS TIME
...forward price tend to be the same price. Because of this definition we could give a first approach to the future spot price by using the forward price. DATE FORWARD PRICE 27/12/02 0.63384888 27/01/03 0.63435113 25/02/03 0.63477423 25/03/03 0.63534882 25/04/03 0.63592987 27/05/03 0.63655048 26/08/03 0.63839146 25/11/03 0.64032337 By May 2003 the spot price should tend to around 0.6365, close to the forward price. HOW THE EXPORTER MIGHT PROTECT THE MAJOR CONTRACT FROM FOREIGN EXCHANGE RISK In the case of a UK exporter with a contract payable in the risk the exporter is facing is the pound becoming stronger against the what would imply that the exporter is going to receive less money at payment time than the profit he would have obtained if the payment had happened the first day. The exporter is facing a possible appreciation of the Pound against the Euro. As this exporter is going to receive an amount of Euro in 6 months time, it is interested in a higher value of the Euro so he can get bigger profit by May when the exporter exchange the Euro contract into Pounds. In 6 months time the £/ exchange rate could vary considerably so it is interesting for the exporter to avoid great losses because of the exchange risk. There are different ways in which an exporter can act in a situation like this, but basically we divide them into two: Do nothing and play risky to see what exchange rate will be trading by the maturity of the contract. Try to hedge our contract with the different tools we can find in the market (forward contracts, currency futures, currency options and money market hedge ) 1. DO NOTHING As your estimation looks favourable to the UK exporter he could think of just waiting until payment time. But us we know exchange rates are nor 100% predictable and everything would happen in this six months (Many indirect factors could lead the exchange rate to move in the opposite direction that we predicted), and this would implies great losses in a big contract. If by May 2003 the £/ exchange rate has risen up the exporter will get an extraordinary profit, but if the £/ go down it will get less amount of money than he had in mind at the establishment of the contract. Nov 02 Spot rate 0.6335 £/ Contract 1.000.000 Potential profit at Nov 02 633.500 May 03 Spot rate Unknown Contract 1.000.000 Two possible scenarios: 1. Spot price May 03 over 0.6335 £/ Extraordinary profit (0.6335 May03 Spot rate)*Contract size 2. Spot price May 03 under 0.6335 £/4 Extraordinary loss (May03 Spot rate 0.6335)*Contract size In our opinion this is not a good alternative as there is a long time the payment and is not reasonable to rely on the market. 2. FORWARD CONTRACTS A forward contract that specifies an interest rate to be paid on an obligation beginning on some future date. Any gain or loss on the contract is treated as a similar gain or loss on a future or options contract would be. A Forward Rate Agreement (FRA) is a forward contract where the parties agree that a certain interest rate will apply to a certain notional loan or deposit during a specified future period of time. A FRA is similar to a FX forward contract where the exchange rate for a future date is set in advance. FRAs are usually used to protect the borrower against rising interest rates. The purpose of a FRA is to guarantee the future interest rate, and there is no direct link between the FRA and the underlying loan. Borrowers use FRAs to gain interest rate certainty on a portfolio of loans, while investors use them to protect asset portfolios from decreasing interest rates. With a forward contract an UK exporter can established the exchange rate in six months time, but this I not a right but an obligation. By the time the contract expires the exporter will have to accept that exchange rate whether the market price is higher or lower. DATE FORWARD PRICE 27/12/02 0.63384888 27/01/03 0.63435113 25/02/03 0.63477423 25/03/03 0.63534882 25/04/03 0.63592987 27/05/03 0.63655048 26/08/03 0.63839146 25/11/03 0.64032337 *Bloomberg 11/20/02 In a contract of 1.000.000 using the forward market to hedge the exporter would get The obligation to exchange in may Euro at a price of 0.63655048, what makes a total value of 636.550 £ 3. FUTURES A standardised, transferable, exchanged-traded contract that requires delivery of a commodity, bond, currency, or stock index, at a specified price, on a specified future date. Also called futures contract. -Futures option An option on a future contract. -Futures commission merchant An individual or organisation accepting orders to buy or sell futures or futures options. -Futures price The prices at which the two participants in a futures contract agree to transact at on the settlement date. In this case the way the exporter has to act is the same way than in forwards. He will try to protect against a strengthening of the £ against what would imply to get a fewer payment in six months time. £/ FUTURE LAST CHANGE DEC 02 0.63710 +.00195 MAR 03 0.63875 +.00205 JUN 03 0.64060 +.00210 SEP 03 0.64200 +.00210 DEC 03 0.64630 +.00215 *Bloomberg 11/20/02 There is no £/ future contract in may so we use a weighted average to obtain it. May 2003: (1/6 * 0.6371) + (1/2 * 0.63875) + (2/6 * 0.64060) = 0.6391 In a contract of 1.000.000 the exporter would get 639.100 £ in May using currency futures hedge. In comparison with forward hedge, futures are cheaper. Apart from the price another advantage of using futures is that futures market is officially regulated, so there is no risk about the payment as all the companies have to make a deposit in order to be solvent. MAY 2003 RESULTS (HYPOTHESIS) POSSIBLE PRICES MAY03 PROFIT/LOSS £/ FUTURE 0.63 + 0.091 0.6391 0.633 +0.061 0.6391 0.635 +0.041 0.6391 0.639 +0.01 0.6391 0.64 -0.09 0.6391 0.642 -0.051 0.6391 0.645 -0.054 0.6391 4. OPTION The right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a given stock, commodity, currency, index, or debt, at a specified price (the strike price) during a specified period of time. For stock options, the amount is usually 100 shares. Also called option contract. -Call An option contract that gives the holder the right to buy a certain quantity (usually 100 shares) of an underlying security from the writer of the option, at a specified price (the strike price) up to a specified date (the expiration date). Also called call option. -Put An option contract that gives the holder the right to sell a certain quantity of an underlying security to the writer of the option, at a specified price (strike price) up to a specified date (expiration date) As it does not exist market for the options at this moment we have considered fictitious data approximated to the reality. Although its not real it will give us the idea about how this contracts work. As we think that euro is going to appreciate, the strategies that we must take are purchase of call and/or sale of put, or combinations of both. We have chosen bull-spread like complex strategy. SELL PUT: When you sell a put option, you give to the buyer the right to sell at the strike price. If you sell put, you expect the currency to rise up. Selling a put you can get limited gains but unlimited losses. The maximum profit will be the premium of the put. BUY CALL: If you buy call, you get the right to buy the currency at the strike price, by paying the premium. This premium will be your maximum lose in case the currency rise down. However, you can get unlimited gains with this option. BULL-SPREAD WITH CALL: This strategy consists on buying a call at certain strike price and sell another call but with higher strike price. With this combined strategy you get limited gains, what is worse than buy one call, but you can limit the losses. The maximum lose and gain will be the difference between premiums. BULL-SPREAD WITH PUT: Its the same as the previous one. It consists on buying put and selling put. The strike of the put bought has to be lower than the strike of the sold put. The maximum gain and lose will be the difference between premiums again. There are many others complex strategies: Bear spread: it is just the opposite to bull spread. Butterfly spread: four trades at one expiration date and three different strike prices; for call options, one option each at the high and low strike price are bought, and two options at the middle strike price are sold; for put options, the trades are reversed. Condor: An options strategy similar to a butterfly spread. The only difference is that the two middle options have different strike prices within the range established by the other...