Futures

1. On October 15, a Japanese firm had imported some equipment worth $10 million from a US company. The
payment for the same was due on December 15. On October 15, the dollar-yen spot exchange rate was
¥115.52/$. A bank in Japan quoted a forward rate for delivery on December 15 as ¥117.22/$. The treasurer
of the Japanese firm is evaluating the alternative of hedging the dollar exposure through December yen
futures traded at IMM.
The December ¥ - futures were quoted at $ 0.008558 on October 15. The contract size of ¥ - futures
contract is ¥12.5 million. On December 15, the spot ¥/$ rate turned out as 116.68 and December futures
price as $ 0.008545.
You are required to
a. Explain how the Japanese firm can hedge the exposure through ¥ - futures contract.
b. Which hedge, forward or futures, has given better result? (show all your computations)
c. Is the hedging through futures a perfect hedge? Explain.

a. The Japanese firm is short on dollar, so it can hedge the exposure by going long on dollar futures. As
dollar futures are not available so it decided to hedge through yen futures which is quoted in terms
of dollar. To hedge the exposure it should sell yen futures, which will give an equivalent
position of going long on dollar futures.
Number of ¥ - futures contract to be sold
$10, 000, 000
= $0.008558 / ¥ × ¥12,500,000 = 93.5 ≅ 94 contracts

b. The firm had sold 94 contracts at $ 0.008558

On December 15, ¥ - futures price is $ 0.008545
Gain on futures contract = $(0.008558 – 0.008545) × 94 × 12,500,000 = $ 15,275
Outflow of dollar to settle the payable = $ 10 million
Net dollar outflow = $10,000,000 – $15,275 = $ 9,984,725
Net outflow in yen at spot market = $ 9,984,725 × ¥ 116.68/$
= ¥ 1165.018 million
If covered through the forward market outflow would be
= $ 10,000,000 × ¥ 117.22/$
= ¥ 1172.20 million
So, futures market cover has given a better result as it entail lower outflow.
c. If the futures hedge would have been perfect then yen outflow would

$ 10, 000, 000

be = = ¥ 1168.50 million
$ 0.008558 / ¥

The futures hedge is not a perfect hedge due to the basis risk. This risk arises due to the difference
between the spot price and futures price. If the contract was settled on the final maturity date of
December futures contract then the hedge would had become perfect as both spot and futures rate
would have been same on that day. Another reason of basis risk is due to the change in futures price
which is not equal to the change in spot price, thus due to the change in basis the hedge became
imperfect.

Financial Engineering Problems Page 1

1. An American investor is holding 25 US T-bonds of remaining maturity 18 years. Underlying interest on the bond
is 5.5% and the bond is currently quoted in the market at 90-12.
The interest rates in the American economy are set to rise in near future, so the investor wants to hedge its holding
of bonds through T-bond futures. The investor has decided to protect his holding for 6-months and identified the
following T-bond futures for hedging:
T-bond futures price 94-24
Underlying coupon rate 6% p.a.
You are required to
a) Advise the investor how to hedge the holding through T-bond futures, and how many futures contract
required for perfect hedge?
b) Calculate the annualized return earned on the holding for the protection period, if T-bond price and futures
price after 6-months closes at
i. 92-26, 97-08
ii. 88-06, 92-22
1. a. As the investor is expecting a rise in interest rate so value of the holding is expected to reduce. To hedge the
falling value of the bonds the investor should sell the T-bond futures, as the rise in interest rate will reduce
the futures price, and hence he can make profit by buying at lower price thus booking gain. This gain will
reduce the loss in holdings value.
To find out the number of futures required for perfect hedge, we have to find out the conversion factor of T-
bonds.
Present value of cash flows from the bond
36

∑ 2.75 100
= i =1 (1.03)i + (1.03)36 = 2.75 x 21.832 + 100x0.345 = 94.538
∴ The conversion factor is = 0.94538

The number of futures contract required for perfect hedge

Face value of T − bonds
= Face value of futures contract x Conversion factor

$ 2,500, 000
x 0.94538 = 23.63 24 contracts
= $100, 000
b. Value of the holding at the time of entering hedge
⎛ 12 ⎞
⎜ 90 32 ⎟
⎜ ⎟
⎜⎜ 100 ⎟⎟
= $ 2,500,000 ⎝ ⎠ = $ 2,259,375
i. After six months,
⎛ 26 ⎞
⎜ 92 32 ⎟
⎜ ⎟
⎜⎜ 100 ⎟⎟
bond value = $ 2,500,000 ⎝ ⎠ = $ 2,320,313
Change in basis points in futures = 80 bs
Loss in futures – 80 x $ 31.25 x 24 = $ 60,000
6
Accrued interest for six months = $ 2,500,000 x 0.055 x 12
= $ 68,750
(2,320,313 − 60, 000 + 68, 750) − 2, 259,375 12
X
Annualized return = 2, 259,375 6
69, 688 12
x
= 2, 259,375 6
= 6.17%
Financial Engineering Problems Page 2
 ii. After six months,
⎛ 6 ⎞
⎜ 88 32 ⎟
⎜ ⎟
⎜⎜ 100 ⎟⎟
bond value = $ 2,500,000 ⎝ ⎠ = $ 2,204,688
Change in basis point in futures = 66 bp
Gain in futures = 66 x $ 31.25 x 24 = $ 49,500
Accured interest = $ 68,750
(2, 204, 688 + 49, 500 + 68, 750) − 2, 259, 375 12
X
Annualized return = 2, 259, 375 6
63,563 12
x = 5.63 %
= 2, 259,375 6

2. On November 1, the March 90-day US T-bill futures contract price was 92.85. The US T-bill maturing at around
the futures expiration was selling at a discount of 7.17. You are interested in using the spot T-bill and the March
futures contract to construct a synthetic T-bill maturing on June 20. The March futures contract expires on March
21.
You are required to
(a) Determine the return on this synthetic T-bill.
(b) Compare with your result in part (a) with the return on the hypothetical T-bill maturing on June 20 if similar
T-bills are selling at a discount of 7.31.
(7 + 3 = 10 marks) < Answer >

< TOP >

2.
a. The March T-bill matures in 140 days; its price is = 100 – 7.17(140/360) = 97.2117
The return on the March T-bill is
(100/97.2117)(365/140) – 1 = 0.0765
You buy the March futures at its price of
(100 – 7.15(90/360)) = 98.2125
This guarantees that a T-bill can be purchased in March at an effective price of 98.2125. The return on such
a T-bill is
(100/98.2125)(365/91) – 1 = .075
The overall return on the synthetic security is
(1.0765)(140/365)(1.075)(91/365) = (1 + r)(231/365)
Solving for r gives
r = 0.0759
b. An actual June T-bill have a price of
100 – 7.31(231/360) = 95.3094
This would imply a return of
(100/95.3094)(365/231) – 1 = 0.0789
The actual T-bill has a higher return. The returns should be equal since they are essentially the same

security. Thus, an arbitrage profit is possible, which would drive the returns together.

Financial Engineering Problems Page 3

1. In January 2005, the T-bill futures on the IMM are trading at the following prices:
March futures : 98.25
June futures : 97.95
A speculator is expecting that the yield curve is about to become steeper. The speculator has no particular views
about the level of interest rates, however, he wishes to profit from this view.
You are required to show how the speculator can profit from this view? Under what circumstances will he make
loss?

1. Rates of T-bill futures in January :

March 98.25
June 97.95
If the dealer expects that the yield curve will become steeper it means that spread between the near and far end
contract will widen, i.e. Longer term interest rates will rise more than the shorter term interest rates. Hence the
speculator will buy a near end contract and sell a far end contract i.e. buying a spread. He buys March contract and
sells June contract. Assume in February the new rates are as under:
Scenario I II
March 98.35 98.10
June 98.00 97.75
If the speculator closes his position
I. Gain on March contract (98.35 – 98.25) × 100 × 25 = $ 250
Loss on June contract (98.00 – 97.95) × 100 × 25 = $ 125
-------
Net gain $ 125
-------
II. Loss on March contract (98.25 – 98.10) x 100 x 25 = $ 375
Gain on June contract (97.95 – 97.95) x 100 x 25 = $ 500
-------
Net gain $ 125
-------
The speculator gains from his expectations that the yield curve becomes steeper under both the scenarios of
increasing interest rates and decreasing interest rates.
The speculator can make loss with this strategy if yield curve become downward sloping i.e. if the fall in long
term interest rate is more than the fall in short term interest rate.

3. A firm in Denmark exports dairy products. On June 15 2004, an order worth $ 5 million to a US super store chain
was shipped. The payment was due after 3 months from the day of shipment. The spot DKr/$ was 6.1569 and the
3 month forward rate was 6.1625 at that time. The firm considered hedging the exposure through futures contract.
Since futures contract for Danish Kroner was not available, it considered either futures on Swiss Franc or Swedish
Kroner on IMM as both the currencies are closely related to Danish Kroner.
The spot SFr/$ rate was 1.2743 and September SFr futures were trading at $0.7875. The spot SKr/$ rate was
7.5833 and September SKr futures were trading at $0.13126 at that time.
On September 15, 2004, dollar was priced in the spot market as at SFr 1.2678, SKr 7.6166 and DKr 6.1602. In the
futures market September SFr future was priced $ 0.7891 and September SKr futures was priced at $ 0.13133.
You are required to find out which hedging strategy would have been better for the Danish firm.
(Standard size of SFr and SKr futures are 125,000 each).

Financial Engineering Problems Page 4

 < TOP >
3. Hedging through SFr futures
As the customer had a receivable in $, he would go long in SFr futures as it amounts to go short in USD i.e. buy
SFr futures
Standard size of SFr future is 125,000.
5, 000, 000
=
The number of SFr futures contracts to be bought = 125, 000 × 0.7875 50.79365079 = 51.
Gain from SFr futures is = (0.7891 - 0.7875) x 51 x 125,000 = $10,200.00
Gain from SFr futures in DKr = 10,200 x 6.1602 = 62,834.04
Inflow in the spot market = 5,000,000 x 6.1602 = DKr 30,801,000
Total inflow = DKr 30,863,834.04
Hedging through SKr futures
Here also as the customer had a receivable in $, he would bought SKr futures.
Standard size of SKr future is 125,000.
5, 000, 000
=
The number of SKr futures contracts to be bought = 125, 000 × 0.13126 304.7386866 = 305.
Gain from SKr futures is = (0.13133 - 0.13126) x 305 x 125,000 = $2,668.75
Gain from SKr futures in DKr =2,668.75 x 6.1602 = DKr 16,440.03
Inflow in the spot market = 5,000,000 x 6.1602 = DKr 30,801,000
Total inflow = DKr 30,817,440.03
So hedging through SFr futures would have given better result since inflow is more there.

Financial Engineering Problems Page 5