Forex Part 2 (Financial Risk Management) by Sir Saud Tariq ST Academy

22.
Financial Risk Management 2 (Futures & Options) SAUD TARIQ

CAF 6 Managerial and Financial Analysis
ST Academy
Currency Futures
A currency future is a standardised contract to buy or sell a fixed amount of currency at a fixed rate at a
fixed future date.
• Buying the futures contract means receiving the contract currency.
• Selling the futures contract means supplying the contract currency.
Key Characteristics:
o Futures are standardised contracts that are traded on an organised exchange, such as the Chicago
Mercantile Exchange and London International Financial Futures and Options Exchange.
o They fix the exchange rate for a set amount of currency for a specified time period.
o When entering into a foreign exchange futures contract, no one is actually buying or selling anything
– the participants are agreeing to buy or sell currencies on pre-agreed terms at a specified future
date if the contract is allowed to reach maturity, which it rarely does. Futures are a derivative (their
value derives from movements in the spot rate).
Question 1)
Waleed holds 19,700 shares of ABC Ltd. He intends to sell them after Annual general meeting on 15th
December 2019. Assume today is 10th November 2019 (Date of hedge) and spot rate of share price of Rs
32 each. Waleed want to hedge using future contract. Price of the future contract (Dec) Rs 33 each and
can only be bought in lots of 1,000 each.
Required: Compute gain or loss due to futures on each of the following independent cases:
(a) On 15th December, ABC Ltd’s spot rate is Rs 25 per share and December future price of Rs
25.3/share
(b) On 15th December, ABC Ltd’s spot rate is Rs 37/share and December future price is Rs 37.2 each.
Question 2)
Mr Anas intends to buy 31,600 shares of Aneeq Ltd on 24th December 2019, Today is 10th November
2019, and spot rate is Rs 20/share. Futures are available on lots of 1,000 as per following information:
Futures Maturing on Futures’ Rate as on 10th Nov
30 Nov, 2019 21
31 Dec, 2019 22
31 Jan, 2020 23
Required:
(a) How Mr Anas should setup future contract.
(b) Compute hedge outcome if on 24th December 2019, spot rate is Rs 29 and future prices are
• December contract = Rs 29.5/share
• January contract =Rs 30.1/share
Lectures: sta.saudtariq.com/Course/Detail/4886 317 Sir Saud Tariq (CAF 3, CAF 6, CFAP 3, CFAP 4, MSA 2)
22. Financial Risk Management 2 (Futures & Options) SAUD TARIQ
ST Academy
Question 3)
Mr Qasim expects to receive SAR 9,380 from export customer XYZ ltd on 10th January 2022. Assume
today is 10th November 2021 and spot rate is 1 SAR = Rs 45. Futures are available in lots of 300 each as
per following:
Futures Maturing on Futures’ Rate as on 10th Nov

31 Dec, 2021 Rs 45.2
31 Jan, 2022 Rs 45.5
29 Feb, 2022 Rs 45.7
Required: Compute gain/loss on hedging and hedge efficiency if following data exists on 10th January
2022: Spot rate: 1 SAR = Rs 40; Futures: December = Rs 40.4, January = Rs 40.8, February = Rs 50.1
Summary to point of time:

Steps for Hedge outcome under Future:
1. Identify Buy or Sell of contract
2. Compute no. of contracts to Buy or Sell
If need to buy later If need to sell later
Then Buy now & Sell later Sell now Buy later
(Tomorrow’s work today)
3. Compute Gain/loss on Hedge:
(assuming Buy now Sell later) Rs
Cost of Purchase (already Purchased at start date) x
Less: sale proceeds at excessive date (x)
(Revised future price of that date)
Gain/loss on futures x
4. Compute Net cost = Purchase at spot – gain/loss hedge

5. Compare with Target cost i.e. Spot at start date.
𝑔𝑎𝑖𝑛 𝑜𝑟 𝑙𝑜𝑠𝑠 𝑜𝑛 𝑓𝑢𝑡𝑢𝑟𝑒𝑠
6. Hedge efficiency =
𝑔𝑎𝑖𝑛 𝑜𝑟 𝑙𝑜𝑠𝑠 𝑜𝑛 𝑠𝑝𝑜𝑡 𝑚𝑎𝑟𝑘𝑒𝑡
*Numerator and denominator can be interchangeable.
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Q4) Summer 2006 Q1
Question to understand Basis:
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Question 5)
On 1st September 2019, spot rate of $ was 156 and future price of November contract is Rs 158 per $.
Saad Ltd purchases Dollars on 15th November 2019, when spot rate is Rs 158. If basis are assumed to
have reduced evenly over the period.
Required: Compute basis, remaining basis and hence futures price on 15th November.
Q6) CAF 6 MFA Model Paper
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Options
An option gives the holder the right, but not the obligation to trade ‘something’. The ‘something’
might be shares, a foreign currency or a commodity.
• The holder of an option pays a premium in exchange for the option. This is similar to paying a
car insurance premium i.e. the fee paid in advance to cover a subsequent event that may or
may not occur.
• If the holder of the option takes up the option this is called ‘exercising’ the option.
• For example, let’s say an investor pays a premium of Rs. 300 for the option to buy a share in
Company A for Rs. 20,000 in 3 months’ time. Rs 20,000 is called the ‘strike price’.
• If the price of shares in Company A is Rs. 25,000 in 3 months’ time then the holder of the option
will exercise their right to buy a share at Rs. 20,000. They could immediately see that share for
Rs. 25,000 in the open market making a profit of Rs. 5,000 (less the original option premium of
Rs. 300).
• However, if in 3 months’ time the market price of shares in company A is only Rs. 18,000. In
this case the holder of the option will not exercise their option to buy for Rs. 20,000 as they can
buy shares in Company A at that time in the open market for Rs. 18,000. In this case the option
‘lapses’ (i.e. is not exercised).
• The option to buy something in the future is called a CALL option. The option to sell something
in the future is called a PUT option.
• When the market price of the underlying product (e.g. a share) is such that to exercise the
option would enable the option holder to make a profit this is called ‘in the money’. If the
underlying price is such that to exercise the option would lose money, the option is said to be
‘out the money’.
• So in the previous example the call option with a strike of Rs. 20,000 is ‘in the money’ when the
market price of the shares is above Rs. 20,000, but ‘out the money’ when the market price of
the shares is trading below Rs. 20,000.
o In the money – where the option strike price is more favourable than current spot rate
o At the money – where the option strike price is equal to the current spot rate
o Out of the money – where the option strike price is less favourable than current spot rate
• A European option can only be exercised at the date of expiry.

• An American option can be exercised at any date up to and including the date of expiry.
• A tailor-made currency option from a bank, suited to the company's specific needs. These are
over the counter (OTC) or negotiated options; or
• (b) A standard option, in certain currencies only, from an options exchange. Such options are
traded or exchange-traded
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• Options have both an intrinsic value and a time value.
Intrinsic value is the difference of an ‘in-the-money’ option between the underlying’s price and the
strike price. An ‘out-the-money’ option has no intrinsic value.
Intrinsic value (call option) = underlying price – strike price

Intrinsic value (put option) = strike price – underlying price
• Time value describes the excess premium paid above the intrinsic value for the ‘potential’ that
the underlying price will move sufficiently before exercise date in order to secure an overall
profit. It follows then that time value decreases over time and decays to zero at expiration. This
is called ‘time decay’.
Time value = premium – intrinsic value

Options can be further classified as follows:
Exchange traded options – these are standardised products traded in an open market.
Over the counter (OTC) options – these are bespoke products where terms are agreed specifically
between the two counterparties.
Example: Options
✓ Company A purchases a call option giving it the right to buy shares in Company B in 6
months’ time for Rs. 500. The current share price of Company B is Rs. 450.
✓ In 6 months’ time, if the market price of shares in Company B is above Rs. 500 then
Company A will exercise its right to buy shares at the pre-determined price of Rs. 500.
✓ However, if the market price of Company B shares is below Rs. 500 in 6 months’ time then
Company A would let the option lapse (i.e. why would it buy shares at Rs. 500 when it could
just go to the open market and buy them for a lower market price).
Q7) Autumn 2015 Q5
Q8) Spring 2016 Q2
ST Academy
Currency Options:
Q9) Shayan Ltd has provided following information:

Call Option Put option
Share Price Oct Nov Dec Oct Nov Dec
80 1.1 1.4 1.7 1.2 1.5 1.9
83 0.8 1.1 1.3 1.6 1.9 2.3
86 0.7 0.9 1.2 1.9 2.4 3
Standard contract size is 1,000 shares. Shayan Ltd wants to sell 16,300 shares of Aneeq Ltd on 15th
December.
Required: Suggest hedge setup using Options.
Question 10)
Haris Ltd is required to pay $938,000 for import of high tech printing machine on 10th January 2020. He
intends to hedge using options:
Options Exercise Price Options Cost (Rs)
Dec Jan Feb
Call 158.5 0.8 1.0 1.3
Put 158.5 0.75 0.9 1.2
*Assume standard contract size of 100,000.
Required:
(a) Determine hedge setup.
(b) Compute hedge outcome where actual spot rate is Rs 161 and Rs 163 (independently).
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Q11) Summer 2012 Q5 (Need to replace October 2012 with September 2012.. Refer Lecture)
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HW: Q12) Summer 2019 Q4 (Indirect Currency Options omitted as not part of MFA Course)
Solution:
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HW: Q13) Winter 2020 Q4
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Concept of Ticks in Futures Hedging
The price of a currency future moves in 'ticks'. A tick is the smallest movement in the exchange rate and
is normally four decimal places.
Tick value (per contract) = size of futures contract x tick size
For example, if a futures contract is for £62,500 and the tick size is $0.0001, the tick value is $6.25.
Tick value = £62,500 x $0.0001 = $6.25
(Note that the tick size and tick value are always quoted in US dollars.)
What this means is that for every $0.0001 movement in the price, the company will make a profit or loss
of $6.25. If the exchange rate moves by $0.004 in the company's favour – which is 40 ticks
(0.004/0.0001) – the profit made will be 40 x $6.25 = $250 per contract
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HW: Autumn 2022 Q8 MFA
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HW: Question
A US company buys goods worth €720,000 from a German company payable in 30 days.
The US company wants to hedge against the € strengthening against the dollar.
Current spot is 0.9215 – 0.9221 $/ € and the € futures rate is 0.9245$/ €. The standard size of a 3 month
€ futures contract is €125,000. In 30 days’ time the spot is 0.9345 – 0.9351 $/ €. The tick size is $0.0001
Evaluate the hedge.
SOLUTION:
Step 1. Setup
(a) Which is contract?
We assume that the three month contract is the best available.
(b) Type of contract

We need to buy € or sell $. As the futures contract is in €, we need to buy futures.
(c) Number of contracts

720,000/125,000 = 5.76, say 6 contracts
(d) Tick size

Minimum price movement x contract size = 0.0001 x 125,000 = $12.50
Step 2. Closing futures price

The basis now is 0.9245 – 0.9221 = 24 ticks.
(0.9221 is used rather than 0.9215 because the company has to pay the bank 0.9221 dollars to obtain
each € it needs – remember the bank always has the advantage).
The basis in 3 months’ time is expected to be zero. If basis reduces evenly over the life of the contract, in
1 month time basis will be 2/3 x 24 ticks = 0.9367
(It would also be legitimate to calculate basis using the average of currency spot 0.9218).
Step 3. Hedge outcome

(a) Outcome in futures market
Opening futures price 0.9245 Buy at lower price
Closing futures price 0.9367 Sell at high price
Movement in ticks 122 ticks Profit
Future profit/loss 122 x $12.50 x 6 contracts = $9,150
(b) Net outcome

$
Spot market payment (720,000 x 0.9351 $/€ ) 673,272
Futures market profit (9,150)
664,122
(c) Hedge efficiency

9150
X 100% = 97.8%
(720,000 𝑥 (0.9351−0.9221)
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Multiple Choice Questions (MCQs)
1)
2)
3)
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4)
5)
6)
7)
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8)
9)
10)
MCQ Answers:
1. A 2. C 3. A 4. C 5. B
6. B 7. C 8. A 9. B 10. B

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22.

Financial Risk Management 2 (Futures & Options) SAUD TARIQ

Futures Maturing on Futures’ Rate as on 10th Nov

Summary to point of time:

If need to buy later If need to sell later

4. Compute Net cost = Purchase at spot – gain/loss hedge

*Numerator and denominator can be interchangeable.

Question to understand Basis:

Q6) CAF 6 MFA Model Paper

• A European option can only be exercised at the date of expiry.

Intrinsic value (call option) = underlying price – strike price

Time value = premium – intrinsic value

Q7) Autumn 2015 Q5

Q8) Spring 2016 Q2

Q9) Shayan Ltd has provided following information:

HW: Autumn 2022 Q8 MFA

(b) Type of contract

(c) Number of contracts

(d) Tick size

Step 2. Closing futures price

Step 3. Hedge outcome

(b) Net outcome

(c) Hedge efficiency

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