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Home / Students / Study resources / Advanced Financial Management (AFM)
/ Technical articles and topic explainers
/ How to answer a foreign exchange risk management question
Professional insights

The Advanced Financial Management syllabus states that there will be at least one question with a focus on syllabus section

E, Treasury and advanced risk management techniques. Within Section E, foreign exchange risk management is frequently
examined. This article will explain the significance of the information you’ll be given in foreign exchange risk management

questions and show you what you’ll be asked to do.

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The scenario is adapted from Nutourne Co, Question 2 in the December 2018 exam, which ACCA published. Some of the 

numbers have been changed. In this question, the closing futures price and spot rate are not given and so the predicted

futures rate has to be calculated. (See the article 'Exchange traded foreign exchange derivatives' for an example of when

the spot rate and futures price on the day of settlement are given). There is also a spreadsheet provided showing how the
calculations could be set out in the spreadsheet tool in the exam.

! ! ! ! ! !!!

Nutourne Co is a company based in the USA, supplying medical equipment to the USA and Europe. Nutourne Co’s

treasury department hedges foreign exchange risk on transactions using forward contracts, the money market, traded futures
or traded options.

It is currently 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.

Exchange rates (quoted as US$/CHF 1)

Spot 1.0292 – 1.0309

Three months forward 1.0322 – 1.0341

Six months forward 1.0356 – 1.0378

Annual interest rates available to Nutourne Co

Investing rate Borrowing rate

 Switzerland 3.2% 4.4%

USA 4.6% 5.8%

Currency futures (contract size CHF125,000, futures price quoted as US$ per $1)

Futures price

December 1.0306

March 1.0336

June 1.0369

Currency options (contract size CHF125,000, exercise price quotation US$ per CHF1, premium: US cents per CHF1)

Calls Puts
 Exercise December March June December March June
price

1.0375 0.47 0.50 0.53 0.74 0.79 0.86

If futures or options are chosen, any amount not hedged by a futures or options contract will be hedged on the forward

market.

Futures and options contracts mature at the month’s end. Basis can be assumed to diminish to zero at contract

maturity at a constant rate, based on monthly time intervals.

Required:

Evaluate which of the possible methods of hedging being considered would give Nutourne Co the highest receipt,
assuming the options are exercised.

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Read the requirements carefully

You must read the requirements before reading the scenario in detail. Knowing what you have to do will help you analyse the

scenario and ensure that you answer the question fully.

Breaking down the requirements for Nutourne Co:

Evaluate which of the The answer needs to state which method gives the highest receipt,
possible methods of but it does not ask you to recommend a method. However, if there
hedging being considered are uncertainties relating to the amounts received for any of the
would give Nutourne Co the methods, it would be legitimate to discuss them.
 highest receipt

Assuming the options are This means that the amount hedged by the options contracts will be
exercised translated at the exercise price.

Identify the important data in the scenario

• Hedging methods to be used

• Transaction to be hedged

• Time period

• Spot and 6 month forward rates

Hedging methods to be used

The scenario states that the following methods should be considered:

• Forward contracts

• The money market

• Traded futures

• Traded options

Transaction to be hedged
Nutourne Co is a company based in the USA … currently dealing with a sale to a Swiss customer of CHF12.3 million

which has just been agreed.

Nutourne Co needs to hedge against the USD strengthening (the CHF weakening).

Implications for hedging methods

Forward contract Money market Futures contracts Options contracts

SELL CHF to bank at BORROW in CHF – SELL CHF futures BUY CHF PUT options
 forward rate when the amount borrowed now to hedge against now to hedge against
money received from will be repaid by the sale of CHF when sale of CHF when
customer. CHF receipt from money received from money received from
Swiss customer. Swiss customer. Swiss customer.

CONVERT amount
borrowed into USD.

INVEST translated
amount.

Time period

It is currently 30 November 20X8… the customer will pay for the equipment on 31 May 20X9.

Two things to note:

• The length of time between today’s date (30 November 20X8) and the date of settlement (31 May 20X9) – 6 months

• The date of settlement – 31 May

Implications for hedging methods

Forward contract Money market Futures contracts Options contracts

6 month forward rate Annual interest rates Date of futures will Date of options will
will need to be used. will have to be divided have to be after May. have to be after May.
by 2.

Spot rate
1.0292 – 1.0309 (quoted as US$/CHF 1)

Remember that the bank ‘always wins’ – so if there is a choice of two exchange rates, choose the one that gives the lowest

receipt.

Implications for hedging methods

Forward contract Money market Futures contracts Options contracts

Not relevant. Determines USD Could be used in basis Could be used in basis
received when calculation. calculation.
translating CHF
amount borrowed.

Use lower of two rates Use lower of two rates

Use lower of two rates (1.0292), as multiplying (1.0292), as multiplying

(1.0292), as multiplying CHF receipt to obtain CHF receipt to obtain

CHF receipt to obtain USD, and use of lower USD, and use of lower
USD, and use of lower rate will mean fewer rate will mean fewer

rate will mean fewer USD are received. USD are received.
USD are received.

Note that premium is

quoted in US$, so it will
not be translated.

6 month forward rate

1.0356 – 1.0378 (quoted as US$/CHF 1)

6 month rate is used, as it is 6 months between today‘s date (30 November) and date of settlement (31 May).

Remember again that the bank ‘always wins’.

Implications for hedging methods
Forward contract
Use lower of two rates
(1.0356) as multiplying
CHF receipt to obtain
USD, and use of lower
rate will mean fewer
USD are received.
ANSWER
Let’s now review the answer:
Forward contract
Receipt = CHF12,300,000 × 1.0356 = $12,737,880
Three months 1.0322 – 1.0341
Six months 1.0356 – 1.0378
Money market Futures contracts Options contracts
Not relevant Could be used if there Could be used if there
is an amount not is an amount not
hedged. hedged.
If there is a under - If there is a under -
hedge, use lower of hedge, use lower of
two rates (1.0356) as two rates (1.0356) as
multiplying CHF receipt multiplying CHF receipt
to obtain USD, and use to obtain USD, and use
of lower rate will mean of lower rate will mean
fewer USD are fewer USD are
received. received.
Use six months rate and lower of two rates (1.0356),
as multiplying CHF receipt to obtain USD, and use of
lower rate will mean fewer USD are received.
Money market hedging

• Borrow CHF

Amount borrowed = CHF12,300,000/(1 + [0.044/2]) = CHF12,035,225

CHF Investing 3.2% Borrowing 4.4% Borrow in CHF at 4.4%, as CHF receipt
from Swiss customer will pay back
borrowing. Adjust rate as borrowing is for 6
months.

• Convert into US$ at spot rate

Receipt = CHF12,035,225 × 1.0292 = US$12,386,654

Use lower of two rates (1.0292), as multiplying

Spot 1.0292 – 1.0309 CHF receipt to obtain USD, and use of lower
rate will mean fewer USD are received.

• Invest in US$

Receipt = US$12,386,654 × (1 + [0.046/2]) = CHF12,671,547

US$ Investing 4.6% Borrowing 5.8% Invest translated receipt at 4.6%. Adjust rate
as investment is for 6 months.

Futures
 • Sell CHF futures

Sell CHF futures now to hedge against sale of CHF when money received from Swiss customer.

• Use June CHF futures contracts

December 1.0306 Must be June (1.0369) as only date after 31

May.
March 1.0336

June 1.0369

• Number of contracts

Number of contracts = CHF12,300,000/125,000 = 98.4, say 98, hedging 98 × CHF 125,000 = CHF12,250,000

Contract size is $125,000 Number of contracts =

Receipt/$125,000, rounded to the nearest

contract

• Remainder to be hedged on forward market

Remainder to be hedged on the forward market = CHF12,300,000 – CHF12,250,000 = CHF 50,000

Receipt = CHF50,000 × 1.0356 = $51,780

 Number of contracts does not cover full amount of transaction, so need to hedge residual receipt of
CHF.

Underhedge = Amount of transaction – Amount hedged

Use same rate as for forward contract above of 1.0356

• Futures price and expected receipt

Estimate from March and June futures rates

Predicted futures rate at the end of May = 1.0336 + ([1.0369 – 1.0336] × 2/3) = 1.0358

Expected receipt = CHF12,250,000 × 1.0358 = $12,688,550

Futures and options contracts mature at
the month’s end. Basis can be assumed to
diminish to zero at contract maturity at a
constant rate, based on monthly time
intervals.
31 May is 2/3 of time between 31 March and
30 June, so use 2/3 of the difference between
March futures price of 1.0336 and June
futures price of 1.0369.

This method is a shortcut, used to work out a

‘lock-in’ rate that will be the net result of the
underlying transaction and the hedge gains or
losses.

Or

Estimate from spot rate and June futures rate

Predicted futures rate at the end of May = 1.0292 + ([1.0369 – 1.0292] × 6/7) = 1.0358

Expected receipt = CHF12,250,000 × 1.0358 = $12,688,550

 Futures and options contracts mature at
the month’s end. Basis can be assumed
to diminish to zero at contract maturity
at a constant rate, based on monthly
time intervals.
• Outcome
! !
Futures
Remainder on forward market
Options
• Buy CHF put options
31 May is 6/7 of time between 30
November and 30 June, so use 6/7 of the
difference between spot rate of 1.0292 and
June futures rate of 1.0369.
This method is a shortcut, used to work out
a ‘lock-in’ rate that will be the net result of
the underlying transaction and the hedge
gains or losses.
12,688,550
51,780
12,740,330
 Buy CHF put options to hedge against sale of CHF when money received from Swiss customer.

• Buy June options

Put: Must be June as only date after May.

December

March

June

• Number of contracts and receipt

Number of contracts = CHF12,300,000/125,000 = 98.4, say 98, hedging 98 × CHF 125,000 = CHF12,250,000 (as for futures)

Receipt = CHF125,000 × 98 × 1.0375 = $12,709,375

Contract size is $125,000 Number of contracts =

Receipt/$125,000, rounded to the nearest

contract

• Remainder to be hedged on forward market

Remainder to be hedged on the forward market = CHF12,300,000 – CHF12,250,000 = CHF 50,000

Receipt = CHF50,000 × 1.0356 = $51,780 (as for futures)

 Number of contracts does not cover full amount of transaction, so need to hedge residual receipt of
CHF.

Underhedge = Amount of transaction – Amount hedged

Use same rate as for forward contract above of 1.0356.

• Premium

1.0375 options = 98 × 125,000 × 0.0086 = $105,350

Put June 0.86 US cents per CHF Multiply number of contracts × size of one
contract × 0.0086, as premium is quoted in US
cents (not US dollars) per CHF.

! !

Receipt 12,709,375

Forward contract 51,780

Premium (105,350)

12,655,805
! ! ! ! ! ! !!

If the options are exercised, the futures would give the higher receipt. The options give a lower receipt because of the
premium that Nutourne Co has to pay. The futures will be subject to the risk that basis (the difference between the futures

price and the spot price) may not decrease linearly as the futures approach maturity, as assumed in the above calculations.
This will mean that the hedge of the CHF12,250,000 is imperfect, and the receipt may be unpredictable despite a futures

hedge being taken out.

! ! ! ! !! ! !! !

This question has demonstrated how to use the data given in the question in foreign exchange hedging calculations.

Hopefully, it will help you tackle this type of question systematically.

View an example of how the question could be attempted in the exam software

Written by a member of the AFM examining team

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