Forward & Futures Contracts

In December 2015, a UK exporter invoiced a US customer for goods worth $407,500 that were to be payable in February 2016. The Investor needs to hedge against exchange exposure whereby the pound is anticipated to become relatively stronger than the dollar hence receiving fewer pounds than now upon the receiver of the respective dollars in February. To hedge against these unfavorable movements in the exchange rates, the investor will use the following methods appropriately.

The following were the exchange rates

Spot rate $1.6275-1.629/£

February

Forward rate $1.6250-1.6275/£

March pound futures contract size is 62,500£

Exchange rate $1.6300/£

The exchange rates in February

Spot rate $1.6370-1.6390/£

March pound futures contracts $1.6355

How the investor will benefit

Using a forward contract, the exporter will commit to sell off 407,500 at February rate of $1.6275/£

The proceeds will be 407,500/1.6275= 250,384.02£

The spot rate in February was $1.6390/£

The proceeds without using the forward contract would have been 407,500/1.6390= 248,627.21

The gain from using the forward contract is therefore, 250,384.02-248,627.21 =£1756.81

Use of futures

The first step is to determine the number of future contracts required.

Number of future contracts =407,500/1.6300= 250,000/62500= 4 futures contracts.

The subsequent step is to determine the futures gain or loss. The cost of buying the fur contracts involves determination of the cost of buying 4 contracts at a rate 1.6300 per pound.

4*62500*1.6300= 407,500

Sell the 4 futures in of March in February at 1.6355/£

4*62500*1.6355 408875

The gain of closing the futures contract is (408875-407500) = $1375

We then convert the dollars to pounds to get the net gain in pounds

1375/1.6390= 838.93£.

Impact of increase in interest rates to the above scenario

The increase in interest rates caused by inflation will cause the spot rates to increase hence increasing the unfavorable movement in the exchange rates such that the forthcoming spot rates are will be expected to scale up. This makes the investor to receive few units of receivables in future hence incurring a loss. This consequently calls for the investor to employ the forward contract to hedge against the risk exposure.

Conversely, the increase in the interest rates does not have effect to the futures contracts. This is because the future contracts have fixed units that are contracted in future. The respective futures cannot therefore be affected as they are traded in an organized market unlike the forward contract that is traded over the counter.