A US company will pay euros in November. It buys euro futures today. In November the euro has risen, so it pays more for the euros, but its futures position has gained by about the same amount. The net cost is back near today’s rate. That is the whole idea of a futures hedge.
The work in the exam is in the details: how many contracts, long or short, what the tick is worth, and what basis does to the result.
This topic covers currency futures contracts and hedges (perfect, imperfect and with basis) and short-term interest rate futures (STIRs): their pricing, tick values, the number of contracts for a loan of a different length, and worked hedges for borrowing. The previous topic covered the basics of futures. The next covers hedging with options. Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on futures.
In 30 seconds
Currency futures are for a standard amount (for example €125,000, £62,500, ¥12.5m); the exam gives the size. Pick the position that profits if the underlying transaction loses. Contracts = exposure in the future’s currency ÷ contract size. Net result = spot cash flow ± futures gain or loss; with no basis, the effective rate is the rate when the hedge was opened.
STIRs are cash-settled contracts on a notional three-month deposit (Eurodollar $1m, tick $25; Euribor €1m, tick €25; short sterling £500,000, tick £12.50), priced at 100 − rate. Hedge a rise in rates by selling; a fall by buying. For a loan period other than three months, multiply the contracts by period ÷ 3. Effective rate = net interest ÷ loan × 12 ÷ months.
With basis, the rate locked is the futures rate plus the expected basis effect; basis risk makes the result differ.
Key terms in plain English
| Term | What it means |
|---|---|
| Currency future | A contract to buy or sell a standard amount of one currency for another |
| STIR | Short-term interest rate future on a notional three-month deposit |
| Eurodollar / Euribor / short sterling | Common STIR contracts in dollars, euros and pounds |
| Effective rate | The net exchange or interest rate after the futures gain or loss |
| Close out | Reverse the original trade to take the gain or loss |
Syllabus check
This topic is in syllabus area E (treasury and advanced risk management). It covers:
- using foreign currency futures to hedge foreign exchange risk;
- using interest rate futures to hedge interest rate risk.
CAMA 2020 and hedging
The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.
| Section | What it says | Link to this topic |
|---|---|---|
| s. 305 | A director must act in good faith in the best interests of the company | Hedging should protect the company, not speculate with its resources |
| s. 308 | A director must use the care, diligence and skill of a reasonably prudent director | Directors should set clear limits for any futures hedges the company uses |
| s. 377(1) and s. 378 | Directors prepare statements that follow IFRS and give a true and fair view | Decisions later affect reported assets, profit and cash |
| s. 385 | The directors’ report covers performance and risk | Major plans and risks are reported to shareholders |
Currency futures
A currency future is for a standard quantity of one currency in exchange for another, priced at the exchange rate. CME contracts include US dollar–euro €125,000, dollar–yen ¥12.5m, dollar–pound £62,500, dollar–Swiss franc SFr125,000 and dollar–Canadian dollar C$100,000. The exam gives the contract size. For the euro, the tick is $0.0001, worth $12.50; for sterling, £62,500 × 0.0001 = $6.25.
Perfect hedge, no basis
ICAN’s example: in July a US company must pay €750,000 in November. December euro futures are 1.2100; tick $12.50. It fears a rise in the euro, so it buys 750,000 ÷ 125,000 = 6 contracts. In November the spot (and futures) rate is 1.2240.
- Gain = 6 × 140 ticks × $12.50 = $10,500.
- Spot cost.
750,000 × 1.2240 = $918,000
less gain = $907,500. - Effective rate.
907,500 ÷ 750,000 = 1.2100, the rate when the position was opened.
Imperfect hedge, no basis
A UK company expects US$1,000,000 in August. September sterling futures are 1.8200 (£62,500, tick $6.25). It fears a fall in the dollar, which is a rise in sterling, so it buys sterling futures: $1,000,000 ÷ 1.8200 = £549,451 ÷ 62,500 = 8.79, so 9 contracts. In August the rate is 1.7800: loss = 9 × 400 ticks × $6.25 = $22,500. Net dollars = 977,500; ÷ 1.7800 = £549,157; effective rate = 1,000,000 ÷ 549,157 = 1.8210, close to 1.8200.
Imperfect hedge with basis
A Dutch company must pay US$1,200,000 in late November. Now (late July) spot is $1.2200 per € and December futures are 1.2170, so basis is 30 points and falls 6 a month (5 months). The dollar rises against the euro, so the euro falls: sell euro futures. € equivalent = 1,200,000 ÷ 1.2170 = €986,031, or 7.9 contracts, so 8. In November spot is 1.2040 and futures 1.2030 (basis 10, expected 6).
- Gain = 8 × 140 ticks × $12.50 = $14,000.
- Dollars to buy.
1,200,000 − 14,000 = 1,186,000; at 1.2040 that costs €985,050. - Effective rate.
1,200,000 ÷ 985,050 = 1.2182.
The actual basis (10) was 4 more than expected, worth 8 × 4 × $12.50 = $400.
Short-term interest rate futures
A STIR is a contract on a notional three-month deposit. The exam gives the size; typical contracts: Eurodollar $1,000,000, tick $25; Euribor €1,000,000, tick €25; short sterling £500,000, tick £12.50. The price is 100 minus the annual rate: 4% is 96.0000; 5.2175% is 94.7825; a price of 93.5618 means 6.4382%. So when rates rise the price falls, like bond prices.
Rules. To hedge against a rise in interest rates (borrowing), sell futures; to hedge a fall (depositing), buy. For a loan period other than three months, adjust: contracts = (amount ÷ contract size) × (months ÷ 3). A $5m loan for six months with $1m contracts needs 5 × 6÷3 = 10; a £10.5m loan for two months with £500,000 contracts needs 21 × 2÷3 = 14.
Perfect hedge, no basis
A company will borrow €8m from the end of May. It is January; Euribor and the June futures price are 3.50% and 96.50. It sells 8 June contracts for a three-month loan. In May the rate is 4.25% and futures 95.75.
- Gain = 8 × 75 ticks × €25 = €15,000.
- Interest = 8m × 4.25% × 3÷12 = €85,000
net = €70,000. - Effective rate.
70,000 ÷ 8,000,000 × 12 ÷ 3 = 3.50%, the opening rate.
For a six-month loan, sell 16 contracts: gain €30,000; interest 8m × 4.25% × 6÷12 = €170,000; net €140,000, again 3.50% a year.
Imperfect hedge, no basis
A UK company will borrow £4.75m for three months from September. In April LIBOR and the futures price are 5.45% and 94.55. £4.75m ÷ £500,000 = 9.5, so it sells 10 September contracts. In September LIBOR is 5.14% and futures 94.86 (a loss on the short position).
- Loss = 10 × 31 ticks × £12.50 = £3,875.
- Interest = 4.75m × 5.14% × 3÷12 = £61,037.50
total cost = £64,912.50. - Effective rate.
64,912.50 ÷ 4,750,000 × 12 ÷ 3 = 5.47%, close to 5.45%.
Hedge with basis
A company will borrow $20m for three months from the end of October. It is June; spot LIBOR is 4.30% (95.70) and December Eurodollar futures are 96.30, so basis is 60 points, falling 10 a month. At the end of October the expected basis is 60 − 4 × 10 = 20. It sells 20 contracts ($20m ÷ $1m). In October spot is 4.10% (95.90) and futures 96.06.
- Gain = 20 × 24 ticks × $25 = $12,000.
- Interest = 20m × 4.10% × 3÷12 = $205,000
net = $193,000. - Effective rate.
193,000 ÷ 20,000,000 × 12 ÷ 3 = 3.86%.
The futures price fixed 3.70%; the actual basis was 16, so the result is 0.16% above 3.70%.
A longer example uses sterling: £60m for four months from April, now November; June futures 94.85; spot 5.50% (94.50) so basis is 35 points over seven months, 5 a month. Contracts = 60m ÷ 500,000 × 4÷3 = 160. The futures rate is 5.15% and the expected basis at closing (two months left) is 10 points, so the locked rate is about 5.25%; with a margin of 0.75%, the effective rate is 6.00%.
If LIBOR is 5.75% (94.25) the expected futures price is 94.35; the gain is 50 points × £12.50 × 160 = £100,000 against interest of £1.3m (6.5% × 60m × 4÷12), net £1.2m, or 6.00% a year.
The rules in more depth
Why selling hedges borrowing
If rates rise, the price (100 minus rate) falls, and a short position gains.
Why the contract count is scaled for loan length
Each contract covers three months of interest on its notional, so a six-month loan needs twice as many.
Why the effective rate equals the opening rate with no basis
The gain or loss on futures exactly offsets the change in the spot rate.
Why the exam gives the tick value
It depends on the contract size and the price quotation.
Effect on analysis
Show the position, contracts, gain or loss, net cost and effective rate, then comment on basis and rounding.
Worked examples
Example 1: price and rate. A STIR price is 94.7825.
- Rate = 100 − 94.7825.
- Rate = 5.2175%.
- If rates rise, the price falls.
Example 2: contracts for a longer loan. A company will borrow $5m for six months. A contract is $1m for three months.
- Base contracts = 5.
- Adjust × 6 ÷ 3 = 2.
- Sell 10 contracts.
Example 3: effective rate. A hedge gives a net interest cost of €70,000 on €8m for three months.
- Rate = 70,000 ÷ 8,000,000.
- = 0.875% for three months.
- Annual = 0.875% × 4 = 3.50%.
Example 4: choose the position. A UK company receives dollars; the futures are in sterling.
- A fall in the dollar is a rise in sterling.
- The company needs a profit if sterling rises.
- Buy sterling futures.
How to score full marks
- Apply the three steps to decide buy or sell.
- Count contracts and scale for loan length.
- Compute gain or loss with the tick value.
- Net it against spot cost or interest.
- Convert to an annual effective rate.
- Explain why it differs from the opening rate.
Common mistakes in the exam
- Buying STIRs to hedge a rise in rates.
- Forgetting the months ÷ 3 adjustment.
- Using the wrong tick value.
- Mixing the futures currency with the exposure currency.
- Forgetting the borrowing margin.
- Ignoring basis when it is given.
Quick revision
- Currency futures: three steps; contracts = exposure ÷ size.
- No basis: effective rate = opening rate.
- STIR: price = 100 − rate; sell to hedge rises, buy to hedge falls.
- Contracts × (months ÷ 3) for other loan periods.
- Effective rate = net interest ÷ loan × 12 ÷ months.
- Basis moves the result away from the opening rate.
- CAMA 2020: ss. 305, 308, 377(1), 378, 385.
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.
Recall check: multiple choice
Recent ICAN papers are written, although older papers such as May 2014 included multiple-choice questions. These questions are for quick recall. The written questions that follow are closer to the exam.
Question 1. A STIR price of 95.75 implies an annual rate of:
- 4.25%
- 95.75%
- 5.75%
- 0.0425%
Show the answer
A. 100 − 95.75.
Question 2. To hedge a borrower against a rise in interest rates, you:
- Sell STIRs
- Buy STIRs
- Buy options on calls only
- Do nothing
Show the answer
A. Prices fall when rates rise.
Question 3. A six-month loan hedged with three-month contracts needs:
- Twice the contracts of a three-month loan
- Half
- The same
- No contracts
Show the answer
A. Months ÷ 3.
Question 4. A Euribor future tick is worth:
- €25
- €12.50
- €100
- €2.50
Show the answer
A. 1,000,000 × 0.0001 × 3÷12.
Question 5. A short sterling future (£500,000) tick is worth:
- £12.50
- £25
- £6.25
- £50
Show the answer
A. 500,000 × 0.0001 × 3÷12.
Question 6. With no basis and a perfect hedge, the effective rate equals:
- The rate when the hedge was opened
- The closing spot rate
- Zero
- The average
Show the answer
A. The gain offsets the move.
Question 7. A US company paying €750,000 should:
- Buy euro futures
- Sell euro futures
- Buy yen futures
- Sell dollar bonds
Show the answer
A. It loses if the euro rises.
Question 8. £4.75m borrowing with £500,000 contracts needs about:
- 9 or 10 contracts
- 5 contracts
- 50 contracts
- 1 contract
Show the answer
A. 4.75m ÷ 500,000 = 9.5.
Question 9. Basis risk means the actual basis may:
- Differ from the expected basis
- Equal zero
- Never change
- Be negative only
Show the answer
A. So the effective rate differs from the locked rate.
Question 10. Which section of CAMA 2020 sets the director’s duty of care and skill?
- Section 308
- Section 400
- Section 405
- Section 409
Show the answer
A. Directors should test the assumptions behind a decision.
Written questions
Question 11 (10 marks). (a) State the three steps in creating a currency futures hedge. (3 marks) (b) Explain why STIR prices are quoted as 100 minus the rate. (3 marks) (c) A company will borrow $5m for six months; contracts are $1m for three months. State the position and number. (4 marks)
Question 12 (20 marks). A company will borrow $20m for three months from the end of October. It is June. Spot three-month LIBOR is 4.30% and December Eurodollar futures are 96.30 (contract $1m, tick $25). In October LIBOR is 4.10% and the December price is 96.06. (a) State the hedge and number of contracts. (3 marks) (b) Calculate the gain, net interest and effective annual rate.
(6 marks) (c) Calculate the expected basis at closing and the effect of the actual basis. (5 marks) (d) A UK company expects US$1,000,000 in August. September sterling futures are 1.8200 (£62,500, tick $6.25); the August rate is 1.7800. Calculate the hedge and the effective rate. (6 marks)
Question 13 (10 marks). (a) A company borrows €8m for six months. A Euribor contract is €1m for three months. Calculate the contracts needed. (3 marks) (b) Spot Euribor is 3.50% and the price 96.50; in May the rate is 4.25% (95.75). Calculate the gain per €1m contract. (3 marks) (c) Explain why the effective rate is the opening rate. (4 marks)
Model answers
Show the model answer to Question 11
(a) Steps (3 marks). Identify the underlying transaction; identify the currency risk in it, stated in the futures currency; choose the futures position that profits if the transaction loses. (1 each)
(b) 100 minus rate (3 marks). When rates rise the price falls. (1.5) So the price moves like bond and other cash market prices. (1.5)
(c) Position and number (4 marks).
- A borrower fears a rise in rates, so sell futures. (2)
- Contracts = 5 × 6÷3 = 10. (2)
Show the model answer to Question 12
(a) Hedge (3 marks).
- The company fears a rise in LIBOR, so it sells December Eurodollar futures. (1.5)
- Contracts = 20m ÷ 1m = 20. (1.5)
(b) Result (6 marks).
- Sold at 96.30 and bought at 96.06: gain 24 ticks. (1)
- Gain = 20 × 24 × $25 = $12,000. (1.5)
- Interest = 20m × 4.10% × 3÷12 = $205,000
- net = $193,000. (2)
- Effective rate.
193,000 ÷ 20m × 12 ÷ 3 = 3.86%. (1.5)
(c) Basis (5 marks).
- Basis in June.
96.30 − 95.70 = 60 points, falling 10 a month over six months. (2) - Expected basis at the end of October.
60 − 40 = 20. (1.5) - Actual basis.
96.06 − 95.90 = 16, worth 20 × 16 × $25 = $8,000 or 0.16%, which is why the result is 3.86% against the 3.70% in the opening price. (1.5)
(d) UK hedge (6 marks).
- The company fears a fall in the dollar, a rise in sterling, so it buys sterling futures. (1)
- £ equivalent = 1,000,000 ÷ 1.82 = £549,451
- contracts = 8.79, so 9. (2)
- Loss = 9 × 400 ticks × $6.25 = $22,500. (1)
- Net dollars = 977,500
- ÷ 1.78 = £549,157. (1)
- Effective rate.
1,000,000 ÷ 549,157 = 1.8210. (1)
Show the model answer to Question 13
(a) Contracts (3 marks).
- 8m ÷ 1m = 8
- × 6÷3 = 16 contracts, sold. (3)
(b) Gain (3 marks).
- Sold at 96.50 and bought at 95.75: 75 ticks. (1.5)
- Gain per contract.
75 × €25 = €1,875. (1.5)
(c) Effective rate (4 marks). With no basis the futures price equals the rate in the market, so the gain exactly offsets the rise in the borrowing rate. (2) The net cost therefore equals borrowing at the 3.50% that was fixed when the position was opened. (2)
Pathfinder on Currency futures hedges, STIRs, tick values, basis and effective rates
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on futures hedges. Practise the three steps and the effective rate in the worked examples.
Revise first: Currency futures
Questions ask for the hedge of a future loan. See the section on short-term interest rate futures.
Revise first: Short-term interest rate futures
Source: ICAN Pathfinder, Strategic Financial Management. Diets covered: No stand-alone question in the May 2014 or November 2014 Pathfinder.
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