Project: Currency Hedge
At the start of the sample period, your company receives 2,500,000 Euros, which you plan to convert into US dollars at the end of sample period for tax reasons.
Since EUR/USD exchange rate fluctuates every day, the US dollar value of your 2.5 mil Euros in the future uncertain, which is called exchange rate risk. Your objective is to lower this exchange rate risk. You decide to hedge against this risk using EUR/USD (=Euro FX) futures contract expiring in December 2015.
10 Questions:
1. What's the difference between Euro FX futures and Eurodollar futures?
2. You are converting the currency in late November. But why do we need to use December 2015 futures instead of November 2015 futures? And what is the contract size of the Euro FX futures contract?
3. How many Euro FX futures contract do you have to buy or short to hedge the risk? Specify explicitly whether you are taking a long or short position of the Euro FX futures.
4. For every trading day (no weekends/holidays) during the sample period, collect the daily EUR/USD exchange rate and EUR/USD futures price. If you do not want to collect these prices every day, see hint #2 below. Create a spreadsheet and enter dates and both prices.
5. Calculate the Euro FX futures daily gains, and cumulative gains for each day using the position you answered in Q3.
6. Assume the initial margin requirement is $5,000 per contract. Calculate the margin account balance each day. Is there a margin call, when the maintenance margin requirement is $3,500 per contract? If yes, add the required cash to the margin account to restore initial margin account requirement.
8. For each day, calculate the value of your unhedged position (= 2.5 mil Euros in US $), and the values of your hedged position (= unhedged value + futures cumulative gain in Q5).
9. Plot the unhedged values and hedged values in Q8 over time. In addition, calculate the standard deviations of the unhedged values and that of the hedged values in Q8. Discuss the results.
10. Using Q9 answers, confirm that you successfully lowered the exchange rate risk.