FIN 5545 Project: Currency Exchange Rate Risk Hedge
The sample period for this project is from 10/25/2016 to 11/25/2016. You will need to collect real data starting from tomorrow.
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 over 5 weeks is 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 2016.
Your task for this project is to come up with a strategy today, 10/24/2016, and confirm that it actually worked befre due date.
10 Questions (each is worth 1 point, consider each as a rubric):
The first 3 questions should be answered today (but submit all the answers in 1 file later).
1. What is the difference between Euro FX futures and Eurodollar futures?
2. You are converting the currency in November but asked to use December expiring futures. Why can’t you use November expiring futures so that you can match the expiration? And what is the contract size of the Euro FX futures contract?
3. Are you selling or buying the 2.5 mil Euros next month? Given your answer to this, in order to hedge the exchange rate risk, what is correct strategy? Specifically, do you need to buy or short Euro FX futures? How many contracts?
The rest of this project is to confirm whether your strategy in Q3 actually works or not at the end. If you answered Q3 correctly, then the exchange rate risk should decrease significantly.
4. For every trading day (which means no weekends/holidays) during the sample period, collect the daily EUR/USD exchange rate and Euro FX futures price. If you do not want to collect these prices every day, see Note #2 at the end to learn where to find price histories. Create a spreadsheet and enter (1) date, (2) exchange rate, and (3) futures price.
5. In the next columns, calculate the Euro FX futures daily gains, and cumulative gains for each day. (Hint: Session 1) Make sure you are calculating these values in your Excel rather than manually inputting the results. If I don’t see any Excel command behind your answers, I’ll assume you copied someone else’s answers, which is not acceptable for an individual project.
6. Assume the initial margin requirement is $5,000 per contract and the maintenance margin requirement is $3,500 per contract. Calculate the margin account balance each trading day. Is there a margin call? If yes, add the required cash to the margin account to avoid liquidation. (Hint: Session 1)
7. For each day, calculate the USD value of your 2.5 mil Euros (= unhedged position), In addition, calculate the values of your hedged position (= unhedged value + futures cumulative gain in Q5).
8. Plot the unhedged values and hedged values in Q7 over time. Explain the different behaviors of each..
9. Calculate the standard deviations of the unhedged values and that of the hedged values from Q7. Discuss these 2 standard deviations.
10. Using your Q8, Q9 answers, confirm that your strategy in Q3 successfully lowered the exchange rate risk.
READ THE FOLLOWING NOTES. IT SHOULD ANSWER ALL YOUR QUESTIONS.
Note 1. Submit 1 Excel file with all your answers/tables/plots. You can re-submit multiple times before the due date. I will only grade the last submission. If you want, you can submit a Word file and an Excel file. But do not submit the Excel file and Word file in 2 different submissions. I’ll only download the file in your last submission.
Note 2. For any calculation question, you must do all the calculations in Excel. If your file doesn’t show your calculations and only shows the results, I’ll assume you copied someone else’s answers instead of you typed your answers manually into hundreds of cells.
Note 3. To collect EUR/USD exchange rate, you can use any resource such as Bloomberg, Google or Yahoo. Each website may have slightly different rates, which is normal. But try to use the same source throughout for consistency. In the past, Bloomberg gave the best results because it provides exchange rate upto 4 decimal points.
Note 4. To collect Euro FX futures price daily, I recommend http://www.cmegroup.com. CME is the official exchange where futures are traded. Navigate and locate the relevant futures for this project. You only need to record the last (or settle) price. Open, high, low prices are unnecessary.
Note 5. Futures price will not be identical to the exchange rate but it should be similar. If your futures price and exchange rate differ by more than 10 cents, then it’s most likely a human error. The CME website not only has the price data but also has contract specifications, which you will need for this project.
Note 6. https://www.quandl.com/data/CME provides price history of all CME futures. You can use this database to collect the futures price data at the end instead of collecting the price daily. Navigate the website to locate the correct futures for this project. It even has an option to download the data.
Note 7. Your final spreadsheet must include at least the following columns for each trading day: 1) Date, 2) EUR/USD exchange rate, 3) Euro FX futures price, 4) Futures daily gain, 5) Futures cumulative gain, 6) Margin account balance, 7) Unhedged value and 8) Hedged value.
Note 8. As of today, 2.5 mil Euros is worth $2,722,200. If your unhedged values differ more than $500,000 from this number, you made an error.
Note 9. Futures daily settlements are explained in page 29-31 or review Session 1. We had a similar example in class.
Note 10. I highly encourage you to work in groups. If you get lost, ask for help in Hangouts. You can even share the data and discuss results with your colleagues. But do NOT share your file or copy other’s answers, which can both result in 0 score project.
Note 11. If you want feedback from me, don’t ask whether you answers are right or wrong. I’ll not tell you what your errors are. Instead, we will discuss so that you can discover your error.