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Hedging using the 3-month JIBAR future
As we used the example of the JSE's 3-month JIBAR future above, we use it here in a hedging example. We assume that it is 23 June 2010 and the 3-month JIBAR future expires on 22 September 2010 (91 days later). We further assume that Company A has a loan of ZAR1 million at an interest rate of 3-month JIBAR + 2% (on 23 June JIBAR = 11%, i.e. the borrowing rate is 11% + 2% = 13%), and it is reprised on the JIBAR future expiry dates (which are the third Wednesday of March, June, September and December).
Thus the borrowing rate now (23 June 2010) for 3 months is 13%, and is due to change again on 22 September (obviously, it is unknown today). The company is concerned that the 3-month JIBAR rate on 22 September will be higher and the company will therefore pay a higher rate for the 3-month period following 22 September.
The company hedges itself by selling ten 3-month JIBAR futures contracts (contract size = ZAR100 000; 10 x ZAR100 000 = ZAR1 million exposure). The rate / price of the future is now 11.3% (when the 3-month JIBAR rate = 11.0%).During the course of the next three months the rate / price of the contract will move up or down in minimum amounts of 0.001 ("minimum price movement" - see the contract specifications in Table 6), also called "minimum tick size". You will recall that the basis point (0.01% pa) value = ZAR2.50 per contract [remember the principle: ZAR100 000 x (0.01 / 100 x (91.25 / 365)].
If the company is correct in its view (increasing rates) and the future closes out at 12.3% pa on 22 September (when the 3-month JIBAR rate = 12% pa), the company makes a profit of ZAR2 500 (100 basis points x 10 contracts x ZAR2.50) on the futures contract. This amount is offset against the new rate it will be paying on its borrowing for the next three months, i.e. 14% (12% + 2%). It will be evident that the "extra" the company will be paying (14% - 13%) in the next 3-month period is ZAR2 493.15 [(1.0 / 100) x (91 / 365) x ZAR1 000 000]. The two amounts are similar.
Table 6: Hedging with interest rate future
It will also be apparent that a speculator, who does not have a cash market "position", and who undertook the above futures position, would have benefited to the extent of ZAR2 500. Had rates declined by 100 basis points over the period, she would have lost this amount, i.e. the correct futures position would have been a long (buy) contract in the case of falling rates.
Hedging with share index futures
Table 7: Hedging with share index future
An individual has a portfolio valued at LCC280 000 that is well spread over the share market (meaning he will earn the change in the ALSI value more or less). The All Share Index (ALSI) currently (28 June) is 28000, and the September all share index future (September ALSI, due 19 September) is trading at 28100. The individual is concerned that share prices "across the board" are about to fall sharply, and that the value of his portfolio will fall commensurately.
The individual decides to sell the September ALSI future. The contract size is 10 times index value, i.e. LCC281 000 (10 x 28100). He sells the ALSI future, and it closes out at 27000 on 19 September. The profit made is LCC11 000 (LCC281 000 - LCC270 000).
He compares this with the loss in the market value of the portfolio of LCC10 080 (280 000 - 269 920 (= a decline of 3.6% = the decline in the value of the ALSI from 28000 to 27000). This loss is more than compensated for by the profit on the futures position of LCC11 000.
Hedging with currency futures
A Local Country exporter is convinced that the USD proceeds (assume USD 100 000) from a export order will be worth less when it is received in three months time, as a result of the dollar depreciating (the LCC appreciating). The exporter sells a USD/LCC futures contract (contract size USD 100 000) at USD / LCC 10.2 which happens to be the same as the spot rate38. It has three months to expiry. The value of the contract now in LCC terms is LCC1 020 000.
At the end of the three month period, i.e. when the contract expires, the USD/LCC exchange rate is USD / LCC 9.55. The contract (which is settled in cash) value on expiry is LCC955 000. The exporter makes a profit of LCC65 000 (LCC1 020 000 - LCC955 000) on the futures contract.
The export proceeds of USD 100 000 are received, which is converted at the new rand/dollar spot rate of USD / LCC 9.55, i.e. a rand value of LCC955 000. On this leg the exporter "loses" LCC65 000 (meaning earns this amount less). Through hedging (short anticipatory hedge) the exporter "locked in" a certain outcome. Of course she gave up a potential gain (if the USD / LCC exchange rate depreciated to say USD / LCC 11.0) in exchange for a certain outcome. This is the price of hedging.
Table 8: Hedging with currency future
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