Tag Archives: Hedging

A case study about hedging

A spanish professional football team plans to play an exhibition game in the United Kingdom next year. Assume that all expenses will be paid by the British government, and that the team will receive a check for £1million. The team anticipates that the pound will depreciate substantially by the scheduled date of the game. In addition, the football authorities must approve the deal, and approval will not occur for 3 months. How can the team hedge its position? What is there to lose by waiting three months to see if the exhibition game is approved before hedging?

The team could purchase put options on pounds in order to lock in the amount at which it could convert the 1 million pounds to dollars. The expiration date of the put option should correspond to the date in which the team would receive the 1 million pounds. If the deal is not approved, the team could let the put options expire.
If the team waits three months, option prices will have changed by then. If the pound has depreciated over this three-months period, put option with the same exercise price would command higher premiums. Therefore, the team may wish to purchase put options immediately. The team could also consider selling future contracts on pounds, but it would be obligated to exchange pounds for dollars in the future, even if the deal is not approved.

Hedging

Hedging refers to the avoidance of a foreign exchange risk, or the covering of an open position. For example, the importer could borrow $100,000 at the present spot rate of SP=$2/£1 and leave this sum on deposit in a bank (to earn interest) for three months, when payment is due.

By so doing, the importer avoids the risk that spor rate in three months will be higher than today’s spot rate and that he or she would have to pay more than $200,000 for the imports. The cost of insuring against the foreign exchange risk in this way is the positive difference between the interest rate the importer has to pay on the loan of £100,000 and the lower interest rate he or she earns on the deposit of £100,000.

Similarly, the exporter could borrow £100,000 today, exchange this sum for £200,000 at today’s spor rate SR=$2/£1 , and deposit the $200,000 in a bank to earn interest. After three months , the exporter would repay the loan of £100,000 with the payment of £100,000 he or she receives.
The cost of avoiding the foreign exchange risk in this manner is, once again, equal to the positive difference between the borrowing and deposit rates of interest.