1.) Explain how futures contracts could be used to hedge a bond portfolio against the risk of rising interest rates. Then explain how futures could be used by exporters and by importers to hedge against their foreign-exchange exposures.
Someone with a large bond oprtfolio may want to hedge against future interest rate movements. When interest rates rise, bond prices decline. The use of futures can be used to hedge against the likelihood of rising interest rates. When the hedging is balanced, the gains/losses in the cash holdings will be ...view middle of the document...
Regardless of what happens to the future exchange rate, therefore, hedging locks in a dollar value for the currency exposure. In this way, hedging can protect a firm from foreign exchange risk, which is the risk of valuation changes resulting from unforeseen currency movements.
2.) Explain how the manager of a bond portfolio could use options to hedge against the risk of rising interest rates. Then explain how exporters and importers could use options to hedge against their foreign-exchange exposures.
3.) Assume that Baker Adhesives, sold 2.6 million Brazilian reals of adhesives to Novo, S/A (a Brazilian firm), to be delivered within 60 days and payable in R$ exactly 90 days after contract signing. Baker is afraid that the R$ will depreciate dramatically against the U.S. dollar during the next 90 days, and so it wants to hedge this foreign-exchange exposure so that it can lock in a guaranteed profit at contract signing. Baker can use one of four possible methods: 1) the forward rate; 2) futures contracts ; 3) option contracts; and 4) a money-market hedge. Using the data on the other side of this paper, calculate the net profit in U.S dollars that Baker will receive under each hedging method, as of 90 days after the contract signing. Show all calculations.