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Question 2c

Nutourne Co is a company based in the USA, supplying medical equipment to the USA and Europe.

It is 30 November 20X8. Nutourne Co’s treasury department is currently dealing with a sale to a Swiss customer of CHF12·3 million which has just been agreed, where the customer will pay for the equipment on 31 May 20X9. The treasury department intends to hedge the foreign exchange risk on this transaction using traded futures or options as far as possible. Any amount not hedged by a futures or option contract will be hedged on the forward market.

Exchange rates (quoted as US$/CHF 1)
Spot 1·0292–1·0309
Three months forward 1·0327–1·0347
Six months forward 1·0358–1·0380
Currency futures (contract size CHF125,000, futures price quoted as US$ per CHF1)
Futures price
December 1·0318
March 1·0345
June 1·0369
Currency options (contract size CHF125,000, exercise price quotation US$ per CHF1, premium: US cents per CHF1)
Calls Puts
Exercise price December March June December March June
1·0375 0·47 0·50 0·53 0·74 0·79 0·86

Futures and options contracts mature at the month end.

Non-executive director’s comments
A new non-executive director has recently been briefed about the work of the treasury department and has a number of questions about hedging activities. He wants to understand the significance of basis risk in relation to futures. He also wants to know the significant features of over-the-counter forward contracts and options, and why Nutourne Co prefers to use exchange-traded derivatives for hedging.

The non-executive director has also heard about the mark-to-market process and wants to understand the terminology involved, and how the process works, using the transaction with the Swiss customer as an example. The treasury department has supplied relevant information to answer his query. The contract specification for the CHF futures contract states that an initial margin of US$1,450 per contract will be required and a maintenance margin of US$1,360 per contract will also be required. The tick size on the contract is US$0·0001 and the tick value is US$12·50. You can assume that on the first day when Nutourne Co holds the futures contracts, the loss per contract is US$0·0011.

Required:
(c) Explain to the non-executive director how the mark-to-market process would work for the CHF futures, including the significance of the data supplied by the treasury department. Illustrate your explanation with calculations showing what would happen on the first day, using the data supplied by the treasury department. (6 marks)