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Veblen: Discuss Derivatives, Future Contracts to Hedge Currency and Interest Rate Risk

Jim Herman is the treasurer of the midsized corporation, Veblen International. The firm manufactures various plastic components used in the computer hardware industry. When the firm opened up, it initially did business in the Midwest region of the United States but now sells its components to customers in other countries. Mr. Herman request that you report and discuss some issues relating to futures contracts, which might be used in the future by the firm to hedge currency risk and interest rate risk. Some of the issues he needs to know more about include the following:

* possible benefits to the firm in using the futures markets
* functions and importance of forward markets
* concept of daily settlement
* regulatory responsibilities of the National Futures Association and the Commodity Futures Trading Commission

Mr. Herman was enlightened by the information you provided on risk reduction, futures, and forwards contracts but would like to learn if there are alternative methods available for dealing with currency risks. He requests that you research material from the Library and/or the Internet to construct a memo on the differences between taking a long position in a futures contract and taking a short position in a futures contract. Also, give an example of a business scenario in which it would be appropriate to use each of the contracts. If you were going to receive 100,000 Japanese yen in 6 months and the current exchange rate was 10 yen equals 1 U.S. dollar, how many yen would you sell or buy in the forward market? Be sure to cite all references using the appropriate format.

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* Possible benefits to the firm in using the futures markets

By effectively using the currency futures, Veblen international will be able to mitigate the exchange rate related risks during to unfavorable exchange rate movements. As there is a significant time lag between the delivery of goods and receipt of payments, it is often seen that unfavorable exchange rate movements between the currencies of two countries eradicates the profitability of exporting firm. Therefore, by utilizing futures contracts, Veblen can lock in the exchange rate and thus, protect itself from exchange rate related risks.

* Functions and importance of forward markets

It is basically over-the-counter financial market in contracts for future delivery. In its simplest form, it is a trade that is agreed to at one point in time but will take place at some later time. For example, two parties might agree today to exchange 500,000 barrels of crude oil for USD 42.08 a barrel three months from today. Forwards are a convenient vehicle for hedging or speculation. For example, Veblen can conveniently hedge its cost of various raw materials by purchasing these commodities several months forward. The hedge eliminates price exposure, and it doesn't require an initial outlay of funds to purchase those raw materials.

Therefore, the forward market allows Veblen to protect itself from price rise in commodities used in production in the future period.

Reference: http://www.riskglossary.com/link/forward.htm

* Concept of daily settlement

Daily settlement can be defined as mark t0 market of futures contract. It is a credit safeguard built into the futures trading system that requires traders to realize any ...

Solution Summary

The solution gives answers to derivatives, future contracts to hedge currency and interest rate risk in 1088 words.