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Problem: An investor in the US has invested £10 million in the shares of a bank in the UK. The investor has used FTSE stock index futures that will expire in three months' time to hedge the stock market risk on the investment. Assume that one month ago, the price of the futures was 2047.84 with a multiplier of £10 and the exchange rate of one pound to the US dollar was $1.5894/£. Also assume that currently, the shares of the bank in the UK which the investor bought is worth £9,960,000, the FTSE stock index futures is 2035.75 and the exchange rate of one pound to the dollar is $1.5596/£. Further assume that the amount that will be covered by the futures contract that the investor will trade will not exceed the value of the portfolio and that the beta of the shares of the bank is 1.00.
Required:
(i) Would the investor have bought or sold futures contracts a month ago in order to hedge the value of his portfolio in the UK against stock market risk? Explain why. How many futures contracts would the investor have traded in order to hedge the value of the portfolio against stock market risk?
(ii) Calculate the net profit or loss (in pounds and dollars) that the investor would have realised on the investment in the shares over the last one month.
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