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INT FINANCE
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Futures Contracts
Similar to forward contracts. Two counterparties agree to exchange currencies of a fixed amount at a predetermined exchange rate at some fixed future date. Used to speculate on or to hedge FX risk.
Exchange
Traded on exchanges such as the Chicago Mercantile Exchange (CME) rather than over-the-counter (OTC) in the interbank market. Standardizations enhance liquidity with specific delivery dates and lot sizes.
Credit Risk and Settlement
Futures contracts have lower credit risk, margin requirements, and daily settlement (mark-to-market) than forward contracts. Most futures contracts are closed out with offsetting trades prior to the delivery date.
CME Euro FX Futures
Example: Euro futures contracts Euro vs US with a contract size of 125,000 Euro. Initial performance bond for speculators/non-members: US$2640 per contract. For hedgers/members: US$2400 per contract. Maintenance performance bond: US$2400 per contract.
Daily Cash Flows
Suppose a US exporter shorts 30 futures contracts of Euro at the prevailing futures price of US$106.61. If we observe prices of this futures contract in the next 3 days as 106.68, 106.92, and 106.56, calculate the daily cash flows and accumulated gain/loss from the futures contract and determine the hedging of the company's FX risk.
Cash Flows Scenario 2
If the prices observed over the next 3 days are 106.59, 106.65, and 106.70, calculate the daily cash flows to determine if the company's FX risk is hedged.
Forward Contracts vs. Futures Contracts
Compare the cash flows and risk hedging if the company had shorted forward contracts rather than futures contracts.
Daily Mark-to-Market
Daily mark-to-market ensures that loss/gain will not be accumulated into a large amount. The bond requirement guarantees a minimum payment of US$2400 per contract.
Client Order Cancellation
If the client cancels the order on the next day, determine the appropriate action, such as entering into offsetting futures contracts or a long futures contract to hedge against foreign currency payable in the future.
Market Players and Motives
Hedgers hedge their cash flows and asset values. FX exposures are managed by arbitrageurs who exploit any price inefficiencies in the market.
Client cancels the order on the next day
If the client cancels the order on the next day, the company can enter into offsetting futures contracts to mitigate the risk.
Hedgers
Hedgers use futures contracts to hedge their cash flows and asset values in order to manage FX exposures.
Arbitrageurs
Arbitrageurs exploit any departure from Interest Rate Parity (IRP) and profit from trading in money markets, interest rate differentials, spot, and futures contracts.
Speculators
Speculators seek exposure in the FX market and trade on their expectations of FX rate movements.
Market Makers/Dealers
Market makers and dealers profit from bid-ask spreads by providing liquidity and facilitating short-term demand/supply in the market.
Currency Options
In contrast to forward and futures contracts, currency options give the buyer the right but not the obligation to exchange currencies.
Buyer of Currency Option
The buyer of a currency option has the right but not the obligation to buy or sell the contracted currency at a pre-specified FX rate (exercise price) and on a pre-specified date (expiration date).
Writer of Currency Option
The writer or seller of a currency option is at the mercy of the buyer and is obliged to fulfill whatever choice the buyer makes. The writer receives an upfront cash premium from the buyer, which is the price of the option.
American Option
An American currency option can be exercised at any time up to the expiration date.
European Option
A European currency option can only be exercised at the expiration date.
In-the-Money Option
An option that is profitable to exercise at the current spot FX rate is in-the-money.
Out-of-the-Money Option
An option that is not profitable to exercise at the current spot FX rate is out-of-the-money.
European option buyer will only exercise option if it is in the money at expiration.
The buyer of a European option will only exercise the option if the prevailing spot FX rate at expiration is favorable (higher for a call option, lower for a put option) compared to the strike price.
Exchange-Traded Currency Options
Similar to futures contracts, currency options are exchange-traded. For example, options against the US dollar are traded in 10,000 unit contracts, and the option premium is in US cents per unit in exchanges like PHLX and CME.
Call Option Payoff Patterns
If a European 730 call option (strike rate US0.730) is trading at 103 cents and the spot FX rate turns out to be US0.720, the call option buyer will not exercise. If the spot FX rate is US0.740, the call option buyer will exercise. The breakeven point is the strike price plus the premium.
Hedging with Call Options
A US company can use a call option to hedge against the FX risk of a C50000 payable in 3 months. The net payoff pattern will depend on the difference between the spot rate at expiration and the strike price. Hedging with call options differs from forward or futures contracts in terms of the premium paid and the potential loss being limited to the premium.
Put Option Payoff Patterns
For a European 735 put option (strike rate US0.735) trading at 151 cents, if the spot FX rate is US0.725, the put option buyer will exercise. If the spot FX rate is US0.745, the put option buyer will not exercise. The breakeven point is the strike price minus the premium.
Hedging with Put Options
A US company can use a put option to hedge against the FX risk of a C50000 receivable in 6 months. The net payoff pattern will depend on the difference between the spot rate at expiration and the strike price. Hedging with put options differs from forward or futures contracts in terms of the premium paid and the potential loss being limited to the premium.
Plain Vanilla Interest Rate Swaps
In plain vanilla interest rate swaps, two parties exchange fixed versus floating interest payments. The swap buyer agrees to pay the swap seller a pre-determined fixed rate, while receiving a floating interest rate in return.
Hedging with a forward or futures contract
Locks in the future exchange rate for a specified amount of currency
