14-2-1 Futures Contracts

LO-2

Describe different ways to hedge exchange rate risk.

hedging

using currency derivatives to reduce potential transaction, translation, and economic risks of currency movements that could lead to losses for a firm or investor

speculators

attempts in currencies and currency derivatives to earn profits from trading them and help to make prices efficient

currency futures contracts

standardized agreements to buy or sell a specified amount of currency at a date in the future at a predetermined price

long position

buying a currency in a currency futures contract and profiting on an increase in the value of the currency over time

short position

selling a currency in a currency futures contract and profiting on a decrease in the value of the currency over time

organized exchanges

the trading of futures contracts in major currencies and offering price transparency and efficiency in addition to elimination of counterparty risk due to guaranteed payments on contacts

marked-to-market

futures contracts in which gains (losses) are earned (paid) in cash at the end of each trading day

margin

small commitment fee needed to purchase a futures contract

14-2 Hedging Forex Risk with Derivatives

Firms and investors exposed to short- and long-term foreign exchange (forex) risks can hedge them using various derivative contracts. Hedging intends to reduce potential transaction, translation, and economic risks of currency movements that could lead to volatile cash flows and losses. It is important to note that speculation is the opposite of hedging. Speculators attempt to earn profits from trading in currencies or currency derivatives. Speculators can be instrumental in aggressively pricing currency contracts that makes the forex market efficient when prices reflect all available information. Unlike speculators, hedgers seek to reduce forex risk and, therefore, are not engaged in efficiently pricing currency contracts. Hedges are similar to insurance contracts where a premium is paid to protect against potential losses. Forex risks can be hedged through the use of several different contracts including futures, forwards, options, and swaps.

14-2-1 Futures Contracts

Currency futures contracts are standardized agreements to buy or sell a specified amount of currency on a particular date in the future at a predetermined price. They are similar to debt, equity, and commodity futures contracts. The buyer agrees to take delivery of a set amount of the currency on the future date at the set price and is considered to be in a long position due to profiting on an increase in the value of the currency. The seller agrees to make delivery of the currency according to the agreed terms and is considered to be in a short position due to profiting on a decrease in the value of the currency. Organized exchanges, such as the Chicago Mercantile Exchange (CME), trade selected futures contracts in major currencies, for example:

• EUR (quoted as the number of U.S. dollars per one euro, EUR-to-USD) • GBP (U.S. dollars per British pound) • CHF (U.S. dollars per Swiss franc) • AUD (U.S. dollars per Australian dollar) • CAD (U.S. dollars per Canadian dollar) • RP (British pounds per euro) • RF (Swiss francs per euro)

Other important forex derivative markets are the pan-European Euronext and Tokyo Financial Exchange.2

There are some common rules in trading currency futures contracts. For example, forex derivatives specify the third Wednesday in March, June, September, and December as the expiration dates for contracts. Futures contracts are marked-to-market daily, which means that gains and losses in futures positions are reconciled at the close of trading each day by the exchange organization. At that time, buyers and sellers must pay them immediately in cash. Another interesting feature of futures contracts is that buyers and sellers can close them at any time prior to the delivery date. The flexibility to unwind forex hedges when they are no longer needed is a convenient advantage. Organized exchanges offer the further advantages of price transparency and efficiency, as well as the elimination of counterparty credit risk (e.g., the possibility that a buyer will not buy a security later that you sold at a previously agreed upon price). The exchange clearinghouse manages all gains and losses and guarantees payments on contracts related to counterparty credit risk. Finally, contracts can be purchased for a small commitment fee known as the margin. This low cost of futures contracts makes them very affordable to use as a way to manage exchange rate and other market risks. If losses occur causing a market

AP Images/M. Spencer Green

The Chicago Mercantile Exchange is just one of the organized exchanges trading in major currencies.

participant’s balance to fall below the maintenance margin at the end of the trading day, a margin call occurs that requires the customer to replenish the margin account.

14-2-1a Example of a Forex Futures Hedge. Suppose a U.S. firm exports its products to European countries and is paid in euros at a later date. If it sells 100,000 units at 1,000 euros each, the revenues it will later receive will equal €1 million. If the current spot EURto-USD exchange rate increases from 1.50 to 1.70 between the time of sale and time of payment (i.e., the cost of one euro increases from $1.50 to $1.70), the €1 million will increase from $1.5 million to $1.7 million for a gain of $200,000. Here the weakening dollar actually increases the revenues of the U.S. exporting firm.

What if the dollar strengthens against the euro? If the EUR-to-USD spot exchange rate falls to 1.30 over the same period, the firm could lose $200,000 in revenues. To hedge this forex transaction risk, the firm can short EUR futures contracts on the CME. As the EURto-USD spot exchange rate declines, the futures price will also fall, but not exactly as much as the spot rate. If the firm sells short a EUR futures contract for 1.4815 and later buys the contract for 1.2850, given that each contract represents €125,000 such that 1 point = $.0001 per euro = $12.50 per contract, the gain would be as follows: ($1.4815 − $1.2850) × €125,000 = $24,562.50.3 Futures and spot prices are typically not the same. In this example, to hedge a potential loss of $200,000 in revenues, the firm would need to sell eight EUR futures contracts. This would result in a gain of $24,562.50 × 8 = $196,500 on the short EUR futures position that offsets all but $3,500 in lost revenues.

Exhibit 14.2 summarizes the gains and losses on futures contracts. The price of a futures contract to buy (long position) and sell (short position) is denoted at P0. If the difference between the sell and buy prices is positive, the payoff on the futures contract is a gain and the converse if the difference is negative. Long positions earn gains as prices rise over time, while short positions earn gains as prices fall. Hedging involves using a futures position (i.e., buying or selling futures contracts) in an attempt to offset losses in the cash position (i.e., the sale of products to Europe by the U.S. exporter in the above example). Speculating, in contrast, implies holding unhedged futures positions with no cash position.

margin call

losses that are incurred and that cause the participant’s balance to fall below the maintenance margin at the end of the trading day