Introduction

Forwards, futures, and options are collectively known as derivatives What is a derivative?
Why are derivatives useful?
They help eliminate the price risk inherent in transactions that call for future delivery of money, security, or a commodity.

Currency Futures & Options Markets

Objectives: to Understand
The nature of currency futures and options contracts and how they are used to manage currency risk & to speculate on future currency movements The difference between forward & futures contracts The difference between futures & options contracts The factors that determine the value of an option

Currency Futures

Currency futures

What is currency futures

A transferable futures contract that specifies the price at which a specified currency can be bought or sold at a future date. Currency future contracts allow investors to hedge against foreign exchange risk.

History of Currency futures

Currency futures were first created at the Chicago Mercantile Exchange (CME) in 1972 International Monetary Market (IMM) launched trading in seven currency futures on May 16, 1972.

Currency futures in India

Currency futures trading was started in Mumbai August 29, 2008. With over 300 trading members including 11 banks registered in this segment, the first day saw a very lively counter, with nearly 70,000 contracts being traded. The first trade on the NSE was by East India Securities Ltd Amongst the banks, HDFC Bank carried out the first trade. The largest trade was by Standard Chartered Bank constituting 15,000 contracts. Banks contributed 40 percent of the total gross volume.

Fundamentals of Indian currency futures

Currency futures can be traded between Indian rupees and US dollar (US$ -- INR) The trading of Indian currency futures can be done between 9 am to 5 pm The minimum size of currency futures is US$ 1000 periodically the value of the contract can be changed by RBI and SEBI The currency future can have maximum validity of 12 months The currency futures contract can be settled in cash

Trade exchanges for currency futures

There are 3 trade exchange that trades in currency futures 1. National Stock Exchange (NSE)
2. Bombay Stock Exchange (BSE) 3. Multi-Commodity Exchange (MCX)

Futures Contracts
A futures contract is an agreement to buy or sell a specified quantity of a specified asset at a certain point in the future at a price agreed upon today In the case of currencies, it is an agreement to buy/sell a specified quantity of a specific currency at a pre agreed upon exchange rate at a certain time in the future

Currency Futures
Trade on an organized exchange Futures contracts are standardized with regard to the following The asset on which you trade a futures contract
The contract size Size [A&C$100K, 62.5k, 125k, 12.5m] Euro = 125,000 , British Pound = 62,500

Delivery arrangements Daily price movement limits-limit up and limit down Position limits Mark to Market on a daily basis
Clearinghouse as counter-party High leverage instrument Daily settlement Margin requirements

Meaning
It is a derivative instrument Definition is the same as currency forward Forwards are traded over the counter Futures are traded in organised exchanges (separate financial futures exchanges) Futures are transacted through brokers Traded only in a limited number of currencies

Features
Standardised terms Clearing house Margin system Closing of futures

Standardised terms
Contract size is standardised Example: 62,500 Sterling; 125,000 Euro; 100,000 Can Dollar Chicago Mercantile exchange Date of delivery is predetermined Third Wednesday of Jan, March, April, June, July, Sept., Oct., Dec.

Clearing house
Each exchange has a clearing house Clearing house arranges for delivery of asset and payment of money Clearing house becomes the counter party to the original parties
Original parties: buyer and seller Clearing house becomes counter party to buyer (to deliver the asset) Clearing house becomes the counter party to the seller (to make payment)

A. Margin
Sometimes called the deposit, the margin represents security to cover any loss in the market value of the contract that may result from adverse price changes. This is the cost of trading in the futures market.

Margin system
There are 3 types of margins Initial margin, maintenance margin and variation margin Initial margin to be paid upfront Balance is marked to the market every day Maintenance margin to be maintained throughout the duration of the contract Variation margin (shortfall in margin) to be remitted promptly

Example for margin system

Can Dollar futures: size = 100,000 Can D Dealer buys one contract at USD 0.75/ Can D Value of contract: USD 75,000 Initial margin: 10 percent = USD 7,500 Maintenance margin: 7.5 percent = USD 5,625 Price moves upto USD 0.755/ Can D: dealer gains USD 500 (100,000 * USD 0.005) Price moves down to USD 0.740: dealer loses USD 1000 (100,000*USD 0.010)

FUTURES CONTRACTS
Available Futures Currencies:
1.) British pound 5.) Euro

2.) Canadian dollar 3.) Deutsche mark 4.) Swiss franc

6.) Japanese yen 7.) Australian dollar

Currency Futures Market

The contracts can be traded by firms or individuals through brokers on the trading floor of an exchange (e.g. Chicago Mercantile Exchange), automated trading systems (e.g. GLOBEX), or the over-thecounter market. Brokers who fulfill orders to buy or sell futures contracts typically charge a commission.

FUTURES CONTRACTS
B. Forward vs. Futures Contracts Basic differences:
1. Trading Locations 2. Regulation 3. Frequency of delivery 4. Size of contract 5. Delivery dates 6. Settlement Date 7. Quotes 8. Transaction costs 9. Margins 10. Credit risk

Futures and Forwards: A Comparison Table

Futures
Default Risk: What to Trade: The Forward/Futures Price Where to Trade: When to Trade: Liquidity Risk: Borne by Clearinghouse Standardized Agreed on at Time of Trade Then, Marked-to-Market Standardized Standardized Clearinghouse Makes it Easy to Exit Commitment Standardized Standardized Required Offset prior to delivery

Forwards
Borne by Counter-Parties Negotiable Agreed on at Time of Trade. Payment at Contract Termination Negotiable Negotiable Cannot Exit as Easily: Must Make an Entire New Contrtact Negotiable Negotiable Collateral is negotiable Delivery takes place

How Much to Trade: What Type to Trade: Margin Typical Holding Pd.

Comparison of the Forward & Futures Markets

Contract size Forward Markets Customized Futures Markets Standardized

Delivery date Participants

Security deposit Clearing operation

Customized Standardized Banks, brokers, Banks, brokers, MNCs. Public MNCs. Qualified speculation not public speculation encouraged. encouraged. Compensating Small security bank balances or deposit required. credit lines needed. Handled by Handled by individual banks exchange & brokers. clearinghouse. Daily settlements to market prices.

Comparison of the Forward & Futures Markets

Forward Markets Futures Markets Marketplace Worldwide telephone network Central exchange floor with worldwide communications.

Regulation

Self-regulating

Commodity Futures Trading Commission, National Futures Association. Mostly settled by offset. Negotiated brokerage fees.

Liquidation Transaction Costs

Mostly settled by actual delivery. Banks bid/ask spread.

Currency Futures Market

Enforced by potential arbitrage activities, the prices of currency futures are closely related to their corresponding forward rates and spot rates. Currency futures contracts are guaranteed by the exchange clearinghouse, which in turn minimizes its own credit risk by imposing margin requirements on those market participants who take a position.

Currency Futures Market

Speculators often sell currency futures when they expect the underlying currency to depreciate, and vice versa.
April 4 1. Contract to sell 500,000 pesos @ $.09/peso ($45,000) on June 17. June 17 2. Buy 500,000 pesos @ $.08/peso ($40,000) from the spot market.

3. Sell the pesos to fulfill contract. Gain $5,000.

Currency Futures Market

MNCs may purchase currency futures to hedge their foreign currency payables, or sell currency futures to hedge their receivables.
April 4 1. Expect to receive 500,000 pesos. Contract to sell 500,000 pesos @ $.09/peso on June 17. June 17 2. Receive 500,000 pesos as expected. 3. Sell the pesos at the locked-in rate.

Currency Futures Market

Holders of futures contracts can close out their positions by selling similar futures contracts. Sellers may also close out their positions by purchasing similar contracts.
January 10 1. Contract to buy A$100,000 @ $.53/A$ ($53,000) on March 19. February 15

March 19
3. Incurs $3000 loss from offsetting positions in futures contracts.

2. Contract to sell A$100,000 @ $.50/A$ ($50,000) on March 19.

FUTURES CONTRACTS

Maximum price movements

Contracts set to a daily price limit restricting maximum daily price movements. If limit is reached, a margin call may be necessary to maintain a minimum margin Transaction costs: payment of commission to a trader Leverage is high Initial margin required is relatively low (e.g. less than .02% of sterling contract value).

Currency Futures Market

Currency futures contracts specify a standard volume of a particular currency to be exchanged on a specific settlement date. They are used by MNCs to hedge their currency positions, and by speculators who hope to capitalize on their expectations of exchange rate movements.

A. Forward vs. Futures Markets (continued)

Assume initial margin was $1400 and maintenance margin is $1100. A has already sustained a loss of $150 so the value of the margin account is $1250. If the price drops the following day another $200 loss is registered. The value of the margin account is down to $1050, below the maintenance margin. This means A will be required to bring the margin account back to $1400.

B. Speculating
Assume a speculator buys a JUNE contract at $459.40 by depositing the required margin of $3,500. One gold contract = 100 troy ounces, it has a market value of $45,940. Hence margin is: $3,500/45,940 = 7.62%

B. Speculating (continued)
1. If Gold contract goes up to $500/ounce by May, then:
Profit = $500 - $459.40 = $40.60*100 Return = $4060/$3500 = 116%

2. If Gold contract goes down to $410.00/ounce by May, then:

Profit = $410 - $459.40 = - 49.40*100 - 4940/3500 = -1.41 or Return = 141%

B. Speculating (continued)
3. Assume the speculator shorts by selling the JUNE contract. If price decreases then:
Receives: (459.40 - 410) = 49.40*100 Profit: $4940 Return: 4940/3500 = +141%

FUTURES CONTRACTS
Advantages of futures: Disadvantages of futures:

1.) Smaller contract size 2.) Easy liquidation 3.) Well- organized and stable market.

1.) Limited to 7 currencies 2.) Limited dates of delivery 3.) Rigid contract sizes.

B. Purposes of Futures Markets

Meets the needs of three groups of futures market users:
1. Those who wish to discover information about future prices of commodities (suppliers) 2. Those who wish to speculate (speculators) 3. Those who wish to transfer risk to some other party (hedgers)

Currency Futures
Performance Bond or Initial Margin: The customer must put up funds to guarantee the fulfillment of the contract - cash, letter of credit, Treasuries. Maintenance Performance Bond or Margin: The minimum amount the performance bond can fall to before being fully replenished. Mark-to-the-market: A daily settlement procedure that marks profits or losses incurred on the futures to the customers margin account.

Sample Performance Bond Requirements From the CME, 15 March 2000

Currency Futures Australian Dollar British Pound Canadian Dollar Deutsche Mark Euro Initial Maintenance $1,317 $975 $1,620 $1,200 $642 $475 $1,249 $925 $2,430 $1,800

Long and Short Exposures

A person that is, for example, long the pound, has pound denominated assets that exceed in value their pound denominated liabilities. A person that is short the pound, has pound denominated liabilities that exceed in value their pound denominated assets.

 To hedge a foreign exchange exposure, the customer assumes a position in the opposite direction of the exposure. For example, if the customer is long the pound, they would short the futures market. A customer that is long in the futures market is betting on an increase in the value of the currency, whereas with a short position they are betting on a decrease in the value of the currency.

Hedging With a Currency Future

How an Order is Executed (Figure from the CME)

Corporate Use of Currency Futures

Hedge open positions in foreign currencies by buying/selling currency futures Foreign currency cash inflows
Risk: domestic currency may appreciate Strategy: sell foreign currency in the futures market at the futures exchange rate (Short)

Foreign currency cash outflows

Risk: domestic currency may depreciate Strategy: buy foreign currency in the futures market at the futures exchange rate (Long)

A. Reading Futures Prices (Contracts)

1. 2. 3. 4. 5. The Product The Exchange Size of the Contract Method of Valuing Contract The delivery month

A. Reading Futures Prices (Prices)

1. 2. 3. 4. Opening High Low Settlement

Price at which the contracts are settled at the close of trading for the day Typically the last trading price for the day

B. The Basis
...is the current cash price of a particular commodity minus the price of a futures contract for the same commodity.
BASIS = CURRENT CASH PRICE FP FP future price

B. The Basis (continued)

Example: Gold Prices and the Basis: 12/16/03
Basis Cash DEC MAR 04 JUN SEP DEC MAR 05 $441.00 441.50 449.20 459.40 469.90 480.70 491.80 -.50 - $7.70 -$17.90 -$28.40 -$39.20 -$50.30

B. The Basis (continued)

Prices
Cash Basis Futures

Present

Time Maturity

B. The Basis (continued)

1. Relation between Cash & Futures 2. Spreads The difference between two futures prices (same type of contract) at two different points in time

C. Spreading
Combining two or more different contracts into one investment position that offers the potential for generating a modest profit

C. Spreading (continued)
Ex: Buy 1 Corn contract at 258
Sell (short) 1 Corn contract at 270 Close out by:
1. Selling the long contract at 264 2. Buy a short contract at 273

Profit:
Long: 264-258 = 6 Short: 270-273 = -3 Profit: = 6 -3 = 3 3 * 5000 bu. = $150 Net

Currency Options

CURRENCY OPTIONS
Definition: a contract from a writer ( the seller) that gives the right not the obligation to the holder (the buyer) to buy or sell a standard amount of an available currency at a fixed exchange rate for a fixed time period.

CURRENCY OPTIONS
Types of Currency Options: a. American exercise date may occur any time up to the expiration date. b. European exercise date occurs only at the expiration date.

CURRENCY OPTIONS
Exercise Price a. Sometimes known as the strike price. b. the exchange rate at which the option holder can buy or sell the contracted currency.

CURRENCY OPTIONS
Status of an option a. In-the-money
Call: Put: Spot > strike Spot < strike Spot < strike Spot > strike

b. c.

Out-of-the-money
Call: Put:

At-the-money
Spot = the strike

CURRENCY OPTIONS
The premium: the price of an
option that the writer charges the buyer.

CURRENCY OPTIONS
When to Use Currency Options 1. For the firm hedging foreign exchange risk a. With sizable unrealized gains. b. With foreign currency flows forthcoming. 2. For speculators - profit from favorable exchange rate changes.

CURRENCY OPTIONS
Option Pricing and Valuation
1. Value of an option equals a. Intrinsic value

b. Time value
2. 3. Intrinsic Value - the amount in-the-money Time Value - the amount the option is in excess of its intrinsic value.

CURRENCY OPTIONS
2. Intrinsic Value the amount in-the-money
3. Time Value the amount the option is in excess of its intrinsic value.

CURRENCY OPTIONS
4. Other factors affecting the value of an option a. value rises with longer time to expiration. b. value rises when greater volatility in the exchange rate.
5. Value is complicated by both the home and foreign interest rates.

CURRENCY OPTIONS
D. Using Forward or Futures Contracts: Forward and futures contracts are more suitable for hedging a known amount of foreign currency flow.

CURRENCY OPTIONS
E. Market Structure 1. Location a. Organized Exchanges b. Over-the-counter 1.) Two levels retail and wholesale

Currency Options
A currency option is a contract that gives the owner the right, but not the obligation, to buy or sell a currency at a specified price at or during a given time. Call Option: An option that gives the owner the right to buy a currency. Put Option: An option that gives the owner the right to sell a currency. How are currency options simultaneously both put & call options?

Currency Options
American Option: An option that can be exercised any time before or on the expiration date. European Option: An option that can only be exercised on the expiration date.

Currency Options
Exercise or Strike Price: The price (spot exchange rate) at which the option may be exercised. Option Premium: The amount that must be paid to purchase the option contract. Break-Even: The point at which exercising the option exactly matches the premium paid.

Currency Options
If the spot rate has not yet reached the exercise price [S<X], the option cannot be exercised and is said to be out of the money. If the spot rate equals the exercise price [S=X], the option is said to be at the money. If the spot rate has surpassed the exercise price [S>X], the option is said to be in the money.

Call Option
The holder of a call option expects the underlying currency to appreciate in value. Consider 4 call options on the euro, with a strike price of 92 ($/) and a premium of 0.94 (both cents per ). The face amount of a euro option is 62,500. The total premium is: $0.0094462,500=$2,350.

Call Option: Hypothetical Pay-Off

Profit Payoff Profile

$1,400
Break-Even

92 0

92.5

92.94 Spot Rate

88.15
-$1,100 -$2,350 Out-ofLoss the-money At In-the-money

93.5

Put Option
The holder of a put option expects the underlying currency to depreciate in value. Consider 8 put options on the euro with a strike of 90 ($/) and a premium of 1.95 (both cents per ). The face amount of a euro option is 62,500. The total premium is: $0.0195862,500=$9,750.

Profit

Put Option: Hypothetical payoff at a spot rate of 88.15 Payoff Profile

Break-Even

88.05 0 -$500

90

88.15

Spot Rate

-$9,750
Loss In-the-money At Out-of-the-money

Option Pricing & Valuation

Value of a call option at maturity
S-X, where S-X>0 [otherwise value is zero], = Intrinsic value

Value of a call option prior to maturity

Intrinsic value + Time value

Time Value is a function of: Time to expiration, volatility, domestic & foreign interest rate differentials

Comparing Futures and Options

The value of a futures contract at maturity (date t+n) to purchase one unit of foreign currency will be:

Value

Zt,t+n

St+n

The value of the futures contract is zero at maturity if the spot rate at maturity is equal to the current futures rate.

Consider now the value of an option to purchase one unit of foreign currency at that same price (i.e. a call option with a strike price X equal to Zt,t+n):

Value

St+n

The value of the call option begins increasing when the exchange rate becomes larger than the exercise price - when the option becomes in the money.

But were missing something. While a futures contract has an expected return of zero, the value of the option looks like it is always positive

Value

St+n

Hence, anyone taking the opposite side of the transaction (writing the option) will demand a price (C) that makes the expected value zero once again:

Value

St+n

Regardless of the outcome, the options value is reduced everywhere by the certain payment of its price.

The value of an option to sell one unit of foreign currency (a put option) at a strike price equal to a corresponding futures contract price will have similar properties:

Value

St+n

Foreign Currency Swaps

A currency swap is an exchange of debt-service obligations denominated in one currency for the service on an agreed upon principal amount of debt denominated in another currency.

A currency swap is often the low-cost way of obtaining a liability in a currency in which a firm has difficulty borrowing. A pair of firms simply borrow in currencies they have relative advantage borrowing in, and then trade the obligations of their respective loans, thereby effectively borrowing in their desired currency.

Dell computers would like to borrow in Swiss Francs to hedge its ongoing cash flows from that country

Dell

SFr

Nestle would like to borrow in Dollars to hedge its sales to the U.S...

Dell

Nestle

SFr

But both firms are relatively unknown to the respective credit markets, and thus anticipate unfavorable borrowing terms.

Dell

Nestle

SFr

But an investment bank comes along and suggests that each borrow in the credit markets that are comfortable with them...

Dell

Nestle

I-Bank

SFr

and then the investment bank will give them sufficient cash flows each period to cover the obligations of these loans...

Dell

Nestle

$ $ I-Bank

Sfr SFr

in return for making the payments in the foreign currency that exactly match the other firms obligations.

Dell Sfr $ $ I-Bank $ Sfr

Nestle

SFr

In other words, the swap effectively completes the market. Giving each firm access to the foreign debt market at reasonable terms.

Dell Sfr $ $ I-Bank $ Sfr

Nestle

SFr

The All-In Cost of a Swap

Clearly, the relative magnitudes of the respective payments determine each firms ultimate cost of borrowing. This cost is called the all-in cost. It is the effective interest rate the firm ends up paying on the money that it raised. It is the discount rate that equates the NPV of future interest and principal payments to the net proceeds received by the issuer.

IRR

Swaps vs. Forwards

Notice that on a one-year loan, a currency swap is no different than a one-year forward contract.
In fact, a currency swap can really be thought of as a firm taking a domestic currency loan and purchasing a series of forward contracts to convert the payments into known foreign currency obligations. The implied forward rates need not equal the actual forward rates, but taken as a whole, should resemble an average forward rate over the term of the loan.

Comparative Borrowing Advantage

Swaps only exist because there are market imperfections. If firms can access foreign and domestic debt markets at equal cost, clearly swaps are redundant. One important reason that currency swaps are so useful is that firms engaged in a swap need not each have an absolute borrowing advantage in the currency in which they borrow vis-a-vis the counterparty.
In fact, it is quite likely that Nestle has better access to both the U.S. and Swiss debt markets than Dell. Comparative Advantage

Key Points
1. A firm wishing to hedge foreign currency exposure has five main financial hedging tools which facilitate doing so: forward contracts, money market hedges, futures contracts, foreign currency options, and currency swaps.
2. Forward contracts have the benefit of being tailor-made, with quantities and timing matched to the needs of the firm. Forward contracts are typically quite costly over longer horizons, as the market becomes highly illiquid. 3. Money market hedges are equally flexible, but depend on a firm having equal access to domestic and foreign credit markets.

Key Points
4. Futures contracts, traded on highly liquid exchanges, have the benefit that they can be sold on the market before the maturity date. As a result, futures contracts are particularly useful for hedging exposures whose maturity is uncertain. 5. On the other hand, futures contracts are standardized in terms of timing and quantities, and therefore they rarely offer a perfect hedge. 6. Options contracts allow a firm to hedge against movements in one direction while retaining exposure in the other.

7. Options are particularly useful in hedging exposures that are highly uncertain with respect to timing and magnitude.

Key Points
8. Currency swaps offer firms the ability to borrow against long-term foreign currency exposures when access to foreign debt markets is costly.
9. Currency swaps converts a domestic liability into a foreign one via what are effectively a bundle of long-dated forward contracts between two firms. 10. The effective cost of a currency swap is its all-in cost the effective rate of interest that the firm ends up paying on the constructed foreign liability. 11. Currency swaps require only that firms have differential relative - rather than absolute - advantage in accessing debt markets.

Currency Options Market

Currency options provide the right to purchase or sell currencies at specified prices. They are classified as calls or puts. Standardized options are traded on exchanges through brokers. Customized options offered by brokerage firms and commercial banks are traded in the over-the-counter market.

Currency Call Options

A currency call option grants the holder the right to buy a specific currency at a specific price (called the exercise or strike price) within a specific period of time. A call option is in the money if exchange rate > strike price, at the money if exchange rate = strike price, out of the money if exchange rate < strike price.

Currency Call Options

Option owners can sell or exercise their options, or let their options expire. Call option premiums will be higher when:
(spot price strike price) is larger; the time to expiration date is longer; and the variability of the currency is greater.

Firms may purchase currency call options to hedge payables, project bidding, or target bidding.

Currency Call Options

Speculators may purchase call options on a currency that they expect to appreciate.
Profit = selling (spot) price option premium buying (strike) price At breakeven, profit = 0.

They may also sell (write) call options on a currency that they expect to depreciate.
Profit = option premium buying (spot) price + selling (strike) price

Currency Put Options

A currency put option grants the holder the right to sell a specific currency at a specific price (the strike price) within a specific period of time. A put option is in the money if exchange rate < strike price, at the money if exchange rate = strike price, out of the money if exchange rate > strike price.

Currency Put Options

Put option premiums will be higher when:
(strike price spot rate) is larger; the time to expiration date is longer; and the variability of the currency is greater.

Firms may purchase currency put options to hedge future receivables.

Currency Put Options

Speculators may purchase put options on a currency that they expect to depreciate.
Profit = selling (strike) price buying price option premium

They may also sell (write) put options on a currency that they expect to appreciate.
Profit = option premium + selling price buying (strike) price

Currency Put Options

One possible speculative strategy for volatile currencies is to purchase both a put option and a call option at the same exercise price. This is called a straddle. By purchasing both options, the speculator may gain if the currency moves substantially in either direction, or if it moves in one direction followed by the other.

Efficiency of Currency Futures and Options

If foreign exchange markets are efficient, speculation in the currency futures and options markets should not consistently generate abnormally large profits. http://www.ino.com/ Currency quotes

Contingency Graphs for Currency Options

For Buyer of Call Option Strike price Premium = $1.50 = $ .02 For Seller of Call Option Strike price Premium = $1.50 = $ .02

Net Profit per Unit +$.04 +$.02 0 $1.46

Net Profit per Unit +$.04 +$.02 0 $1.50 $1.54 Future Spot Rate $1.46 $1.50 $1.54

Future Spot Rate

$.02

$.02 $.04

$.04

Contingency Graphs for Currency Options

For Buyer of Put Option Strike price Premium = $1.50 = $ .03 For Seller of Put Option Strike price Premium = $1.50 = $ .03

Net Profit per Unit +$.04 +$.02 Futur e Spot Rate $1.46 $1.50 $1.54

Net Profit per Unit +$.04 +$.02 0 $1.46

0 $.02 $.04

$1.50

$.02 $.04

$1.54 Future Spot Rate

Closing of futures
Forward contract is settled on delivery date by delivery of asset and payment of money Futures can be closed:
Exchange of asset and cash on delivery date Cash settlement through a reverse trade on any day

Hedgers prefer exchange of asset; speculators prefer cash settlement

Hedging with currency futures

Importer buys the required currency futures contract Thus locks in a price for the purchase of foreign currency Hedges (avoids) risk due to exchange rate fluctuations Exporter sells the expected currency futures contract locks in a price for the sale Hedges risk due to exchange rate fluctuations

Imperfections in hedging with currency futures

Maturity mismatch
Mismatch in maturity date of futures contract and date of cash transaction

Size mismatch
Mismatch between size of futures contract and size of cash transaction

Maturity and size mismatch Hedging with currency futures may not result in perfect hedge

Speculation with currency futures

Fluctuations in exchange rates used to reap speculative profits Spot rate: USD = Rs.46.40 1 month future rate: USD = Rs.46.60 Expected spot rate on maturity: USD = Rs. 46.75 Dealer buys one currency futures contract of size 100,000 USD Value of contract: Rs.46,60,000; Margin deposit: Rs.4,66,000 If exchange rate move up to Rs.46.75 as anticipated, dealer gains profit of Rs.15,000 (100,000* Re.0.15) Rate of return: (15000/466,000)(12)(100) = 38.63%

Speculation through cash transaction

Spot rate: USD = Rs.46.40 Dealer buys 100,000 USD at spot rate Investment required: Rs.46,40,000 If exchange rate moves upto Rs.46.75 within a month, dealer gains profit of Rs.35,000 (100,000* Re.0.35) Rate of return: (35000/46,40,000)(12)(100) = 9.05% Speculation with currency futures - larger returns on smaller investment