Role of Currency Futures in Risk Management

Table of contents

Executive Summary

Table of contents

List of figures

1. Introduction

2. Literature Review
2.1 Why to hedge with Currency Futures?
2.2 Currency Futures Outline and Scope

3. Application
3.1 Hedging with Currency Futures
3.2 Currency Futures: Case Studies

4. Conclusion

References

Appendices

List of figures

Figure 1 Currency volatility USTW$ Index 1974 -2010, Source: Bloomberg (2011)

Figure 2 Comparison ofFutures and Forward contracs, Source: Madura (2010)

Figure 3 Currency Futures contracts traded in the CME, Source: Madura (2010)

Figure 4 Cash Flows in the futures contract

Figure 5 Spot price GBP-USD during 21th March 2011, Source: Bloomberg (2011)

Figure 6 One year GBP-USD spot and forward rate, Source: Bloomberg (2011)

Figure 7 Expectation of GBP depreciation against USD in the next years, Source: Bloomberg (2011)

Figure 8 Range of expectations of GBP against USD, Source: Bloomberg (2011)

Executive Summary

This paper examines the role of currency futures contracts in risk management. The reader can find a brief introduction to the history of foreign exchange markets and under which cir­cumstances the markets appeared in 1970s. Furthermore, the question of why to use curren­cy futures to hedge risk exposures is answered. A more in-depth analysis of how currency futures contracts are structured, especially their specifications and their advantages and limi­tations for the user. Moreover this paper addresses issue of how currency futures are used by participants. Finally, a brief use of currency futures is also examined with a case study on the FX-market.

1. Introduction

“Financialfutures (currencyfutures) are the most significantfinancial innovation on the last twenty years”

This statement in 1986 from Merton H. Miller could indicate the importance of currency futures contracts nowadays.

In the first seven decades of the 20th century futures market was just for a small number of businesses that traded almost futures on agricultural products. In 1971 futures based on fi­nancial instruments where introduced in the Chicago Mercantile Exchange (CME). So the first financial based futures which was a foreign exchange futures contract was launched at the International Monetary Market (IMM), an independent division of CME which is specia­lized in futures trade. This innovation opened the futures market to participants who never participated before in the futures market such as corporate treasurers, multinational corpora­tions, pension fund managers and financiers. (Melamed, 2003)

The management of currency risk (also known as foreign exchange risk or FX risk) became for companies more and more important in the last years. According to Albuquerque (2007) the globalization of goods and capital markets means that an increasing number of firms have to make decisions about hedging their foreign exchange exposures. This need is streng­then by strongly volatile foreign exchange markets. The higher volatility results from the higher speculative amounts, traded on foreign exchange markets, which are not based on operative underlying business transactions. Because of speculators, the real trading volume is exceeding.

Furthermore, it is to state that the Bretton Woods Agreement from 1945 which regulated fixed exchange rates between most Western countries and their currencies was dropped in 1971. This opened the door to free float currencies which logically increased volatility. In response to this multinational firms take foreign exchange risk management very serious. (Chang and Pong Wong, 2003)

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Figure 1: Currency volatility USTW$ Index 1974 - 2010

As we can see in figure 1 the volatility for the USTW$ Index has fluctuating over time. The USTW$ Index is the major currency Index which is a weighted average of the foreign ex­change values of the US dollar against a subset of the broad Index currencies that circulate widely outside the country of issue.

The exchange rate volatility characterizes the resulting system that increased the need for foreign exchange instruments capable of protecting operating capital from the risk of ad­verse exchange rate movements. (Chalupa, 1982) Thus, could be seen as an additional effect which gave the necessity to hedge against currency fluctuation risk within the public futures market. Other developments and technologies made it possible for news and information to broadcast rapidly around the world. Additionally, the effect of growth and interrelationship of private sector industries strengthen the need for international hedge by futures. Markets became more interdependent because of globalization and global integration in trade and business. (Madura, 2010) The first currency futures contracts that were available at CME in 1972 were British pounds, Deutsche mark, Canadian dollars, French francs, Japanese yen, Mexican Pesos and Swiss franc. (Melamed, 2003)

2. Literature Review

2.1 Why to hedge with Currency Futures?

According to Chan and Lien (2006) futures markets provide a tool for risk management and price discovery. The price discovery function arises because spot market participants can observe the information revealed by the futures prices and adjust their positions. Corpora­tions need to hedge their businesses to avoid losses. International active companies are fac­ing foreign exchange risks, if they have liabilities booked in a foreign currency. As foreign exchange markets have grown, more need arises for companies, investors and bans to hedge their foreign exchange risks from their foreign exchange transactions. According to Ghosh (1996) corporations have to deal with three main currency risk exposures. Firstly the trans­action risk that refers to the risk of the future cash flows in a foreign currency which will be affected by the exchange rate fluctuations. This situation can occur if a company signs an agreement now and the payment will be in foreign currency in the future. Secondly, the eco­nomic risk which is characterized by the variability of the present value of the future cash flows inducted by the exchange rate changes. Lastly, the translation risk is more an account­ing issue and which will arise from changing exchange rates while translating the firm’s consolidated financial statement. Generally, these risk exposures can be hedge by different ways. In literature we distinguish between internal^[1] and external methods. (Madura, 2010) Internally, Currency risk can be hedged using either systematic instruments, such as futures or asymmetric instruments, such as options. (Bhargava and Brooks, 2002) In this paper we will concentrate on the external methods, which are using financial derivatives to hedge risk, especially on currency futures. Furthermore Lien and Yang (2006) state that it is well docu­mented in the literature that currency risk can be minimized through futures hedging.

These financial instruments are derived from underlying foreign exchange purchase or sale transaction. They include currency Forwards/Futures, Swaps and Options.^[2] There exist many categories of Future contracts which re named according to the underlying or the financial instrument.^[3] In this work we will emphasize on the role of currency futures contracts in risk management.

2.2 Currency Futures Outline and Scope

Currency futures are traded on futures exchanges. The largest currency futures exchange in the world is the Chicago Mercantile Exchange. (Graham, 2000) Almost futures exchanges establish their own rules and procedures; however they are regulated and supervised by gov­ernments. In the US the futures exchange is supervised by the Commodity Futures Trade Commission (CFTC).

As I mention above, there are many different financial derivatives which can be used to manage foreign exchange risk. Very similar to the currency futures are the currency for­wards. Futures are like forwards contracts specifying a standard volume of a particular cur­rency to be exchange on a specific date. However, the main difference is that forwards are almost over-the-counter (OTC) products at which futures are mostly traded on the market floor of several exchanges worldwide and therefore they are highly liquid. Some of them are for instance the CME, the Tokyo International Financial Futures Exchange (TIFFE), the Eu­ropean Exchange (Eurex), the Euronext, the Sydney Futures Exchange, the New Zealand Futures Exchange, the New York Futures Exchange and the Singapore International Mone­tary Exchange (SIMEX). Whereby the CME the biggest and the most important foreign fu­tures exchange in the world is. (Madura, 2010) Forwards are agreed directly between two parties and there is no secondary market. Traders and brokers can be located all over the world and deal with each other over the phone. In figure 2 we can see the main differences between forward contracts and futures contracts.

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Figure 2: Comparison ofFutures and Forward contracts

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^[1] Internal methods can be for instance Pricing policies, Netting, Matching, Leading and Lagging.

^[2] There exist several sub-groups of financial derivatives.

^[3] These can be for instance: Commodity Futures, Energy Futures, Metal Futures, Stock Index Futures, Money Markets Futures, Bond and Note Futures etc.