Since the 1970s futures contracts have proven a real success story, but in the course of the crisis, several futures-trading businesses went bankrupt. Because of a lack of trust, futures trading volumes started decreasing. But, even though the futures market has been adversely affected, futures contracts still serve as a fundamental risk management tool.
This paper provides an insight into the use of futures contracts in risk management, trading on US exchanges. After a brief introduction to the topic of futures contracts, current literature will be reviewed. The literature review focuses primarily on current issues and developments on the futures market, while the third chapter explains step by step - based on an example of foreign exchange hedging - the use of futures contracts as well as how futures transactions are processes. Finally, the third chapter summarises relevant criteria a company has to reflect when considering to invest in futures contracts.
Table of Contents
1 Introduction
2 Literature Review
3.1 Problem definition
3.2 Risk exposure
3.2.1 Exchange of foreign currency at spot rate in October
3.2.2 Exchange of foreign currency at spot rate in December
3.3 Exchange of foreign currency using FX futures
4 Conclusion
Objectives and Topics
This paper examines the role of futures contracts as a fundamental risk management tool for companies, specifically focusing on hedging transaction exposure in international currency markets.
- The theoretical foundations and market functions of futures contracts.
- Risk exposure analysis in international business transactions.
- Hedging strategies using Euro FX futures as a practical example.
- Operational processes including margin accounts and daily settlement.
- Critical criteria for companies to evaluate when utilizing futures for risk mitigation.
Excerpt from the Book
3.3 Exchange of foreign currency using FX futures
Because the US company is unsure about the development of the USD/EUR rate, it is advisable to hedge currency risk. To hedge, various financial instruments are available. Futures contracts can be used to hedge an exposure to currency risk when a company or financial institution expects to make or receive a payment in the future in a foreign currency (Coyle, 2000, p. 56).
In this particular example, the US company can obtain ‘Euro FX Future’ (see Figure 3) at the CME. This means that the company can secure in October an exchange rate for their payment in December. This is especially advisable, when the company expects the USD to appreciate against the EUR.
A characteristically element for futures contracts in general is that they are standardised to a certain degree and not customised as e.g. forward contracts. This makes them cheaper in terms of transaction costs, which makes it attractive for traders, which ultimately leads to highly liquid markets. Highly liquid markets in turn provide efficient and transparent trading opportunities with fair prices. (Nowman & van Dellen, 2012, p. 20)
Figure 3 shows the standardised features of the particular ‘Euro FX future’, such as contract size, margin payment, delivery date, tick size and tick value.
Chapter Summary
1 Introduction: This chapter introduces futures contracts as complex financial derivatives and outlines the paper's goal to analyze their effectiveness as a hedging tool for companies.
2 Literature Review: This section reviews existing academic perspectives on the role of futures in risk management, market regulation, and the classification of market participants.
3.1 Problem definition: This section presents a practical case study of a US company facing exchange rate risks due to a future payment obligation to a German business partner.
3.2 Risk exposure: This chapter details the potential financial outcomes for the company based on fluctuating spot rates in October and December.
3.2.1 Exchange of foreign currency at spot rate in October: This part analyzes the implications and risks of converting currency at the initial spot rate.
3.2.2 Exchange of foreign currency at spot rate in December: This part explores the financial risks associated with delaying the currency exchange until the actual date of payment.
3.3 Exchange of foreign currency using FX futures: This section explains the mechanism of using Euro FX futures to hedge against unfavorable currency movements.
4 Conclusion: The final chapter summarizes the utility of futures contracts and provides a checklist of criteria for companies to assess before implementing them in their risk management strategies.
Keywords
Futures contracts, Risk management, Hedging, Transaction exposure, Currency risk, US exchanges, Derivatives, Margin account, Financial instruments, Commodity chain, Spot rate, Clearinghouse, Trading volume, Market liquidity.
Frequently Asked Questions
What is the primary focus of this paper?
The paper focuses on the utility of futures contracts as instruments for hedging transaction exposure within the context of international risk management.
What central themes are addressed?
The core themes include price risk, currency fluctuations, market standardization, the role of clearinghouses, and the practical application of hedging for corporations.
What is the main objective of the research?
The objective is to demonstrate how companies can utilize futures contracts traded on US exchanges to mitigate financial risks associated with foreign currency payments.
Which scientific method is applied?
The author uses a qualitative literature review combined with a practical case study to illustrate the application of financial derivatives.
What is covered in the main section?
The main section covers the definition of the problem, an analysis of currency risk exposure, and a step-by-step application of hedging with futures, including margin calculations.
Which keywords characterize this work?
Key terms include Futures contracts, Hedging, Risk management, Transaction exposure, and Financial derivatives.
How are margin accounts used in the case study?
Margin accounts serve as a guarantee mechanism where the US company deposits funds to cover potential losses and maintain their position in the futures market.
What are the limitations of using standard futures contracts?
The high degree of standardization can be problematic, as the fixed contract sizes and specific delivery dates may not perfectly align with every company's unique financial needs.
Why did trading volumes decrease during the financial crisis?
Decreasing volumes were primarily attributed to a loss of trust among market participants, particularly following the collapse of major futures-trading businesses like MF Global.
- Quote paper
- Hedwig Heerdt (Author), 2012, The general use of futures contracts in risk management companies can use trading on US exchanges, Munich, GRIN Verlag, https://www.grin.com/document/207374
