TABLE OF CONTENTS
(i) Why hedge using currency futures
(ii) Contract specifications and trading mechanisms
(iii) Pricing and usefulness of currency futures in predicting the spot rate changes and currency futures returns..
Applications of Currency Futures
Currency futures using Hypothetical Cases
(i) Hedging FX risk where the hedger holds the contract until maturity-Importer perspectiv.
(ii) Hedging FX risk where the hedger closes out the contracts before maturity-Exporter perspective
Appendix I: Formulas and Footnotes
Futures contracts are simple derivative instruments used for hedging purposes that is to counter financial risk. This study examines the role played by these instruments for managing risks in the global business world whilst highlighting the merits and demerits of their applications relative to other plain vanilla products (i.e. forwards, swaps and options). Further, this report presents the details on the structure/typical specifications and pricing of currency futures (CFs) contracts as well as the key differences inherent between the futures and other derivative products.
In the literature review, the study seeks to answer the question on why firms need to use currency futures to hedge against FX risk, and provide a justification on the usefulness of currency futures in predicting the spot rate changes and currency futures returns. Finally, the study uses two hypothetical cases to demonstrate how CFs can effectively be used to hedge against FX risk.
Since time immemorial, a number of approaches have been used by traders to manage risk exposures, key amongst them being the use of plain vanilla derivatives. The futures market can be traced as far back as the 1980s when it was informally espoused to reduce price risk on agricultural products (Hieronymus 1977; Pramborg, 2005). In 1971, the Chicago Mercantile Exchange (CME) introduced financial futures contract to respond to the risks businesses faced that arose from high inflation rates, deregulated financial markets and increasing volatilities in interest rates. This replaced the traditional use of ‘Gold standard’measure of providing currency guarantees (Pike, et. al., 2009).
Currency futures (CFs) are therefore defined by Redhead (1994) as foreign currency derivatives that provide a simultaneous right and an obligation to buy or sell a standard amount of a particular currency at the stipulated delivery date and at a price that is agreed upon at the time of entering the contract. Futures contracts are fundamentally the same forward contracts in definition and functionality but differs substantially in a number of areas; whereas futures are traded in a formal or organized market (i.e. security exchanges) and standardized, forwards are customer tailored and are over the counter (OTC) contracts (Guay, and Kothari, 2003). Moreover, futures are highly liquid in the secondary market and can go into delivery four times per year based on the quarterly cycle.
In risk management, futures and forwards are external approaches used by firms to hedge foreign exchange risks. Indeed, the fluctuation in exchange rates can produce risk which according to Pike, et. al., (2009) occur as a result of three main forms of exposures; transaction, transaction and economic exposure but more emphasis is given to transaction exposure which arises from sending and receiving money over a currency frontier. Futures contracts may be categorised based on the underlying market of commodities, interest rates, equity indices, currency, metals, and even weather. On this note, Marshall, (2000) emphasizes that CFs are the most actively traded financial instruments by many multinational corporations (MNCs) in the contemporary times with an aim of minimizing potential losses that could arise from a change in the foreign exchange rate fluctuations as this can have a significant implication on business decisions/outcomes. The same assertions were also echoed by Baker and Filbeck (2015) where they alluded that, in the recent times, companies are increasingly using CFs to hedge business risks associated with cross-border transactions. Furthermore, global managers may also use futures to hedge their investments in other currencies so as to protect their investments (Pike, et. al., 2009). Unlike OTC-forward contracts, exchange traded CFs has a number of advantages. These include but not limited to; elimination of interparty credit risk, price transparency and efficiency and are largely accessible to all market participants.
The role of currency derivatives in risk management has been documented in several studies since its introduction in 1972. The findings on the subject matter can be discussed in three main viewpoints/strands. Firstly, a justification on why companies would be interested in using CFs for FX risk management, secondly, the CFs contract specifications/trading mechanisms, and lastly, the usefulness of currency futures in predicting the spot rate changes and currency futures returns.
(i) Why hedge usingcurrency futures
According to Brown (2001), CFs are very vital instruments of hedging against foreign exchange risks that may arise due to the fluctuation in the foreign exchange rate. Most corporations with either, foreign subsidiaries or which transacts business in the foreign market are exposed to foreign exchange risk. On this note, Guay and Kothari (2003) indicates that if such a firm sells/buys goods overseas and their transactions are denominated in a foreign currency, it will expect to receive/pay a sum of foreign currency after the transaction is agreed upon. Both the seller and buyer will be exposed to foreign exchange risk that occurs in such a way that, if the foreign currency depreciates relative to the domestic currency, the amount due to the seller will be reduced, consequently decreasing their profits and perhaps even render them loss making. As such, there is a strong need for companies to minimise FX risk exposure through hedging. In a study on the elimination of FX risk exposure on MNCs value, Fraser and Pantzalis (2004) agrees with these assertions where they mention that, by hedging with CFs, firms are able to guarantee the rate of exchange at which they will buy/sell in the foreign market. However, the guaranteed exchange rate might be less favourable than the current rate but at least these firms will be free from the risk that the rate might be unfavourable as to render their transactions unprofitable. It is, therefore, imperative to conclude that changes in exchange rates drive the changes in cash flows and the ultimate value of the firm (Adler and Dumas,1984).
On this note, firms will always have to grapple with three major types of risks that stem from adverse FX rate movements as indicated by (Pike, et. al., 2019). Firstly, the transaction exposure, which is concerned with the risk of loss due to adverse foreign exchange rate movement that affects the domestic currency value of imports and exports contracts that are denominated in the foreign currency. This occurs when a company enters into a contract and the payment is in the future period. Secondly, translation exposure which is a pure accounting issue involving risks that may arise due to adverse currency movements that are likely to affect the value of assets, liabilities and other income statement transactions when preparing the consolidated financial statements. Lastly, the economic/operating exposure which relates to ongoing risks that a firm’s cash flows, foreign investments, and earnings may be negatively impacted as a result of fluctuating foreign currency exchange rates. Consequently, any unexpected change in exchange rates may cause considerable losses or provide unexpected gains hence prompting for a risk control action by firms in order to smooth their cash flows (Labuszewski, et.al., 2013). To hedge these risks, a firm can either use internal methodsor external approaches. This paper focuses more on the external methods and precisely finds CFs effective in minimizing FX risk.
(ii) Contract specifications and trading mechanisms
A futures contract can be arranged to suit any product/commodity including currencies, financial instruments and can operate the same way as forward contracts. Labuszewski, et.al., (2013) mentions that the definition and pricing of futures is the same as forwards except that, futures are highly regulated and can be liquidated before the maturity date. Unlike forwards, the CME requires parties involved in the future contract to deposit a down paymentin case they default on their contractual obligations. CFs are traded on the futures exchanges e.g. Chicago Board Options Exchange (CBOE), Eurex Exchange (E-X), National Stock Exchange (NSE) of India just to mention but a few, which according to Adler and Dumas (1984) are regulated and supervised by the respective governments, however, in the US, it is regulated Commodity Futures Trading Commission (CFTC).
Currency futures are usually deliverable only four times per year based on the quarterly cycle. This is emphasised by Redhead (1994) that future contracts largely call for delivery of a specific quantity of currency on a specified currency on the first Wednesday of March, June, September and Decemberwithin the normal trading hours (9 am-5pm). Thence, the last trading day of a currency future befalls on the Monday before expiration, after which an official roll over date will be published by CME recommending traders to move positions (roll over) from the expiring month to the next month. On the same note, (Allayannis and Weston, 2001; Pramborg, 2005) indicates that futures contract can exist on many global currencies. These includes; GBP-USD (the cable), yen-USD, Australian dollar-USD (Aussie-dollar), Canadian dollar-USD (loonie), Swiss franc-USD (dollar swissy), New Zealand dollar-USD (Kiwi) amongst others. Furthermore, according to Srinivasan and Youngren, (2003), CFs exist in standardised sizesof different currencies as shown in the figure below:
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Figure 1.0: The standard Futures contract specifications
Source: CME website, (2017)
(iii)Pricing andusefulness of currency futures in predicting the spot rate changes and currency futures returns
Unlike, the FX pairs where the dollar might or might not be the quote, CFs, in most cases are traded in ‘American terms’with ask and bid spread just like other markets (Harvey and Huang, 1991). Similarly, Sarang, (2001) indicates that the pricing of CFs is determined by the prevailing rate of interest as well as the spot rate through a certain specified formula.The application of this was done by Inci and Lu (2007) where they conclude that CFs prices of short maturity contracts are better predictors of the cash-market spot rate up to maturity, which is consistent with Uncovered Interest Rate Parity (UIP) but cannot predict CF’s returns. On the other hand, long-term maturity CFs can effectively predict CFs’ returns but cannot predict the cash-market spot exchange rates. In a nutshell, currency futures contracts trade on a transparent, legitimate and liquid marketplace and are suitable for removing the uncertainty about the future price of an item. Companies are able to eliminate the exposures associated with the expected expenses and profits by locking in the price of the transition now for delivery in the future period.
Applications of Currency Futures
In currency futures, one party to the contract agrees to long (buy) the futures at a prearranged exchange rate and the other agrees to short (sell) it at the expiry date (Marshall 2000). On this note, the underlying instrument of CFs is the rate of exchange between one unit of the of the foreign currency and that of the domestic currency. According to Brown (2001) contracts are cash settled in the domestic currency and no physical delivery of the foreign currency takes place.
In real practice, CFs have been found to be suitable for importers, investors, exporters and travellers who would want to hedge their operations against the movement in the exchange rate. Similarly, Pike, et. al., (2009) indicates that speculators can also use the currency futures to make a profit on short-run price movements. Similarly, arbitrageurs use them to profit from the price differentials of similar products in different markets while investors trade on currency futures to enhance the performance of a portfolio of assets in the long run (Marshall, 2000). The following are some of the applications of the CFs using hypothetical examples.
Currency futures using Hypothetical Cases
(i) Hedging FX risk wherethe hedger holdsthe contract until maturity-Importer perspective
AssumingCastrol Distributers (UK) limitedmakes an order of purchasing 400 Toyota Prius cars from General Motors (US) Ltd at a price of $25,000 today on April 5, 2017, to be delivered in 12 months’ time. The Sterling pound/Dollar Spot rate is $1.2483: £1 as shown in figure 2.0 below.
This is a monetary system of a country’s currency whose value is directly linked to Gold where paper money could be converted into a specific amount of Gold.
 Internal methods are adopted within the firm. e.g. netting, lagging, pricing policies, matching or leading.
This down payment is also called performance bond or margin of about 1.5% of the contract value
The ‘March quarterly cycle’ implying the first Wednesday of March, June, September and December
All other CFs contract trade in full sizes except Yen (¥) and British pound (£) (i.e. trading at full size, mini and E-micro futures- one tenth on the normal standard futures contract).
Using FX Lingo-USD is the quote currency and the futures market listed prices represent the dollar price for each foreign currency.
See formula for determining the contract price of a given pair in Appendix I
- Quote paper
- Richard Ondimu (Author), 2017, Role of Currency Futures in Risk Management, Munich, GRIN Verlag, https://www.grin.com/document/367826