Currency Futures

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10. Currency futures
In 1972, Chicago Mercantile Exchange started currency futures
contracts, in response to the demand for foreign currencies, due
to import and export foreign goods by most of the countries.
Huge volume of international transactions led to the
development of foreign currency markets, which created
necessity for foreign currency futures. In India, NSE started he
currency futures contracts in August 2008.
In the currency futures, underlying assets for the futures contracts
are different currencies. Foreign currency futures contracts need
to specify a trading unit (such as £, €, ¥ etc.), quotations (such as
US$/£, US$/€, US$/¥ etc.), minimum price change, contract
month, US$ value of currency as on day and delivery date.
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10. Currency futures
Currency futures can thus be defined as ‘a binding obligation to
buy or sell a particular currency against another at a designated
rate of exchange on a specified future date.’
Hedging with Currency Futures
The exporters and importers are exposed to foreign currency
risk. This exposure can be hedged through derivatives like
futures, options etc. Since the futures market does not require
upfront premium for entering into contract as in the case of
options, it provides a cost-effective way for hedging the foreign
exchange risk. Basic advantage of using currency futures is that
it provides a means to hedge the traders’ position or anybody
who wishes to lock-in exchange rates on future currency
transactions.
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10. Currency futures
By purchasing (long hedge) or selling (short hedge) foreign
exchange futures, a firm or an individual can fix the incoming
and outgoing cash flows in one currency with respect to
another currency.
A person who is long or is expected to go long in a foreign
currency will have to sell the same on a given day. A hedge can
be obtained now by selling futures in that currency against the
domestic currency. Similarly a person who is short or is
expected to go short in a foreign currency will have to go long
on the same on a given day. A hedge can be obtained now by
buying futures in that currency against the domestic currency
instead of buying the currency later in the spot market.
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10. Currency futures
Major disadvantage of in foreign exchange futures is that they
are limited to a few currencies only. Following illustration
explains how a US exporter, using futures hedge his Euro
inflows.
Illustration 1:
Suppose a US exporter is exporting goods to his German client.
On Sept 14, 20x1, the exporter got the confirmation from the
German importer that the payment of Euro 625,000 will be
made on Nov 1, 20x1. Here the US exporter is exposed to the
risk due to currency fluctuations. If the Euro depreciates, there
will be loss on his dollar receivables. To cover this risk, the
exporter can sell Euro futures contract on the CME. Following
working explains how the exporter is hedged.
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10. Currency futures
Sept 14, 20x1
Spot market exporter gets confirmation of receivables equal to
Euro 625,000 on Nov 1, 20x1. Spot rate on Sept 14, 20x1 $/€ is
0.4407, expected cash inflows are $275,437.5 i.e. € 625,000 x
0.4407 if he were able to convert Euro to US dollars. But he
cannot do so since he did not receive the €. However he can go
to futures market and sell futures in €.
Futures Market
Sell five December Euro futures contracts, since size of each
contract is €125,000 at the rate which is prevailing in the
market. Let the rate be $/€ 0.4442. Hence the equivalent
notional amount in US dollars will be $277,625 (i.e. 0.4442 x
€625,000).
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10. Currency futures
November 1, 20x1
Spot Market
Dollar has appreciated and spot exchange rate is 0.43908. The
dollar value of €625,000 now is $274,425.
Loss on spot market position = $275,437.5 - $274,425
= $1,012.5
Futures Market
Buy five December Euro futures contracts. The quantity of
futures contracts bought should be same as that sold on Sept 14.
Let the futures rate be 0.44258. This gives the exporter the
notional right to buy €625,000 by paying $276,612.5 i.e. €625,000
x 0.44258.
Profit on futures contracts = $277,625 - $276,612.5 = $1,012.5
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10. Currency futures
The loss in the spot market, arising from the appreciation of dollar
is offset by the profit in the futures market. In the above
illustration, the exporter received the same amount of US dollars
as if he had sold Euro in the market on Sept 14, 20x1. This is
because the change in the rate of Euo during the period and the
change in the price of futures during the same period are equal.
Spot price (t0) – Spot Price (t1) = 0.4407 – 0.43908 = 0.00162
Futures Price (t0) –Futures Price (t1) =0.4442 -0.44258 = 0.00162

The same is explained in a table below.
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10. Currency futures
Date

Spot Exchange
Rate $/€

December
Futures Rate $/€

Difference

Sept 14, 20x1

0.4407

0.4442

0.0035

Nov 1, 20x1

0.43908

0.44258

0.0035

Difference

0.00162

0.00162

-

The difference between spot price and futures price is known as basis.
The basis at time t0 in the above illustration is 0.0035 and the basis at
time t1 is also 0.0035.
We observe that the basis remained unchanged. When the basis remains
unchanged, the gain / loss in spot market matches with the loss / gain
in futures market and hence the amounts are exactly offset. However,
it is unlikely that the basis remains the same throughout the period.
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10. Currency futures
Speculation Using Currency Futures
Speculators differ from hedgers in that their basic objective is
to capitalize on the difference between their own forecasts and
market expectations. When a speculator is betting on the price
movement associated with a particular contract, it is called
open position. When the speculator is trying to take advantage
of movements in the price differential between two separate
futures contracts, it is called spread trading. This type of
trading can involve
i. The same currency but contracts of different maturities.
ii. Two contracts of same maturity but different currencies.
iii. A combination of the above.
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Pricing of currency futures

10. Currency futures
Useful links for further reading
http://www.nseindia.com/marketinfo/fxTracker/fxTracker.jsp
http://www.nseindia.com/content/us/fact2009_sec7.pdf
http://www.nseindia.com/content/press/prs_usdinrcd.pdf
http://www.nseindia.com/content/ncfm/CDBM_workbook.pdf

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