chapter 18 currency futures and futures markets

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Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-1 Chapter 18 Chapter 18 Currency Futures and Futures Currency Futures and Futures Markets Markets 18.1 The Evolution of Financial Futures Exchanges 18.2 The Operation of Futures Markets 18.3 Futures Contracts 18.4 Forward versus Futures Market Hedges 18.5 Futures Hedges Using Cross Exchange Rates 18.6 Hedging with Currency Futures 18.7 Summary

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Chapter 18 Currency Futures and Futures Markets. 18.1The Evolution of Financial Futures Exchanges 18.2The Operation of Futures Markets 18.3Futures Contracts 18.4Forward versus Futures Market Hedges 18.5Futures Hedges Using Cross Exchange Rates 18.6Hedging with Currency Futures - PowerPoint PPT Presentation

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Page 1: Chapter 18 Currency Futures and Futures Markets

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-1

Chapter 18Chapter 18 Currency Futures and Futures MarketsCurrency Futures and Futures Markets

18.1 The Evolution of Financial Futures Exchanges

18.2 The Operation of Futures Markets

18.3 Futures Contracts

18.4 Forward versus Futures Market Hedges

18.5 Futures Hedges Using Cross Exchange Rates

18.6 Hedging with Currency Futures

18.7 Summary

Page 2: Chapter 18 Currency Futures and Futures Markets

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-2

Currency futures contractsCurrency futures contracts

Forward contracts and default risk

» Forward contracts are a pure credit instrument; one party always has an incentive to default.

The futures contract solution

» An exchange clearinghouse takes one side of every transaction

» Futures contracts are marked-to-market on a daily basis

» Initial and maintenance margins are required on futures contracts

Page 3: Chapter 18 Currency Futures and Futures Markets

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-3

Financial futures exchangesFinancial futures exchanges

The International Monetary Market (IMM)

(a subsidiary of the Chicago Mercantile Exchange)

The Philadelphia Board of Trade (PBOT)

(a subsidiary of the Philadelphia Stock Exchange)

The Bolsa Mercadorias & de Futuros (BM&F) in Brazil

The London International Financial Futures Exchange (LIFFE)

The Marché à Terme des Instruments Financiers (MATIF)

The Singapore International Monetary Exchange (SIMEX)

The Tokyo International Financial Futures Exchange (TIFFE)

(a subsidiary of the Tokyo Stock Exchange)

Page 4: Chapter 18 Currency Futures and Futures Markets

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-4

A comparison of currency forwardA comparison of currency forwardand CME futures contractsand CME futures contracts

Forwards Futures

Location Interbank Exchange floor

Maturity Negotiated 3rd week of the month

Amount Negotiated Standard contract (e.g. ¥12,500,000 )

Fees Bid-ask Commissions (e.g. $30 per contract)

Counterparty Bank CME Clearinghouse

Collateral Negotiated Margin account

Settlement At maturity Most are settled early

Trading hours 24 hours During exchange hours

Page 5: Chapter 18 Currency Futures and Futures Markets

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-5

Been there, done that...Been there, done that...

Futures contracts are similar to forward contracts

» Futures contracts are like a bundle of consecutive one-day forward contracts

» Daily settlement is the biggest difference between a forward and a futures contract.

Futures and forward contracts are nearly identical in their ability to hedge currency risk

Page 6: Chapter 18 Currency Futures and Futures Markets

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-6

Hedging with forwards and futuresHedging with forwards and futures

Currency forward contracts can provide a perfect hedge when the size and the timing of a foreign currency transaction are known.

Exchange-traded futures contracts come in only a few currencies, contract sizes, and maturity dates, and hence may not provide a perfect hedge against transaction exposure to foreign currency risk.

Page 7: Chapter 18 Currency Futures and Futures Markets

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-7

The growth of exchange-traded derivativesThe growth of exchange-traded derivatives

Source: Futures Industry Association (1995 figures are estimates)

Millions of contracts traded

0

500

1,000

1,500

2,000

2,500

1990 1991 1992 1993 1994 1995 1996 1997 1998

Options

Futures

Page 8: Chapter 18 Currency Futures and Futures Markets

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-8

Spot and futures price convergenceSpot and futures price convergence

Forward and futures prices are determined by IRP:

Futt,Td/f = Ft,T

d/f = Std/f [(1+id)/(1+if)]Tt

T

Forwardpremium

FutTd/f = ST

d/f

Fut0d/f

S0d/f

Page 9: Chapter 18 Currency Futures and Futures Markets

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-9

Maturity mismatches and basis riskMaturity mismatches and basis risk

If there is a maturity mismatch, futures contracts may not provide a perfect hedge.

The difference in interest rates (idif) is called the basis.

» The basis determines the relation of futures prices to spot prices through interest rate parity.

» The risk of change in the relation between futures and spot prices is called basis risk.

» When there is a maturity mismatch, basis risk makes a futures hedge slightly riskier than a forward hedge.

Page 10: Chapter 18 Currency Futures and Futures Markets

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-10

Maturity mismatches and the delta-hedgeMaturity mismatches and the delta-hedge

A delta-hedge: std/f = + futt

d/f + et

std/f = percentage changes in spot exchange rates

futtd/f = percentage changes in futures prices

The hedge ratio can be used to minimize the variance of the hedged position:

NFut* = (Amount in futures contracts)/(Amount exposed)

=

Hedge quality is measured by (s,fut )2

Page 11: Chapter 18 Currency Futures and Futures Markets

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-11

Maturity mismatches and the delta-hedge:Maturity mismatches and the delta-hedge:An exampleAn example

You work in the United States and need to hedge a €100 million obligation due on June 3. It is now January 15.

» The spot exchange rate is S0$/€ = $1.10/€.

» The CME trades a euro futures contract expiring on June 16 with a contract size of €100,000.

» Based on the regression st$/€ = + futt

$/€ + et ,

you estimate = 1.020. The r-square is 0.95. » How many CME futures contracts should you buy

to minimize the risk of your hedged position?

Page 12: Chapter 18 Currency Futures and Futures Markets

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-12

June 18June 3January 15

-€100 million

underlying obligation

Futures expiration date following the

cash flow

Maturity mismatches and the delta-hedge:Maturity mismatches and the delta-hedge:An exampleAn example

Page 13: Chapter 18 Currency Futures and Futures Markets

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-13

Maturity mismatches and the delta-hedge:Maturity mismatches and the delta-hedge:SolutionSolution

The optimal hedge ratio for this delta-hedge is given by

NFut* = (amt in futures)/(amt exposed) = -

(amt in futures) = (-)(amt exposed)

= (-1.020)(€100 million) = €102 million

so buy

(€102 million) / (€100,000/contract)

= 1,020 contracts

Page 14: Chapter 18 Currency Futures and Futures Markets

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-14

Currency mismatches and the cross-hedgeCurrency mismatches and the cross-hedge

If there is a currency mismatch but not a maturity mismatch, a futures cross-hedge can be used.

A cross-hedge: std/f1 = + st

d/f2 + et

std/f1 = percentage changes in the currency (f1)

of the underlying exposure

std/f2 = percentage changes in the currency (f2)

of the futures contract

Page 15: Chapter 18 Currency Futures and Futures Markets

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-15

The delta-cross-hedgeThe delta-cross-hedge

If there is a currency mismatch and a maturity mismatch, a delta-cross-hedge can be used.

A delta-cross-hedge: std/f1 = + futt

d/f2 + et

std/f1 = percentage changes in the currency (f1)

of the underlying exposure

futtd/f2 = percentage changes in the value of the

futures contract on currency f2

Page 16: Chapter 18 Currency Futures and Futures Markets

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-16

A classification of futures hedgesA classification of futures hedges

Currency

Maturity

Exact match

Exactmatch

Mismatch

Mismatch

Cross-hedge(st

d/f2 = + std/f1 + e)

Delta-cross-hedge(st

d/f2 = + futtd/f1 + e)

Perfect hedge(st

d/f = + std/f + e)

(so that &

Delta-hedge(st

d/f = + futtd/f + e)

Hedge(hedge ratio estimation)