Currency Futures
Professor Brooks
BA 444
02/12/08
The Underlying Asset
 FX is the abbreviation for foreign currency
exchange
 Foreign Currency is the underlying asset
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Just think of the foreign currency as a commodity
that you buy or sell
Currency relationship around the world
Purchasing Power Parity
Exchange rates set so that currency of one
country should be able to buy the exact same
goods of another country
Example: Shoes in US vs. Japan
Purchasing Power Parity
 Shoe sells for $150 in USA
 Same shoe sells for ¥18,750
 Where do you buy your shoes?
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Note you can have them shipped directly to you and the
shipping charge is included in the price
The current exchange rate is ¥125 for $1
No advantage for where you buy the shoe
 What about a year from now?
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US inflation rate is 5% and Japanese inflation rate is 8%
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US price will be $157.50 – Japanese will be ¥20,250
Exchange rate in one year will be: ¥128.57 for $1
Forward exchange rates reflect inflation differences
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Foreign Exchange Rates
 Change daily due to expected inflation
rates in the various countries
 Anticipated or Forward Rates reflect the
impact of the expected inflation rate
 Future Forward Rate Calculation:
Forward Ratet ≈ Spot Rate x (1 + (InfFor – InfUS))t
 Example
Forward Rate ≈ 125 x (1 + (0.08 – 0.05))
Forward Rate ≈ 125 x 1.03 = 128.75
Forward Rates
 More Exact Model using the Indirect Quote:
 1  r foreign 
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Ft  S  
 1  rus 
t
Interest Rate Parity
 Components of interest rate
The real rate – compensation for waiting
 Inflation rate – the general rise in the prices
of goods over time
 Risk premium(s) – default, maturity,
liquidity, etc.
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 The real rate is the same the world round
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Example…investing in country with the
highest nominal interest rate
Investing Around the World
 Current risk-free rate in U.S. is 4%
 Current risk-free rate in Japan is 7%
 Convert U.S. dollars to Yen (say $100)
 Invest in Japan (¥12,500)
 Wait 1 Year (¥13,375)
 Convert Yen back to U.S.dollars…($104)
 Same place in wealth if you had left money in U.S.
bank…except for transaction costs…
 Proof…used ¥125 to $1 and then ¥128.60577 to $1
 US deposit at end of one year $104
Where is the Risk?
 Weak Dollar
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The term weak dollar usually means that the
U.S. dollar is losing buying power in a foreign
currency
Example, today the U.S. dollar can buy 125
yen…but if the dollar weakens next month it
can only buy 115 yen
 Strong Dollar is just the opposite
 What does this mean for imports and
exports?
Where is the Risk?
 Weak U.S. Dollar and Imports/Exports
 Imports become more expensive (for U.S. buyer),
exports become cheaper (for foreign buyer)
 Helps exporters (manufacturers) of U.S. goods – Hurts
importers (consumers) of foreign goods
 Strong U.S. Dollar and Imports/Exports
 Imports become cheaper (for U.S. buyer), exports
become more expensive (for foreign buyer)
 Helps importers (consumers) of foreign goods – Hurts
exporters (manufacturers) of U.S. goods
 Balance of Trade Issues for U.S. economy
Where is the Risk?
 Accounting Risks – Multinational Company based in
U.S.
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Transaction Risk
 Company buys a good (on credit) in a foreign currency
 Price of the good may go up or down due to changes
in the exchange rate
Translation Risk
 Company owns property in a foreign country
 Must consolidate assets for U.S. reporting
 Foreign asset value must be translated into U.S.
dollars
 Value may go up or down due to changes in the
exchange rate
Where is the Risk?
 Economic Exposure
 Own foreign stock or foreign asset
 Value will fluctuate with change in exchange rate
 Example – Purchase Nestle stock five years ago at
€45 when the exchange rate was €1 = $1
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In five years the stock has gone up 60%
In five years exchange rate has changed to €1=$0.75
Gain on stock should be 60% (in Euros)
Translated gain is only 20%
€45 x (1.60) x 0.75 = $54 and
$54 / $45 – 1 = 20%
Dealing with the Risk
 Ignore the exposure
 Expectation is that FX will have small or very
moderate changes
 Eliminate the potential risk
 Don’t hold foreign assets or securities
 Hedge the risk
 With forward market, enter into a forward
exchange agreement (lock in the future
exchange rate)
 Hedge with futures contract – contracts large
Hedge Example
 Wine Importer – Buys French Wines
 Purchases wines at harvest but will not have shipment
of wines until following year
 Futures on FX for Euros – contract is for €125,000
 One year rate is 1.45
 It would take $181,250 to purchase €125,000 in one
year
 Assume Wine Importer has ordered $10,000,000 of
wine (order is in Euros)
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Current obligation (at €1.25 to $1) is for €8,000,000
Needs 64 Futures Contracts to Buy Euros (long in
Euros futures contract, short Euros)
Locks in exchange rate at 1.45 for one year from now
and anticipates paying $11,600,000
Hedge Example Continued
 Exchange Rate is higher at 1.60
 Needs $12,800,000 to buy the wine
 With Futures…makes $1,200,000 on futures contract,
 Net outflow is $11,600,000
 Exchange Rate is at anticipated 1.45
 Pays $11,600,000 for wine
 No gain or loss on futures
 Exchange Rate stays at 1.25
 Needs only $10,000,000 to pay for wine
 Losses $1,600,000 on futures
 Net outflow $11,600,000
 Locked in cost of wine…$11,600,000
What about French Winemaker?
 Opposite Risk?
 Wine will be purchased with Euros…no
currency exposure
 Price is €8,000,000 today…tomorrow…
 Winemaker has a forward contract for sale of
wine in one year…he has hedged wine with a
forward contract