Lecture 6a: Futures
Forwards and Futures Contracts
• Are instruments that allow the buying and
selling of a stated amount of foreign
currency at a stated price per unit at a
specific date in the future
• When signed, there is no up-front costs
• Are classified as derivatives because their
values are derived from the value of the
underlying security
• While they play a similar role in the
management of FX risk, there are some
key differences
• Any futures contract specifies a standard quantity of a
good will be bought or sold at a specified time in the
future.
• The Chicago Mercantile Exchange began trading in
currency futures in 1972
– Other markets include:
– The Philadelphia Board of Trade (PBOT)
– The MidAmerica commodities Exchange
– The Tokyo International Financial Futures Exchange
– The London International Financial Futures Exchange
Currencies traded and contract
size
•
•
•
•
•
•
•
•
Yen (12.5 Million)
DM (125,000)
C$ (100,000
British Pound (62,500)
Swiss Franc (125,000)
Australian Dollar (100,000)
Mexican Peso (500,000)
Euro (125,000)
Forwards and Futures Contracts
Futures
Forward
Amount
Standardized
Negotiated
Delivery Date
Standardized
Negotiated
Counter-party
Clearinghouse
Bank
Collateral
Margin Acct.
Negotiated
Market
Auction Market
Dealer Market
Costs
Brokerage and
exchange fees
Bid-ask spread
Liquidity
Very liquid
Highly illiquid
Regulation
Government
Self-regulated
Location
Central exchange
Worldwide
Hedging with Futures
• Example: Long Hedge
• It is March, a US firm has to pay JPY 25 million in
180 days. The company decides to hedge its
currency risk.
• It hedges the JPY payables by buying JPY
September futures for JPY 25 million
• On the CME, the JPY contract is for 12.5 million
yen, so they buy two CME contracts
• If the Yen strengthens, the payables become
more expensive
• However, the forward contract becomes more
valuable, perfectly hedging the payables
Advantages and Disadvantages of Futures
• Advantages
– Small Contract Size
– Easy liquidation
– Well organized and stable market (no risk of default)
• Disadvantages
– Limited number of currencies (but think about how one
futures might be a close hedge against another currency)
– Rigid contract size
– Fixed expiration dates (but if you can get close, it doesn’t
matter all that much).
Interest Rate Futures Exchange rate risk is not the
only risk facing a business who expects to get paid
or is obligated to pay in the future. Consider the
following:
• On October 23, 2001 the Film Board of Canada signs a
contract in which it agrees to pay a $1 million subsidy to
an American studio that is making a sequel to “DudleyDo-Right” in Toronto. The funds will be paid on July 1,
2002, but filming won’t start until the first blizzard
(usually in the last part of September). No money is
required until filming starts.
• This is good news, since the studio will be able to earn
interest on the subsidy while they wait for filming to start.
• For example if they can wait three months
to start filming and if interest rates are 8%,
they will earn interest of
1,000,000x.08/4=$20,000
• But the studio can’t know for sure what the
interest rate on 3 month time deposits will
be six months in the future.
• The eurodollar futures contract is a written
by the CME on a hypothetical 90-day
deposit of $1 million eurodollars. Delivery
of the deposit is never taken. Instead,
settlement is made through a realization of
gains and losses on the buyers or sellers
margin accounts.
• The quote is expressed as an index of the 3 month
LIBOR. So, for example, the November 2001 price of
97.71 implies a 3-month LIBOR of 100-97.71=2.29%.
• If you bought that contract today and the LIBOR was
1.29% on settlement day, the contract would be worth
• 100-1.29=98.71
• and your profit would be
• 1,000,000x(98.71-97.71)/4 = $2,500
• (remember, it’s an annual rate but only lasts for 90 days).
• Now consider the example. If the studio were to buy the
June 2002 contract, they could lock in an interest rate of
2.67% (100-97.33). To understand why, suppose that
when the money arrives in June, 2002, the 3-month rate
is actually 1.67%.
• This means that the studio will deposit the $1 million and
make 1,000,000x.0167/4=$4,175
• But they will have a profit on the futures contract of
• 1,000,000x(98.33-97.33)/4=$2,500.
• They have made $6,675 for 3-months (or an annual
amount of $26,667)