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CURRENCY FUTURES



Lakshmi Ananthanarayan
NOV 2013


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Basics
Major impetus to their introduction was the end of the
fixed exchange rates and the widespread adoption of
floating exchange rates, which resulted in a sharp increase
in exchange rate volatility
Currency futures a binding obligation to buy or sell a
particular currency against another at a designated rate of
exchange on a specified future date
Foreign currency futures provide a mechanism for
managing currency risk
Can be used to speculate on changes in exchange rates


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Example 1 Hedging Payables with Forward
ABC Films Ltd. has imported raw materials worth $2 million for
which the payment is due after 3 months. Following rates are quoted
by the bank:
Spot (Rs / $) 47.00 47.45
3 months forward 47.50 48.00
The firm is expecting appreciation of USD by more than 5% in 3
months time.
a) Should it hedge its payable?
b) What rate would be paid by it if it decides to hedge?
c) What would be the gain / loss if the actual spot rates after 3
months turn out to be (i) Rs 46.50 47.00 (ii) Rs 49.30 49.85?



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Example 2
Assume that a US exporter is exporting goods to his German client
On Sep 14, 20X1, the exporter gets 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 risk of currency fluctuations (Euro depreciation)
Here, the exporter can sell 5 Euro futures contract. Size of each contract is Euro
125,000





Spot market on Nov 1, 20X1: Loss of USD 1,012.5
Futures market on Nov 1, 20X1: Profits = USD 1,012.5
The loss in the spot market, arising from the appreciation of dollar is offset by the
profit in the futures market
Date
Spot Exchange Rate
$ / Euro
December Futures Rate
$ / Euro
Sept. 14, 20X1 0.4407 0.4442
Nov 1, 20X1 0.43908 0.44258
Difference 0.00162 0.00162


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Example 3
Assume that a US exporter is exporting goods to his German client
On Sep 14, 20X1, the exporter gets 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 risk of currency fluctuations (Euro depreciation)
Here, the exporter can sell 5 Euro futures contract. Size of each contract is Euro
125,000





Spot market on Nov 1, 20X1: Loss of USD 1,012.5
Futures market on Nov 1, 20X1: Profits = USD 700
Date
Spot Exchange Rate
$ / Euro
December Futures Rate
$ / Euro
Sept. 14, 20X1 0.4407 0.4442
Nov 1, 20X1 0.43908 0.44308
Difference 0.00162 0.00112


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Example
Direct currency hedge involves two currencies
directly involved in the transaction
Cross hedge for a cross hedge to be effective, the
firm has to choose a contract on an underlying
currency which is almost perfectly correlated with the
exposure which is being hedged


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Hedge ratio
Allows the hedger to determine the number of contracts that must be
employed in order to minimize the risk of the combined cash-futures
position
Number of futures contracts to hold for a given position in the
underlying asset
HR = Futures Position
Underlying asset position
If hedge ratio is 1, there will be a perfect hedge when there is no
change in basis
In the earlier example, if the exporter takes a position on 7.23214
contracts, he would have gotten the perfect hedge


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Speculation using currency futures
When a speculator is betting on 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:
The same currency but contracts of different maturities
Two contracts of same maturity but different currencies
A combination of the above