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The Wide World of Futures Contracts

Currency contracts
Eurodollar futures
An introduciton to commodity futures

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Currency Contracts

Currency rate is the price of one currency in another

Widely used to hedge against changes in exchange rates
WSJ listing

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Listings for various currency futures contracts from the Wall Street Journal

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Currency Contracts: Pricing

Currency prepaid forward
Suppose you want to purchase U1 one year from
today using $S
= x0 ery T
Where x0 is current ($/U) exchange rate, and ry
is the yen-denominated interest rate
Why? By deferring delivery of the currency one
loses interest income from bonds denominated in
that currency
Currency forward
F0,T = x0 e(rry )T (Covered interest rate parity)
r is the $-denominated domestic interest rate
F0,T > x0 if r > ry (domestic risk-free rate
exceeds foreign risk-free rate)

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Currency Contracts: Pricing (contd)

U-denominated interest rate is 2% and current ($/ U)

exchange rate is 0.009. To have U1 in one year one needs
to invest today
0.009/U U1 e0.02 = $0.008822
U-denominated interest rate is 2% and $-denominated
rate is 6%. The current ($/ U) exchange rate is 0.009.
The 1-year forward rate
0.009e0.060.02 = 0.009367

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Covered Interest Arbitrage

Synthetically creating a yen forward contract by borrowing in
dollars and lending in yen. The payoff at time 1 is U1 $0.009367.

Borrow x0 ery dollar
at 6% ($)
Convert to yen
@ 0.009 $/U
Invest in yendenominated bill (U)

Cash flows
Year 0
Year 1




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Covered Interest Arbitrage (Contd)

Consider the following set of foreign and domestic interest

rates and spot and forward exchange rates
Spot exchange rate ($/)
= $1.25/
360-day forward rate ($/) F0,360 = $1.20/
U.S. interest rate
= 7.1390%
British interest rate
= 11.2212%
A trader with $1,000 could invest in the U.S. at 7.1390%, in
one year his investment will be worth
$1,074 = $1,000 er = $1,000 (1.074)

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Covered Interest Arbitrage (Contd)

Alternatively, this trader could


Exchange $1,000 for 800 at the prevailing spot rate,

Invest 800 for one year at ry = 11.2212%; earn 800
ery = 800 1.1187 = 895.
Translate 895 back into dollars at the forward rate F0,360
= $1.20/, the 895 will be exactly $1,074.

If F360 6= $1.20/,


an astute trader could make money with one of the

following strategies:

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Arbitrage Strategy I
If F0,360 > $1.20/

Borrow $1,000 at t = 0 at r = 7.1390%.

Exchange $1,000 for 800 at the prevailing spot rate,
(note that 800 = $1,000$1.25/) invest 800 at
11.22% for one year to achieve 895
Translate 895 back into dollars

If F0,360 > $1.20/, then 895 will be more than enough to

repay your debt of $1,074.
For example, consider F0,360 = $1.30/, then

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Arbitrage Strategy II
If F0,360 < $1.20/

Borrow 800 at t = 0 at ry = 11.22% .

Exchange 800 for $1,000 at the prevailing spot rate,
invest $1,000 at 7.139% for one year to achieve $1,074.
Translate $1,074 back into pounds

If F0,360 < $1.20/, then $1,074 will be more than enough to

repay your debt of 895.
For example, consider F0,360 = $1.10/, then

Be careful what currency you started with, and what you

ended up with
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Carry trade

If we do not hedge the exchange rate risk then it is

uncovered interest arbitrage
Instead of forward contract, we will rely on future spot
Not really an arbitrage opportunity then
Carry trade is defined as borrowing at a lower interest rate
and lending in a higher interest rate
it is a speculation as high-rate currency may depreciate

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Eurodollar Futures Contract

Derivatives on the interest rates (more to come in the

next chapter...)
The Eurodollar futures contract refers to the futures
contract based upon Eurodollar deposits, traded at the
Chicago Mercantile Exchange (CME).
What if you want to borrow money or lend not now, but
from a certain time in the future?
Interest rate is unknown yet
You can use these contracts to lock in an interest rate
today, for money to borrow or lend in the future
Eurodollars are deposits denominated in U.S. dollars at
banks outside the United States

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Eurodollar Futures Contract Specifications

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Listing for interest rate futures contracts, including the 1-month LIBOR
and 3-month Eurodollar contracts, from WSJ

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Introduction to Commodity Futures

Different commodities have their distinct forward curves

(plotting prices against maturities), reflecting different
properties of
Storability (Fruits and electricity can not be stored,
while metals can)
Storage costs (Corn is consumed throughout the year
but harvested at only one time. Corn must be stored,
but it is costly)

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Introduction to Commodity Futures (Contd)

In general, commodity forward prices can be found using

the same economic principles used for financial forward
F0,T = S0 e(r)T

For financial assets, is the dividend yield

For commodities, is the commodity lease rate
The lease rate is the return that makes an investor
willing to buy and lend a commodity
Some commodities (metals) have an active leasing
More typically, lease rates can only be estimated by
observing forward prices

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Forward Prices and the Lease Rate

The lease rate has to be consistent with the forward price

Therefore, when we observe the forward price, we can
infer what the lease rate would have to be if a lease
market existed
The annualized lease rate l = r T1 ln(F0,T /S)

The effective annual lease rate l =

(F0,T /S)1/T

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