Chapter 6

Currency Futures and Forwards

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
Currency Futures Market (1)
Currency futures contracts specify a standard
volume of a particular currency to be exchanged on
a specific settlement date at a specified exchange
rate.

They are used by:

MNCs to hedge their currency positions
speculators who hope to capitalize on their expectations of
exchange rate movements.

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
Currency Futures Market (2)
The contracts can be traded by firms or individuals
through brokers on the trading floor of an exchange
(e.g. Chicago Mercantile Exchange), automated
trading systems (e.g. GLOBEX), or the over-the-
counter market.

Person to person

Brokers who fulfill orders to buy or sell futures

contracts typically charge a commission.

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Currency Futures Market (3)
Enforced by potential arbitrage activities, the prices of
currency futures are closely related to their
corresponding forward rates and spot rates.

Currency futures contracts are guaranteed to be fulfilled

by the exchange clearinghouse, which in turn minimizes
its own credit risk by imposing margin requirements on
those market participants who take a position.

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Currency Futures Market (3)
Margin:

When participants in the currency futures market take a

position, they need to stablish an initial margin (deposit
an amount of money with the clearing house), which may
represent the 10% of the contract value.
To ensure that the losses or gains are debited or
credited to the customer account on the day they occur.

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Currency Futures Market (3)
Margin:
initial margin is the minimum amount required to enter
into a new futures contract
maintenance margin is the lowest amount an account
can reach before needing to be replenished. For
example, if your margin account drops to a certain level
because of a series of daily losses, brokers are required
to make a margin call and request that you make an
additional deposit into your account to bring the margin
back up to the initial amount.

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Currency Futures Markets
Future contract (EXCHANGE) -- Speculate
Specific quantities
(SFr 125 000, P 500 000, 12 500 000, 125 000, C$ 100 000,
62 500, A$ 100,000)
Australian dollar, Brazilian real, British pound, Canadian dollar,
euro, Japanese yen, Mexican peso, New Zealand dollar,
Russian ruble, South African rand, and Swiss franc
March, June, September and December
Contract expires two business days before the 3rd. Wed of the
delivery month

Forward contract,
are private deals between two individuals who can sign any type of
contract they agree on.
 Currency Futures Markets
Participants (speculators, importers,
exporters, companies with foreign currency
assets and liabilities, and bankers)
 Currency Futures Markets
Assume on Feb 10th, a futures contract on $20,000 with a
march settlement date is priced at 0.80 in the xx market.
Firm A buys the contract
Firm B sells the contract

On Mar 10th :
The buyer (A) of the contract will receive
The seller (B) of the contract will receive
Currency Futures Market (5)
A U.S.-based MNC has agreed to import raw materials
from Canada. The MNC invoices for these goods in
Canadian dollars and the Canadian dollar will appreciate
in the near future.

a) futures contract to buy Canadian dollar?

b) futures contract to sell Canadian dollar?

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
Currency Futures Market (5)
MNCs may purchase currency futures to hedge their
foreign currency payables,
or sell currency futures to hedge their receivables.

April 4 June 17
1. Expect to receive 2. Receive 500,000 pesos
500,000 pesos. as expected.
Contract to sell
500,000 pesos @ 3. Sell the pesos at the
.056/peso on locked-in rate.
June 17.
For use with International Financial Management, 3e
Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
Currency Futures Market (5)
MNCs may purchase currency futures to hedge their
foreign currency payables,
or sell currency futures to hedge their receivables.

April 4 June 17
1. Needs to pay 2. Buys 500,000 pesos as
500,000 pesos. at .056/peso
Contract to buy 3. pays the pesos at the
500,000 pesos @ payment term
.056/peso on June
17.
For use with International Financial Management, 3e
Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
Currency Futures Market (4)
Speculators often sell currency futures
when they expect the underlying currency
to depreciate, and vice versa.
April 4 June 17
1. Contract to sell 2. Buy 500,000 pesos @
500,000 pesos .050/peso (25,000)
@ .056/peso from the spot market.
(28,000) on
June 17.
3. Sell the pesos to fulfill
contract.

Gain = 3,000.
Gains and losses are settled on daily basis by the clearing house to
ensure creditworthiness
 Forward Market (1)
A forward contract is an agreement between a firm
and a commercial bank to exchange a specified
amount of a currency at a specified exchange rate
(called the forward rate) on a specified date in the
future.

Forward contracts are often valued at 1 million or

more, and are not normally used by consumers or
small firms.

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Forward Market (3)
Forward contracts accommodate large corporations.
Normally not used by consumers or small firms
Most common: 30 60 90 180 360 days but other periods can
be available

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Forward Market (2)
When MNCs anticipate a future need for or future
receipt of a foreign currency, they can set up
forward contracts to lock in the exchange rate.

The % by which the forward rate (F ) exceeds the

spot rate (S ) at a given point in time is called the
forward premium (p ).

F = S (1 + p )
F exhibits a discount when p < 0.

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Forward Market (3)
Example S = 0.60:$1,
90-day F = 0.59:$1

F S 360
annualized p =
S n
= 0.59 0.60 360 = .017%
0.60 90

The forward premium (discount) usually reflects the difference

between the home and foreign interest rates.
 Forward Market (3)
Because of arbitrage possibilities the forward
exchange rate will depend on the interest rates

Arbitrage ties the forward rate to spot and to

interest rates, thus forward rates are not
independent forecasts
 Comparison of the Forward & Futures
Markets (1)
Future contracts Forward contracts
1 Standardized contracts Tailored contracts
2 Publicly traded Privately traded
Daily settlement of profits and
The gain or loss accumulates until
3 losses, which is known as
the expiration of the contract
"mark to market".
They are traded on futures
exchanges, which are properly
4 Over The Counter (OTC)
centralized and regulated
markets.
There is a risk of default, although
5 No risk of default
this rarely occurs.

Clearinghouse assumes
No clearinghouses present
responsibility for payment
6 between the parties in a Forward
defaults and are responsible
contract.
for paying the other party.
 Comparison of the Forward & Futures
Markets (1)
Future contracts Forward contracts

Participants: Banks Brokers Participants: Banks Brokers MNCs

7 MNCs and Qualified public. and Unqualified public.
Speculation encouraged Speculation NOT encouraged

The trading parties have

indirect contracts with each Both parties - the buyer and the
other, since the seller - have a direct contract with
clearinghouse writes a each other, and the payments are
8
contract between both also handled directly by them
participants. The Clearing independently according to their own
House is responsible for negotiated terms and conditions..
settling payments.
 Comparison of the Forward & Futures
Markets (1)
Future contracts Forward contracts

Most Forward contracts are hold to

maturity, however, it is possible for
9 97% do not get to maturity the parties to make opposing
transactions before the contract
expires.

Futures markets offer

Since Forward contracts are
participants a high level of
generally created to be in effect
liquidity. Because of this
10 until their maturity, the Forwards
liquidity, a participant may
markets are less liquid than the
open and close positions
Futures markets
frequently.

Transaction costs = Negotiated

Transaction costs = Bid-Ask spread
brokerage fees
 Example

2. A Mexican MNC wants to hedge pound

payables, then the Mexican MNC

a. Will purchase pesos forward

b. Will purchase pounds forward
 Example

2. A US MNC wants to hedge yen receivables, then the

US MNC

a. Will sell dollars forward

b. Will sell yen forward
 Example
Scanlon plc, based on the UK, exports products to a
French firm and will receive payment of 400,000 in 4
months.

Scalon can negotiate a forward contract with the bank to

SELL or BUY?
400,000 for British pounds at a specific forward rate
 Exercise 1
What would you do if your company has a forward contract with the
Bank A to buy 1,000,000USD in 90 days but you want to cancel it?

Note: For forwards, closing out is unusual.

 Exercise 1
The obligation can be ended by taking out a forward contract
to sell 1,000,000USD to Bank B

Then Bank A will sell directly to Bank B and your companys

position will be closed out

Any loss will be on the forward holder account

 Exercise1
March 10 Green Bay plc hired a French company and agreed to pay
200,000 on 10 Sept. Negotiates a 6 month forward contract with bank
A to buy 200,000 at 0.70 per euro.
On 10 April the French company backs up Then Green Bay offset its
existing contract by negotiating a forward contract with Bank B to sell
200,000 for date 10 Sept.
However the spot date of the euro has decreased and the prevailing
forward contracts price is now 0.66

A loss of 0.04 x 200,000= 8,000 will be paid to bank A

Now bank A will be willing to sell the forward to bank B for 0.66
 Exercise 2
In Jan 10th C company buys a futures contract specifying
100,000USD and March settlement date. Price of the contract is
0.41 per dollar.
By February cancels the supply order and will not have the need to
buy dollars.
What can company C do to offset the contract?
 Exercise
Company C can sell a futures contract on USD with March
settlement date.
However the price of the contract at that moment is 0.39

Does the company bear a loss, a gain or none?

 Exercise 2
Company C pays
( 0.39 - 0.41 ) * 100,000$ = 2,000

This is settled at the transaction date on February. Settlements are

done on daily basis

On march the contracts are offset, so no further payments are

required.