Foreign Exchange Risk

Management Product: Future

Md. Nehal Ahmed

Professor, BIBM
Foreign Exchange Risk

Foreign Exchange Risk maybe defined as the

risk that a bank may suffer losses as a result
of adverse exchange rate movements during
a period
Important Issues Regarding Risk
• Nature and magnitude of exchange risk.

• The strategy to be adopted for hedging or

managing exchange risk.

• The tools of managing exchange risk.

Risk Management Products
 Forward Contracts
 Futures Contracts
 Options
 Swaps
Who Trades Risk Management
Products?
Futures traders are traditionally placed in one of two
groups:

 Hedgers who have an interest in the underlying

commodity and are seeking to hedge out the risk of
price changes.

 Speculalors who seek to make a profit by

predicting market moves and buying a commodity "on
paper" for which they have no practical use.
Futures Contract
To buy or sell a certain underlying instruments at a
certain date in the future, at a specified price.

The future date is called the delivery date or final

settlement date. The pre-set price is called the futures
price.

A futures contract gives the holder the obligation to buy

or sell.

Both parties of a "futures contract" must fulfill the

contract on the settlement date.
Futures Contract
Futures contracts are exchange traded derivatives. The
exchange's clearinghouse acts as counterparty on all
contracts, sets margin requirements, etc.

Futures are rebalanced, or "marked to market," every

day to the daily spot price of a forward with the same
agreed-upon delivery price and underlying asset.

The rebalancing of futures eliminates much of this credit

risk by forcing the holders to update daily to the price of
an equivalent forward purchased that day.
Standardization
Futures contracts ensure their liquidity by being highly
standardized, usually by specifying:

The underlying asset or instrument - This could be

anything from a barrel of crude oil to a short term
interest rate.

The type of settlement - Either cash settlement or

physical settlement.

Contract Size - The amount and units of the underlying

asset per contract.
Standardization
• The currency in which the futures contract is
quoted.

• The grade of the deliverable - In the case of

bonds, this specifies which bonds can be delivered.

• The delivery months – vary form contract to

contract and are choosen by the cxchange.

• Daily price movements limits.

Margin
Margin requirements are waived or reduced in some
cases for hedgers who have physical ownership of the
covered commodity.

Initial margin is paid by both buyer and seller.

A futures account is marked to market daily. If the

margin drops below the margin maintenance
requirement established by the exchange listing the
futures, a margin call will be issued to bring the account
back up to the required level.
Settlement
Settlement is the act of consummating the contract,
and can be done in one of two ways, as specified per
type of futures contract:

• Physical delivery - the amount specified of the

underlying asset of the contract is delivered by the
seller of the contract to the exchange, and by the
exchange to the buyers of the contract.

• Cash settlement - a cash payment is made based

on the underlying reference rate.
Mark-to-market process
For Example
Initial futures price = $100,
Initial margin requirement = $5,
Maintenance margin requirement = $3
Panel A: Holder of Long position
of 10 contracts
Day  Beginning  Funds  Settlement       Futures Price  Gain/ Loss  Ending 
  Balance  Deposited       Price  Change    Balance 
         
0 0 50 100.00     50
             
1 50 0 99.20 -0.80 -8 42
             
2 42 0 96.00 -3.20 -32 10
             
3 10 40 101.00 5.00 50 100
             
4 100 0 103.50 2.50 25 125
             
5 125 0 103.00 -0.50 -5 120
             
6 120 0 104.00 1.00 10 130
             
Panel B: Holder of short position
of 10 contracts
Day  Beginning  Funds  Settlement  Futures  Gain/ Loss  Ending 
  Balance  Deposited       Price  Price    Balance 
        Change   
   
0 0 50 100.00     50
             
l 50 0 99.20 -0.80 8 58
             
2 58 0 96.00 -3.20 32 90
             
3 90 0 101.00 5.00 -50 40
             
4 40 0 103.50 2.50 -25 15
             
5 15 35 103.00       -0.50 5 55
             
6 55 0 104.00 1.00 -10 45
             
Currency Futures Contracts
A currency future, or foreign exchange future, is a
future contract to exchange one currency for another at
a specified date in the future at a price (exchange rate)
that is fixed on the purchase date.

Typically, one of the currencies is the US dollar. The

price of a future is then in terms of US dollars per unit
of other currency.
Currency Futures Contracts
In the United States, the primary currencies on which
trading occurs are the euro, Canadian dollar, Swiss
franc, Japanese yen, British pound, Mexican peso, and
Australian dollar. Each contract has a designated size
and a quotation unit.

For example, the euro contract covers €125,000 and is

quoted in dollars per euro. A futures price such as
$0.8555 is stated in dollars and converts to a contract
price of 125,000($0.8555) = $106,937.50.
Regulation
In most countries, futures contracts are regulated at
the federal government level. State and regional laws
may also apply. In the United States, the Commodity
Futures Trading Commission(CFTC) regulates the
futures market which was established in 1974.

In the United Kingdom, the Securities and Futures

Authority regulates both the securities and futures
markets.
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