Chapter 18 Currency Futures and Futures Markets

1. Chapter 18Currency Futures and Futures Markets 18.1 The Evolution of Financial Futures Exchanges 18.2 The Operation of Futures Markets 18.3 Futures Contracts 18.4 Forward versus Futures Market Hedges 18.5 Futures Hedges Using Cross Exchange Rates 18.6 Hedging with Currency Futures 18.7 Summary

2. Currency futures contracts • Forward contracts and default risk • Forward contracts are a pure credit instrument; one party always has an incentive to default. • The futures contract solution • An exchange clearinghouse takes one side of every transaction • Futures contracts are marked-to-market on a daily basis • Initial and maintenance margins are required on futures contracts

3. Financial futures exchanges • The International Monetary Market (IMM) (a subsidiary of the Chicago Mercantile Exchange) • The Philadelphia Board of Trade (PBOT) (a subsidiary of the Philadelphia Stock Exchange) • The Bolsa Mercadorias & de Futuros (BM&F) in Brazil • The London International Financial Futures Exchange (LIFFE) • The Marché à Terme des Instruments Financiers (MATIF) • The Singapore International Monetary Exchange (SIMEX) • The Tokyo International Financial Futures Exchange (TIFFE) (a subsidiary of the Tokyo Stock Exchange)

4. A comparison of currency forwardand CME futures contracts ForwardsFutures Location Interbank Exchange floor Maturity Negotiated 3rd week of the month Amount Negotiated Standard contract (e.g. ¥12,500,000 ) Fees Bid-ask Commissions (e.g. $30 per contract) Counterparty Bank CME Clearinghouse Collateral Negotiated Margin account Settlement At maturity Most are settled early Trading hours 24 hours During exchange hours

5. Been there, done that... • Futures contracts are similar to forward contracts • Futures contracts are like a bundle of consecutive one-day forward contracts • Daily settlement is the biggest difference between a forward and a futures contract. • Futures and forward contracts are nearly identical in their ability to hedge currency risk

6. Hedging with forwards and futures • Currency forward contracts can provide a perfect hedge when the size and the timing of a foreign currency transaction are known. • Exchange-traded futures contracts come in only a few currencies, contract sizes, and maturity dates, and hence may not provide a perfect hedge against transaction exposure to foreign currency risk.

7. The growth of exchange-traded derivatives Millions of contracts traded Source: Futures Industry Association (1995 figures are estimates)

8. Spot and futures price convergence Forward and futures prices are determined by IRP: Futt,Td/f = Ft,Td/f = Std/f [(1+id)/(1+if)]T-t

9. Maturity mismatches and basis risk • If there is a maturity mismatch, futures contracts may not provide a perfect hedge. • The difference in interest rates (id-if) is called the basis. • The basis determines the relation of futures prices to spot prices through interest rate parity. • The risk of change in the relation between futures and spot prices is called basis risk. • When there is a maturity mismatch, basis risk makes a futures hedge slightly riskier than a forward hedge.

10. Maturity mismatches and the delta-hedge • A delta-hedge: std/f = a + b futtd/f + et std/f = percentage changes in spot exchange rates futtd/f = percentage changes in futures prices • The hedge ratio can be used to minimize the variance of the hedged position: NFut* = (Amount in futures contracts)/(Amount exposed) = -b • Hedge quality is measured by (rs,fut )2

11. Maturity mismatches and the delta-hedge:An example • You work in the United States and need to hedge a €100 million obligation due on June 3.It is now January 15. • The spot exchange rate is S0$/€ = $1.10/€. • The CME trades a euro futures contract expiring on June 16 with a contract size of €100,000. • Based on the regression st$/€ = a + b futt$/€ + et , you estimate b = 1.020. The r-square is 0.95. • How many CME futures contracts should you buy to minimize the risk of your hedged position?

12. Maturity mismatches and the delta-hedge:An example Futures expiration date following the cash flow January 15 June 3 June 18 -€100 million underlying obligation

13. Maturity mismatches and the delta-hedge:Solution • The optimal hedge ratio for this delta-hedge is given by NFut* = (amt in futures)/(amt exposed) = -b  (amt in futures) = (-b)(amt exposed) = (-1.020)(€100 million) = €102 million so buy (€102 million) / (€100,000/contract) = 1,020 contracts

14. Currency mismatches and the cross-hedge • If there is a currency mismatch but not a maturity mismatch, a futures cross-hedge can be used. • A cross-hedge: std/f1 = a + b std/f2 + et std/f1 = percentage changes in the currency (f1) of the underlying exposure std/f2 = percentage changes in the currency (f2) of the futures contract

15. The delta-cross-hedge • If there is a currency mismatch and a maturity mismatch, a delta-cross-hedge can be used. • A delta-cross-hedge: std/f1 = a + b futtd/f2 + et std/f1 = percentage changes in the currency (f1) of the underlying exposure futtd/f2 = percentage changes in the value of the futures contract on currency f2

16. A classification of futures hedges