Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-1 Chapter 18 Currency Futures and Futures Markets 18.1The Evolution of Financial Futures Exchanges 18.2The Operation of Futures Markets 18.3Futures Contracts 18.4Forward versus Futures Market Hedges 18.5Futures Hedges Using Cross Exchange Rates 18.6Hedging with Currency Futures 18.7Summary

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-2 Currency futures contracts F Forward contracts and default risk »Forward contracts are a pure credit instrument; one party always has an incentive to default. F 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

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-3 Financial futures exchanges F The International Monetary Market (IMM) (a subsidiary of the Chicago Mercantile Exchange) F The Philadelphia Board of Trade (PBOT) (a subsidiary of the Philadelphia Stock Exchange) F The Bolsa Mercadorias & de Futuros (BM&F) in Brazil F The London International Financial Futures Exchange (LIFFE) F The Marché à Terme des Instruments Financiers (MATIF) F The Singapore International Monetary Exchange (SIMEX) F The Tokyo International Financial Futures Exchange (TIFFE) (a subsidiary of the Tokyo Stock Exchange)

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-4 A comparison of currency forward and CME futures contracts ForwardsFutures LocationInterbankExchange floor MaturityNegotiated3rd week of the month AmountNegotiatedStandard contract (e.g. ¥12,500,000 ) FeesBid-askCommissions (e.g. $30 per contract) CounterpartyBankCME Clearinghouse CollateralNegotiatedMargin account SettlementAt maturityMost are settled early Trading hours24 hoursDuring exchange hours

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-5 Been there, done that... F 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. F Futures and forward contracts are nearly identical in their ability to hedge currency risk

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-6 Hedging with forwards and futures F Currency forward contracts can provide a perfect hedge when the size and the timing of a foreign currency transaction are known. F 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.

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-7 The growth of exchange-traded derivatives Source: Futures Industry Association (1995 figures are estimates) Millions of contracts traded

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-8 Spot and futures price convergence Forward and futures prices are determined by IRP: Fut t,T d/f = F t,T d/f = S t d/f [(1+i d )/(1+i f )] T  t

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 18-9 Maturity mismatches and basis risk F If there is a maturity mismatch, futures contracts may not provide a perfect hedge.  The difference in interest rates (i d  i f ) 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.

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e Maturity mismatches and the delta-hedge  A delta-hedge: s t d/f =  +  fut t d/f + e t s t d/f =percentage changes in spot exchange rates fut t d/f =percentage changes in futures prices F The hedge ratio can be used to minimize the variance of the hedged position: N Fut *=(Amount in futures contracts)/(Amount exposed) =   Hedge quality is measured by (  s,fut ) 2

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e Maturity mismatches and the delta-hedge: An example F 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 S 0 $/€ = $1.10/€. »The CME trades a euro futures contract expiring on June 16 with a contract size of €100,000. »Based on the regression s t $/€ =  +  fut t $/€ + e t, you estimate  = The r-square is »How many CME futures contracts should you buy to minimize the risk of your hedged position?

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e June 18June 3January 15 -€100 million underlying obligation Futures expiration date following the cash flow Maturity mismatches and the delta-hedge: An example

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e Maturity mismatches and the delta-hedge: Solution F The optimal hedge ratio for this delta-hedge is given by N Fut * = (amt in futures)/(amt exposed) = -   (amt in futures) = (-  )(amt exposed) = (-1.020)(€100 million) = €102 million so buy (€102 million) / (€100,000/contract) = 1,020 contracts

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e Currency mismatches and the cross-hedge F If there is a currency mismatch but not a maturity mismatch, a futures cross-hedge can be used.  A cross-hedge: s t d/f 1 =  +  s t d/f 2 + e t s t d/f 1 =percentage changes in the currency (f 1 ) of the underlying exposure s t d/f 2 =percentage changes in the currency (f 2 ) of the futures contract

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e The delta-cross-hedge F If there is a currency mismatch and a maturity mismatch, a delta-cross-hedge can be used.  A delta-cross-hedge: s t d/f 1 =  +  fut t d/f 2 + e t s t d/f 1 =percentage changes in the currency (f 1 ) of the underlying exposure fut t d/f 2 =percentage changes in the value of the futures contract on currency f 2

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e A classification of futures hedges