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Hedging with Futures Contracts Tyler Gaspard. Futures Contracts  Futures contracts specify delivery of fixed quantities of foreign currencies on a set.

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Presentation on theme: "Hedging with Futures Contracts Tyler Gaspard. Futures Contracts  Futures contracts specify delivery of fixed quantities of foreign currencies on a set."— Presentation transcript:

1 Hedging with Futures Contracts Tyler Gaspard

2 Futures Contracts  Futures contracts specify delivery of fixed quantities of foreign currencies on a set date in the future  Traded on an organized exchange.  Standardized by size and delivery date to make trading easier

3 Futures vs Forwards  FUTURES  Traded on organized exchange  Market determines price  ~ $100,000  Standardized maturity  Require initial deposit into margin account  Daily settlement of G/L  FORWARDS  Traded on inter-bank market  Prices set by contract  > $1 million  Customer-tailored maturity  Rarely require cash payment before maturity  Settled on maturity

4 Futures Contracts  Advantages  Liquidity: can be traded before maturity at little cost  Size: more useful for hedging small exposures  Limitations  Only available in a few currencies, thus requiring cross- hedging  Must be purchased in whole contracts, thus perfect hedging is not always possible

5 Most Useful Hedges  Unknown transaction dates  Can liquidate futures position anytime before maturity or roll over to a later maturity  Unknown transaction amounts  Easy to change futures position  Small transactions

6 Hedging with Futures  Important dates to keep in mind:  t---------------- t + n -------------------T  inception liquidation maturity  Gain/Loss Equation = X[(S t+n – bS t ) – (Z t+n - Z t )]  b = [1 + i t,t+n ] months/12 / [1 + i* t,t+n ] months/12

7 Futures Held to Maturity  Enables a perfect hedge just like a forward contract  Futures and forwards are priced according to covered interest parity  Futures at maturity = Spot Rate  Futures at inception = Forward with same maturity  Losses from exchange rate changes will be perfectly offset by gains in the futures contract

8 Futures Not Held to Maturity  Will not provide for perfect hedges for two reasons  Futures price at liquidation date has not yet converged to the spot exchange rate.  Interest rates at liquidation date are not known in advance and are likely to change between inception and liquidity.

9 Example  Atkinson Enterprises, a US consulting firm, has provided services to its neighbors to the north, Cannuck Manufacturing, a Canadian firm. These two firms have done business together for years, so Atkinson has allowed Cannuck up to six months to pay its bill of 100,000 $Canadian. The current spot rate is $.70 US/ 1 C$. Interest rates are 5% on Canadian deposits and 8% on US deposits. Three months later, Cannuck pays its bill. The US dollar has appreciated over this time to a spot rate of $.68/1 C$.

10 Scenario 1  Atkinson chooses to not hedge  Loss from exchange risk =  100,000 [(.68 – b(.70)]  b = [1.083/12]/[1.053/12] = 1.0071  Loss from exchange risk = -$2,494.73

11 Scenario 2  Atkinson hedges the original transaction by selling one Canadian Futures contract with a six month maturity date. The contract is sold at a price of.7150. When Cannuck payment is received three months later, Atkinson buys one Canadian futures contract to close its position. The futures price at this time has dropped to.7000.

12 Scenario 2  Loss from exchange risk = -2,494.73  Gain from futures contract =  100,000(.7150 -.7000) = 1500  Net Loss = -2,494.73 + 1500 = -994.73  Hedging has saved Atkinson Enterprises $1500.


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