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Lecture 6a: Futures

Lecture 6a: Futures . Forwards and Futures Contracts. Are instruments that allow the buying and selling of a stated amount of foreign currency at a stated price per unit at a specific date in the future When signed, there is no up-front costs

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Lecture 6a: Futures

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  1. Lecture 6a: Futures

  2. Forwards and Futures Contracts • Are instruments that allow the buying and selling of a stated amount of foreign currency at a stated price per unit at a specific date in the future • When signed, there is no up-front costs • Are classified as derivatives because their values are derived from the value of the underlying security • While they play a similar role in the management of FX risk, there are some key differences

  3. Any futures contract specifies a standard quantity of a good will be bought or sold at a specified time in the future. • The Chicago Mercantile Exchange began trading in currency futures in 1972 • Other markets include: • The Philadelphia Board of Trade (PBOT) • The MidAmerica commodities Exchange • The Tokyo International Financial Futures Exchange • The London International Financial Futures Exchange

  4. Currencies traded and contract size • Yen (12.5 Million) • DM (125,000) • C$ (100,000 • British Pound (62,500) • Swiss Franc (125,000) • Australian Dollar (100,000) • Mexican Peso (500,000) • Euro (125,000)

  5. Forwards and Futures Contracts

  6. Hedging with Futures • Example: Long Hedge • It is March, a US firm has to pay JPY 25 million in 180 days. The company decides to hedge its currency risk. • It hedges the JPY payables by buying JPY September futures for JPY 25 million • On the CME, the JPY contract is for 12.5 million yen, so they buy two CME contracts • If the Yen strengthens, the payables become more expensive • However, the forward contract becomes more valuable, perfectly hedging the payables

  7. Advantages and Disadvantages of Futures • Advantages • Small Contract Size • Easy liquidation • Well organized and stable market (no risk of default) • Disadvantages • Limited number of currencies (but think about how one futures might be a close hedge against another currency) • Rigid contract size • Fixed expiration dates (but if you can get close, it doesn’t matter all that much).

  8. Interest Rate Futures Exchange rate risk is not the only risk facing a business who expects to get paid or is obligated to pay in the future. Consider the following:

  9. On October 23, 2001 the Film Board of Canada signs a contract in which it agrees to pay a $1 million subsidy to an American studio that is making a sequel to “Dudley-Do-Right” in Toronto. The funds will be paid on July 1, 2002, but filming won’t start until the first blizzard (usually in the last part of September). No money is required until filming starts. • This is good news, since the studio will be able to earn interest on the subsidy while they wait for filming to start.

  10. For example if they can wait three months to start filming and if interest rates are 8%, they will earn interest of 1,000,000x.08/4=$20,000 • But the studio can’t know for sure what the interest rate on 3 month time deposits will be six months in the future.

  11. The eurodollar futures contract is a written by the CME on a hypothetical 90-day deposit of $1 million eurodollars. Delivery of the deposit is never taken. Instead, settlement is made through a realization of gains and losses on the buyers or sellers margin accounts.

  12. The quote is expressed as an index of the 3 month LIBOR. So, for example, the November 2001 price of 97.71 implies a 3-month LIBOR of 100-97.71=2.29%. • If you bought that contract today and the LIBOR was 1.29% on settlement day, the contract would be worth • 100-1.29=98.71 • and your profit would be • 1,000,000x(98.71-97.71)/4 = $2,500 • (remember, it’s an annual rate but only lasts for 90 days).

  13. Now consider the example. If the studio were to buy the June 2002 contract, they could lock in an interest rate of 2.67% (100-97.33). To understand why, suppose that when the money arrives in June, 2002, the 3-month rate is actually 1.67%. • This means that the studio will deposit the $1 million and make 1,000,000x.0167/4=$4,175 • But they will have a profit on the futures contract of • 1,000,000x(98.33-97.33)/4=$2,500. • They have made $6,675 for 3-months (or an annual amount of $26,667)

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