ESSEC

Business School

International Finance

CLASS HANDOUTS

SESSION 4

Peng Xu

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 Hedging Currency Risk with Futures and Money

Market Instrument

Outline

– Futures on Foreign Exchange

– Money Market Hedge

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 I. Futures on Foreign Exchange

– A futures contract is like a forward contract in that it specifies

that a certain currency will be exchanged for another at a

specified time in the future at prices specified today.

– A futures contract is different from a forward contract in that

futures are standardized contracts trading on organized

exchanges with daily resettlement through a clearinghouse.

– Currency Futures Markets

• The CME Group (formerly Chicago Mercantile Exchange) is

by far the largest currency futures market.

• The Singapore Exchange also offers currency futures

contracts.

• There are other markets, but none are close to CME and

SIMEX trading volume.

• Expiry cycle: March, June, September, December.

• The delivery date is the third Wednesday of delivery month.

• The last trading day is the second business day preceding

the delivery day.

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 I. Futures on Foreign Exchange

• Example: CME Group Currency Futures Contract Quotations

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 I. Futures on Foreign Exchange

– Standardizing features:

• Contract size

• Delivery month

• Daily settlement:

Long position gets: 𝐹𝑡,𝑇 − 𝐹𝑡−1,𝑇

Short position gets: −(𝐹𝑡,𝑇 − 𝐹𝑡−1,𝑇 )

• After the daily resettlement, each party has a new contract at

the new price with one-day-shorter maturity.

• Initial performance bond (initial margin): e.g. about 2 percent

of contract value, cash or T-bills

• Maintenance performance bond (maintenance margin): e.g.

90% of the initial performance bond

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 I. Futures on Foreign Exchange

– Summary of Differences between Futures and Forward

contracts

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 I. Futures on Foreign Exchange

– The futures price can be computed similarly to forward contract:

– The value of the currency futures:

• The value of the futures contract is 0 at initiation.

• The value of the futures contract is 0 after daily settlement.

– The value of the currency forward:

• The value of the forward contract is 0 at initiation.

• The value of the forward contract is 𝑆𝑇 − 𝐹0,𝑇 at maturity.

• The value of the forward contract at 𝑡 ∈ (0, 𝑇), is

𝑆𝑡 𝐹0,𝑇
𝑇−𝑡 − (1 + 𝑟)𝑇−𝑡
(1 + 𝑟𝑓 )

• Example:

Some time ago, a company entered into a forward contract to

buy £1 million for $1.5 million. The contract now has 6

months to maturity. The current exchange rate is 1.53.

Assume that the 6-month interest rate in both sterling and

dollars is 5% per annum.

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 I. Futures on Foreign Exchange

– There are three types of market participants for Currency

Forward and Futures:

• Hedgers

• Speculators

• Arbitrageurs

– Forward Market Hedge:

• Imports

If you expect to pay foreign currency in the future, you can

hedge by agreeing today to buy the foreign currency in the

future at a set price by entering into a long position in a

forward contract.

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 I. Futures on Foreign Exchange

• Exports

If you are going to receive foreign currency in the future,

agree to sell the foreign currency in the future at a set price

by entering into short position in a forward contract.

• Recall that when firms hedge with forward contract, they

hedge the downside risk, but also give up the potential gain

from foreign currency appreciation/depreciation.

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 I. Futures on Foreign Exchange

• Cross Currency Hedge:

Example:

Your firm is a U.K.-based exporter of bicycles.

You have sold €2,500,000 worth of bicycles to an Italian

retailer.

Payment (in euros) is due in six months.

Your firm wants to hedge the receivable into pounds.

The quotation in the forward market is as follows:

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 I. Futures on Foreign Exchange

Solution:

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 I. Futures on Foreign Exchange

– Cross-Hedging Minor Currency Exposure

• If a firm has receivables or payables in minor currencies like

Korean won, Thai Bhat, and Czech Koruna, it may be either

very costly or impossible to use financial contracts in these

currencies to manage its exchange risk exposure.

• Cross-hedging involves hedging a position in one asset by

taking a position in another asset.

• The effectiveness of cross-hedging depends upon how well

the assets are correlated.

• Example:

A U.S. importer with liabilities in Swedish krona hedges

it exposure to Krona by long forward contracts on the euro.

If the krona is expensive when the euro is expensive, or

even if the krona is cheap when the euro is expensive, it

can be a good hedge. But they need to co-vary in a

predictable way.

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 II. Money Market Hedge

– Money Market Hedge:

• This is the same idea as covered interest arbitrage.

• To hedge a foreign currency payable,

Borrow domestic currency from the domestic bank

Buy the present value of the foreign currency payable

today at the spot exchange rate.

Invest that amount at the foreign rate.

At maturity your investment will have grown enough to

cover your foreign currency payable.

• To hedge a foreign currency receivable,

Borrow foreign currency from the foreign bank

Sell the present value of the foreign currency receivable

today at the spot exchange rate.

Invest that amount at the domestic rate.

At maturity your foreign currency receivable can be

used to pay the foreign bank.

• Import Example:
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 II. Money Market Hedge

A U.S.–based importer of British bicycles needs to pay

£100,000 to a British supplier in one year.

The spot exchange rate is $1.50 = £1.00.

The one-year interest rate in the U.K. is i£ = 4%. The U.S.

interest rate is i$ = 3%.

Solution:

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