Foreign Currency Futures Versus Forward Contracts

CME Australian Dollar

F. Foreign Currency Futures Versus Forward Contracts

Foreign currency futures contracts differ from forward contracts in a number of important ways. Nevertheless, both futures and forward contracts are used for the same commercial and speculative purposes. Exhibit 47 provides a comparison of the major features and characteristics of the two instruments.

The following example illustrates how currency futures contracts are used for hedging purposes and gains and losses calculations, and how they compare with currency options.

EXAMPLE 50

TDQ Corporation must pay its Japanese supplier ¥125 million in three months. The firm is contemplating two alternatives:

1. Buying 20 yen call options (contract size is ¥6.25 millions) at a strike price of $0.00900 in order to protect against the risk of rising yen. The premium is $0.00015 per yen.

2. Buying 10 3-month yen futures contracts (contract size is ¥12.5 million) at a price of $0.00840 per yen. The current spot rate is $0.008823/¥. The firm’s CFO believes that the most likely rate for the yen is $0.008900, but the yen could go as high as $0.009400 or as low as

$0.008500.

Note: In all calculations, the current spot rate $0.008823/¥ is irrelevant.

1. For the call options, TDQ must pay a call premium of $0.00015 × 125,000,000 = $18,750.

If the yen settles at its minimum value, the firm will not exercise the option and it loses the entire call premium. But if the yen settles at its maximum value of $0.009400, the firm will

EXHIBIT 47

Basic Differences of Foreign Currency Futures and Forward Contracts

Characteristics Foreign Currency Futures Forward Contracts Trading and location In an organized exchange By telecommunications

networks

Parties involved Unknown to each other In direct contact with each other in setting contract specifications.

Size of contract Standardized Any size individually tailored

Maturity Fixed Delivery on any date

Quotes In American terms In European terms

Pricing Open outcry process By bid and offer quotes

Settlement Made daily via exchange clearing house; rarely delivered

Normally delivered on the date agreed

Commissions Brokerage fees for buy and sell (roundtrip)

Based on bid–ask spread Collateral and margin Initial margin required No explicit margin specified

Regulation Highly regulated Self-regulating

Liquidity and volume Liquid but low volume Liquid but large volume Credit risk Low risk due to the exchange

clearing house involved

Borne by each party

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exercise at $0.009000 and earn $0.0004/¥ for a total gain of $0.0004 × 125,000,000 = $50,000.

TDQ’s net gain will be $50,000 − $18,750 = $31,250.

2. By using a futures contract, TDQ will lock in a price of $0.008940/¥ for a total cost of

$0.008940 × 125,000,000 = $992,500. If the yen settles at its minimum value, the firm will lose $0.008940 − $0.008500 = $0.000440/¥ (remember the firm is buying yen at $0.008940, when the spot price is only $0.008500), for a total loss on the futures contract of $0.00044 × 125,000,000 = $55,000. But if the yen settles at its maximum value of $0.009400, the firm will earn $0.009400 − $0.008940 = $0.000460/¥, for a total gain of $0.000460 × 125,000,000 ₌

$57,500.

Exhibits 48 and 49 present profit and loss calculations on both alternatives and their corresponding graphs.

See CURRENCY OPTION; FORWARD CONTRACT; FUTURES.

FOREIGN CURRENCY OPERATIONS

Also called foreign-exchange market intervention, foreign currency operations involve purchase or sale of the currencies of other countries by a central bank in order to influence foreign exchange rates or maintaining orderly foreign exchange markets.

EXHIBIT 48

Profit or Loss on TDQ’s Options and Futures Positions

Contract size: 125,000,000 Yens

Expiration date: 3.0 months

Exercise or strike price: 0.00900 $/Yen

Premium or option price: 0.00015 $/Yen

(1) CALL OPTION Ending spot

rate ($/Yen) 0.00850 0.00894 0.00915 0.00940 0.00960

Payments

Premium (18,750) (18,750) (18,750) (18,750) (18,750)

Exercise

cost 0 0 (1,125,000) (1,125,000) (1,125,000)

Receipts

Spot sale 0 0 1,143,750 1,175,000 1,200,000

of Yen

Net ($) (18,750) (18,750) 0 31,250 56,250

(2) FUTURES Lock-in price = 0.008940$/Yen

Receipts 1,062,500 1,117,500 1,143,750 1,175,000 1,200,000

Payments (1,117,500) (1,117,500) (1,117,500) (1,117,500) (1,117,500)

Net ($) (55,000) 0 26,250 57,500 82,500

Exhibit 50 provides a comparison between a futures contract and an option contract.

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FOREIGN CURRENCY OPTION

A financial contract that gives the holder the right (but not the obligation) to exercise it to purchase/sell a given amount of foreign currency at a specified price during a fixed time period. Contract specifications are similar to those of futures contracts except that the option requires a premium payment to purchase (and it does not have to be exercised).

See also PORTFOLIO INVESTMENTS.

FOREIGN EXCHANGE

Foreign exchange (FOREX) is not simply currency printed by a foreign country’s central bank. Rather, it includes such items as cash, checks (or drafts), wire transfers, telephone transfers, and even contracts to sell or buy currency in the future. Foreign exchange is really any financial transaction that fulfills payment from one currency to another. The most common form of foreign exchange in transactions between companies is the draft (denominated in a foreign currency). The most common form of foreign exchange in transactions between banks is the telephone transfer. A foreign exchange market is available for trading foreign exchanges.

FOREIGN EXCHANGE ARBITRAGE

Foreign exchange arbitrage involves simultaneous contracting in two or more foreign exchange markets to buy and sell foreign currency, profiting from exchange rate differences without suffering currency risk. Foreign exchange arbitrage may be two-way (simple), three-way (tri- angular), or intertemporal; and it is generally undertaken by large commercial banks that can exchange large quantities of money to exploit small rate differentials.

See also INTERTEMPORAL ARBITRAGE; SIMPLE ARBITRAGE; TRIANGULAR ARBITRAGE.

FOREIGN EXCHANGE CONTRACT See FUTURES; FORWARD CONTRACT.

EXHIBIT 51

Strategic Reasons for Foreign Direct Investment

Demand Side Supply Side

To serve a portfolio of markets and to explore new markets To lower production and delivery costs To enter an export market closed by restrictions such as a quota or tariff To acquire a needed raw material

To establish a local presence To do offshore assembly

To accommodate “buy national” regulations To respond to rivals’ threats

To gain visibility as a local firm, employing To build a “portfolio” of manufacturing local workforce, paying local taxes, etc. resources

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FOREIGN EXCHANGE HEDGING

Foreign exchange hedging involves protecting against the possible impact of exchange rate changes on the firm’s business by balancing foreign currency assets with foreign currency liabilities. Elimination of all foreign exchange risk is not necessarily the objective of a financial manager. Risk is a two-way street; gains are possible as well as losses. If gains from exchange-rate fluctuations appear more likely than losses, then it may make sense to bear the currency risk (that is, retain the exchange-rate exposure) so that gains may be realized.

Another important consideration is that elimination of exchange risk entails a cost. In a cost- benefit analysis, elimination of all exchange risk may not be beneficial, while elimination of part of the risk may be. Exchange risk may be neutralized or hedged by a change in the asset and liability position in the foreign currency. An exposed asset position can be hedged or covered by creating a liability of the same amount and maturity denominated in the foreign currency. An exposed liability position can be covered by acquiring assets of the same amount and maturity in the foreign currency.

The objective, in the hedging strategy, is to have zero net asset position in the foreign currency. This eliminates exchange risk, because the loss (gain) in the liability (asset) is exactly offset by the gain (loss) in the value of the asset (liability) when the foreign currency appreciates (depreciates). Two popular forms of hedge are the money-market hedge and the forward market hedge. In both types of hedge the amount and the duration of the asset (liability) positions are matched. Many MNCs take long or short positions in the foreign exchange market, not to speculate, but to offset an existing foreign currency position in another market. Note: The forward market hedge is not adequate for some types of exposure.

If the foreign currency asset or liability position occurs on a date for which forward quotes are not available, then the forward hedge cannot be accomplished. In these situations, MNCs may have to rely on other techniques such as leading and lagging.

See also BALANCE SHEET HEDGING; CURRENCY RISK MANAGEMENT; FORWARD MARKET HEDGE; HEDGE; LEADING AND LAGGING; MONEY-MARKET HEDGE.

FOREIGN EXCHANGE MARKET

A foreign exchange (FOREX) market is a market where foreign exchange transactions take place, that is, where different currencies are bought and sold. Or, more broadly, a foreign exchange market is a market for the exchange of financial instruments denominated in different currencies. The most common location for foreign exchange transactions is a commercial bank, which agrees to “make a market” for the purchase and sale of currencies other than the local one. This market is not located in any one place, most transactions being conducted by telephone, wire service, or cable. It is a global network of banks, investment banks, and brokerage houses that makeup an electronically linked infrastructure servicing international corporations, banks, and investment funds. FOREX trading follows the sun around the world—starting in Tokyo, the market activity moves through to London, the last banking center in Europe, before traveling on to New York and finally returning to Japan via Sydney. The interbank market has three sessions of trading. The first begins on Sunday at 7:00 p.m., NYT, which is the Asia session. The second is the European (London) session, which begins at approximately 3:00 a.m.; and the third and final session is the New York, which begins at approximately 8:00 a.m. and ends at 5:00 p.m. The majority of all trading occurs during the London session and the first half of the New York session. As a result, buyers and sellers are available 24 hours a day. Investors can respond to currency fluctuations caused by economic, social, and political events at the time they occur—day or night.

The functions of the foreign exchange market are basically threefold: (1) to transfer purchasing power, (2) to provide credit, and (3) to minimize exchange risk. The foreign exchange market is dominated by:

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1. Large commercial banks (thus often called bank market);

2. Nonbank foreign exchange dealers, commercial customers (primarily MNCs) con- ducting commercial and investment transactions;

3. Foreign exchange brokers who buy and sell foreign currencies and make a profit on the difference between the exchange rates and interest rates among the various world financial centers; and

4. Central banks, which intervene in the market from time to time to smooth exchange rate fluctuations or to maintain target exchange rates (for example, the Federal Reserve Bank of New York in the U.S.).

In addition to the settlement of obligations incurred through investment, purchases, and other trading, the foreign exchange market involves speculation in exchange futures. New York, Tokyo, and London are the major centers for these transactions. The various linkages between banks and their customers in the foreign exchange market are displayed in Exhibit 52.

Exhibit 53 is a list of a variety of participants in the foreign exchange market.

EXHIBIT 52

Structure of Foreign Exchange Markets Customer buys $ with

Local bank

Major banks interbank market

Customer buys ¥ with

$ Local bank Foreign

exchange broker

Stockbroker

• International Money Market (IMM)

• London International Financial Futures Exchange (LIFFE)

• Philadelphia Stock Exchange (PSE)

Stockbroker FOREIGN EXCHANGE MARKET

118

Exhibit 54 shows the major economics forces moving today’s FOREX markets, while Exhibit 55 chronicles the history of the FOREX market.

EXHIBIT 53

Participants in the Foreign Exchange Market

Suppliers of Foreign Currency (e.g., ¥) Demanders for Foreign Currency (e.g., ¥)

U.S. exporters U.S. direct investors in Japan

Japanese direct investors remitting profits Japanese foreign investors in the U.S. remitting their profits

Japanese portfolio investors U.S. portfolio investors

Bear speculators Bull speculators

Arbitrageurs

Government interveners

‘

EXHIBIT 54

Economics Forces Moving Today’s FOREX Markets

Economic Indicators Leading Indicators

Balance of Payments Employment Cost Index

Trade Deficits Consumer Price Index (CPI)

Gross Domestic Product (GDP) Produce Price Index (PPI)

Industrial Production Retail Sales

Unemployment Rate Prime Rate

Business Inventories Discount Rate

Federal Funds Rate Personal Income

‘

EXHIBIT 55

History of the FOREX Market

1944—The major Western Industrialized nations agree to attempt to “stabilize” their currencies. The International Monetary Fund (IMF) is created and the U.S. dollar is “pegged” at $35.00 to the Troy ounce of gold. This was known as the Gold Standard.

1971—President Nixon abandons the Gold Standard, directly pegging major currencies to the U.S. dollar.

1973—Following the second major devaluation in the U.S. dollar, the fixed-rate mechanism is totally discarded by the U.S. Government and replaced by the Floating Rate. All major currencies seek to move independently of each other.

1999—Eleven European nations unite under one currency, the euro, and resolve to have a single monetary policy set by the European Central Bank (ECB).

Today—Leading global investment firms have made programs available for individual investors to capitalize on the opportunities offered. The FOREX interbank market was developed as a means of handling the huge transaction business in trading, lending, and consolidating deposits of foreign currencies. The vast size and volume of the FOREX market makes it impossible to manipulate the market for any length of time. As a result, FOREX is an action-based, decentralized international forum that allows various major currencies of the world to seek their true value.

Source: http://www.knewmoney.com.

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FOREIGN EXCHANGE MARKET INTERVENTION See FOREIGN CURRENCY OPERATIONS.

FOREIGN EXCHANGE RATE

A foreign exchange rate, or exchange rate for short, specifies the number of units of a given currency that can be purchased with one unit of another currency. Exchange rates appear in the business sections of newspapers each day and financial dailies such as Investor’s Business Daily and The Wall Street Journal. Exchange rates are also available at many finance Web sites such as the Bloomberg World Currency Values Web site (http://www.bloomberg.com/markets/wcv.html). The actual exchange rate is determined by the interaction of supply and demand in the foreign exchange market. Such supply and demand conditions are determined by various economic factors (e.g., whether the country’s basic balance of payments position is in surplus or deficit). Exchange rates can be quoted in direct or indirect terms and in American terms or European terms. Exchange rates can be fixed at a predetermined level (fixed exchange rate), or they can be flexible to reflect changes in demand (floating exchange rate). Foreign exchange is the instruments used for international payments. Exchange rates can be spot (cash) or forward.

Foreign exchange rates are determined in various ways:

1. Fixed exchange rates are an international financial arrangement in which govern- ments directly intervene in the foreign exchange market to prevent exchange rates from deviating more than a very small margin from some central or parity value.

From the end of World War II until August 1971, the world was on this system.

2. Flexible (floating exchange) rates are an arrangement by which currency prices are allowed to seek their own levels without much government intervention (i.e., in respond to market demand and supply). Arrangements may vary from free float (i.e., absolutely no government intervention) to managed float (i.e., limited but sometimes aggressive government intervention in the foreign exchange market).

3. Forward exchange rate is the exchange rate in contract for receipt of and payment for foreign currency at a specified date, usually 30, 90, or 180 days in the future, at a specified current or “spot” (or cash) price. By buying and selling forward exchange, importers and exporters can protect themselves against the risks of fluctuations in the current exchange market.

FOREIGN EXCHANGE RATE FORECASTING

The forecasting of exchange rates is different under the freely floating and fixed exchange rate systems. Nevertheless, exchange rate forecasting in general is a very difficult and time- consuming task, because so many possible factors are involved. Therefore it might be worth- while for firms to always hedge their future cash flows in order to eliminate the exchange rate risk and to have predictable cash flows and earnings. With the world becoming smaller and the businesses getting more and more multinational, companies are increasingly exposed to transaction risk, the risk that comes from a fluctuation in the exchange rate between the time a contract is signed and when the payment is received. With most of the exchange rates floating nowadays, they can vary easily as much as 5% within a week, and the exchange rate risk is therefore very considerable. There are four primary reasons why it is imperative to forecast the foreign exchange rates.

1. Hedging Decision: Multinational companies (MNCs) are constantly faced with the decision of whether to hedge payables and receivables in foreign currency. An exchange rate forecast can help MNCs determine if they should hedge their transactions. As an example, if forecasts determine that the Swiss franc is going to

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appreciate in value relative to the dollar, a company expecting payment from a Swiss partner in the future may decide not to hedge the transaction. However, if the forecasts showed that the Swiss franc is going to depreciate relative to the dollar, the U.S. partner should hedge the transaction.

2. Short-Term Financing Decision for MNC: A large corporation has several sources of capital market and several currencies in which it can borrow. Ideally, the currency it would borrow would exhibit low interest rate and depreciate in value over the financial period. For example, a U.S. firm could borrow in Japanese yens; during the loan period, the yens would depreciate in value. At the end of the period, the company would have to use fewer dollars to buy the same amount of yens and would benefit from the deal.

3. International Capital Budgeting Decision: Accurate cash flows are imperative in order to make a good capital budgeting decision. In case of international projects, it is not only necessary to establish accurate cash flows but it is also necessary to convert them into an MNC’s home country currency. This necessitates the use of foreign exchange forecast to convert the cash flows and there after, evaluate the decision.

4. Subsidiary Earning Assessment for MNC: When an MNC reports its earning, international subsidiary earnings are often translated and consolidated in the MNC’s home country currency. For example, when Nokia makes a projection for its earnings, it needs to project its earnings in Japan, then it needs to translate these earnings from Japanese yens into U.S. dollars. A depreciation in yens would decrease a subsidiary’s earnings and vice versa. Thus, it is necessary to generate an accurate forecast of yens to create a legitimate earnings assessment.

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