Kirt C Butler Multinational Finance 4e 2008

Kirt C.
Butler, Multinational Finance, 4e, 2008, John Wiley & Sons Ltd
Chapter 5
Currency Futures and Futures Markets
Part II
Derivative Securities for
Financial Risk Management
Learning objectives
3 Currency futures
Ch 5 Currency futures and futures markets
Credit risk and the futures contract solution
Ch 6 Currency options and options markets
Currency futures exchanges

Currency forwards versus currency futures
Ch 7 Currency swaps and swaps markets
3 Hedging with futures contracts

Basis risk and the hedge ratio
5-1
Butler / Multinational Finance
Chapter 5 Currency Futures and Futures Markets
Currency futures contracts and exchanges

Hedging with currency futures

Forwards are a pure credit instrument
- A futures exchange clearinghouse takes one side

of every transaction (and makes sure that its
exposures cancel one another)
- Initial and maintenance margins ensure settlement
5-3

2006 contract
volume (mil)
1 CME - Chicago Mercantile Exchange (U.S.)
1,101.7
2 Eurex - Eurex (Germany & Switzerland)
960.6
3 CBOT - Chicago Board of Trade (U.S.)
678.3
4 Euronext - (Amsterdam/Brussels/Lisbon/Paris/London) 420.0
5 Mexican Derivatives Exchange - (Mexico City)
274.7
6 BM&F - Bolsa Mercadorias & de Futuros (Brazil)
258.5
7 NYMEX - New York Mercantile Exchange (U.S.)
216.3
8 Dalian Commodity Exchange - (China)
170.6
9 National Stock Exchange of India - (India)
117.7
10 ICE Futures - (U.K.)
92.6
Top futures exchanges
The futures contract solution
- Contracts are marked-to-market daily

Financial futures exchanges are often associated

with a commodity futures exchange
- Forwards are a zero-sum game, so that

one party always has an incentive to default
5-2

Delta, cross, and delta-cross hedges

Source: Futures Industry Association (www.futuresindustry.org)



5-4

Growth of derivatives trading
A forward hedge of the dollar
Millions of contracts traded
Underlying position of a French exporter (long $s)

+$40 million
-Goods
Short $s
v/$
Long $s
Sell $s forward at Ft/$ = 0.80/$ (short $)
Net position
Source: Futures Industry Association (www.futuresindustry.org)
5-5
+50 million
-$40 million
s/$
+50 million
-Goods
5-6
Kirt C. Butler, Multinational Finance, 4e, 2008, John Wiley & Sons Ltd


Forwards versus futures

Been there, done that...
Forwards Futures
Counterparty Bank
CME Clearinghouse
Maturity
Negotiated
3rd week of the month (US)
Amount
Negotiated
Standard contract size
Fees
Bid-ask
Commissions
Collateral
Negotiated
Margin account
Settlement
At maturity
Most are settled early
Futures contracts are similar to forward

contracts
- Futures contracts are like a bundle of consecutive
one-day forward contracts
- Futures and forwards are nearly identical in their
ability to hedge risk
- The biggest difference between a forward and a
futures contract is daily marking-to-market
5-7


Maturity mismatches and the delta hedge
Currency mismatches and the cross hedge
Delta-cross hedges

Hedging with forwards and futures
5-8

Delta-cross hedges
Interest rate parity revisited
Forward contracts can be tailored to match the

underlying exposure
Some definitions
Forward contracts thus can provide a perfect hedge

of a transaction exposure to currency risk
Std/f = spot price at time t
Exchange-traded futures contracts are

standardized
Futt,Td/f = futures price at time t for expiry at time T
They will not provide a perfect hedge if they do not

match the underlying exposures
- maturity
- currency
- contract size
Currency forward and futures prices are equal

through interest rate parity
Futt,Td/f = Ft,Td/f = Std/f [(1+id)/(1+if)]Tt
5-9

Ft,Td/f = forward price at time t for expiry at time T
5-10

Delta-cross hedges

Spot & futures price convergence at expiry
FutTd/f = STd/f
If there is a maturity mismatch, futures

contracts may not provide a perfect hedge
The difference (id-if) is called the basis

- The risk of change in the relation between
futures and spot prices is called basis risk
Forward
premium

Delta-cross hedges
Maturity mismatches and basis risk
Futt,Td/f = Std/f [(1+id)/(1+if)]T-t
Fut0d/f
S0d/f
- When there is a maturity mismatch, basis risk

makes a futures hedge slightly riskier than a
forward hedge
T
5-11
5-12

Delta-cross hedges
An example of a delta hedge
Jan 18

The futures
expiration date
is after the
underlying
exposure
A delta hedge
std/f = + futtd/f + et
std/f = percentage change in the spot rate
futtd/f = percentage change in the futures price
Jun 3 Jun 16
-100
million
Underlying
obligation
Hedge quality is measured by (s,fut )2

5-13
5-14

Delta-cross hedges

A CME delta hedge
The hedge ratio is used to minimize the variance

of the hedged position
NFut*= (Amount in futures)/(Amount exposed)
= -


Delta-cross hedges

Delta-cross hedges
The delta hedge solution
It is now January 18. You need to hedge a

100 million obligation due on June 3.
- The spot exchange rate is S0$/ = $1.10/
The optimal hedge ratio for this delta hedge is

given by
NFut* = (amount in futures)/(amount exposed)
= -
- A 125,000 CME euro futures contract

expires on June 16
(amount in futures) = (-)(amount exposed)

= (-1.040)(-100 million) = 104 million
- Based on st$/ = + futt$/ + et , you estimate

= 1.040 with r2 = 0.98.
- How many CME futures contracts should you
buy to minimize the risk of your hedged
position?
or (104 million) / (125,000/contract)

= 832 contracts
5-15


Delta-cross hedges

Currency mismatches and cross hedges

Delta-cross hedges
A CME cross hedge
std/f1 = + std/f2 + et
5-16
It is now January 18. You need to hedge a

DKr 100 million obligation due on June 16.
A cross hedge is used when there is a maturity

match but a currency mismatch
- Spot (cross) exchange rates are $0.75/DKr,

0.75/DKr, and $1.00/.
std/f1 = percentage change in the currency f1
- A CME futures contract expires on June 16

with a contract size of 125,000
of the underlying exposure
- Based on st$/DKr = + st$/ + et , you estimate

= 0.960 with r2 = 0.94.
std/f2 = percentage change in the spot price of
- How many CME futures should you buy to

minimize the risk of your hedged position?
currency f2 of the futures contract

5-17
5-18

Delta-cross hedges

The cross hedge solution

Delta-cross hedges
A delta-cross hedge
std/f1 = + futtd/f2 + et
Optimal hedge ratio:

NFut* = (amt in futures)/(amt exposed) = -
(amt in futures) = (-)(amt exposed)

= (-0.960)(-DKr100 million) = DKr96 million
A delta-cross hedge is used when there is both a

currency and a maturity mismatch
std/f1
or 72 million at (DKr96m) (0.75/DKr)
= percentage change in the currency f1

of the underlying exposure
futtd/f2 = percentage change in the value of the

futures contract on currency f2
or 576 contracts at 125,000/contract

5-19


Delta-cross hedges

A CME delta-cross hedge
5-20

Delta-cross hedges
The delta-cross hedge solution
It is now January 18. You need to hedge a DKr

100 million obligation due on June 3.
Optimal hedge ratio:

NFut* = (amt in futures)/(amt exposed) = -
- Spot exchange rates are $0.75/DKr, 0.75/DKr,

and $1.00/.
(amt in futures) = (-)(amt exposed)

= (-1.020)(-DKr100 million) = DKr102 million
- A CME futures contract expires on June 16

with a contract size of 125,000
- Based on st$/DKr = + futt$/ + et , you estimate
= 1.020 with r2 = 0.85.
or 76.5 million at (DKr102m) (0.75/DKr)
- How many CME futures should you buy to

minimize the risk of your hedged position?
or 612 contracts at 125,000/contract
5-21


Delta-cross hedges
A classification of futures hedges

Currency
Hedge
Hedge ratio estimation
Exact match
Mismatch
Exact
Perfect hedge
Cross hedge
match
std/f = +std/f+et
std/f1 = +std/f2+et
such that =0, = 1, & et= 0
Maturity
Mismatch
Delta hedge
Delta-cross hedge
std/f = +futtd/f+et
std/f1 = +futtd/f2+et
5-23
5-22

Kirt C Butler Multinational Finance 4e 2008

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Kirt C.

Ch 5 Currency futures and futures markets

Credit risk and the futures contract solution

Ch 6 Currency options and options markets

Currency futures exchanges

Ch 7 Currency swaps and swaps markets

3 Hedging with futures contracts

Butler / Multinational Finance

Chapter 5 Currency Futures and Futures Markets

Currency futures contracts and exchanges

Credit risk and the futures contract solution

Forwards are a pure credit instrument

- A futures exchange clearinghouse takes one side

Butler / Multinational Finance

Chapter 5 Currency Futures and Futures Markets

Currency futures contracts and exchanges

Top futures exchanges

The futures contract solution

- Contracts are marked-to-market daily

Credit risk and the futures contract solution

Financial futures exchanges are often associated

- Forwards are a zero-sum game, so that

Chapter 5 Currency Futures and Futures Markets

Currency futures contracts and exchanges

Credit risk and the futures contract solution

Delta, cross, and delta-cross hedges

Source: Futures Industry Association (www.futuresindustry.org)

Currency futures contracts and exchanges

Credit risk and the futures contract solution

Chapter 5 Currency Futures and Futures Markets

Credit risk and the futures contract solution

Growth of derivatives trading

A forward hedge of the dollar

Millions of contracts traded

Underlying position of a French exporter (long $s)

Sell $s forward at Ft/$ = 0.80/$ (short $)

Chapter 5 Currency Futures and Futures Markets

Chapter 5 Currency Futures and Futures Markets

Currency futures contracts and exchanges

Credit risk and the futures contract solution

Forwards versus futures

Credit risk and the futures contract solution

Been there, done that...

3rd week of the month (US)

Standard contract size

Most are settled early

Futures contracts are similar to forward

Chapter 5 Currency Futures and Futures Markets

Currency futures contracts and exchanges

Currency forwards versus currency futures

Chapter 5 Currency Futures and Futures Markets

Currency futures contracts and exchanges

Hedging with forwards and futures

Currency forwards versus currency futures

Interest rate parity revisited

Forward contracts can be tailored to match the

Forward contracts thus can provide a perfect hedge

Std/f = spot price at time t

Exchange-traded futures contracts are

Futt,Td/f = futures price at time t for expiry at time T

They will not provide a perfect hedge if they do not

Currency forward and futures prices are equal

Chapter 5 Currency Futures and Futures Markets

Currency futures contracts and exchanges