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SMU FINA 4329 - Lecture Notes

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Lecture 6a: FuturesForwards and Futures ContractsSlide 3Currencies traded and contract sizeSlide 5Hedging with FuturesAdvantages and Disadvantages of FuturesInterest 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:Slide 9Slide 10Slide 11Slide 12Slide 13Lecture 6a: FuturesForwards and Futures ContractsForwards and Futures Contracts•Are instruments that allow the buying and Are instruments that allow the buying and selling of a stated amount of foreign selling of a stated amount of foreign currency at a stated price per unit at a currency at a stated price per unit at a specific date in the futurespecific date in the future•When signed, there is no up-front costsWhen signed, there is no up-front costs•Are classified as derivatives because their Are classified as derivatives because their values are derived from the value of the values are derived from the value of the underlying securityunderlying security•While they play a similar role in the While they play a similar role in the management of FX risk, there are some management of FX risk, there are some key differences key differences•Any futures contract specifies a standard quantity of a Any futures contract specifies a standard quantity of a good will be bought or sold at a specified time in the good will be bought or sold at a specified time in the future.future.•The Chicago Mercantile Exchange began trading in The Chicago Mercantile Exchange began trading in currency futures in 1972currency 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 ExchangeCurrencies traded and contract Currencies traded and contract sizesize•Yen (12.5 Million)Yen (12.5 Million)•DM (125,000)DM (125,000)•C$ (100,000C$ (100,000•British Pound (62,500)British Pound (62,500)•Swiss Franc (125,000)Swiss Franc (125,000)•Australian Dollar (100,000)Australian Dollar (100,000)•Mexican Peso (500,000)Mexican Peso (500,000)•Euro (125,000)Euro (125,000)Forwards and Futures ContractsForwards and Futures ContractsFuturesFuturesForwardForwardAmountAmountStandardizedStandardizedNegotiatedNegotiatedDelivery DateDelivery DateStandardizedStandardizedNegotiatedNegotiatedCounter-partyCounter-partyClearinghouseClearinghouseBankBankCollateralCollateralMargin Acct.Margin Acct.NegotiatedNegotiatedMarketMarketAuction MarketAuction MarketDealer MarketDealer MarketCostsCostsBrokerage and Brokerage and exchange feesexchange feesBid-ask spreadBid-ask spreadLiquidityLiquidityVery liquidVery liquidHighly illiquidHighly illiquidRegulationRegulationGovernmentGovernmentSelf-regulatedSelf-regulatedLocationLocationCentral exchangeCentral exchangeWorldwideWorldwideHedging with FuturesHedging with Futures•Example: Long HedgeExample: Long Hedge•It is March, a US firm has to pay JPY 25 million in It is March, a US firm has to pay JPY 25 million in 180 days. The company decides to hedge its 180 days. The company decides to hedge its currency risk. currency risk. •It hedges the JPY payables by buying JPY It hedges the JPY payables by buying JPY September futures for JPY 25 millionSeptember futures for JPY 25 million•On the CME, the JPY contract is for 12.5 million On the CME, the JPY contract is for 12.5 million yen, so they buy two CME contracts yen, so they buy two CME contracts •If the Yen strengthens, the payables become If the Yen strengthens, the payables become more expensivemore expensive•However, the forward contract becomes more However, the forward contract becomes more valuable, perfectly hedging the payables valuable, perfectly hedging the payablesAdvantages and Disadvantages of FuturesAdvantages and Disadvantages of Futures•AdvantagesAdvantages–Small Contract Size–Easy liquidation–Well organized and stable market (no risk of default)•DisadvantagesDisadvantages–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).Interest Rate Futures Exchange rate risk is not the Exchange rate risk is not the only risk facing a business who expects to get paid only risk facing a business who expects to get paid or is obligated to pay in the future. Consider the or is obligated to pay in the future. Consider the following:following:•On October 23, 2001 the Film Board of Canada signs a On October 23, 2001 the Film Board of Canada signs a contract in which it agrees to pay a $1 million subsidy to contract in which it agrees to pay a $1 million subsidy to an American studio that is making a sequel to “Dudley-an American studio that is making a sequel to “Dudley-Do-Right” in Toronto. The funds will be paid on July 1, Do-Right” in Toronto. The funds will be paid on July 1, 2002, but filming won’t start until the first blizzard 2002, but filming won’t start until the first blizzard (usually in the last part of September). No money is (usually in the last part of September). No money is required until filming starts.required until filming starts.•This is good news, since the studio will be able to earn This is good news, since the studio will be able to earn interest on the subsidy while they wait for filming to start.interest on the subsidy while they wait for filming to start.•For example if they can wait three months For example if they can wait three months to start filming and if interest rates are 8%, to start filming and if interest rates are 8%, they will earn interest of they will earn interest of 1,000,000x.08/4=$20,0001,000,000x.08/4=$20,000•But the studio can’t know for sure what the But the studio can’t know for sure what the interest rate on 3 month time deposits will interest rate on 3 month time deposits will be six months in the future. be six months in the future.•The eurodollar futures contract is a written The eurodollar futures contract is a written by the CME on a hypothetical 90-day by the CME on a hypothetical 90-day deposit of $1 million eurodollars. Delivery deposit of $1 million eurodollars. Delivery of the deposit is never taken. Instead, of the deposit is never taken. Instead, settlement is made through a realization of settlement is made through a


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