Currency Forward and Currency Futures - Coursework Example

International Finance Table of Contents Introduction The modern financial markets offer a variety of hedging instruments ranging from forwards to options to futures. Globalization has exposed many companies to foreign currency either in the form of foreign currency receivable or payable. Software exporting companies like IBM that has global operations has receivables denominated in another currency. As a major part of its revenue is in terms of foreign currency, the company is vulnerable to exchange rate fluctuations. To counter this, companies having a global presence hedge their positions by entering into currency options or forwards or futures. This keeps the revenues of the company intact and also caps the amount of its currency outflows. In the event of any adverse movement in the foreign currency receivables, the company can exercise the forwards or the options. If a company having dollar receivables is afraid of strengthening the domestic currency against dollar then by taking the desired position in dollar futures the company can keep the value of its receivables intact. All these financial instruments have their own set of merits and limitations. In the following paragraphs, these instruments have been discussed with various examples that will give an idea about their usefulness. Currency Forward A forward contract on a foreign currency eliminates the risks related to exchange rate fluctuations. In this case the parties entering the contract agree to exchange a specified amount of currency at a future date at a pre-determined exchange rate (Redhead, 2008, pp.730; Von Pfeil, 1988, pp.127). Suppose A Ltd, a British company got $1 million receivable after 3 months. The company is afraid of British pounds appreciating against dollar as this will lower the value of its receivables. To hedge its position the company can enter into a forward contract that will entitle it to sell the receivables after three months at an agreed upon rate irrespective of the rate prevailing in the market. Suppose the spot rate is GBP 0.60/$. In three months time the company expects that the value of pounds will strengthen against dollar due to which the rate will fall to GBP 0.55/$. A Ltd can enter into a 3 month forward contract of GBP 0.62/$ which will freeze the exchange rate of the company. Now suppose after three months the spot rate is GBP 0.56/$, the company will then be able to sell the dollar receivable at GBP 0.62/$. As evident from the above calculations, the amount realized if the position is hedged through forward contract is GBP 620000, whereas the amount realized if the position is unhedged is GBP 560000. Therefore by way of forward contract A Ltd is able to keep the value of its receivables intact. The only limitation of currency forward is that it prohibits the party from entering into a forward contract to take advantage of any favourable movements in the exchange rates. Like, in the above example if the exchange rate after 3 months increases to GBP 0.65/$, then A Ltd cannot take the advantage of this favourable movement in the exchange rate. This means that forward contract is binding on both the parties. Currency Futures Currency futures contracts are standardized, exchange traded derivative instruments to buy or sell a specified amount of currency on a fixed future date. A futures contract has similarity with the forward contract except in the way of its trading. These are commonly used by the multinationals to hedge their exposure in foreign currency. Besides, these are also used by the speculators to take advantage of anticipations in exchange rate movements. An individual, who, initiates a long position or buys a currency futures contract, “locks in” the rate of exchange of foreign currency that he will pay at a fixed future date. Similarly an individual who takes a short position or sells currency futures “locks in” the rate of exchange at which he will sell the currency. Like in United States, currency futures are bought to “lock in” the dollar outflow to purchase a fixed amount of foreign currency (Madura, 2009, pp.108). Suppose in January, B Ltd, a US company, has pound receivable of GBP 1 million after 3 months i.e. in March. The company is afraid of appreciation of domestic currency as this will reduce the actual inflow. To hedge this it can sell March pound futures at the rate of $1.59/GBP. Now, if at the date of maturity the exchange rate in the market is $1.40/GBP, then the loss in the spot market will be compensated by the gain in the currency futures. In other words the receivables of the company will remain intact. But if the exchange rate at maturity is $1.65/GBP then there will be a loss on the currency futures contract. In other words the futures contract is obligatory. This requires maintenance of margins which are fixed at a certain percentage of the value of the position. Currency Options A foreign currency option is similar to an option on a stock except that here the underlying asset is ‘foreign currency’ and not stock (Jain, n.d.). Like currency futures, currency option gives the buyer of the option, the right to buy or sell foreign currency without an obligation to do so. A currency put option, gives the buyer the right to sell an amount of foreign currency to the seller of the option at a price called the “strike price” on or before the date of expiry of the option. Similarly, currency call option gives the buyer of the option the right to buy an amount of foreign currency at a fixed price on or before the date of expiry of the option (DeRosa, 2000, pp.29). Suppose a UK company has a payable of $1 million after 3 months. If the value of dollar appreciates against pounds then the company will have to shell out more pounds to buy the necessary amount of dollars. To tackle this, the company can buy a call option at a strike price of GBP 0.62/$. Now suppose after three months the exchange rate is GBP 0.70/$, then the company can exercise the call option i.e. it can buy $1 million at the strike price of GBP 0.62/$. If the company hedges its position using call option then the amount of pound outflow is less. The company has to shell out GBP 620000 to buy the required amount of dollars. But if the company does not hedge its position then the pound outflow is GBP 700000. This shows that by entering into a call option, the company can keep the value of it payables intact. The purchase of the option however involves an amount of premium that is an outflow. Hence, the net outflow to the company is the amount of premium paid to hedge the position and the outflow of home currency to buy the requisite amount of dollars. Similarly if a U.S. company has receivables of GBP 1 million then it can buy a put option on the foreign currency. The U.S. Company is afraid of appreciation of home currency against foreign currency as this will reduce the value of its receivables. To hedge suppose the company buys a put option at a strike price of $1.65/GBP. Now if the exchange rate reaches $1.50/GBP then the company can sell its pound receivables at the strike price of $1.65/GBP irrespective of the market rate. But if there is a depreciation of home currency i.e. if the exchange rate depreciates to $1.70/GBP then the company can let the put option lapse and can sell its receivables at the market rate. Comparison of currency forwards, currency futures and currency options Forwards and futures are similar financial instruments with proximity in their price. But there are some important differences. The parties in the forward contract are same till the point of exchange of currencies. But the futures contract rarely reaches the “point of delivery” of the currency. As most of the futures are settled before the expiry date and are thus often referred as “notional commitments”. Forwards are over-the-counter (OTC) derivative instruments and the futures are exchange traded. In case of an OTC contract there is a risk of counterparty default. However, this is not possible in the case of futures as the stock exchange is the guarantor. The forwards are customised but the futures are standardised. This means that the forwards can be tailor-made to suit the needs of a company. But the futures are available in fixed sizes. Therefore large corporations with good relationship with the banks can use forwards instead of futures as the former can be designed to meet the precise amount of exposure but this is not possible in futures (Madura, 2009, pp. 110). For this reason the futures are said to provide ‘imperfect hedge’. The futures also require strict maintenance of margin. But there is no such margin requirement for the forward contract. This saves the interest charges that one has to bear to maintain the margin money. A currency forward is an obligation to buy or sell a specified amount of currency at a fixed future date at a rate agreed upon today. This contract removes the downside risk for the foreign currency exposure but it forgoes the possibility of an upside potential if there is a favourable movement in the exchange rate. In contrast, currency option provides insurance against any adverse movements in the exchange rate besides retaining any upside potential. In the event of a favourable movement in the exchange rate the option simply remain unexercised. For this reason the currency forwards are said to be more rigid hedging tools as compared to currency options (Zopounidis et al., 2008, pp.246). But the purchase of an option involves an immediate outflow in the form of ‘option premium’ whereas no such amount is required in a forward contract. Despite the initial premium outflow, currency option is more desirable as this is not obligatory unlike forward contract. Moreover, like futures contract this does not even require any maintenance margin, thus saving the interest expenses that are paid to maintain minimum margin requirements. Conclusion The rise of multinational companies has increased exposure in another currency. Considering the volume of these foreign currency receivables and payables, most of the companies hedge their overseas exposures through currency forwards or options or futures. The currency conversions give rise to currency risks as there is uncertainty about the movement in the exchange rate in future (Singal, 2006, pp.247). Hence taking a position in the currency derivative can protect the company from any adverse fluctuations in the exchange rate. The modern financial markets offer a number of financial instruments that can be used for hedging the currency risks. Each has its own set of merits. Like the currency options give the ‘right’ to enter into a contract without an obligation to do so. Forward contracts on the other hand are obligatory but unlike options the forwards do not involve any premium outflow. Like forwards, the futures also do not require any premium but it requires margin maintenance. Therefore the choice of derivative here will depend on the anticipation of the future exchange rate. If a company is certain about the direction of the exchange rate then it can enter into a forward contract and save on the premium outflow. If the exchange rate is highly volatile then it is better to enter into an options contract as this will offer the upside potential as well offer protection from any downside risk. Reference DeRosa, F.D. 2000. Options on foreign exchange. John Wiley and Sons. Jain, C. No Date. Overview. CURRENCY OPTIONS. Available at: http://www.iimcal.ac.in/community/finclub/dhan/dhan7/CURRENCY%20OPTIONS.pdf [Accessed on August 5, 2010]. Madura, J. 2009. International financial management. Cengage Learning. Redhead, K. 2008. Personal Finance: A Guide to Money Management. Taylor & Francis. Singal, V. 2006. Beyond the Random Walk: A Guide to Stock Market Anomalies and Low-Risk Investing. Oxford University Press US. Von Pfeil, E. 1988. Effective control of currency risks: a practical, comprehensive guide. Palgrave Macmillan. Zopounidis, C. Doumpos, M. Pardalos, M.P. 2008. Handbook of Financial Engineering. Springer. Bibliography Chew, H. D. 2008. Corporate risk management. Columbia University Press. Coyle, B. 2000. Currency options. Lessons Professional Publishing. Grubel, G.H. 1966. Forward exchange, speculation, and the international flow of capital. Stanford University Press. Read More