Question

a) Explain a foreign currency futures contract and outline the differences between futures and forwards. b) The Chicago Mercantile Exchange (CME) and the New York Board of Trade (NBOT) operate futures markets in currencies in the following pairs US$/pounds and US Dollar/Pound. The value standardize size of a sterling futures contract is 6,500 pounds. Describe how a UK company that expects to received US$800,000 in three months time can use a futures contract to hedge transaction exposure if the following apply i) Currency spot rate US$ 1.64/pounds - US$1.68pounds ii) Sterling futures price US$1.64/Pounds

Answer 1

A foreign currency futures contract is a contract entered by a party inorder to hedge it's risk against the inflow of foreign currency that is expected to be received in future, or the outflow of payment that is to be made in future.

It is mainly used by importers' and exporters' to hedge their risk against the outflow or inflow of money in future. By entering into a future contract they get their obligations or inflows amount fixed.

Differences between futures and forwards:

Futures	Forwards
They are Standardised contracts i.e. contracts of standard sizes available on indexes are entered into.	They are cusomised contracts as per the requirements of the counterparties to the contracts.
They face Low counterparty risk due to clearing house in middle.	They face high counterparty risks.
Initial margin payments needs to be done	No initial margin payment is required
They are regulated by various regulatory authorities like SEBI in India	Forwards are unregulated markets.

The UK company has a receivable amount of $800000 in three months.

Standard contract size = 6500 Pounds

Converting $800000 into pounds using Spot rate $/Pounds= 1.64/1.68

Hence $800000/1.68=476190 Pounds.

Number of contracts that has to be entered= Pound 476190/ Pound 6500

= 73 contracts

Unhedged amount = 6500 Pounds * 0.26 contracts

= 1690 Pounds

Hence the Uk company has hedged = Pounds 474500 @ US$/Pound= 1.64

Hence 474500*1.64$ = 778180$ are hedged.

The remaining amount of $800000-$778180 = $21820 is unhedged and remains subject to currency fluctuations.