Question

1.) What are the characteristics of a futures contract?

2.) How it can a futures contract be used to hedge a currency's transaction risk exposure?

Answer 1

Ans 1) Futures Contract: Futures contract is a derivative instrument which is used for hedging the long and short position on the underlying. There are many characterisitic of the futures contract which differentiate it with other derivative instruments. Future contract is standardized contract which has a standard size, strike price, duration and delivery method. There is intial margin requirement for the futures contract which reduce the risk on non cofrorming to the loss. Futures contract are traded on the centralized clearing house which take care of counterparty risk in case of losing party not fulfil the commitment. It is transact at predefined date and price.

Ans 2) Currency transaction is exposed to exchange risk and interest rate risk, futures contract can be used to hedge exchange risk. Futures contract which is used to hedge currency risk is currency futures. Currency futures is a futures contract that specify the future exchnge rate against other currency at a future date.

One can use currency futures to hedge currency risk by going long or short if he/she thinks that currency will fall or rise respectively. Futures rate of currency futures is determined by the spot rate and expected interest rate of the two currencies. If one is long on the currecy futures then he is thinking that the rate might come down thats why he lock on the future rate so even spot future rate is less that expected future rate one will be benifited by locking on the higher rate.