AFMP4
Syllabus E. Treasury And Advanced Risk Management Techniques E2. The use of financial derivatives to hedge against forex risk

E2b. Currency Futures 7 / 13

Syllabus E2b)

b) Evaluate, for a given hedging requirement, which of the following is the most appropriate strategy, given the nature of the underlying position and the risk exposure:

iii) Exchange-traded currency futures contracts

What is this little baby all about then?

  • It’s a standard contract for set amount of currency at a set date

  • It is a market traded forward rate basically

    *Calculations of how these work are required only for P4 exam (not F9)

Explanation

When a currency futures contract is bought or sold, the buyer or seller is required to deposit a sum of money with the exchange, called initial margin.

If losses are incurred as exchange rates and hence the prices of currency futures contracts change, the buyer or seller may be called on to deposit additional funds (variation margin) with the exchange

Equally, profits are credited to the margin account on a daily basis as the contract is ‘marked to market’.

Most currency futures contracts are closed out before their settlement dates by undertaking the opposite transaction to the initial futures transaction, ie if buying currency futures was the initial transaction, it is closed out by selling currency futures. A gain made on the futures transactions will offset a loss made on the currency markets and vice versa.

Advantages

  1. Lower transaction costs than money market

  2. They are tradeable and so do not need to always be closed out

Disadvantages

  1. Cannot be tailored as they are standard contracts

  2. Only available in a limited number of currencies

  3. Still cannot take advantage of favourable movements in actual exchange rates (unlike in options…next!)