9.4.2Forward versus futures contracts

We have seen that forward forex contracts are OTC contracts and so are not tradable

in organised markets. On the other hand, they benet from the additional exibility

of OTC contracts in terms of both the period and the amount of the contract. Forward

contracts are available on a much wider range of currencies than are exchange-

traded futures and options since futures exchanges are only willing to offer derivatives

contracts that are likely to be popular with both buyers and sellers. As with OTC

derivatives, specially arranged forward forex contracts involving unpopular currencies

are bound to be relatively expensive because of the extra risk that the market-maker

(the bank) has to accept. This is made greater by the fact that the spot markets in

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Chapter 9 • Exchange rate risk, derivatives markets and speculation

these currencies are likely to be thin and hence their exchange rates more volatile –

a small number of large deals in the same direction might shift the exchange rate

by a considerable amount.

There may also be important cash-ow differences between forward forex contracts

and futures. Net prots on a futures hedge are accrued on a daily basis whereas the net

prots on a forward hedge are realised only on the date of delivery of the currency.

9.4.3Forward and futures contracts versus options

Forward and futures contracts lock in an investor to a given exchange rate. Thus,

the contract provides a hedge if the exchange rate moves in the direction that would

have produced a loss in the underlying cash market, but also reduces the prot

that would have resulted in the underlying market from a movement of the spot

exchange rate in the opposite direction. Consider the following example.

A British rm importing goods from the US in June 2006 has to make a payment

of $1 million before the end of September and faces the risk that the dollar will

rise against sterling, increasing the sterling cost of the transaction to the rm. The

spot exchange rate is £1 $1.85, but if that were to fall to £1 $1.80 the goods

would cost the rm a little more than £20,000 extra. This could obviously seriously

affect the company’s prot margin when it sold the goods in Britain. Consequently,

it chooses to buy a September sterling future with the Chicago Metal Exchange at

a price of £1 $1.8680. If sterling falls to £1 $1.80, the value of the futures con-

tract will rise. Thus the company loses on its payment for the imported goods but is

able to offset this by reversing its futures contract and making a prot. However, if

sterling strengthens, rising say to £1 $1.90, the rm gains on its import of goods

(they now cost less in sterling) but loses on the futures contract because it loses value

as sterling rises. That is, the hedge removes both the risk of loss and the possibility

of prot. On the other hand, an option allows most of any potential prot to be

taken. If the US dollar rose, the option would become out-of-the-money but would

simply be abandoned by the rm with the loss only of the premium.

Whether a trader chooses futures or options depends on what she thinks is likely

to happen to the price of the underlying product and on her attitude towards risk.

l	A trader who has a long position in the underlying market and who is convinced that the price of the instrument in question is not going to fall may choose not to hedge at all and remain in an open position. That is, she will accept the risk of an exchange rate change.

l	A trader who is condent that the price will fall may (a) sell the product before the price falls; (b) take an offsetting short position by selling futures contracts; or (c) sell the currency forwards. This eliminates entirely her exposure to the price fall.

l

A trader who is uncertain in which direction the price will move may choose options. Even then, if she thinks that the price is more likely to fall than to rise, nancial futures are preferable to options because they are likely to offer her cheaper protection. Options are preferable if the trader has no view or thinks that the price is more likely to rise than fall.

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