- •Chapter 3: The international financial marketplace key chapter concepts
- •Glossary of new terms
- •Financial challenge
- •Introduction
- •The global economy and multinational enterprises
- •Table 3—1
- •Table 3—1
- •Foreign currency markets and exchange rates
- •Direct and Indirect Quotes
- •Table 3 — 2 Spot Foreign Exchange Rates
- •Spot Rates
- •Forward Rates
- •Table 3 — 3. Forward Foreign Exchange Rates
- •Foreign Currency Futures
- •Table 3-4. Futures Contract Quotations
- •Foreign Currency Options
- •The Eurocurrency Market
- •Factors that affect exchange rates
- •Covered Interest Arbitrage and Interest Rate Parity
- •Purchasing Power Parity
- •Expectations Theory and Forward Exchange Rates
- •The International Fisher Effect
- •An Integrative Look at International Parity Relationships
- •Figure 3—1. International Parity Conditions: An Integrative Look
- •Forecasting future exchange rates
- •Using Forward Rates
- •Using Interest Rates
- •Foreign exchange risk
- •Transaction Exposure
- •Table 3-5. Example of Transaction Exchange Rate Risk
- •Economic Exposure
- •Translation Exposure
- •Table 3 – 6. Effect of a Decrease in the Exchange Rate on American Products' Balance Sheet
- •International finance and the practice of financial management
- •Ethical issues: payment of bribes abroad
- •Summary
- •Questions and topics for discussion
- •Self test problems
- •Problems
- •Solutions to self test problems
Foreign Currency Futures
A foreign currency futures contract is similar to a forward contract. Both call for the delivery of a specified amount of some item, such as a foreign currency, at a future point in time at a price set at the present time. A forward contract is normally a contract between two individuals who are known to each other, such as an importer and a commercial bank. Performance on the contract by the seller and the buyer depends on the character and capacity of the two parties. Because these contracts are negotiated between two individuals, forward contracts can be established for any future time period, and for any quantity of any item that is agreeable to the parties. Forward contracts are not liquid; that is, it is difficult or impossible for either party to transfer their interest in the contract to another party once the contract has been agreed upon. The seller of the contract must deliver the promised item at the time agreed to in the contract, and the buyer must pay for it and accept delivery.
In contrast to a forward contract, a futures contract is an exchange traded agreement that calls for the delivery of a standardized amount of an item (such as DM125,000) at a standardized maturity date. The most important foreign currency futures market in the United States is the Chicago Mercantile Exchange (CME). Contracts traded on the CME mature on the third Wednesday of the contract month, with the last trading day being two days prior to that. Unlike forward contracts, there is virtually no performance risk in a futures contract. Rather than the buyer and seller of the contract dealing directly with each other, the "exchange clearing house" acts as the buyer and seller of all contracts. Buyers and sellers of futures contracts must post collateral (as their performance bond). Each day the value of the contract is "marked to market", with all gains and losses being paid between the parties in cash. If payment is not made, the contract is sold by the clearing house and the performance bond of the defaulting party is charged for any losses. In essence, one can think of a futures contract as a series of forward contracts that are settled each day. Only about five percent of foreign currency futures contracts are settled by means of delivery of the underlying currency from the seller to the buyer. More commonly, the parties will offset their position prior to expiration by making a transaction opposite to the original one. For example, a buyer of a contract for DM125,000 with delivery in March usually sells an identical contract prior to expiration. The sale of an identical contract by an initial buyer of the same contract fully offsets the position from the perspective of the clearing house.
Table 3-4 shows foreign currency futures contract quotations for the German mark (Deutsche mark or DM) as of December 1, 1993. The first line under the headings indicates that the contract is for Deutsche marks, that the contract is traded on the Chicago Mercantile Exchange (CME), that the contract is for 125,000 marks, and that the prices are direct quotes ("$ per mark"). The next three lines provide quotes for the contracts maturing on the third Wednesday of December 1993, March 1994, and June 1994. The column numbers indicate