International Financial Management

P G Apte
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P.G Apte International Financial Management
 CURRENCY FUTURES
• A futures contract, like a forward contract is an agreement
between two parties to exchange one asset for another, at a
specified date in the future, at a rate of exchange specified up
front. However, there are a number of significant differences.

•Major Features of Futures Contracts

• Organised Exchanges not OTC markets.

• Standardisation : Amount of asset, expiry dates,
deliverable grades etc.
• Clearing House: A party to all contracts. Guarantees
performance. Mitigates/Eliminates Credit Risk
• Daily mark-to-market and a system of margins.
• Actual delivery is rare.
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System of Margins
•Initial margin : When position is opened
•Variation Margin: Settlement of daily gains and losses
•Maintenance Margin : Minimum balance in margin account.
Balance falls below this, margin call issued. If not met, position
liquidated.
•Regulators specify minimum margins between clearing members
and clearinghouse. Margins at other levels negotiated
• Margins can be deposited in cash or specified securities such as T-
bills. Interest on securities continues to accrue to owner. Margin is a
performance bond.
•Levels of margins may be changed if volatility increases.

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System of Margins
• With clearing house guarantee, buyer-seller need not worry
about each other’s creditworthiness.
• Standardised contracts with margin system increase
liquidity.

Protects clearing house; enhances financial integrity

of the exchange. Credit risk issues almost eliminated

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 CLEARING
HOUSE

CLEARING CLEARING
MEMBER A MEMBER B

NON-CLEARING
MEMBER CUSTOMER
CUSTOMER NON-CLEARING
MEMBER

CUSTOMER CUSTOMER

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 TYPES OF ORDERS IN FUTURES
MARKETS
Market Orders : Execute at best available price
Limit Orders: Sell above or buy below stated limits
Market If Touched or MIT Orders: Become market orders
If price touches a trigger
Stop-Loss Orders : Sell if price falls below a limit; buy if it rises
above a limit. Used to limit losses on existing positions
Stop Limit Orders : Stop loss plus limit
Time of Day Orders, Day Orders, Good Till Canceled
Brokers, Floor Traders, Dual Traders, Futures Commission
Merchants. Hedgers and speculators both participate.
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 Currency Futures Contract Specifications
Exchange: Chicago Mercantile Exchange CME

British Pound Japan Yen

Size: £625000 ¥12,500,000
"Tick": $ 0002 per £ $0.000001 per ¥
(Per Contract) ($12.50) ($12.50)

Expiry Months: January, March, April, June, July, September,

October, December, & Spot Month (Both GBP and JPY)
Limit: NO LIMIT FOR THE FIRST 15 MINUTES OF TRADING.
A schedule of expanding price limits will be in effect when the 15-
minute period is ended. (Both GBP and JPY)

“Tick” : Minimum size of price movement.

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 Futures Price Quotations
JAPAN YEN (CME) - 12.5 million yen ; $ per Yen 100
Open Latest Chg. High Low Open Int.

Sept 0.9216 0.9275 +0.0059 0.9287 0.9208 78169

Dec 0.9412 0.9417 +0.0052 0.9432 0.9412 3782

SWISS FRANC (CME) – CHF 125,000 ; $ per CHF

Sept 0.5871 0.5844 -0.0025 0.5888 0.5830 50630
Dec 0.5916 0.5891 -0.0024 0.5931 0.5880 432

EURO (CME) : Euro 125000; $ per Euro

Sept 0.9153 0.9109 -0.0040 0.9194 0.9079 66772
Dec 0.9191 0.9145 -0.0045 0.9191 0.9127 1257
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FUTURES PRICES, SPOT PRICES
AND EXPECTED SPOT PRICES
• Basis = (Spot Price – Futures Price)
• Normal Backwardation : Hedgers net long.
Futures price rises as maturity
approaches.
• Contango : Hedgers net short. Futures price falls
as maturity approaches
• Net Hedging Hypothesis
• Risk Aversion and behaviour of futures prices
•Futures Price = Expected Spot Price ?
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 Figure 1: Backwardation Fig. 2 : Contango
EXPECTED SPOT PRICE

FUTURES FUTURES PRICE

PRICE

Expiry Expiry
Time

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FUTURES PRICES AND FORWARD PRICES
• DETERMINISTIC INTEREST RATES:
FUTURES PRICES EQUAL FORWARD PRICES
• STOCHASTIC INTEREST RATES : FUTURES
PRICES DIFFER FROM SPOT PRICES DUE TO
DAILY GAINS AND LOSSES
•SPOT PRICE AND INTEREST RATE
POSITIVELY CORRELATED : FUTURS PRICE
EXCEEDS FORWARD PRICE
• NEGATIVE CORRELATION: FUTURES PRICE
LESS THAN FORWARD PRICE
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 FUTURES PRICE AND SPOT PRICE
CASH-AND -CARRY ARBITRAGE
• Spot Price of a dollar : Rs.46.00
• 3-month Futures Price : 49.00
• Rupee interest rate : 10% p.a.
• Dollar interest rate : 8% p.a.
• Borrow rupees, buy dollars and deposit, sell futures.
• 3 months later, deliver, get rupees, repay loan.

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Suppose contract size is $50000.
Must deposit $(50000)/(1.02) = $49019.61
Must borrow Rs.(49019.61)(46.0) = Rs.2254901.96
Must repay (2254901.96)(1.025) = 2311274.51
On expiry, liquidate deposit, deliver on futures collect
Rs.2450000. Net profit: 138725.49
Futures Price “too high” : Buy asset in spot market, store,
pay storage cost, sell futures, deliver at expiry.
Futures Price too low (e.g.46.10)
Reverse cash-and- carry arbitrage. Borrow dollars, convert
to rupees and deposit, buy futures. Take delivery at expiry
and repay dollar loan. Nothing but Covered Interest
Arbitrage
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Arbitrage and Theoretical Futures Price

Let C denote the present value of carrying costs, St the spot price, r
the interest rate, and FUt,T the futures price for delivery at T, Then
theoretical futures price is given by

FUt,T = (St + C)[1 + r(T-t)]

Actual futures price higher : cash-and-carry arbitrage

Actual futures price lower: reverse cash-and-carry arbitrage

For currency futures, futures prices are almost identical to forward

prices.

A similar relation will hold between FUt,T1 and Fut,T2, T2>T1>t 14

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In practice futures price does not exactly equal
theoretical futures price. Reasons:
1 Transaction costs – bid-offer spreads, brokerage
2 In some cases, restrictions on short sales (Does not
apply to currency futures)
3 Non-constant interest rates
4 Mark-to-market gains/losses.
5 “Convenience yield” (Commodity futures)
A band of variation around theoretical price.

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 Hedging with Currency Futures
A corporation has an asset e.g. a receivable in a currency A.
•To hedge it should take a futures position such that futures generate
a positive cash flow whenever the asset declines in value.
•The firm is long in the underlying asset, it should go short in futures
i.e. it should sell futures contracts on A against its home currency.
•When the firm is short in the undelying asset – a payable in
currency A – it should go long in futures.
Cash Position: Receive A; Futures Position: Deliver A
Cash Position: Deliver A; Futures Position: Receive A
If no futures between A and HC, use futures between A and a
currency closely correlated with HC.

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 Futures Hedge : An Example
A UK firm on January 30 books a USD 250000 payable to be
settled on August 1.
£/$ spot:1.5650. Futures: September: 1.5225 December: 1.4875
Sells September contracts. £ value of payable at $1.5225 per £ is
(250000/1.5225) = £164203.6. Each futures contract is £62500.
Sells (164203.6/62500) = 2.62 rounded off to 3 contracts
July 30: £/$ spot: 1.4850 September futures: 1.4650
Firm buys USD spot. Outlay: GBP(250000/1.4850)
= GBP 168350.17. Loss of GBP 8605.76 (Compared to spot at
start). Buys 3 September contracts. Gain on futures
$(1.5225-1.4650)(3)(62500) = £7260.10. Not a perfect hedge. Basis
narrowed. 17
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 Futures Hedge : Example (contd)
• Choice of contract underlying was obvious.
• Firm chose a contract expiring immediately after the payable
was to be settled. Is this necessarily the right choice?
• The number of contracts chosen was such that value of
futures position equaled the value of cash market exposure,
aside from the unavoidable discrepancy due to standard size of
futures contracts. Is this the optimal choice?
Futures hedge involves three considerations: Underlying,
expiry date of the contract, number of contracts. The latter
two problems do not arise with forwards. Why?

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 Three Decisions
(1) Which contract should be used i.e. the choice of "underlying".

Home currency A; exposure in B; futures on B against A

available – Direct hedge.

Home currency A; exposure in C; no futures on C against A. B

and C are highly correlated; use futures on B – Cross Hedge

(2) Choice of expiry date : In February A UK firm books a USD

payable maturing on June 3. To hedge, must sell GBP futures (Buy
USD futures). Which month? June or later?

(3) How many contracts? Choice of “hedge ratio”.

Value of futures position = Value of underlying exposure?
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Choice of expiry date: As expiry date approaches, basis narrows.
On expiry date futures price equals spot price. “Convergence”.
Does convergence help you or hurt you?
If convergence helps, choose near contract
If convergence hurts, choose far contract.
However, liquidity less in far contracts; bid-offer spreads are
higher; basis volatility more.
Thumb rule: Choose expiry date immediately after underlying
exposure is to be settled.

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 Choice of Expiry Date
Basis at the start
Positive Negative
Nature of hedge

Long F A
Short A F

Long Hedge: You must take delivery of underlying in your

futures position. You have bought futures contracts.
Short Hedge : You must make delivery of underlying in your
futures position. You have sold futures.
F: Convergence favours you. A: Convergence against you.
Positive Basis: Spot price > Futures Price
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 Choosing the Number of Contracts
•A Swiss firm has a USD payable of $500,000, maturing August 15.
• It decides to sell September contracts priced at $0.54/CHF.
•At this price, the CHF equivalent of $500,000 is CHF 925,925.93.
•Since one CHF contract is for CHF 125,000, it should sell :
(925925.93/125000) = 7.4074 rounded off to 7 or 8 contracts.

Straightforward, but is it correct?

What is the objective of hedging?
• To minimize the variance of the hedged position?
Define the "Hedge Ratio"(HR) as : VF/VH
= (Value of futures position/Value of cash position)
Should HR = 1.0 always?
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Direct Hedge with a Timing Mismatch : Choosing Hedge Ratio
• A Swiss firm on February 28 has a USD 500,000 payable to be
settled on June 1.
• Cash market position short USD. Must buy USD futures or short
CHF futures.
• It chooses to hedge by selling September CHF contracts. This
contract matures on September 18.
• The spot rate is USD/CHF 1.7544 or CHF/USD 0.5700
• September futures price is USD/CHF 1.8518 or CHF/USD 0.5400
• Each CHF contract is for CHF 125000.
• Determine the number of contracts it should short.
.

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Choosing Hedge Ratio
VC : The value of the cash market position measured in the foreign
currency.
St : The spot rate at the start stated as units of home currency(HC)
per unit of foreign currency(FC).
T1 : The date when the cash position has to be settled.
T2 : The date when the futures contract expires, T2 > T1
VF : The value of the futures position measured in US dollars.
Ft,T2 : The price at time t of the futures contract maturing at T2
stated as units of HC per unit of FC.
In the example HC: CHF FC: USD
Vc = $500000 St = 1.7544 T1: June 1
T2: September 18 Ft,T2 = 1.8518 24
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Choosing Hedge Ratio

F~ T1,T2 : The price of the same contract at time T1 (a random

variable)
S~ T1 : The spot rate at time T1 when the hedge is lifted. Stated as
units of HC per unit of FC. (Random variable)
The value of the hedged cash flow at time T1 is given by
V˜H,T1 = - VCS˜T1 + VF (Ft,T2 – F~ T1,T2)
To minimize the variance of this, choose hedge ratio given by
HR = VF/VC = COV(S~T1, F~T1T2) / VAR(F~T1T2)
We need forward-looking estimates of these parameters.
Can be estimated with past data on spot rates and futures prices but
that would be a historical estimate.
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• Let us apply this result to the Swiss firm's case.
• Assume that we have somehow obtained estimates of the
covariance of S˜T1 and F˜T1,T2 and the variance of F˜T1,T2.
• Their ratio is 0.90.
• Then the USD value of the futures position must be
(500,000×0.90) = USD 450,000.
• At the futures price of $0.54/CHF this translates into
CHF 833,333.33.
• With each contract being CHF 125,000 this is equivalent
to 6.67 contracts rounded off to 6 or 7 contracts.

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The interest parity relation tells us that
[1 + r$(T-t)]
Ft,T2(£/$) = St(£/$) --------------- = k St(£/$)
[1 + r£(T-t)]

[1 + r$(T-t)]
where k = ---------------
[1 + r£(T-t)]

If the factor k remains constant, then

(FT1,T2-Ft,T2) = k(ST1 - St)
and a hedge ratio VF/VC = 1/k = β would give a perfect hedge.
But k does not remain constant. Optimal hedge ratio keeps changing
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• Dynamic hedging: As interest rates and spot rate
keep changing, recalculate the optimal hedge ratio
and rebalance the hedge by selling more futures or
buying futures. How frequently?
• Transaction costs must be considered. Any gain
from frequent rebalancing must be weighed against
increased transaction costs.
• Large position, long duration of hedge, more
frequent rebalancing warranted.
• Standard-size problem cannot be circumvented.

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 SPECULATION WITH CURRENCY
FUTURES
• Open Position Trading
In April Spot EUR/USD: 0.9750
June Futures : 0.9925
September Futures: 1.0225
You do not think EUR will rise. It will fall.
You do not think EUR will rise so much.
How to profit from this view? Sell September.
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 SPECULATION WITH CURRENCY
FUTURES
On September 10 the rates are :
Spot EUR/USD: 0.9940 September futures: 0.9950
Close out by buying a September contract.
Profit USD(1.0205-0.9950) per EUR on 125000 EUR
= USD 3187.50 minus brokerage etc.
First view was wrong; EUR did appreciate but not as
much as implied by futures price.

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 SPREAD TRADING
• Intercommodity Spread
In April : Spot EUR/USD : 0.9500 GBP/USD: 1.5000
September Futures: EUR: 0.9800 GBP: 1.4980
Your view: GBP is going to rise against EUR.
What should you do?
• Intracommodity Spread:
June EUR: 0.9800 September EUR : 1.0500
Your view: Between June and September EUR will not
rise so much. What should you do?
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 INTEREST RATE FUTURES
Treasury Bill Futures
A futures contract on US treasury bills is traded on
the CME. Its specifications are as follows:
Product and Trading unit: 13 WEEK TREASURY
BILL FUTURES
3-month (13-week) U.S. Treasury Bills having a face
value at maturity of $1,000,000
Point Description: ½ point = .005 = $12.50. A point
here is one basis point or (1/100)th of 1 percent.
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T-Bill Futures Contract on CME….
• The dollar value of a point represents interest at 0.01%
p.a. on $1 million for a period of 3 months, which works
out to $25.
• Contract Listings: Mar, Jun, Sep, Dec,
Four months in March quarterly cycle plus 2 two months
not in the March cycle (serial months).
• The short must deliver a US T-bill with face value USD 1
mio, with 90, 91 or 92 days to maturity.
• Futures price stated as: 100.000-Discount yield
• Rates rise, price falls; rates fall, price rises.
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 T-bill Futures Prices
_____________________________________________________________

Treasury Bills (IMM) - $1 mil. ; pts. of 100%

CME U. S. Treasury Bills:

Prices as of 12/15/00 11:30 AM

MTH SESSION PT
OPEN HIGH LOW LAST CHGE OPINT

DEC00 94.13 94.145 94.13 94.145 +.5 1165

MAR01 ---- 94.41 94.38 94.41 +.5 1568

_____________________________________________________________
_
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THE EURODOLLAR DEPOSIT CONTRACT
• The underlying asset is a 3-month Eurodollar deposit
of USD 1 million beginning on expiry date of futures.
• Contract price is stated as (100-Implied Interest Rate)
• May be cash settled only or both cash settled and
physical delivery. If latter, long is actually assigned a
deposit at a eurobank.
• As interest rate rises, contract price falls. As rates fall,
contract price rises.
• To hedge against falling rates, buy futures; to hedge
against rising rates sell futures 35
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LONG TERM INTEREST RATE FUTURES
• The CBT contract on US T-bonds and T-notes;
LIFFE contract on UK guilts. DTB contract on
German Bunds etc.
• The short must deliver a long term bond from
among a set of eligible bonds -”Basket Delivery”
• The CBT contract on US T-bonds: Underlying is a
notional T-bond with 15 years to maturity and 8%
YTM.
•Exchange calculates a conversion factor for all
eligible bonds.
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LONG TERM INTEREST RATE FUTURES
For US T-bond futures, price stated as % of face value with
minimum 1/32% e.g.
Price : 103-18 means 103 and (18/32) percent of $100000
Long pays: Settlement Price × Conversion factor
+ Accrued Interest
Conversion Factor necessary because different bonds have
different coupons and maturities.
An eligible bond has CF of 1.5 - Each of these bonds equals 1.5
of notional bonds.

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 T-Bonds Futures Quotations 15/12/2000
______________________________________________________________

Treasury Bonds (CBT) - $100,000 ; pts 32nds of 100%

Contract Month Open High Low Settle Chg. Op.Int.

Dec 00 104-16 104-27 104-11 104-23 +8 39030

Mar 01 104-18 104-30 104-12 104-25 +8 422750
Jun 01 104-14 104-27 104-14 104-24 +8 1321

______________________________________________________________

Source : www.cbot.com
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 Hedging a Commercial Paper Issue.
•In January a corporation finalises its plans to make an issue
of $50 million 90-day commercial paper around mid May.

•Paper of comparable quality is now yielding 12.05%.

•At this yield the company hopes to realise $48,493,750.

•To protect itself against the possibility that rates may rise
before its issue hits the market decides to hedge using
EURO$ futures.

• June futures currently quoted at 88.75

• What should it do?

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 SPECULATION WITH INTEREST RATE
FUTURES
Open Position Trading

On September 1, December eurodollar futures on the IMM is

trading at 89.25. A trader believes that short term interest rates
are going to fall very soon. He buys a December contract at
89.25. On subsequent days, the prices and consequent
losses/gains are :
Day 1: 89.35 (+$250) Day 2: 89.32 (-$75)

Day 3: 89.45 (+$325) Day 4: 89.47 (+$50)

Day 5: 89.45 (-$50) Day 6: 89.50 (+$125) Liquidates position.

Total gain: $625 minus brokerage commissions.
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 An Intra-Contract Spread Trade

On February 25 the following prices are quoted for T-

bill futures on the IMM :

March : 96.02
June : 95.25
September : 94.50
December : 93.00
A trader feels that the yield curve is going to become
flatter. He has no particular ideas about how interest
rates as a whole are going to change but he is confident
that long term rates will be lower relative to short-term
rates than they are now.

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 Intra-Contract Spread Trade…..
If his prediction comes true the spread between near
and far contracts will narrow. To profit from this he
must sell a near contract and buy a far contract. (”sell
a spread"). He sells a September contract at 94.50 and
buys a December contract at 93.00.
By August 10, rates have fallen, yield curve is flatter:
September: 95.50 December: 94.75
Close out. Buy September sell December. Net gain 75 ticks or
USD 1875 minus brokerage.
Better strategy: Sell T-bill futures buy T-bond futures.

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