CHAPTER 11

Foreign Exchange Futures

In this chapter, we discuss foreign exchange futures. This

chapter is organized as follows:

1. Price Quotations

2. Geographical and Cross-Rate Arbitrage

3. Forward and Futures Market Characteristics

4. Determinants of Foreign Exchange Rates

5. Futures Price Parity Relationships

6. Speculation in Foreign Exchange Futures

7. Hedging with Foreign Exchange Futures

Chapter 11 1
 Price Quotation

In the foreign exchange market, every price is a relative

price. That is, there is a reciprocal rate.

Example:

To say that $1 = € 2.5 (2.5 euros) implies that € 2.5 will buy
$1

Or

€ 1 = $0.40

Figure 11.1 shows foreign exchange rate quotations as

they appear in the Wall Street Journal.

Chapter 11 2
 Price Quotation

Insert Figure 11.1 here

Chapter 11 3
 Price Quotation

Forward rates are the rates that you can contract today for
the currency.
If you buy a forward rate, you agree to pay the forward
rate in 30 days to receive the currency in question.
If you sell a forward rate, you agree to deliver the currency
in question in receipt of the forward rate.
The transactions are in the interbank market. The
transactions are for $1,000,000 or more.
One rate is the inverse of the other (e.g., $/€ reverse of €/
$).
Using the previous example $1 = €2.5

1 1
U .S .$ / € rate  € rate / US $rate 
€ rate / U .S .$rate US $rate / € rate

1 1
U .S .$ / € rate  € rate / US $rate 
2.5 0.40

U .S .$ / € rate  0.40 € rate / US $rate  2.50

Chapter 11 4
 CME’s Euro FX Futures
Product Profile

Product Profile: The CME=s Euro FX Futures

Contract Size: 125,000 Euro
Deliverable Grades: N/A
Tick Size: 0.0001=$12.50
Price Quote: U.S dollars per Euro.
Contract Months: Six months in the March, June, September, and December cycle
Expiration and final Settlement: Eurodollar futures cease trading at 9:16 a.m. Chicago Time
on the second business day immediately preceding the third Wednesday of the contract month.
The contract is physically settled.
Trading Hours: Floor: 7:20 a.m.-2:00 p.m; Globex: Mon/Thurs 5:00 p.m.-4:00 p.m.; Shutdown
period from 4:00 p.m. to 5:00 p.m. nightly; Sunday & holidays 5:00 p.m.-4:00 p.m.

Daily Price Limit: None

Chapter 11 5
Geographical and Cross-Rate Arbitrage

Pricing relationships exist in the foreign exchange market.

This sections explores two of these relationships and
associated arbitrage opportunities:

1. Geographical Arbitrage

2. Cross-Rate Arbitrage

Chapter 11 6
 Geographical Arbitrage

Geographical arbitrage occurs when one currency sells for

a different prices in two different markets.

Example

Suppose that the following exchange rates exist between

German marks and U.S. dollars as quoted in New York
and Frankfurt for 90-day forward rates:

New York $/€ 0.42

Frankfurt €/$ 2.35

To identify the opportunity for an arbitrage we can compute

the inverse. From the price in New York, we can compute
the appropriate exchange rate in Frankfurt.

1
 € / $  2.381
0.42

Chapter 11 7
 Geographical Arbitrage

If the transpose is equal to the price of the currency in

another market, there is no opportunity for a geographic
arbitrage.

If the transpose is not equal to the price of the currency in

another market, the opportunity for a geographic arbitrage
exists. In this case:

1
 € / $  2.381
0.42

In New York, the €/$ rate is 2.381, but in Frankfurt it is

2.35. Thus, an arbitrage opportunity exists.
Table 11.1 shows how to exploit this pricing discrepancy.

Chapter 11 8
 Geographical Arbitrage

Tab le 11 .1
Ge o g rap hical Arb itrag e
This is an arbitrage transaction since it has a certain profit with no investment.
Notice that the arbitrage is not complete until the transactions at t = 90 are
completed.

t = 0 (the present)
Buy  1 in New York 90 days forward for $.42
Sell  1 in Frankfurt 90 days forward for $.4255.

t = 90
Deliver  1 in Frankfurt; collect $.4255.
Pay $.42; collect  1.
Profit: $.4255
B .4200
$.0055

Chapter 11 9
 Cross-Rate Arbitrage

Cross-rate arbitrage, if present, allows you to exploit

misalignments in cross rates. A cross-rate is the exchange
rate between two currencies that is implied by the
exchange on other currencies.
Example
In New York, there is a rate quoted for the U.S. dollar
versus the euro. There is also a rate quoted for the U.S.
dollar versus the British pound. Together these two rates
imply a rate that should exist between the euro and the
British pound that do not involve the dollar. This implied
exchange rate is called the cross rate. Cross rates are
reported in the Wall Street Journal.

Cross-Rate Arbitrage

US$ € (Euro)

US$ ₤ (B. Pound)

Figure 11.2 shows quotations for cross rates from the

Wall Street Journal.

Chapter 11 10
 Cross-Rate Arbitrage

Insert Figure 11.2 here

Chapter 11 11
 Cross-Rate Arbitrage

If the direct rate quoted somewhere does not match the

cross rate, an arbitrage opportunity exists.

Suppose that we have the following 90-day forward rates.

FS indicates the Swiss franc (FS):

New York $/€ 0.42

$/SF 0.49

Frankfurt €/SF 1.20

The exchange rates quoted in New York imply the

following cross rate in New York for the €/SF:

€ / SF  ($ 1/ € )$ / SF
€ / SF  (0.142)0.49
€ / SF  1.167

Chapter 11 12
 Cross-Rate Arbitrage

Because the rate directly quoted in Frankfurt differs from

the cross rate in New York, an arbitrage opportunity is
present.
Table 11.2 shows the transactions required to conduct the
arbitrage.
Table 11.2
Cross BRate Arbitrage Transactions
t = 0 (the present)
Sell SF 1 90 days forward in Frankfurt for  1.2.
Sell  1.2 90 days forward in New York for $.504.
Sell $.504 90 days forward in New York for SF 1.0286.

t = 90 (delivery)
Deliver SF 1 in Frankfurt; collect  1.2.
Deliver  1.2 in New York; collect $.504.
Deliver $.504 in New York; collect SF 1.0286.
Profit: SF 1.0286
B 1.0000
SF .0286

Chapter 11 13
 Forward and Futures Market
Characteristics
The institutional structure of the foreign exchange futures
market resembles that of the forward market, with a
number of notable exceptions as shown in Table 11.3.
Table 11.3
Futures vs. Forward Markets
Forward
Size of Contract Tailored to individual needs.
Delivery Date Tailored to individual needs.
Method of Established by the bank or
Transaction broker via telephone contract
with limited number of buyers
and sellers.
Participants Banks, brokers, and multiB
national companies. Public
speculation not encouraged.
Commissions Set by Aspread@ between
bank's buy and sell price.
Not easily determined by
customer.
Security Deposit None as such, but compen-
sating bank balances re-
quired.
Clearing Operation Varies across individual
(Financial Integrity) banks and brokers. No sepa-
rate clearinghouse function.
Marketplace Over the telephone world-
wide.
Economic Facilitate world trade by pro-
Justification viding hedge mechanism.
Accessibility Limited to very large custom-
ers who deal in foreign trade.
Regulation SelfBregulating.
Frequency More than 90% settled by
of Delivery actual delivery.
Price Fluctuations No daily limit.
Market Liquidity Offsetting with other banks.
Source: IMM, AUnderstanding Futures in Foreign Exchange Futures,@ pp. 6B7.
Chapter 11
Futures
Standardized.
Standardized.
Determined by open auction
among many buyers and
sellers on the exchange floor.
Banks, brokers, and multina-
tional companies. Qualified
public speculation encourag-
ed.
Published small brokerage fee
and negotiated rates on block
trades.
Published small security
deposit required.
Handled by exchange clear-
inghouse. Daily settlements to
the market.
Central exchange floor with
worldwide communications.
Same as forward market. In
addition, it provides a broader
market and an alternative
hedging mechanism via public
participation.
Open to anyone who needs
hedge facilities, or has risk
capital with which to specu-
late.
April 1975CRegulated under
the Commodity Futures
Trading Commission.
Less than 1% settled by
actual delivery.
No daily limit.
Public offset. Arbitrage offset.
14
 Determinants of Foreign Exchange
Rates

This section explores the following determinants of foreign

exchange rates:

1. Balance of Payments

2. Fixed Exchange Rates

3. Other Exchange Rate Systems

– Freely Floating

– Managed Float or Dirty Float Policy

– Pegged Exchange Rate System

– Joint Float

Chapter 11 15
 Balance of Payments

Balance of payments is the flow of payments between

residents of one country and the rest of the world. This flow
of payments affects exchange rates.
The balance of payments encompasses all kinds of flows
of goods and services among nations, including:
– The movement of real goods

– Services

– International investment

– All types of financial flows

Deficit Balance of Payment

Expenditures by a particular country exceed receipts. A
constant balance of payments deficit will cause the value of
the country’s currency to fall.
Surplus Balance of Payment
Receipts by particular country exceed expenditures.

Chapter 11 16
 Fixed Exchange Rates

Fixed Exchange Rates

A fixed exchange rate is a stated exchange rate between

two currencies at which anyone may transact.

For a particular country, a continual excess of imports over

exports puts pressure on the value of its currency as its
world supply continues to grow.

Eventually, the fixed exchange rate between the country’s

currency and that of other nations must be adjusted either
by devaluating or revaluating.
– Devaluation: the value of the currency will fall relative to
other countries.

– Revaluation: the value of the currencies will increase

relative to other countries.

Exchange Risk

The risk that the value of a currency will change relative to

other currencies.

Today a free market system of exchange rates prevails.

Daily fluctuations exists in the exchange rates market.

Chapter 11 17
 Other Exchange Rates Systems
Freely Floating
A currency has no system of fixed exchange rates. The
country's central bank does not influence the value of the
currency by trading in the foreign exchange market.
Managed Float or Dirty Float Policy
The central bank of a country influences the exchange
value of its currency, but the rate is basically a floating rate.
Pegged Exchange Rate System
The value of one currency might be pegged to the value of
another currency, that itself floats.
Joint Float
In a joint float, currencies participating in the joint float have
fixed exchange values relative to other currencies in the
joint float, but the group of currencies floats relative to
other currencies that do not participate in the joint float.
This is particularly important for the foreign exchange
futures market.

Chapter 11 18
 Future Price Parity Relationships

In this section, other price relationships will be examined,

including:

1. Interest Rate Parity Theorem (IRP)

2. Purchasing Power Parity Theorem (PPP)

Chapter 11 19
 Interest Rate Parity Theorem

The Interest Rate Parity Theorem states that interest rates

and exchange rates form one system.

Foreign exchange rates will adjust to ensure that a trader

earns the same return by investing in risk-free instruments
of any currency, assuming that the proceeds from
investment are converted into the home currency by a
forward contract initiated at the beginning of the holding
period.

To illustrate the interest rate parity, consider Table 11.4.

Table 11.4
Interest Rates and Exchang e Rates to
Illustrate Interest Rate Parity
Interest Rates
Exchange Rates $/ U.S. Germany
Spot .42 B B
30Bday .41 .18 .576
90Bday .405 .19 .33
180Bday .40 .20 .323

Chapter 11 20
 Interest Rate Parity Theorem

If interest rate parity holds, you should earn exactly the

same return by following either of two strategies:

Strategy 1:

Invest in the U.S. for 180 days with a current rate of 20%

Strategy 2:

a) Sell $ for euros (€) at the current rate (spot rate) of

0.42.

b) Invest € proceeds for 180 days in Germany with a

current rate of 32.3 percent.

c) Receive the proceeds of the German investment

receiving (€ 2.7386 in 180 days).

d) Sell the proceeds of the German Investment for dollars

through a 180-day forward contract initiated at the
outset of the investment horizon for a rate of 0.40.

Chapter 11 21
 Interest Rate Parity Theorem

Strategy 1

Invest in the U.S. for 180 days. You will have the following
in 6 months:

FV = PV(1+i)N

Alternative notation:

FV = DC (1+RDC)

FV = $1(1+.20)0.5

FV = $1.095

Chapter 11 22
 Interest Rate Parity Theorem

Strategy 2:

a) Sell $ for euros (€) at the current rate (spot rate) or 0.42. You will receive:

1
 €2.381
0.42
b) Invest euro proceeds for 180 days in Germany with a
current rate of 32.3 percent.

FV = PV(1+i)N or FV = DC (1+RDC)

= 2.381(1+.323)0.5

= €2.7386

c) Receive the proceeds of the German Investment

(receiving € 2.7386 in 180 days). Take your euros out
of bank.

Chapter 11 23
 Interest Rate Parity Theorem

Strategy 2:

d) Sell the proceeds of the German investment for dollars

through a 180-day forward contract initiated at the
outset of the investment horizon for a rate of 0.40.

$U.S. = €($/€)

$U.S. = 2.7386 (0.40) or $U.S. = $1.09544

This amount can be stated as:

FV  ( DC / FC )(1  rFC ) F0,t

DC/FC = the rate at which the domestic currency can

be converted to the foreign currency today.

rFC = the rate that can be earned over the time

period of interest on the foreign currency.

F0,t = the forward or futures contract rate for

conversion of the foreign currency into the
domestic currency.
Chapter 11 24
 Interest Rate Parity Theorem

FV  ( DC / FC )(1  rFC ) F 0, t

1
FV  ( )(1  0.323) 0.5 0.40
0.42

FV  $1.0954

The two strategies produce the same return, so there is no

arbitrage opportunity available. If the two produced
different returns, an arbitrage strategy would be present.

Chapter 11 25
 Interest Rates Parity Theorem

The equality between the two strategies can also be stated

as:

DC(1 + rDC) = (DC/FC)(1 + rFC)F0,t

Where

DC = the dollar amount of the domestic currency

rDC = the rate that can be earned over the time period
of interest on the domestic currency

DC/FC = the rate at which the domestic currency can be

converted to the foreign currency today

rFC = the rate that can be earned over the time period
of interest on the foreign currency

Fo,t = the forward or futures contract rate for

conversion of the foreign currency into the
domestic currency

Chapter 11 26
 Interest Rates Parity Theorem

Using the previous example:

DC (1  rDC )  ( DC / FC )(1  rFC ) F 0, t

$1.0954  $1.0954

We can manipulate the equality to solve for other

variables:

F 0, t 
DC (1  rDC )
( DC / FC )(1  rFC )
(
 FC
1  rDC
1  rFC
)
The above equation says that, for a unit of foreign
currency, the futures price equals the spot price of the
foreign currency times the quantity:

 1+ r 
 DC

 1+ r FC 

This quantity is the ratio of the interest factor for the

domestic currency to the interest factor for the foreign
currency.

Chapter 11 27
 Interest Rates Parity Theorem

We can compare the last equation to the Cost-of-Carry

Model in perfect markets with unrestricted short selling, we
obtain:
 1 + r DC 
1 + Cost- of- Carry =    1 + (r DC -r FC )
 1 + r FC 

The cost of carry approximately equals the difference

between the domestic and foreign interest rates for the
period from t = 0 to the futures expiration.
Applying this equation for the 180-day horizon using
the rates from Table 11.4.
F0,t = .40
S0 = .42
rDC = .095445 for the half-year
rFC = .150217 for the half-year

The result is:

 1.095445 
.40 = .42  
 1.150217 

Chapter 11 28
Exploiting Deviations from Interest Rate
Parity

In the event that the two rates are not equal, the arbitrage
that would be undertaken is referred to as covered interest
arbitrage. Where we would borrow the $1 needed to
undertake Strategy 2 above. If the rate earned on the
investment is higher than the cost of borrowing the $1, an
arbitrage profit can be earned. This is equivalent to cash-
and-carry arbitrage.

This cash-and-carry strategy is known as the covered

interest arbitrage in the foreign exchange market.

Chapter 11 29
 Exploiting Deviations from Interest Rate
Parity
Covered Interest Arbitrage
0 1

1. Borrow DC @ RDC 5. Receive DC/FC

plus accrued RFC
2. Sell FC forward/futures
6. Deliver FC at RFC
3. Exchange & 7. Receive DC
receive DC/FC
4. Invest FC @ RFC 8. Pay loan (DC +RDC)
DC = Domestic fund/currency
FC = Foreign currency/funds
RDC = Domestic interest rate
RFC = Foreign interest rate

If Interest Rate Parity (IRP), the exchange rate equivalent of

the Cost-of-Carry Model, holds the trader must be left with
zero funds. Otherwise an arbitrage opportunity exists.

Chapter 11 30
Exploiting Deviations from Interest Rate
Parity

Using the data from our previous example, Table 11.5

shows the transactions that will exploit this discrepancy.

Tab le 1 1 .5
Co v e re d Inte re st Arb itrag e
t = 0 (present)
Borrow  2.3810 in Germany for 90 days at 33%.
Sell  2.3810 spot for $1.00.
Invest $1.00 in the U.S. for 90 days at 19%.
Sell $1.0355 90 days forward for DM 2.5570.

t = 90 (delivery)
Collect $1.0444 on investment in U.S.
Deliver $1.0355 on forward contract; collect  2.5570.
Pay  2.5570 on  2.3810 that was borrowed.
Profit: $1.0444
B 1.0355
.0089

Chapter 11 31
 Purchasing Power Parity Theorem

The Purchasing Power Parity Theorem (PPP) asserts that

the exchange rates between two currencies must be
proportional to the price level of traded goods in the two
currencies. Violations of PPP can lead to arbitrage
opportunities, such as the example of “Tortilla Arbitrage”
shown in Table 11.6.
Assume that transportation and transaction costs are zero
and that there are no trade barriers. The spot value of
Mexican Peso (MP) is $.10.

Table 11.6
Tortilla Arbitrage
MP/$ Cost of One Tortilla
Mexico City 10 MP 1
New York 10 $.15

Arbitrage Transactions:
Sell $1 for MP 10 in the spot market.
Buy 10 tortillas in Mexico City.
Ship the tortillas to New York.
Sell 10 tortillas in New York at .15 for $1.50.
Profit: $1.50
B 1.00
.50

Chapter 11 32
 Purchasing Power Parity Theorem

Over time, exchange rates must conform to PPP. Table

11.7 presents prices and exchange rates at two different
times (PPP at t = 0, PPP at t = 1).

Table 11.7
Purchasing Pow er Parity Over Time
Expected Inflation Rates from t = 0 to t = 1: $ .10
MP .20

t=0 t=1
Exchange Rates MP/$ 10.00 10.91
Tortilla Prices
Mexico City MP 1.00 MP 1.20
New York $ .10 $ .11

Chapter 11 33
 Speculation in Foreign Exchange
Speculating with an Outright Position

Assume that today, April 7, a speculator has the following

information about the exchange rates between the U.S.
and the euro. Table 11.10 shows the exchange rates.

Based on the exchange rate information, the market

believes the euro will rise relative to the dollar. The
speculator disagrees. The speculator believes that the
price of the euro, in terms of dollars, will actually fall over
the rest of the year.

Table 11.10
Foreign Exchange Prices CSpot and Futures, April 7
$/
Spot .4140
JUN Futures .4183
SEP Futures .4211
DEC Futures .4286

Chapter 11 34
 Speculation in Foreign Exchange
Speculating with an Outright Position

Table 11.11 shows the speculative transactions that the

speculator enters to take advantage of her/his belief.

Tab le 1 1 .1 1
Sp e culatio n in Fo re ig n Exchang e
Cash Market Futures
Market
April 7 Anticipates a fall in the value Sell one DEC
of the euro over the next 8 euro futures
months. contract at
.4286.
December 10 Spot Price $/ = .4211 Buy one DEC
euro futures
contract at
.4218.
Profit:
$ .4286
B .4218
Profit per euro $ .0068
Times euro per contract 125,000
Total Profit $ 850

The speculator’s hunch was correct, and thus made a

profit.

Chapter 11 35
 Speculation in Foreign Exchange
Speculating with Spreads

Spread strategies include intra-commodity and inter-

commodity. Assume that a speculator believes that the
Swiss franc will gain in value relative to the euro but is also
uncertain about the future value of the dollar relative to
either of these currencies.

The speculator gathers market prices for June 24 $/C and

$/SF spot and future exchange rates. Table 11.12
summarizes the information.

Table 11.12
Spot and Futures Exchange Rates, June 24
Implied DM/SF
$/ $/SF CrossBRate
Spot .3853 .4580 1.1887
SEP .3915 .4616 1.1791
DEC .4115 .4635 1.1264
MAR .4163 .4815 1.1566
JUN .4180 .5100 1.2201

Chapter 11 36
 Speculation in Foreign Exchange
Speculating with Spreads

Table 11.13 shows the transactions that the speculator

enters to exploit his/her belief that the December cross rate
is too low.

Table 11.13
A Speculative Cross BRate Futures Spread
Date Futures Market
June 24 Sell one DEC euro futures contract at .4115.
Buy one DEC SF futures contract at .4635.
December 11 Buy one DEC euro futures contract at .3907.
Sell one DEC SF futures contract at .4475.
Futures Trading Results:
euro SF
Sold .4115 .4475
Bought B .3907 B .4635
$.0208 B$.0160

 125,000 = $2,600 B $2,000

Total Profit: $600

Chapter 11 37
 Speculation in Foreign Exchange
Speculating with Spreads

Assume that a speculator observes the spot and futures

prices as shown in Table 11.14. The speculator observes
that the prices are relatively constant, but believes that the
British economy is even worse than generally appreciated.
She anticipates that the British inflation rate will exceed the
U.S. rate. Therefore, the trader expects the pound to fall
relative to the dollar.

Tab le 11.14
Spo t and Futures Prices, Aug ust 12
$/British Pound
Spot 1.4485
SEP 1.4480
DEC 1.4460
MAR 1.4460
JUN 1.4470

Because the speculator is risk averse, she decides to trade

a spread instead of an outright position.

Chapter 11 38
 Speculation in Foreign Exchange
Speculating with Spreads

Table 11.15 shows the transactions that the speculator

enters to exploit her belief.

Table 11.15
Time Spread Speculation in the British Pound
Date Futures Market
August 12 Buy one DEC BP futures contract at 1.4460.
Sell one MAR BP futures contract at 1.4460.
December 5 Sell one DEC BP futures contract at 1.4313.
Buy one MAR BP futures contract at 1.4253.
December March

Sold 1.4313 1.4460

Bought B 1.4460 B 1.4253
B $.0147 $.0207

 25,000 = B $367.50 + $517.50

Total Profit: $150

As a result of her conservatism, the profit is only $150. Had

the trader taken an outright position by selling the MAR
contract, the profit would have been $517.50.

Chapter 11 39
Hedging with Foreign Exchange Futures
Hedging Transaction Exposure

You are planning a six-month trip to Switzerland. You plan

to spend a considerable sum during this trip. You gather
the information in Table 11.6.

Table 11.16
Swiss Exchange Rates, January 12
Spot .4935
MAR .5034
JUN .5134
SEP .5237
DEC .5342

After analyzing the data, you fear that spot rates may
rise even higher, so you decide to lock-in the existing
rates by buying Swiss franc futures.

Chapter 11 40
Hedging with Foreign Exchange Futures
Hedging Transaction Exposure

Table 11.17 shows that transaction that you enter in order

to lock in your exchange rate.

Table 11.17
Moncrief's Sw iss Franc Hedge
Cash Market Futures Market
January 12 Moncrief plans to take a sixB Moncrief buys 2 JUN SF futures
month vacation in Switzerland, contracts at .5134 for a total
to begin in June; the trip will cost of $128,350.
cost about SF 250,000.
June 6 The $/SF spot rate is now .5211, Moncrief delivers $128,350 and
giving a dollar cost of $130,275 collects SF 250,000.
for SF 250,000.
Savings on the Hedge = $130,275 B 128,350 = $1,925

In this example, you had a pre-existing risk in the

foreign exchange market, since it was already
determined that you would acquire the Swiss francs.
By trading futures, you guaranteed a price of $.5134
per franc.

Chapter 11 41
Hedging with Foreign Exchange Futures
Hedging Import/Export Transaction

You, the owner of a import/export business, just finished

negotiating a large purchase of 15,000 Japanese watches
from a firm in Japan. The Japanese company requires your
payment in yens upon delivery. Delivery will take place in
6 months. The price of the watches is set to Yen 2850 per
watch (today’s yen exchange rate). Thus, you will have to
pay Yen 42,750,000 in about seven months.

You gather the information shown in Table 11.18. After

analyzing the information, you fear that dollar may lose
ground against the yen.

Table 11.18
$/Yen Foreign Exchange Rates, April 11
Spot .004173
JUN Futures .004200
SEP Futures .004237
DEC Futures .004265

Chapter 11 42
Hedging with Foreign Exchange Futures
Hedging Import/Export Transaction

To avoid any worsening of your exchange position, you

decide to hedge the transaction by trading foreign
exchange futures. Table 11.19 shows the transactions.

Table 11.19
The Importer's Hedg e
Cash Market
April 11 The importer anticipates a
need for Yen 42,750,000 in
November, the current value
of which is $178,396, and
which have an expected val-
ue in November of $182,329.
November 1 Receives watches; buys Yen
42,750,000 at the spot market
rate of .004273 for a total of
$182.671.
Spot Market Results:
Futures Market
The importer buys 3 DEC yen
futures contracts at .004265
for a total commitment of
$159,938.
Sells 3 DEC yen futures con-
tracts at .004270 for a total
value of $160,125.
Futures Market Results:

Anticipated Cost $182,329 Profit = $187

B Actual Cost B 182,671
B$ 342
Net Loss: B $155

Notice that because you were not able to fully hedge

your position, you still had a loss.

Chapter 11 43
Hedging with Foreign Exchange Futures
Hedging Translation Exposure

Many global corporations have subsidiaries that earn

revenue in foreign currencies and remit their profits to a
U.S. parent company. The U.S. parent reports its income in
dollars, so the parent's reported earnings fluctuate with the
exchange rate between the dollar and the currency of the
foreign country in which the subsidiary operates. This
necessity to restate foreign currency earnings in the
domestic currency is called translation exposure.

Chapter 11 44
Hedging with Foreign Exchange Futures
Hedging Translation Exposure

The Schropp Trading Company of Neckarsulm, a

subsidiary of an American firm, expects to earn 4.3 million
this year and plans to remit those funds to its American
parent. The company gathers information about the euro
exchange rates for January 2 and December 15 as shown
in Table 11.20.

With the DEC futures trading at .4211 dollars per euro on

January 2, the expected dollar value of those earnings is
$1,810,730. If the euro falls, however, the actual dollar
contribution to the earnings of the parent will be lower.

Table 11.2 0
Exchange Rates for the Euro
January 2 December 15
Spot .4233 .4017
DEC Futures .4211 .4017

Chapter 11 45
Hedging with Foreign Exchange Futures
Hedging Translation Exposure

The firm can either hedge or leave unhedged the value of

the earnings in euros, as Table 11.21 shows.

Table 11.21
Schropp Trading Company of Neckarsulm
January 2
Expected earnings in Germany for the year: 4.3 million
Anticipated value in U.S. dollars: $1,810,730
(computed @ .4211 $/ )

Schropp Trading Company's Contribution to Its Parent's Income:

Unhedged Hedged
Contribution to parent's income in U.S. Dol-
lars from  4.3 million earnings (Assumes $1,727,310 $1,727,310
spot rate of .4017)

Futures profit or loss 0 $ 84,875

(Closed at the spot rate of .4017)

Total $1,727,310 $1,812,185

Chapter 11 46