Hedging with Futures Contracts

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Hedging with Futures Contracts

• Tyler Gaspard

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Futures Contracts

• Futures contracts specify delivery of fixed
  quantities of foreign currencies on a set date in
  the future
• Traded on an organized exchange.
• Standardized by size and delivery date to make
  trading easier

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Futures vs Forwards

• FUTURES
• Traded on organized exchange
• Market determines price
• 100,000
• Standardized maturity
• Require initial deposit into margin account
• Daily settlement of G/L

• FORWARDS
• Traded on inter-bank market
• Prices set by contract
• gt 1 million
• Customer-tailored maturity
• Rarely require cash payment before maturity
• Settled on maturity

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Futures Contracts

• Advantages
• Liquidity can be traded before maturity at
  little cost
• Size more useful for hedging small exposures

• Limitations
• Only available in a few currencies, thus
  requiring cross-hedging
• Must be purchased in whole contracts, thus
  perfect hedging is not always possible

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Most Useful Hedges

• Unknown transaction dates
• Can liquidate futures position anytime before
  maturity or roll over to a later maturity
• Unknown transaction amounts
• Easy to change futures position
• Small transactions

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Hedging with Futures

• Important dates to keep in mind
• t---------------- t n
  -------------------T
• inception liquidation
  maturity
• Gain/Loss Equation X(Stn bSt) (Ztn -
  Zt)
• b 1 it,tnmonths/12 / 1 it,tnmonths/12

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Futures Held to Maturity

• Enables a perfect hedge just like a forward
  contract
• Futures and forwards are priced according to
  covered interest parity
• Futures at maturity Spot Rate
• Futures at inception Forward with same maturity
  
• Losses from exchange rate changes will be
  perfectly offset by gains in the futures contract

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Futures Not Held to Maturity

• Will not provide for perfect hedges for two
  reasons
• Futures price at liquidation date has not yet
  converged to the spot exchange rate.
• Interest rates at liquidation date are not known
  in advance and are likely to change between
  inception and liquidity.

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Example

• Atkinson Enterprises, a US consulting firm, has
  provided services to its neighbors to the north,
  Cannuck Manufacturing, a Canadian firm. These
  two firms have done business together for years,
  so Atkinson has allowed Cannuck up to six months
  to pay its bill of 100,000 Canadian. The
  current spot rate is .70 US/ 1 C. Interest
  rates are 5 on Canadian deposits and 8 on US
  deposits. Three months later, Cannuck pays its
  bill. The US dollar has appreciated over this
  time to a spot rate of .68/1 C.

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Scenario 1

• Atkinson chooses to not hedge
• Loss from exchange risk
• 100,000 (.68 b(.70)
• ? b 1.083/12/1.053/12 1.0071
• Loss from exchange risk -2,494.73

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Scenario 2

• Atkinson hedges the original transaction by
  selling one Canadian Futures contract with a six
  month maturity date. The contract is sold at a
  price of .7150. When Cannuck payment is received
  three months later, Atkinson buys one Canadian
  futures contract to close its position. The
  futures price at this time has dropped to .7000.

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Scenario 2

• Loss from exchange risk -2,494.73
• Gain from futures contract
• 100,000(.7150 - .7000) 1500
• Net Loss -2,494.73 1500 -994.73
• Hedging has saved Atkinson Enterprises 1500.