Currency futures are currency futures contracts that define the cost of exchanging one currency for another at a later date. The rate for currency futures contracts is generated from the currency pair’s spot rates. Currency futures are used to mitigate the risk of receiving foreign currency payments.
Companies use futures contracts for a variety of reasons.
Futures contracts enable the organization to better control risk and generate more predictable revenue. Currency futures can be used by companies doing business worldwide to mitigate the risk of currency volatility.
How do businesses make advantage of currency call options?
A currency option (also known as a forex option) is a contract that offers the buyer the right, but not the responsibility, to purchase or sell a specific currency at a predetermined exchange rate on or before a set date. A premium is paid to the seller for this right.
What is the purpose of currency swaps?
Currency swaps are used to get foreign currency loans at a lower interest rate than a corporation could get by borrowing directly from a foreign market, or to hedge transaction risk on foreign currency loans that have already been taken out.
What is the difference between foreign currency futures and foreign currency forwards?
Futures are standardized and traded on a public market, whereas forwards can be modified to match the individual needs of the buyer or seller and are not traded on a public exchange.
The expiration date and the negotiated amount are two aspects of futures contract standardization. Euro (EUR) futures contracts, for example, have quarterly expiration dates: March, June, September, and December, with a contract size of 125,000 EUR for each euro future. Forward currency contracts, on the other hand, are not limited in size or value date, and hence can often fulfill the needs of investors more accurately.
Furthermore, investors must pay for the futures contract and may be forced to post specific margin requirements, whereas a forward currency transaction frequently requires no initial expenditure because collateral is not required in many circumstances. As a result, an investor who uses forward currency contracts may be able to invest in a variety of assets until the contract’s value date.
Forward currency contracts have historically been used by both the Merk Absolute Return Currency Fund and the Merk Asian Currency Fund to gain currency exposure. T-Bills or other money market instruments are often used to fully collateralize the notional value of these contracts.
How do you protect yourself against currency futures?
Forex risk is a danger that any individual or business that deals with foreign currency is exposed to. Whether you’re an exporter, importer, ECB borrower, FCNR borrower, or a worldwide tourist, currencies have a significant impact on your finances. Payables in foreign currency are owed to an importer or a foreign borrower. As a result, they’ll be looking to keep the INR high so that they may collect more dollars for the same amount of rupees when their foreign currency obligation is due. Importers and foreign currency borrowers will need to protect their businesses from the rupee’s depreciation.
The exporter, on the other hand, has foreign currency receivables that will be paid at a later period. The exporter must ensure that the rupee remains weak, as this will result in his receiving more INR for each dollar received. The exporter will be glad if the rupee weakens, but he will need to protect himself if the currency strengthens. The USD-INR pair can be used by both importers and exporters to achieve the same result. Futures or options can be used to hedge the risk, and we’ll look at how each of these strategies can be used. While the USD-INR pair is presented as an example because of its liquidity and popularity, the same rationale may be applied to receivables in the Pound, Euro, and Yen.
Let’s look at an illustration to assist us comprehend this. Assume Raghav Exports Ltd. has a $50,000/- export inward remittance that is due on September 30th. While Raghav is aware of the dollar amount he will receive on September 30th, he is unsure of how much INR that will translate into, as it will be determined by the USD-INR exchange rate on that date. The current exchange rate is Rs.64 to $1. On September 30th, this will translate into a rupee inflow of INR 32 lakhs. Raghav has obligations on October 10th and is satisfied with the exchange rate of 64/$ on settlement day.
Raghav Exports, on the other hand, has been warned by their banker that the INR may actually appreciate to 62/$ by September 30th as a result of large FDI inflow into India. In rupee terms, this means Raghav exports will only receive Rs.31 lakhs. Raghav Exports is concerned that this will result in a shortfall in meeting their October 10th outflow pledge. As a result, the corporation must manage its inbound dollar risk. How would Raghav Exports be able to accomplish this?
Simply put, Raghav Exports can mitigate this risk by selling 50 lots of the USD-INR pair at Rs.64 per lot (each lot is worth $1000). This will provide them with complete protection. This is how it is going to function. Assume that the INR has appreciated to 62/$ on the 30th of September, the inbound date. On September 30th, Raghav Exports will receive a transfer of $50,000/-, which will be translated to Rs.31 lakhs. Raghav, on the other hand, has sold 50 units of USD-INR futures for Rs.64 each. Raghav exporters will gain a Rs.1 lakh profit on the position now that the price has dropped to 62. As a result, the total receivable is now Rs.32 lakh (Rs.31 lakh from conversion and Rs.1 lakh from the short USD-INR futures). Raghav Exports has effectively hedged its conversion price at Rs.64/$.
What happens if the INR depreciates to Rs.68, on the other hand? Raghav Exports would have made a profit in normal circumstances, but due to the hedging, it will be locked in at Rs.64/$. This will result in a Rs.4 notional loss, but the goal is to protect your downside risk rather than to profit. There are two ways to get around this. The USD-INR pair can be held with a stringent stop loss, or hedging can be done with put options rather than futures, limiting the maximum risk to the amount of the option premium.
In this case, the situation will be the polar opposite of the exporter’s. A dollar will be due at a later date to an importer or a foreign currency borrower. As a result, they must guarantee that the INR does not decline too much, as this will necessitate the use of more rupees to obtain the same amount of dollars. By purchasing USD-INR futures, the importer or foreign currency borrower might reduce their risk. When the rupee falls in value, the dollar rises in value, increasing the value of USD-INR futures. Any dollar loss he incurs as a result of the weaker INR will be offset by long USD-INR futures. Hedging can also be done using options in the event of an importer or foreign currency borrower by purchasing a call option on the USD-INR pair.
Currency derivatives (futures and options) are also a useful way to hedge future dollar risk. While the OTC forward market continues to dominate, currency derivatives are quickly becoming the preferred method of managing currency risk.
How do you tell the difference between commodity and currency futures?
Commodities are physical products that may be bought or sold, such as oil, grain, or metals. Futures contracts are agreements to buy and sell goods in the future.
With futures contracts, how do you manage currency risk?
Taking a short position in the futures market is referred to as a short hedge. In a currency market, a short hedge is taken by someone who already possesses or expects to receive the base currency in the future.
After three months, an exporter expects a payment of USD 1,000,000. Assume the current spot currency rate is INR 57.0000 to 1 USD. If the spot currency rate remains unchanged after three months, the exporter will get INR 57,000,000 from the USD obtained from the export contract. If the exchange rate climbs to INR 58.0000: 1 USD after three months, the exporter will receive INR 58,000,000. If the currency rate falls to INR 56.0000: 1 USD, the exporter will receive INR 56,000,000, resulting in a loss of INR 1,000,000. As a result, the exporter faces an exchange rate risk, which it might mitigate by holding a position in the futures market. Exporters can lock in the currency rate at INR 57.0000 per USD after three months by establishing a short position in the futures market (suppose the 3 month futures price is Rs. 57). Because a contract for USD-INR futures is worth 1000 USD, the exporter must have a short position in 1000 contracts. Whatever the currency rate is after three months, the exporter will receive INR 57,000,000. A profit in the futures contract will compensate for a loss in the spot market, and vice versa.
What advantages can currency options provide that futures and forward contracts do not?
What advantages can currency options provide that futures and forward contracts do not? Leverage. You can use options to gain a lot of power. Disciplined traders that understand how to use leverage benefit from this.