1. 1 Lec 5B Currency Futures and Hedging Currency Risk Lec 5B: Currency futures, Forward Contracts, and Hedging Currency Risk (Hull, Ch. 5.10) FX Futures Contract Contract:SFr Contract Size:Sfr 125,000 Exchange:Chicago Mercantile Exchange (CME) Trading Hours:7:20-2:00 PM (Chicago time) Delivery:Mar, Jun, Sep, Dec Suppose I am the CFO of a financial institution. I am bullish on the SFr (relative to the $), go long 1 Dec SFr futures contract @ 0.75 $/SFr, for SFr 125,000 In English,

2. 2 Lec 5B Currency Futures and Hedging Currency Risk In English, CFO has agreed to buy SFr 125,000 and pay $ 93,750 for it. Short has agreed to sell (to long) SFr 125,000 and receive $ 93,750. Trade will take place 3 rd week in December. Clear? Any questions? (I would have 6 Questions): 1) Do I pay for the Swiss Francs now? 2) How much does the futures contract itself cost? 3) Broker's commission ∼ $20 per contract or less (e.g. $10 for new customers) paid only at opening of contract. No charge for closing it. 4) Is there a margin deposit? Yes. Initial margin = $2,485 (may vary). Maintenance Margin = $1,000 (may vary) 5) Daily Settlement Process i.e., Mark to Market

3. 3 Lec 5B Currency Futures and Hedging Currency Risk 5) Daily Settlement Process i.e., Mark to Market DaySettle FX Rate $ValueΔvalue Margin for long Short Day 0, 9AM 0.7500$/SFr$93,750 $2,485 Day 0, Close 0.7501$93,762.50 $12.50$2,497.50$2,472.50 Day 1, Close 0.7491$93,637.50-$125$2,372.50$2,597.50 Day 2, Close 0.7591$94,887.50$1,250$3,622.50$1,347.50... Expiration0.74$92,500

4. 4 Lec 5B Currency Futures and Hedging Currency Risk Last Day, Expiration of Dec futures Suppose the last Settle XR is 0.7400 $/SFr ➃ Last Settle Price = SFr 125,000 ( 0.74 $/SFr ) = $ 92,500 Cumulative Δ = SFr 125,000 ( 0.74 $/SFr - 0.75 $/SFr ) = - $1,250 ➟ Long lost $ 1,250, ➟ Short gained $ 1,250 NOTE: at Expiration, forward rate must = spot exchange rate ➟ Spot or Cash Price = SFr 125,000 ( 0.74 $/SFr ) = $ 92,500

5. 5 Lec 5B Currency Futures and Hedging Currency Risk 6) What happens at Expiration? Long has two choices A. Close out Futures and Buy currency in the spot market. ▸ prior to expiration, close futures, (i.e., Short 1 Dec futures) @$0.74. ▸ Buy SFr in the cash market for $92,500. ▸ BUT, Long also has a loss in the futures = -$1,250. ➟ Actual cost of SFr = 92,500 + 1,250 = $93,750. (Same as original futures price) B. Buy SFr thru futures: Short buys SFr 125,000 in the spot market for $92,500 Short delivers the currency to Long and receives $92,500 in cash from long, and the Contract is closed. ▸ BUT, BUT, BUT, Long also has a loss in the futures = -$1,250. ➟ Actual cost of SFr = 92,500 + 1,250 = $93,750. (Same as original futures price)

6. 6 Lec 5B Currency Futures and Hedging Currency Risk ➟ Actual cost of SFr = 92,500 + 1,250 = $93,750. Mathematically: CF for Long must = - SFr 125,000 x Spot XR Expiration + SFr 125,000 x (Spot XR Expiration - 0.75 $/SFr ) = - SFr 125,000 x ( 0.75 $/SFr ) CF for Short must = + SFr 125,000 x Spot XR Expiration - SFr 125,000 x (Spot XR Expiration - 0.75 $/SFr ) = + SFr 125,000 x ( 0.75 $/SFr )

7. 7 Lec 5B Currency Futures and Hedging Currency Risk Use Futures Contracts to hedge Risk ▸ UTC buys high precision parts for helicopters from a Swiss watch manufacturer for SFr 1.25 M payable in December ▸ UTC has an A/P i.e., is “Short” SFr How to hedge this risk? Answer: ▸ Go LONG 10 Dec SFr futures contracts @ 0.75 $/Sfr, ▸ Contract Size = SFr 125,000. i.e., UTC agrees to BUY SFr 1.25M for $937,500 (=10 x SFr 125,000 x 0.75 $/SFr ). Then, in December UTC will use SFr 1.25M from the futures to cover the A/P ⇨ $ cost = $937,500 for sure (no matter if price of SFr goes ↑ or ↓ )

8. 8 Lec 5B Currency Futures and Hedging Currency Risk Thank You! (a favara)