Currency Derivatives: Futures Contracts

Currency Derivatives

• Futures contracts are similar to forward contracts but are sold on an exchange, specifying a standard volume of a particular currency to be exchanged on a specific settlement date.
• The futures rate is the exchange rate at which one can purchase or sell a specified currency on the specified settlement date.
• The future spot rate is the spot rate that will exist at a future point in time and is uncertain as of today.

Currency Options Contracts

• A currency call option provides the right to buy currency at a specified strike price within a specified period of time.
• A currency put option provides the right to sell currency at a specified strike price within a specified period of time.

International Money Market

• Corporations or governments need short-term funds denominated in a currency different from their home currency.
• The international money market has grown because firms may need to borrow funds to pay for imports denominated in a foreign currency.
• The floating exchange rate system allows widely traded currencies to fluctuate in accordance with market forces.

Foreign Exchange Transactions

• The over-the-counter market is the telecommunications network where companies normally exchange one currency for another.
• Foreign exchange dealers serve as intermediaries in the foreign exchange market.
• A foreign exchange transaction for immediate exchange is said to trade in the spot market, where the exchange rate is the spot rate.
• Trading between banks occurs in the interbank market.

Spot Market

• The U.S. dollar is the commonly accepted medium of exchange in the spot market.
• Spot market time zones are limited to normal business hours in a given location, allowing for 24-hour foreign exchange trading.
• Spot market liquidity increases with more buyers and sellers.

Attributes of Banks That Provide Foreign Exchange

• Currency risk refers to economic or political conditions that cause the demand for and supply of the currency to change abruptly.

Interpreting Foreign Exchange Quotations

• Direct quotation represents the value of a foreign currency in dollars (number of dollars per currency).
• Indirect quotation represents the number of units of a foreign currency per dollar.
• Indirect quotation = 1 / Direct quotation

Interpreting Changes in Exchange Rates

• When the euro is appreciating against the dollar, the indirect exchange rate of the euro is declining.
• When the euro is depreciating against the dollar, the indirect exchange rate is rising.

Risk of International Bonds

• Credit risk represents the potential for default.
• Interest rate risk represents the potential for the value of bonds to decline in response to rising long-term interest rates.
• Exchange rate risk represents the potential for the value of bonds to decline because the currency denominating the bond depreciates against the home currency.
• Liquidity risk represents the potential for the value of bonds to decline because there is not a consistently active market for the bonds.

Impact of the Greek Crisis on Bonds

• Greece experienced weak economic conditions and a large increase in the government budget deficit in spring 2010.
• Concern spread to other European countries with large budget deficits.
• Many European countries and the IMF agreed to provide Greece with new loans in May 2010.

International Stock Markets

• Direct foreign investment involves the acquisition of foreign real assets.
• Short-term investment or financing involves foreign securities.
• Longer-term financing occurs in the international bond or stock markets.

International Capital Markets

• The international money markets are composed of several large banks that accept deposits and provide short-term loans in various currencies.
• The international credit markets are composed of commercial banks that convert some of the deposits received into loans (for medium-term periods) to governments and large corporations.

This quiz covers the basics of futures contracts, a type of currency derivative. Learn about the specifications and settlement dates of futures contracts.