Derivatives

CHAPTER 7Currency Forwards and Futures

Aims

• To outline contract specifications, settlement procedures and price quotes for selected foreign exchange (FX) futures contracts – also called ‘currency futures’.
• To price a FX-forward contract by creating a replication portfolio using two money market interest rates and the spot exchange rate. This is ‘covered interest arbitrage’.
• To show how FX-futures can be used to hedge future payments and receipts in foreign currency.
• To demonstrate how both FX-forwards and futures can be used for speculation.
• To compare the pricing of currency futures with those for forward contracts.

Two major types of ‘deal’ on the foreign exchange (FX) market involve the spot-rate and the forward-rate. We assume, the spot rate is the exchange rate quoted for immediate delivery of the currency to the buyer (actually, delivery is 2 working days later). The second type of deal involves the forward rate, which is the price agreed today, at which the buyer will take delivery of the currency at some future date. Currency forwards and futures are very similar analytically, even though in practice the contractual arrangements differ.

Both, an FX-forward and an FX-futures contract is an obligation to trade one currency for another at a pre-specified exchange rate on a specific future (delivery) date. The dealing costs in both type of contract are very small. Why then do we need both types of contract? The reasons are slight differences between the two types of contract. ...