The Role of Currency Futures in Risk Management - Essay Example

?Executive Summary This paper examines the role of currency futures in mitigating the impact of adverse movement in foreign exchange rates. The currency futures have been compared with other derivative instruments and it has been emphasized that how currency futures overcome the disadvantages posed by other derivative instruments. Multinational corporations who have denominations in different currencies are largely exposed to foreign exchange risk and they need to eliminate the impact of severe losses due to adverse movements in foreign exchange rates. Various other forms of managing currency risk have been compared with currency futures to determine that which form is the most credible one. Forward contracts have certain advantages over currency futures but their disadvantages cannot supersede the advantages provided by currency futures. Because of their standardized features and a high liquidity in the market, currency futures have gained widespread importance. Even with the advent of sophisticated derivative instruments such as options, yet the currency futures lie ahead of them because of the cost factors and their advantages in providing superior performances in covered hedges. Introduction In the contemporary world, currency risk management is gaining a widespread importance because of the globalization. Companies and individuals who are exposed to foreign exchange risk, which implies that either they have imports or exports which will cause their domestic purchasing power to decline by converting a foreign currency to a home currency will always aim to minimize this risk. These currency risks arise during certain conditions; when the firm or businesses have assets or liabilities which are expressed in terms of foreign currency. We can define foreign exchange risk more specifically as the risk faced due to fluctuating exchange rates. For instance, if a Malaysian businessman exports palm oil to one of the European countries and if he expects payments to be made in Euros, than he is exposed to considerable amount of foreign exchange risk if the Euro depreciates against the Malaysian Ringgit. In case if it happens, the Malaysian trader will get fewer amounts of Ringgits in exchange of Euros thus a successful business venture might turn out to a blunder because of poor risk management practices. The trade transactions are shelved between the countries as businesses are unwilling to bear foreign exchange risk. As the fear of foreign currency risk looms over the businesses, it can reduce its trade with these countries. But as the world has stepped ahead in the technological breakthroughs, so it has been able to develop financial tools which can help the traders to minimize the risk faced in the businesses. The derivatives market primarily consists of many instruments such as forwards, futures, swaps and options. The aim of this paper is to discuss about the role of currency futures and how they provide an advantage over other derivative instruments in managing foreign exchange risk. A currency futures contract is an agreement between two parties to buy a particular currency at a specific rate in the future. Future contracts are identical to forward contracts but they differ in a sense that they are traded on the exchange and are more liquid than forwards. Futures are liquid as they have a formal exchange like stocks where you can trade your legal contracts. Similarly, they are standardized contracts like shares and you can remove them from your portfolio in certain chunks. We can illustrate futures currency with the help of an example involving two parties who are exposed to foreign exchange risk. The party which is exposed to the risk of an appreciation of value in a currency will buy futures to protect. These are usually parties who have revenues or exports and they feel that the value of their home currency appreciates making the currency in which the sales are denominated weak thus resulting in lower revenues. To hedge their position, they enter in to a futures contract and buy a certain amount of principle at a fixed rate which minimizes their risk. Similarly, a party which believes that its home currency depreciates again the foreign currency will sell a futures contract. For instance, if a firm in Japan is exporting cars to United States, it will keep in mind the fact that the value of yen may appreciate against the dollar within the time period. It is estimating that it will be able to sale $50 million worth of its luxurious cars in the next quarter. So it will enter into a long position of futures contract by fixing the Yen/Dollar rate and making its position favorable if the value of yen appreciates. In this situation, the firm will experience stable sales as they have been able to minimize the foreign exchange risk due to appreciating home currency. Literature Review According to Rodriquez (1980) foreign exchange exposure can be broken down into three components; the real economic exposure, translation exposure and the transaction exposure. The most crucial among these is the transaction exposure. This type of exposure relates to the changes in the value of cash flows due to changing foreign exchange rates. Futures have been considered as an indispensable tool to manage foreign exchange risk. As the drawbacks of forward contracts become apparent in the financial arena, currency futures become a preferred instrument to hedge the risk. Forward contracts have generally credit risk inherent in their concept, since it’s only legally binding whereas there is no proposed way to how to implement the contract. The contract is presumed to be implemented by the parties at the end of the period. On the other hand, futures involve a systematic procedure to execute the terms of the contract. Currency futures contract are not traded in the over-the-counter market but rather they have standardized features and traded on exchange. These currency futures are denominated in standardized currencies and with a standard duration. In a futures contract, the parties who are entering into a contract must pay a deposit which is the initial margin to a clearing house. The clearing house plays its role to adjust the balances from each part on day to day basis which is also called marked to market. It is marked to market at the settlement price. Each party also needs to maintain a maintenance margin, so if the account is running out of the money, the party receives a margin call to deposit money in order to maintain the minimum maintenance margin requirement. The idea behind the concept of margin account is that margin should cover virtually all of the one-day risk. The literature emphasizes that firms which have their assets or liabilities denominated in foreign currency are exposed to foreign exchange risk. The choice of the instrument tool for hedging the currency risk depends on several factors which include; the type of currency exposure, industry effect, the firm size and the risk tolerance or preference level of the manager to give priority to a certain tool over other (Abouf 1986, Dell 1981 and Lewent 1990). In currency risk futures contract there are favorable or adverse movements in exchange rate which results in a cash inflow or outflow to the parties who are involved in the transaction. Comparisons between the effectiveness of options and currency futures have been also made to identify which is the most effective tool. Currency futures have been mainly considered appropriate for hedging the covered position (Chang and Shanker 1986). In a covered position, the hedger of the risk covers his position from price fluctuations by simultaneously involving in short and long positions. In the same way, the options have been considered as a better tool for uncovered hedges. The cost of acquiring the desired risk profile is an important input in determining which of the tools is selected in managing currency risk. Some of the hedging instruments are more effective while others have a better risk profile, so there involves a tradeoff between effectiveness of hedging instruments and the extra risk protection provided between the instruments. The markets for currency futures and currency options are considered to be linked with each other as they are written on the same underlying currency (Giddy 1983). Synthetic futures can be formed by combining a call and put option having same terms and conditions. By combining a call and put option with the same currency, exercise price and maturity we can form a synthetic future. Some analysts have argued that after the introduction of currency option which was in early 90’s, one of the markets is redundant because synthetic futures can be formed from the options market. However, it can be considered in an alternative way that each of the market is targeting to a special niche with its own needs. Chandar and Shanker (1986) concluded that currency futures provide a more effective method of hedging a covered position than there similar counterparts, synthetic future contracts which are derived from combinations of options. Application The corporate treasurers of the multinational corporations have been concerned about the risk associated with cash flows different from the home country. In analyzing whether to use currency futures to hedge currency risk, the cost of decisions is deemed to be of utmost importance. Generally, corporate managers consider and analyze the following three questions: What is the net risk exposure? What are the chances of loss as a result of involving in this risk exposure? What is the probable size of loss? The first question considers the net risk exposure which refers to the amount of money that will be lost if the exchange rate of the underlying currency changes. The second question deals with the probability of loss if the exchange rate changes. The fluctuation in exchange rates can be beneficial at times but it results in loss at other times. It is the subjective process in which the corporate manager evaluates the forces that will shape the currency rate. For instance, the economic and political environment of a certain country has a direct effect on the exchange rate. Finally, the third question analyzes the probability of the size of change in the exchange rate which can be gathered from an economic forecasting services provider but it is relatively expensive as compared to the amount of risk exposure. In addition to these questions, the manager estimates the cost of hedge through entering to a futures currency contract and decides whether it’s worth hedging or not. Futures currency contracts have particularly commissioning costs and interest costs on the margin amount deposited to the clearing house. This analysis can be illustrated with the help of an example. The net risk exposure of a subsidiary which has its parent company located in UK has estimated that the sales in the next period will be $2 million. This is the value of net risk which the company is exposed to since changes in Pound/Dollar rates will cause the value of sales to fluctuate. Once the company believes that the amount is worth for consideration, it can move to the next step of calculating the probability of loss and its probable size. Let’s assume that the company has found these probabilities to be 50% and 10% respectively. The expected loss can be determined by multiplying the probability of loss with the size of loss. The value obtained must be compared with the costs of entering to a futures contract. For instance, if the cost to entering this future contract was 3% and the Expected value of the loss was 5%, than the corporate manager have entered to the contract to mitigate the impact of loss by investing 3% in to the futures. The whole process is described in the figure given below. Figure 1: The decision to hedge The applications of futures currency have been vast and it has been especially used by multinational corporations to hedge their currency risk. Companies located in a certain country with their subsidiaries or plants located in a foreign country have used futures extensively to manage their risk and make the cash flows stable. Consider the example of a US based tractor maker having a plant located in Canada. The Canadian plant has an outstanding performance and will have an excess amount of cash in Canadian dollars for the next six months. The parent company has another plant in Chicago and is facing a liquidity crisis because of shortage of cash. It needs fund to meet the short term operating expenses which the corporate treasurer has planned to fulfill by the excess funds of Canadian Plant but it has also recognized that it is exposed to foreign exchange risk since the changes in US/Canadian Dollar rates will cause the amount to decrease if there are unfavorable movements in exchange rate in the next six months. The company can enter into a contract of currency futures by selling the Canadian dollars to the US Dollars at a fixed rate thus reducing the impact of unfavorable exchange rate movements. The Chicago based company has contacted a German firm on December 1, 2010 to buy equipments for the plant having a value of 2 million Euros. The payment will be released on Feb 7, 2011. The US based firm believes that the dollar will depreciate relative to Euros in the upcoming period therefore it will end up in paying a higher amount of dollars on Feb 7, 2011. It enters into a currency futures contract at a fixed rate thus minimizing the risk of unfavorable changes in exchange rate. Conclusion Currency futures have played an instrumental role in managing the foreign exchange risk of the corporations. They have been considered as an indispensable tool in derivatives market for eliminating the currency risk. The advantages of currency futures are not limited to mitigate the impact of adverse foreign exchange rates but they also provide a way to minimize the credit risk and transfer the contract to a third party by trading it in the secondary market. The futures market for currency has been a very liquid market and provided a way for investors to close their position by entering into an opposite transaction. However, they had some disadvantages over other derivative instruments such as forward contracts. Forward contracts have custom features which allowed the parties involved in the transaction to tailor the contract according to their needs which was not possible in futures contract due to their standardized features which inhibits the parties to make a perfect hedge as per his needs. References Abouf, N., 1986. The Nature and Management of Foreign Exchange Risk. Journal of Applied Corporate Finance, pp. 30-44. Chang, J., and Shanker, L. 1986. Hedging Effectiveness of Currency Options and Currency Futures. The Journal of Futures Markets, 6, pp. 289-306. Dale, C., 1981. The Hedging Effectiveness of Currency Futures Markets. The Journal of Futures Markets, 1 , pp. 77-88. Giddy, I., 1983. The Foreign Exchange Option as a Hedging Tool, Midland Corporate Finance Journal, 1, pp. 32-42. Lewent, J. C., and Kearney, A. J., 1990. Identifying, Measuring, and Hedging Currency Risk at Merck. Journal of Applied Corporate Finance, pp. 19-28. Mathur, I. and Loy, D. 1984. The Use of Foreign Currency Futures to Reduce Exchange Rate Risk. International Marketing Review, pp-58-64 Rodriquez, R., 1980. Foreign-Exchange Management in U.S. Multinationals. Mass.: Lexington Books Read More