Table of contents
2. Literature Review
2.1 The Use of Currency Futures
2.2 Currency Futures Rate as Estimator of Spot Exchange Rate
3.1 Trading on Currency Futures Exchanges
3.2 Hedging Foreign Exchange Risk Assuming Perfect Correlation between Spot and Futures Prices
3.3 Hedging Foreign Exchange Risk Assuming Basis Risk
3.4 Estimation of the Hedge Ratio
The purpose of this report is to discuss the role of currency futures in risk management as well as their main advantages and drawbacks. The report will analyse the global rate of utilization of currency futures by comparison with other main currency derivatives and the geographic differences in their usage. Possible explanations for the preference for certain currency derivatives in risk management will be given.
The usefulness of currency futures rate as an estimator of future spot rate will be discussed by reviewing and summarizing the existing literature on this subject.
The practical application of currency futures also will be covered in this report.
The overall objective of foreign exchange risk´s management is to minimize the potential losses derived from foreign exchange rate fluctuations. Specifically; certainty of cash flows and minimisation of fluctuation in earnings are recognized in the literature as the most relevant aims of managing foreign exchange risk (see Geczy et al, 1997; Marshall, A.P. 2000).
Foreign exchange risk is classified in three different categories; transaction, translation and economic exposure. Nevertheless, according to the existing literature (Khoruy and Chan, 1988; Joseph and Hewins, 1991; Marshall, A.P., 2000) firms generally place more emphasis on transaction risk than on economic and translation risk.
Firms may use internal and/or external techniques to hedge foreign exchange risk. Currency derivatives fall in the external techniques category and may be used for either hedging or speculation purposes. However; several researches, such as Allayannis, G. and Ofek, E. (2001), support the hypothesis that firms use currency derivatives as a protection against foreign exchange risk rather than to speculate.
According to Gay et al (2007) the use of currency derivatives reduces the firm´s cost of equity. This hypothesis is consistent with the findings obtained by Allayannis, G and Weston, JP (2001) who assert that there is a positive relationship between the use of foreign currency derivatives and the firm value.
Currency futures are foreign currency derivatives used as an external technique for protecting the company against potential adverse changes in exchange rates. A currency futures contract can be defined as a commitment to deliver a specific amount of a specified currency at a specified future date for an agreed price incorporate in the contract. (Pike and Neale,2009). It performs a similar function to a forward contract, but has important differences.
Unlike currency forwards, currency futures are traded on organized markets, they can be liquidated before the maturity date, are dealt in standard contracts, are relatively inflexible, require a deposit and involve variation payments.
The main advantages of currency futures are their low transaction costs, open and efficient trading, liquidity of the market and the lack of credit risk because of efficient clearing services.
2. LITERATURE REVIEW.
2.1 The Use of Currency Futures.
The literature shows that currency futures are not popular among currency derivatives users. A study undertaken by Glaum, M. and. Belk P.A (1992) on the UK multinational corporations´ management of foreign exchange risk, surprisingly concludes that none of the firms included in the study used, or had ever used, currency futures. The fact that the study´s sample was composed of just 17 companies and was carried out during 1988(when futures contracts were considered as an innovation) make its results not sufficiently relevant, however they are consistent with more complete and recent studies.
The data collected by a survey carried out by Phillips (1995) indicate that currency futures are the least used instrument for foreign exchange risk management, accounting for just 4.1% of the sample. Forward contracts are the most popular derivatives for exchange risk accounting for 36.9% of the sample, followed by currency swaps (15%) and currency options (14%).
Similarly, Joseph NL (2000) finds that foreign exchange forward contract is the most used external hedging technique. Currency options and futures have a low rate of utilization for all types of exposures, but currency options are more widely used than currency futures.
Regarding geographical differences in the rate of utilization, Marshall A.P. (2000) indicates that the usage of currency futures is significantly higher in Asia Pacific, especially in Japan and Singapore, in the management of transaction and translation exposure. This study finds that currency futures are more popular in Asia Pacific than in the UK and USA.
The results in the literature clearly reveal that currency forward is the most popular external method to manage foreign exchange risk and companies do not favour the exchange-traded instruments such as currency futures. The reasons generally used to justify such results are the flexibility limitations due to standardized nature of futures and liquidity´s requirements of currency futures trading.
Unlike currency forwards, which are tailored to meet the specific needs of the companies, currency futures trading presents serious flexibility problems arisen from the standardisation of delivery dates, contract sizes and the number of currencies available in the market. These characteristics of currency futures trading most often do not enable the company to hedge its open positions perfectly.
In addition to this, the exchange of currency futures establishes specific requirements such as initial margin, maintenance margin and marking to market (or pay variation margin) procedure in order to eliminate the credit or default risk. These requirements can adversely affect the liquidity of the firms.
2.2 Currency Futures Rate as Estimator of Spot Exchange Rate.
Numerous studies have analysed the relationship between currency futures exchange rates and spot exchange rate (spot basis).
Although there are several theories which try to explain the determination of spot exchange rates, the most tested theory is the uncover interest parity hypothesis (UIP). Under this hypothesis the future exchange rate is an unbiased estimator of spot exchange rate at maturity.
Many studies have rejected UIP hypothesis and suggested that futures prices do not provide any useful information to predict spot rates. Later, a new stream of literature emerged seeking for variations in risk premiums which could explain the different correlations between the future rates and the spot rates at maturity. While Frankel (1982) and Domowitz and Hakkio (1983) fail to identify such premiums, Hansen and Hodrick (1983) and Hodrick and Srivastava (1984) find evidence of time varying risk premiums.
Fama (1984) defines forward rate as a sum of a risk premium and the expected spot rate, and states that, under the hypothesis of rational markets, both components vary through time and are negatively correlated.
The random walk in currency futures prices found by Pana, Chanb and Fokc (1997), implies that futures price is not an unbiased predictor of future spot exchange rate, and suggests the existence of time-varying risk premium.
According to Inci, A.C. and Lu, B. (2007), currency futures prices of shot-maturity contracts are good predictors of the spot rate changes until maturity, validating the UIP, but cannot predict currency futures returns. Conversely currency futures of long-maturity cannot predict future spot exchange rates, but can predict currency futures returns. This hypothesis can be somehow supported by the following graphs.