International-Financial-Management---Bekaert-2e---

©2012PearsonEducation,Inc.Chapter20ForeignCurrencyFuturesandOptionsQUESTIONS1.Howdoesafuturescontractdifferfromaforwardcontract?Answer:Foreigncurrencyfuturescontracts,orfuturescontractsforshort,allowindividualsandfirmstobuyandsellspecificamountsofforeigncurrencyatanagreed-uponpricedeterminedonagivenfutureday.Althoughthissoundsverysimilartoforwardcontracts,thereareanumberofimportantdifferencesbetweenforwardcontractsandfuturescontracts.Thefirstmajordifferencebetweenforeigncurrencyfuturescontractsandforwardcontractsisthatfuturescontractsaretradedonanexchange,whereasforwardcontractsaremadebybanksandtheirclients.Ordersforfuturescontractsmustbeplacedduringtheexchange’stradinghours,andpricingoccursinthe“pit”byfloortradersoronanelectronictradingplatformwheredemandismatchedtosupply.Incontrasttoforwardcontracts,wheredealersquotebidandaskpricesatwhichtheyarewillingeithertobuyorsellaforeigncurrency,foreachpartythatbuysafuturescontract,thereisapartythatsellsthecontractatthesameprice.Thepriceofafuturescontractwithspecifictermschangescontinuously,asordersarematchedonthefloororbycomputer.Asecondmajordifferenceisthatfuturesexchangesstandardizetheamountsofcurrenciesthatonecontractrepresents.Thus,futurescontractscannotbetailoredtoacorporation’sspecificneedsascanforwardcontracts.Butthestandardizedamountsarerelativelysmallcomparedtoatypicalforwardcontract,andiflargerpositionsaredesired,onemerelypurchasesmorecontracts.Standardizationwithsmallcontractsizesmakesthecontractseasytotrade,whichcontributestomarketliquidity.Athirdmajordifferenceinvolvesmaturitydates.Intheforwardmarket,aclientcanrequestanyfuturematuritydate,andactivedailytradingoccursincontractswithmaturitiesof30,60,90,180,or360days.Thestandardizationofcontractsbythefuturesexchangesmeansthatonlyafewmaturitydatesaretraded.Forexample,IMMcontractsmatureonthethirdWednesdayofMarch,June,September,andDecember.Thesedatesarefixed,andhencethetimetomaturityshrinksastradingmovesfrom1daytothenext,untiltradingbeginsinanewmaturity.Typically,onlythreeorfourcontractsareactivelytradedatanygiventimebecauselonger-termcontractsloseliquidity.Thefinalmajordifferencebetweenforwardcontractsandfuturescontractsconcernscreditrisk.Thisissueisperhapsthechiefreasonfortheexistenceoffuturesmarkets.Intheforwardmarket,thetwopartiestoaforwardcontractmustdirectlyassessthecreditriskoftheircounterparty.Banksarewillingtotradewithlargecorporations,hedgefunds,andinstitutionalinvestors,buttheytypicallydon’ttradeforwardcontractswithindividualinvestorsorsmallfirmswithbadcreditrisk.Thefuturesmarketisverydifferent.Inthefuturesmarkets,aretailclientbuysafuturescontractfromafuturesbrokeragefirm,whichintheUnitedStatesistypicallyregisteredwiththeCommodityFuturesTradingCommission(CFTC)asafuturescommissionmerchantChapter20:ForeignCurrencyFuturesandOptions©2012PearsonEducation,Inc.2(FCM).Legally,FCMsserveastheprincipalsforthetradesoftheirretailcustomers.Consequently,FCMsmustmeetminimumcapitalrequirementssetbytheexchangesandfiduciaryrequirementssetbytheCFTC.Inaddition,ifanFCMwantstotradeontheIMM,itmustbecomeaclearingmemberoftheCME.Inyearspast,clearingmembershipsusedtobetradable,andthepricesatwhichtheytradedwereindicationsofhowprofitablefuturestradingontheexchangewasexpectedtobe.In2000,theCMEbecameafor-profitstockcorporation,anditssharesnowtradeontheNYSE.Toobtaintradingrights,anFCMmustbuyacertainamountofB-sharesofCMEstockandmeetallCMEmembershiprequirements.Whenatradetakesplaceontheexchange,theclearinghouseoftheexchange,whichisanagencyoraseparatecorporationofafuturesexchange,actsasabuyertoeveryclearingmembersellerandasellertoeveryclearingmemberbuyer.Theclearinghouseimposesmarginrequirementsandconductsthedailysettlementprocessknownasmarkingtomarketthatmitigatescreditconcerns.Thesemarginrequirementsarethenpassedontotheindividualcustomersbythefuturesbrokers.2.Whateffectsdoes“markingtomarket”haveonfuturescontracts?Answer:Theprocessofmarkingtomarketimpliesthatfuturescontractshavedailycashflowsassociatedwiththem.Onecanbeeitherlong(havingboughtthecontract)orshort(havingsoldthecontract)inthefuturesmarketataparticularprice.Sincebothsidesaretreatedsymmetrically,let’sassumeyouarelong.Youmustpostfundsinamarginaccount,andifonsubsequentdays,thefuturespricemovesinyourfavor,thatis,theforeigncurrencyfuturespricesrisesastheforeigncurrencystrengthens;fundsareplacedintoyourmarginaccountandaretakenoutofthemarginaccountsofthosewhosoldtheforeigncurrencyfuturescontract.Thisprocesscontinueseverydayuntilthematuritydateofthecontract.3.Whatarethedifferencesbetweenforeigncurrencyoptioncontractsandforwardcontractsforforeigncurrency?Answer:Theprimarydifferencebetweenaforeigncurrencyoptioncontractandaforwardcontractisthattheoptioncontractgivesthepurchaseroftheoption,theright,butnottheobligationtotransact.Ifthestateoftheworldinthefutureisfavorabletothepurchasersoftheoption,theywilltransact.Ifthestateoftheworldisunfavorable,theoptionisworthless.Forwardcontractsarecompletelyuncontingentonthestateoftheworldinthefuture.4.WhatareyoubuyingifyoupurchaseaU.S.dollarEur