International-Financial-Management---Bekaert-2e---Solutions---Ch20.doc

International-Financial-Management---Bekaert-2e---Solutions---Ch20.doc

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13

Chapter20:

ForeignCurrencyFuturesandOptions

Chapter 20

ForeignCurrencyFuturesandOptions

QUESTIONS

1.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）asafuturescommissionmerchant（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,thati