The Wide World of Futures Contracts

• Currency contracts
• Eurodollar futures
• An introduciton to commodity futures

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 Currency Contracts

• Currency rate is the price of one currency in another

• Widely used to hedge against changes in exchange rates
• WSJ listing

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Listings for various currency futures contracts from the Wall Street Journal

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 Currency Contracts: Pricing
• Currency prepaid forward
• Suppose you want to purchase U1 one year from
today using $S
P
• F0,T = x0 e−ry T
• Where x0 is current ($/U) exchange rate, and ry
is the yen-denominated interest rate
• Why? By deferring delivery of the currency one
loses interest income from bonds denominated in
that currency
• Currency forward
• F0,T = x0 e(r−ry )T (“Covered interest rate parity”)
• r is the $-denominated domestic interest rate
• F0,T > x0 if r > ry (domestic risk-free rate
exceeds foreign risk-free rate)

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 Currency Contracts: Pricing (cont’d)

• U-denominated interest rate is 2% and current ($/ U)

exchange rate is 0.009. To have U1 in one year one needs
to invest today
• 0.009/U × U1 × e−0.02 = $0.008822
• U-denominated interest rate is 2% and $-denominated
rate is 6%. The current ($/ U) exchange rate is 0.009.
The 1-year forward rate
• 0.009e0.06−0.02 = 0.009367

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 Covered Interest Arbitrage

Synthetically creating a yen forward contract by borrowing in

dollars and lending in yen. The payoff at time 1 is U1 − $0.009367.

Cash flows
Year 0 Year 1
Transaction $ U $ U
Borrow x0 e−ry dollar +0.008822 – –0.009367 –
at 6% ($)
Convert to yen –0.008822 +0.9802 – –
@ 0.009 $/U
Invest in yen- – –0.9802 – 1
denominated bill (U)

Total 0 0 –0.009367 1

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 Covered Interest Arbitrage (Cont’d)

Consider the following set of foreign and domestic interest

rates and spot and forward exchange rates
Spot exchange rate ($/£) x0 = $1.25/£
360-day forward rate ($/£) F0,360 = $1.20/£
U.S. interest rate r = 7.1390%
British interest rate ry = 11.2212%
A trader with $1,000 could invest in the U.S. at 7.1390%, in
one year his investment will be worth
$1,074 = $1,000 × er = $1,000 × (1.074)

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 Covered Interest Arbitrage (Cont’d)

Alternatively, this trader could

1 Exchange $1,000 for £800 at the prevailing spot rate,
2 Invest £800 for one year at ry = 11.2212%; earn £800
×ery = £800 × 1.1187 = £895.
3 Translate £895 back into dollars at the forward rate F0,360
= $1.20/£, the £895 will be exactly $1,074.
If F360 6= $1.20/£, /?
• an astute trader could make money with one of the
following strategies:

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 Arbitrage Strategy I

If F0,360 > $1.20/£

1 Borrow $1,000 at t = 0 at r = 7.1390%.
2 Exchange $1,000 for £800 at the prevailing spot rate,
(note that £800 = $1,000÷$1.25/£) invest £800 at
11.22% for one year to achieve £895
3 Translate £895 back into dollars
If F0,360 > $1.20/£, then £895 will be more than enough to
repay your debt of $1,074.
For example, consider F0,360 = $1.30/£, then
£895=$1,163.50

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 Arbitrage Strategy II

If F0,360 < $1.20/£

1 Borrow £800 at t = 0 at ry = 11.22% .
2 Exchange £800 for $1,000 at the prevailing spot rate,
invest $1,000 at 7.139% for one year to achieve $1,074.
3 Translate $1,074 back into pounds
If F0,360 < $1.20/£, then $1,074 will be more than enough to
repay your debt of £895.
For example, consider F0,360 = $1.10/£, then


$1,074=£976.63

Be careful what currency you started with, and what you

ended up with

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 Carry trade

• If we do not hedge the exchange rate risk then it is

“uncovered” interest arbitrage
• Instead of forward contract, we will rely on future spot
price
• Not really an arbitrage opportunity then
• Carry trade is defined as borrowing at a lower interest rate
and lending in a higher interest rate
• it is a speculation as high-rate currency may depreciate

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 Eurodollar Futures Contract

• Derivatives on the interest rates (more to come in the

next chapter...)
• The Eurodollar futures contract refers to the futures
contract based upon Eurodollar deposits, traded at the
Chicago Mercantile Exchange (CME).
• What if you want to borrow money or lend not now, but
from a certain time in the future?
• Interest rate is unknown yet
• You can use these contracts to lock in an interest rate
today, for money to borrow or lend in the future
• Eurodollars are deposits denominated in U.S. dollars at
banks outside the United States

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Eurodollar Futures Contract Specifications

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Listing for interest rate futures contracts, including the 1-month LIBOR
and 3-month Eurodollar contracts, from WSJ

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 Introduction to Commodity Futures

• Different commodities have their distinct forward curves

(plotting prices against maturities), reflecting different
properties of
• Storability (Fruits and electricity can not be stored,
while metals can)
• Storage costs (Corn is consumed throughout the year
but harvested at only one time. Corn must be stored,
but it is costly)
• Production
• Demand

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Introduction to Commodity Futures (Cont’d)

• In general, commodity forward prices can be found using

the same economic principles used for financial forward
prices:
F0,T = S0 e(r−δ)T
• For financial assets, δ is the dividend yield
• For commodities, δ is the commodity lease rate
• The lease rate is the return that makes an investor
willing to buy and lend a commodity
• Some commodities (metals) have an active leasing
market
• More typically, lease rates can only be estimated by
observing forward prices

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 Forward Prices and the Lease Rate

• The lease rate has to be consistent with the forward price

• Therefore, when we observe the forward price, we can
infer what the lease rate would have to be if a lease
market existed
• The annualized lease rate δl = r − T1 ln(F0,T /S)
1+r
• The effective annual lease rate δl = (F0,T /S)1/T
−1

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