Risk Management IIa: Forwards, Futures and Options

Ian Garrett

BMAN30060
International Finance

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Quick Recap Of The Story So Far I
Foreign exchange exposure:
Transaction exposure
Translation exposure
Economic/operating exposure
This is about exposure to movements in the exchange rate and the
effect this may have on firm value
foreign exchange risk
exchange rate volatility

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Quick Recap Of The Story So Far II

Techniques for managing exposure:

Internal techniques
techniques internal to the firm
netting, matching, invoicing currency and so forth
External techniques
involve transacting with a third party (usually a bank or other financial
institution)
tend to be more formal transactions (contractual)
involve transactions costs

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Roadmap

We will start to look at external techniques for exposure management.

In particular, we will look at
1 Forwards
2 Futures
3 Options

Before getting into what these instruments are, we will

1 remind ourselves of why FOREX exposure matters and
2 investigate whether the markets for these instruments are important
and worth our attention

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A Reminder Of Why FOREX Exposure Matters I
Consider the following from British Telecom’s 2020 Annual Report:

The consolidated financial statements are prepared on the histor-

ical cost basis, except for certain financial and equity instruments
that have been measured at fair value. The consolidated finan-
cial statements are presented in sterling, the functional currency of
BT Group plc. . . Foreign currency transactions are translated into
the functional currency using the exchange rates prevailing at the
date of the transaction. . . On consolidation, assets and liabilities
of foreign undertakings are translated into sterling at year end ex-
change rates. The results of foreign undertakings are translated
into sterling at average rates of exchange for the year.

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A Reminder Of Why FOREX Exposure Matters II
BT are not alone. Here is Vodafone from their 2020 Annual Report

The consolidated financial statements are presented in euro, which

is also the Company’s functional currency. . . Transactions in for-
eign currencies are initially recorded at the functional currency rate
prevailing at the date of the transaction. Monetary assets and lia-
bilities denominated in foreign currencies are retranslated into the
respective functional currency of the entity at the rates prevailing
on the reporting period date. Non-monetary items carried at fair
value that are denominated in foreign currencies are retranslated at
the rates prevailing on the initial transaction dates. Non-monetary
items measured in terms of historical cost in a foreign currency are
not retranslated.

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A Reminder Of Why FOREX Exposure Matters III

In a survey of Chief Financial Officers in 2019, Deloitte report that, in

terms of the strategic challenges for treasury organisations
participating in the survey,
1 68% report visibility into global operations, cash and financial risk
exposures as a challenge
2 50% report foreign exchange (FX) volatility as a challenge

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A Reminder Of Why FOREX Exposure Matters IV

In a survey conducted in 2018, HSBC report that

1 58% of CFOs in larger businesses say that FX risk management is one
of the two risks occupying the largest proportion of their time
2 72% of treasurers say FX risk management is one of the most
important aspects of their job
3 51% of CFOs say their business is least well-placed to deal with FX risk
4 70% of CFOs say their company has been hit by unhedged FX
exposures in the past two years that could have been avoided
Have things changed? Here is the 2021 Corporate Risk Management
Treasury Report

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Before We Get Going. . .

A fair bit of the material is “institutional,” by which I mean that it is

straightforward stuff about the structure of the markets, or differences
between them etc..
I may not go through all of the slides containing this material but that
does not mean you can ignore them.

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Are These Markets Important?

If you click on this link you will find data on the size of the markets for
currency forwards, futures, options and swaps from the Bank for
International Settlements
Exchange-traded derivatives are futures and options
Over-the-counter (OTC) derivatives are forwards, options (these can
be both exchange-traded and OTC) and swaps
As an aside, if you are not sure what open interest is (you will come
across it in the tables,) you may find this link useful.

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Forward Contracts

A commitment agreed by two parties (the buyer and seller) to buy

(take delivery of) and sell (deliver) the underlying asset on a stated
future date at a price agreed at the time the contract is purchased
They are traded over-the-counter, not through an organized exchange
They can be highly customized
Mainly used by banks and corporations to manage foreign exchange risk
Forwards are subject to credit risk

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Futures Contracts

A commitment to buy (take delivery of; the long position) or sell

(deliver; the short position) the underlying asset on a stated future
date at a price agreed at the time the contract is purchased
Unlike forward contracts, futures contracts are
traded on organized exchanges
standardized with respect to contract terms and conditions such as
(among others)
the units of the contract and contract size
delivery months
futures are not subject to credit risk
the clearing house guards against default risk by taking both sides of
the trade and “marking-to-market” their positions (more on this later)

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Forwards -v- Futures: Summary Table

Source: Exhibit 6.1, Eun, Resnick and Saberwhal, International Finance, 6th edition, or Exhibit
7.1, Eun, Resnick and Chuluun, International Financial Management, 9th edition

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Currency Futures I

Why Do We Have Currency Futures?

Why ask this question?

Currency futures are less important than currency forwards in the FX
market (in terms of value and volume traded)
However. . .
Currency futures allow for for smaller transactions
the E-micro FOREX futures trading on the Chicago Mercantile
Exchange (CME) are one-tenth the size of the standard futures contract
Market transparency
Price discovery for the spot market
They are affordable because they are traded on margin (more on this
below)
They are a hedging tool

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Currency Futures II

A few things that might interest us:

1 What currencies are available?
2 What might a currency futures contract look like in terms of
specification?
3 How do margins work?
4 How many futures contracts do I need to hedge?
I will return to this in the Hedging session

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Examples Of Currency Futures On The CME I

Source: Exhibit 6.2, Eun, Resnick and Saberwhal, International Finance, 6th edition, or Exhibit
7.2, Eun, Resnick and Chuluun, International Financial Management, 9th edition

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Examples Of Currency Futures On The CME II

A Brief Note About The Exhibit On The Previous Slide

The cross-rate futures listed in the exhibit are the main cross-futures
traded on the CME (they also have options traded on them)
The CME also offers a range of E-Micro futures
For a more complete list, click here

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Examples Of Currency Futures On The CME III

A Few Examples In A Bit More Detail

AUD EUR GBP

Contract size AUD 100,000 EUR 125,000 GBP 62,500
Initial Deposit (bond) 3 − 12% of the value of the futures contract;
this is set by the exchange
Maintenance level USD 1,450 USD 2,200 USD 2,150
Minimum price change USD 0.0001 USD 0.00005 USD 0.0001
(1 tick) (1 tick) (1 tick)
Value of 1 tick USD 10 USD 6.25 USD 6.25
Maturity months March, June, September, December

Prices are quoted as USD per unit of the other currency

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Margins and Marking-to-Market in Futures Markets I

What Are Margins?

The Margin is the amount of money deposited by a customer with the

broker or by a broker or clearing member with the clearing house to
insure the broker or clearing house against any loss on outstanding
futures positions
Two types:
1 Initial Margin (also known as the Performance Bond)
entitles a trader or firm to trade
2 Maintenance Margin
this must cover any unrealized loss and must be posted in cash by any
trader holding an overnight position with a negative profit & loss (P&L)

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Margins and Marking-to-Market in Futures Markets II
What Is Mark-to-Market?

In futures markets, losses on your account must be cleared every day

losses cannot be carried forward

This is what mark-to-market is about

The difference between yesterday’s and today’s settlement price

determines profit or loss
If any daily loss results in the balance in your account falling below the
maintenance margin level, you have to deposit money (could be cash,
could be T Bills) into your account to bring the amount back to
required levels

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Margins and Marking-to-Market in Futures Markets III

Example

On 17th February 2022, the (settlement) price of the March 22 GBP

futures contract was 1.3620 USD/GBP. What does this mean?
If I buy (go long) one contract it means I have notionally agreed to buy
GBP 62,500 on 14th March for a price of:

1.3620 × GBP 62, 500 = USD 85, 125.00 (1)

On 14th March, I will deliver USD 85,125.00 to the exchange

On 14th March the exchange will deliver GBP 62,500 to me

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Margins and Marking-to-Market in Futures Markets IV
The (settlement) price on 18th February 2022 was 1.3601. What does
this mean?
Anyone buying the USD/GBP futures contract on 18th February are
agreeing to deliver

1.3601 × GBP 62, 500 = USD 85, 006.25 (2)

The buyer (me) and seller of the contract will have their accounts
“marked-to-market” to reflect the change in settlement price. As it has
moved against me, my account will decrease by

(1.3601 − 1.3620) × GBP 62, 500 = USD − 118.75 (3)

The seller’s account will increase by that amount

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Margins and Marking-to-Market in Futures Markets V

If this took the amount in my account below the maintenance margin,

the Clearing House would require me to deposit sufficient funds to
take my account back up to the initial margin
What if the price had increased instead?
Suppose I had bought at the closing price of 1.3597 on 16th February.
What would the position look like at the close on 17th February?

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Margins and Marking-to-Market in Futures Markets VI

In futures markets, delivery does not occur that often

Traders normally ‘reverse out’ by entering in to an offsetting trade
If I want to reverse out on a particular date, in this case I sell since I
am long in the futures contract

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Profit On Long and Short Futures Positions Graphically

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Options

What Is An Option?

An option is a contract that confers on the owner the right but not
the obligation, to buy (call option) or sell (put option) an agreed
amount of the underlying asset (fixed by the contract) at a given price

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Some Options Terminology

Call: an option to buy the underlying asset

Put: an option to sell the underlying asset
Exercise price: the agreed price at which the future transaction can be made
to occur
Exercise: the option buyer forces the option seller to do the transaction
Expiry date: the date on which the option ceases to exist
European option: Exercise can occur only on the expiry date, and not before
American option: Exercise can occur at any time on or before the expiry date
Payoff: the cash flow (if any) from the option
Option price: the amount paid by the option buyer to the option seller
(writer) at the initiation of the option; determined by market forces

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Valuing Options I
The intrinsic value of a call option value can be calculated as:

C = max[0, S − X ] (4)

C call option price

S price of the underlying asset
X exercise price
For a put option
P = max[0, X − S] (5)
P put option price
The time value of the option is

Time value = option price - intrinsic value (6)

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Valuing Options II

An option is said to be at the money if S = X

A call option is said to be out of the money if S < X ; for a put option
it is S > X
A call option is said to be in the money if S > X ; for a put option it is
S <X

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Example of Option Price Quotations I

Source: Exhibit 6.6, Eun, Resnick and Saberwhal, International Finance, 6th edition, or Exhibit
7.6, Eun, Resnick and Chuluun, International Financial Management, 9th edition

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Example of Option Price Quotations II

To refresh your memory/reinforce your understanding, you may find

the following useful:
https://www.investing.com/currencies/forex-options

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Profit Diagram, Call Option

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Profit Diagram, Put Option

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 Reading

Much of the reading for this material is standard textbook stuff but you
can supplement your reading by following up references in the relevant
chapters below. Pretty much any International Financial Management or
International Finance text will have chapters on forwards, futures and
options. Likewise for texts on financial derivatives.

Bekaert, G. and R.J. Hodrick (2018), International Financial

Management, 3rd ed., Cambridge University Press, chapter 20.
Eun, C.S, B.G. Resnick and T.G Chuluun (2021), International
Financial Management, International Student Edition, 9th ed.,
McGraw-Hill, US, chapter 5 (the section titled “The Forward Market”)
and chapter 7.

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The Chicago Mercantile Exchange website (link) has a wealth of
information about FX futures and options contracts (and more.)
You may find this part of the website of particular interest:
https://www.cmegroup.com/education.html.

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