Firm Manning Enterprises has several options how to avoids currency risk and to use financial derivative instruments in this subchapter it broken down in detail the example that belongs to the easiest and financial derivatives are currency forwards and currency futures.
Currency derivatives where just one currency futures and currency forwards imagine subgroup, where the underlying asset of this type is the exchange rate. Alternatively it can be said that there is a defines category of financial derivatives exchange risk. Under this group also include currency swap and currency options. In the following subsections the different types of currency derivatives will be described in detail.
Is fixed term contract traded on the exchange. Each exchange has for futures trading their own terms and conditions. This is actually standardized forward which binds both parties to meet the terms of this contract arising from a certain date in the future. Currency futures can be defined as ,, futures exchange a fixed amount of cash in one currency for a fixed amount of cash in another currency.,, among items listed in currency futures contract include the following:
Definition of underlying assets for exchange foreign currency futures
Types of futures
Commercial quantity of foreign currency per one lot
Term of settlement and the month in which the settlement will take place
Price calculation futures
Minimum and maximum allowable amount of price movement ( tick size, tick value -the absolute value of the contract)
The time of the contract can be traded
Futures can be divided into interest rate, equity, commodity, currency, credit, interest rate futures and futures on debt securities.
Entities currency futures
Currency futures upon between entities through the exchange including the following:
First buyer – long position. Entry through the position through the purchase contract the buyer has an obligation to live up to a predetermined date in the future obligation created by the futures exchange (e.g. buyer buys one futures contract the purchase price of the futures at one USD 0.7639 USD/EUR and is obliged to buy at maturity 400,000 USD for the agreed exchange rate).
Second seller – short position. Entry into the position by selling the contract, the seller is obliged to meet a predetermined date in the future obligation created by the futures exchange (e.g. selling on the stock market sell one futures contract to buy futures at a price of USD 0.7639 USD/EUR and is obliged to sell at maturity 400,000 USD for the fixed rate)
Forward fixed term contract is not standardized as futures and traded on the over the counter – OTC. Forward is used to exchange a fixed amount of cash in one currency for a fixed amount of cash in another currency at a certain date in the future. The agreed exchange rate is referred to as the forward exchange rate.
Forwards do standardized period therefore they must be differentiation from spot transactions. due to technical problems with the spot transactions can sometimes settle in identical day in what was to negotiate transactions on the spot market. Forwards have time settlement known in advance and this time is longer than on the spot market.
Entities currency forward
Forward exchange contracts entered into between two entities one takes a short position – sale contract and counterparty position for a long time – purchase contract. Financial institutions are selling on the contrary, the buyers are importers or exporters. It is essential that both parties agree on the parameters of the forward between them. The resulting form is tailored to specific needs (even though there are some habits that when dealing with compliance forwards). So forward becomes very unattractive to other investors causing the forwards are not as liquid as futures contracts. Also forward cancellation must be preceded by the mutual agreement of both parties.
Both sides are due to the fact that forwards are not traded on the stock market at risk counterparty that satisfies the conditions arising from the contract – credit risk. This risk increases if the spot price at maturity contract prices significantly deviated from the forward. While this means for one of the participating significant profit but for the other significant loss.
Currency futures, spot and forward market
Chart 1. Interest rates – futures
Chart 2. Dollar spot forward against the dollar
Chart 3. Euro spot forward against the euro
Bid – the price at which someone is willing to buy
Offer – the price at which someone is willing to sell
Forward rate – is the price at which currency can be bought and sold today for delivery at some date in the future
Closing point – the mid – point between the bid and the offer
Bid offer spread – shows the last three decimal points of the bid rate and offer rate
One month rate – the price at which the currency can be bought and sold today for delivery in one month
Three month rate – the price at which the currency can be bought and sold today for delivery in three months
12 month rate – the price at which the currency can be bought and sold today for delivery in one year
*All information from part of explanatory been used by International Finance – seminar one by Karen McGrath
Critically appraise the use of forward contracts and currency futures to hedge exchange rate risk.
The essence of the exchange rate risk involves changing exchange rates. When changes in exchange rates arising in each accounting entity that values its obligation or its assets in foreign currency exchange differences. Exchange differences are reflected in profit entity and therefore affect the costs of revenues.
Disadvantages of currency futures and forward contract :
Although standardization ensures relatively good liquidity on the other hand investors buy a well – defined product which does not always match their requirements. Whether it is the maturity date or the size of the contract the parties must decide whether it would not be more advantageous contract tailored to all their needs.
On closer acquaintance with any derivative exchange we find that there currency futures in large numbers only on the most important currencies of the world e.g. USD, EUR, JPY. The currencies of countries with a problematic economic situation, poor monetary policy and low involvement in the international trade currency futures will look very bad. This is due to low liquidity because other market players do not use those currencies in such a large scale as the currency stronger economies.
With margins during the period of futures trading each day may be requirement to replenish the margin account. This is for an entity whose futures rate does not develop the expected direction means that it is forced to provide additional recourses and can be a threat to its economic stability. Otherwise ( when the body can drain available funds on margin account) entity at risk when interest rates dropped since the futures contract was negotiated.
Theory of the exchange rate
Means of expressing the value of their national currency in terms of other national currencies. The exchange rate is divided into nominal and real ( expresses the real purchasing power of the currency). The real exchange rate is the value depended nominal exchange rate and price level as for example rate of growth in average economic.
Completion unique prices – says that the nominal exchange rate of the sets based on the ratio of prices of individual goods.
Sets the nominal exchange rate as the ratio of price levels in observed economies
Works with the change of the nominal exchange rate in relation to changes in the price levels
International capital flows
The presence of tradable goods
Barriers to international trade
Interest parity will occur when deposits denominated in any currency when converted to have a single menu same expected rate of return. Expected rate of return is :
Domestic interest rates
Foreign interest rates
Expected changes in the nominal exchange rate
Domestic investor when considering investment abroad makes expectations about future exchange rate, for which the investment return transferred back to the domestic currency if which the investment return transferred back to the domestic currency.
If uncovered interest parity then the investor expects future course only
If the covered interest rate parity, then the investor has a pre – agreed future course
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