International Financial Management

This chapter considers foreign currency futures and options and demonstrates how they can be used for hedging or speculative purposes. Because the profits and losses earned on futures and option contracts, as well as those earned on forward contracts, depend on how the spot exchange rate evolves over time, all these instruments are considered derivative securities. Derivative securities are securities whose values depend on the values of other, more basic underlying variables – in this case, the spot exchange rate.

As with other instruments in the foreign exchange market, much of the trade in futures contracts and options is conducted by banks. Commercial and investment banks deal aggressively in foreign currency options in order to meet the demands of their corporate and institutional customers, who use them to hedge their foreign exchange risks. In addition to banks, hedge funds and other investors trade foreign currency futures and options purely for speculative purposes – that is, strictly in order to earn a profit.

This chapter begins by introducing the foreign currency futures market and discussing how futures and forward contracts differ. It then discusses hedging with futures. Sections 20.3 and 20.4 present the basics of foreign currency options and their use in risk management. Section 20.5 examines some exotic options. As we first mentioned in Chapter 3, exotic derivatives caused a large number of international firms in emerging markets to suffer substantial losses during the 2007–2010 global financial crisis, and it is important to understand the risks involved.

The Basics of Futures Contracts

Futures Versus Forwards

Foreign currency futures contracts allow individuals and firms to buy and sell specific amounts of foreign currency at an agreed-upon price determined on a given future day. Although this sounds very similar to the forward contracts discussed in Chapter 3, there are a number of important differences between forward contracts and futures contracts.

Exchange Trading The first major difference between foreign currency futures contracts and forward contracts is that futures contracts are traded on an exchange, whereas forward contracts are made by banks and their clients.