Suppose Rio Tinto will receive $40 million from its US...

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Week 3 Øඏ Currency Futures and Futures Markets - Ref: Butler ch 5 Øඏ Currency Options and Option Markets - Ref: Butler ch 6
Chapter 5 Currency Futures and Futures Markets Learning objectives Currency futures Credit risk and the futures contract solution Currency futures exchanges Currency forwards versus currency futures Hedging with futures contracts Basis risk and the hedge ratio Delta, cross, and delta-cross hedges
1. Suppose Rio Tinto will receive $40 million from its US customer one year later (1 st August 2012), what can they do to hedge against currency rate volatility?
Forward Contract Date: 1 st August 2011 Parties: Rio Tinto (US dollar seller) & ANZ bank (US dollar buyer) Maturity: one year, 1 st August 2012 Amount: $40 million Forward rate: A$1.2/$ Location: ANZ bank
Future Contract Date: 1 st August 2011 Parties: Rio Tinto (US dollar seller) & ASX (US dollar buyer) Maturity: 1 st Sep 2012 Amount: $1 million (Rio Tinto has to purchase 40 contracts) Future rate: A$1.2/$ Location: Exchange floor of ASX
Credit risk and the futures contract solution Øඏ Forwards are a pure credit instrument - Forwards are a zero-sum game , so that one party always has an incentive to default Øඏ The futures contract solution - A futures exchange clearinghouse takes one side of every transaction (and makes sure that its exposures cancel one another) - Initial and maintenance margins ensure settlement - Contracts are marked-to-market daily Currency futures contracts and exchanges Hedging with currency futures Credit risk and the futures contract solution Currency futures exchanges Currency forwards versus currency futures
Financial futures exchanges are often associated with a commodity futures exchange 2006 contract Top futures exchanges volume (mil) 1 CME - Chicago Mercantile Exchange (U.S.) 1,101.7 2 Eurex - Eurex (Germany & Switzerland) 960.6 3 CBOT - Chicago Board of Trade (U.S.) 678.3 4 Euronext - (Amsterdam/Brussels/Lisbon/Paris/London) 420.0 5 Mexican Derivatives Exchange - (Mexico City) 274.7 6 BM&F - Bolsa Mercadorias & de Futuros (Brazil) 258.5 7 NYMEX - New York Mercantile Exchange (U.S.) 216.3 8 Dalian Commodity Exchange - (China) 170.6 9 National Stock Exchange of India - (India) 117.7 10 ICE Futures - (U.K.) 92.6 Source: Futures Industry Association ( ) Currency futures contracts and exchanges Hedging with currency futures Credit risk and the futures contract solution Currency futures exchanges Currency forwards versus currency futures
A forward hedge of the dollar Underlying position of a Australian exporter (long $s) Sell $s forward at F t A$/$ = A$1.20/$ (short $) Net position -Goods + A$ 48 million - $ 40 million v A$ /$ Long $s s A$/$ Short $s + $ 40 million + A$ 48 million -Goods Currency futures contracts and exchanges Hedging with currency futures Credit risk and the futures contract solution Currency futures exchanges Currency forwards versus currency futures
Forwards versus futures Forwards Futures Counterparty Bank CME Clearinghouse Maturity Negotiated 3rd week of the month (US) Amount Negotiated Standard contract size Fees Bid-ask Commissions Collateral Negotiated Margin account Settlement At maturity

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