566-7 - CHAPTER 7 CURRENCY FUTURES AND OPTIONS Opening...

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CHAPTER 7 - CURRENCY FUTURES AND OPTIONS Opening story on p. 165 of a 31-year old rogue trader in France who took unauthorized positions on $73 billion worth of European stock index futures that resulted in losses of $7.2 billion when the market turned downward against the trader’s position (he was betting the market would go up). Illustrates the extreme danger/volatility of derivatives. Options and futures can be used to eliminate, reduce, hedge and manage risk, like insurance, but can also be extremely speculative. Why?? MECHANICS OF FUTURES CONTRACTS Differences/similarities between futures and forward contracts, see summary Exhibit 7.1 on p. 167: Similarities: 1. Both are derivative securities for future delivery/receipt. Agree on P and Q today for future settlement or delivery in 1 week to 10 years. 2. Both are used to hedge currency risk, interest rate risk or commodity price risk. 3. In principal they are very similar, used to accomplish the same goal of risk management. Differences: 1. Forward contracts are private, customized contracts between a bank and its clients (MNCs, exporters, importers, etc.) depending on the client's needs. There is no secondary market for forward contracts since it is a private contractual agreement, like most bank loans (vs. bond). 2. Forward contracts are settled at expiration, futures contracts are continually settled, daily settlement. 3. Most (90%) of forward contracts are settled with delivery/receipt of the asset. Most futures contracts (99%) are settled with cash, NOT the commodity/asset. 4. Futures markets have daily price limits. FUTURES CONTRACTS Currency Futures Contracts are standardized contracts, with fixed, standardized contract sizes and fixed expiration dates, that are exchange-traded , i.e., traded as securities on organized exchanges. Futures contracts have secondary markets, can be traded many times during life of contract, like a bond (vs. bank loan). See Exhibit 7.2 on p. 170. Contract Examples: Yen contracts: ¥12.5m (approx. $152,000), Pound: £62,500 (approx. $100,000), Euro: €125,000 (approx $170,000), SF: 125,000 (approx $122,500), etc. Expiration dates: March, June, Sept, and December on the 3rd Wednesday. Note : If you wanted to hedge receipt/payment of £100,000, you would have to either do a partial hedge of £62,500 (1 contract) or "over-hedge" with 2 contracts for £125,000 total. MGT 566: International Finance – CH 7 Professor Mark J. Perry 1
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Initial Performance Bond (formerly called margin): The initial investment required to establish a futures position, set by the exchange, e.g. Chicago Mercantile Exchange (CME). To buy/sell one U.K. pound futures contract as a speculator, you have to put up $2,430, which is only about 2.4% of the contract value of $100,000. You would also have to keep a "maintenance margin," usually 70-75% of the initial margin ( CME link ). In this case, you could never let your account go below $1,800 (about 74% of $2,430). If you can't make margin call, your contract is liquidated by broker.
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This note was uploaded on 11/18/2011 for the course ECON 351 taught by Professor Westbrook during the Fall '08 term at Rutgers.

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566-7 - CHAPTER 7 CURRENCY FUTURES AND OPTIONS Opening...

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