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Foreign exchange risk

5.4 Foreign currency derivatives

Currency futures

 like a forward in that they fix the foreign currency rate and are binding

 are tradable on futures exchanges (the futures contract is separate from the
underlying currency exchange)

 are settled on three monthly cycles (unlike forwards which can be for any date)

 are for standardised amounts (unlike forwards which can be for any amount)

 are priced at the exchange rate specified in the contract

Because of their standardised nature, by date and by amount, they rarely cover the
exact currency transaction exposure.

The operation of the futures contract is that if an unfavourable currency movement
affects the underlying transaction, the futures contract will generate a profit to offset
this and if the underlying transaction sees a favourable movement, the futures
contract will generate an offsetting loss.

e.g. if due to sell a foreign currency in the future, sell today a futures contract in that
currency ready to buy it back in the future. The buy back of the futures contract and
the selling of the currency will offset each other and cancel out exchange rate
movements between now and that date.

Note that calculations for futures contracts will not be required in the exam.

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