Hedging with futures contracts on organized market...
On 16 June, 1972, the Chicago Mercantile Exchange (CME)opened the market for futures contracts on the pound sterling, the Canadian dollar, the German mark, the yen, the Mexican peso, the Swiss franc and the Italian lira.The popularity of these and later contracts caused other exchanges to introduce their own contracts and by 1992 currency futures were traded on exchanges all over the world.
The organized futures markets have four important features: the contracts are standardized; trading takes place in one location; contracts are settled through the exchange’s clearing house; and contracts are marked to market each day, which means that they are revalued according to their market value.
Contrary to the workings of the inter-bank market, CME trading conforms strictly to the exchange’s internal rules and the currencies that are traded are limited.Maturities are based on a quarterly cycle of March, June, September and December and each contract has a precise delivery date.Each contract also corresponds to a given amount of foreign exchange.For example, the yen contract is for JPY 12,500,000 and the sterling contract for GBP 62,500.Contrast this with the inter-bank over-the-counter market.On the inter-bank market there is no unique trading area and transactions are carried out by phone between traders and brokers.On the organized futures markets only those owning or renting a seat on the exchange are allowed to trade.The system of continuous trading is transparent and competitive and ensures that the buying price is the same as the selling price.There is no bid-ask spread as there is in the inter-bank market.The broker makes his money by charging the client a commission and in practice this is quite small.A “round trip”, meaning one-buy and one-sell, can be as low as 0.05％ of the value of the contract.
Hedging with futures is similar to hedging with forwards.Furthermore, the futures markets are easy to use.To cover a short position in foreign currency, a futures contract can be bought with a maturity closest to the maturity of the short position.To cover a long position in foreign currency, a futures contract with a maturity closest to the maturity of the long position can be sold.Because the contracts are standardized and guaranteed by the clearing house, they are liquid and positions can be closed out easily.A short position in futures can be closed out by a purchase of the same contract.A long position in futures can be closed out by a sale of the same contract.The facility of opening and closing out positions makes it possible to manage relatively small levels of foreign exchange exposure on a continuous basis.This is especially attractive to commercial customers who have a fairly regular stream of payments and receipts.
When contract maturities do not correspond exactly to the cash flows being hedged or when there is no contract on the currency in question, unexpected variations in the basis subject the hedger to basis risk.Expected variations in the basis are associated with the passage of time and the convergence of the futures and spot prices.Unexpected variations are associated with unexpected changes in the interest rate differential.With this in mind, a perfect hedge using futures contracts can only be achieved if the hedging instrument is the same as the currency being hedged and if the hedge date corresponds perfectly with the futures maturity date.Investor should be aware of this risk and realize that the basis increases with a contract’s time to maturity.In practice, investors with imperfect hedges tend to use contracts closer to maturity in spite of the cost of rolling them over.