Futures contract currency example
By locking into a forward contract to sell a currency, the seller sets a future exchange rate with no upfront cost. For example, a U.S. exporter signs a contract today to sell hardware to a French importer. The terms of the contract require the importer to pay euros in six months' time. The exporter now has a known euro receivable. Over the next six months, the dollar value of the euro receivable will rise or fall depending on fluctuations in the exchange rate. To mitigate his uncertainty about the direction of the exchange rate, the exporter may elect to lock in the rate at which he will sell the euros and buy dollars in six months. To accomplish this, he hedges the euro receivable by locking in a forward.
This arrangement leaves the exporter fully protected should the currency depreciate below the contract level. However, he gives up all benefits if the currency appreciates. In fact, the seller of a forward rate faces unlimited costs should the currency appreciate. This is a major drawback for many companies that consider this to be the true cost of a forward contract hedge. For companies that consider this to be only an opportunity cost, this aspect of a forward is an acceptable "cost". For this reason, forwards are one of the least forgiving hedging instruments because they require the buyer to accurately estimate the future value of the exposure amount.
Like other future and forward contracts, foreign currency futures contracts have standard contract sizes, time periods, settlement procedures and are traded on regulated exchanges throughout the world. Foreign currency forwards contracts may have different contract sizes, time periods and settlement procedures than futures contracts. Foreign currency forwards contracts are considered over-the-counter (OTC) because there is no centralized trading location and transactions are conducted directly between parties via telephone and online trading platforms at thousands of locations worldwide.Key Points:
- Developed and grew in the late '70s when governments relaxed their control over their currencies
- Used mainly by banks and corporations to mange foreign exchange risk
- Allows the user to "lock in" or set a future exchange rate.
- Parties can deliver the currency or settle the difference in rates with cash.
Example: Currency Forward Contracts
Corporation A has a foreign sub in Italy that will be sending it 10 million euros in six months. Corp. A will need to swap the euro for the euros it will be receiving from the sub. In other words, Corp. A is long euros and short dollars. It is short dollars because it will need to purchase them in the near future. Corp. A can wait six months and see what happens in the currency markets or enter into a currency forward contract. To accomplish this, Corp. A can short the forward contract, or euro, and go long the dollar.
Corp. A goes to Citigroup and receives a quote of .935 in six months. This allows Corp. A to buy dollars and sell euros. Now Corp. A will be able to turn its 10 million euros into 10 million x .935 = 935, 000 dollars in six months.
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How does one decide on the future value of a currency?
For example, i have money in dollars and i want to buy today for 3 months forward in another currency,how will i calculate the future value of the currency today and what role does the interest rate have to play in such a transaction?Is there any website where i can learn more about these kind of transactions
One theory says the future value of a currency is dictated purely by supply and demand at that time. Another looks at the relative economic strength in each currency, and assumes the stronger economy will have the higher rates, and so the stronger currency. Another theory (interest rate parity) says the future currency value is dictated by the difference between interest rates and inflation of the 2 currencies. Yet another, purchasing power parity, says the future interest rate is the one that makes a basket of goods cost the same in each currency. All in all, its very hard to predict i…