Ch.5 Exam Questions Currency Futures And Futures Markets

PART II Derivative Securities for Currency Risk Management

Chapter 5 Currency Futures and Futures Markets

Notes to instructors:

Answers to non-numeric multiple choice questions are arranged alphabetically, so that answers are randomly assigned to the five outcomes.

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1. A foreign currency futures contract is a commitment to exchange a specified amount of one currency for a specified amount of another currency at a specified time in the future.

2. A foreign currency futures contract is a commitment to exchange a specified amount of one currency for another currency at a specified time in the future using the actual spot rate on that future date.

If you want to exchange currency at the actual spot rate, simply wait until that date.

3. A currency futures contract is closer in function to a currency option contract than to a currency forward contract.

Currency futures are similar in function to forward contracts.

4. The choice between a currency forward or futures contract depends on whether the instrument is to be used for hedging or for speculation.

The choice depends on the tradeoffs between flexibility, liquidity, cost, and price.

5. Exchange-traded currency futures contracts are customized to fit the needs of individual clients.

Exchange-traded futures contracts are highly standardized instruments.

6. Changes in the underlying spot rate of exchange are settled daily in a futures contract whereas they are settled at maturity in a forward contract.

7. A major problem with a currency forward contract is that one party always has an incentive to default when the actual spot rate diverges from the contract price.

8. If the closing spot rate is $0.5800/C$ at the expiration of a forward contract, the party that has sold C$ at a forward rate of $0.5754/C$ has an incentive to default.

9. If the closing spot rate is $0.5800/C$ at the expiration of a forward contract, a party that has sold dollars at a forward rate of $0.5754/C$ has an incentive to default.

This price is profitable for the short dollar (long C$) forward position.

10. Forward contracts are marked-to-market daily.

Futures contracts are marked-to-market daily.

11. Initial and maintenance margins are required on currency futures contracts.

12. If an investor cannot meet a margin call, the exchange clearinghouse subtracts the amount due from the margin account and closes out the futures contract.

13. If one of the parties to a futures contract defaults, it is the clearinghouse that usually bears the loss.

The broker initiating the trade (the registered futures merchant) must bear any loss.

14. Standardization in currency futures contracts increases liquidity and marketability, but reduces their flexibility relative to forward contracts.

15. In a forward contract, an exchange clearinghouse takes one side of every transaction.

An exchange clearinghouse takes one side of every transaction in a futures contract. Forward contracts are usually issued by commercial banks.

16. One disadvantage of exchange-traded currency futures contracts is that the buyer doesn’t know the identity of the seller of the contract.

The exchange clearinghouse is on the other side of every transaction.

17. Futures contracts can be viewed as a bundle of renewable one-day forward contracts.

18. A 90-day currency futures contract on the Chicago Mercantile Exchange contains three renewable one-month contracts.

A 90-day futures contract can be viewed as 90 renewable one-day forward contracts.

19. Price limits are intended to avoid overreaction by giving market participants ample time to incorporate new information into prices.

20. prices can never change more than the daily trading limits on exchange-traded futures contracts.

(underlying) prices may go outside of this range.

21. Forward and futures contracts are equivalent once they are adjusted for contract terms and liquidity.

22. Both currency forward and currency futures contracts allow you to hedge against unexpected changes in nominal currency values.

23. Both currency forward and currency futures contracts allow you to hedge against unexpected changes in real exchange rates.

Because they are based on nominal exchange rates, neither protect you from unexpected changes in real exchange rates.

24. Currency forward contracts can hedge the currency risk exposure of a contractual cash flow to be received in a foreign currency on a known future date.

25. Gains and losses are settled monthly on Chicago Merc futures contracts.

They are settled daily.

26. The sum of the daily settlements on a currency futures contract equals the net gain or loss at the expiration of a comparable forward contract.

27. Cross rate futures market hedges can be used to reduce commissions.

28. When choosing between forwards and futures in hedging a transaction exposure to currency risk, the benefits of a higher quality hedge with a forward contract must be weighed against the transactions costs of the forward contract.

29. A company should compare forward and futures contracts solely on the basis of cost.

Futures contracts usually do not exactly match a company’s underlying exposure. Forward contracts offer higher quality hedges, often at a higher cost.

30. Forward contracts are designed to reduce the default risk inherent in a futures contract.

Futures contracts are designed to reduce default risk.

31. Any collateral required in a forward contract is negotiated between the bank and the customer.

32. Margin requirements on futures contracts are determined by the futures exchange.

33. The majority of forward contracts are settled at maturity.

34. One advantage of currency futures contracts traded on organized futures exchanges is that there is no initial margin requirement.

There is an initial margin requirement.

35. Transactions costs in forward contracts typically take the form of a bid-ask spread whereas transactions costs on futures contracts are charged as a fee per contract.

Multiple Choice Select the BEST ANSWER

1. Advantages of currency futures contracts relative to forward contracts include ____.

a. the ability to trade in any currency

b. extensive availability of delivery dates

c. freedom to liquidate the contract at any time before its maturity

d. more than one of the above

e. none of the above

2. On exchange-traded currency futures contracts, ____.

a. commissions are charged as a bid-ask spread

b. expiration dates are negotiated

c. initial and maintenance margins are required

d. the contracts are traded only during normal banking hours

e. the contracts are typically settled by physical delivery

3. A futures hedge in which there is a match with the underlying position on both currency and maturity is called a ____.

a. cross hedge

b. delta-cross hedge

c. delta hedge

d. perfect hedge

e. none of the above

4. The exposure of a futures hedge in which there is a match with the underlying position on currency but not on maturity is called a ____.

a. cross hedge

b. delta-cross hedge

c. delta hedge

d. perfect hedge

e. none of the above

5. The exposure of a futures hedge in which there is a match with the underlying position on maturity but not on currency is called a ____.

a. cross hedge

b. delta-cross hedge

c. delta hedge

d. perfect hedge

e. none of the above

6. Which of statements (a) through (d) concerning futures contracts is ?

a. An exchange clearinghouse takes one side of every transaction.

b. An initial margin and a maintenance margin are required.

c. Futures contracts are marked-to-market on a daily basis.

d. Futures contracts are pure credit instruments and have significant default risk.

e. All of the above are

7. At the expiration of a futures contract, futures prices converge to ____.

a. Eurocurrency rates

b. forward prices

c. market prices

d. shadow prices

e. spot prices

8. A currency futures contract can be viewed as ____.

a. a combination of a long (or short) position in a foreign currency forward contract and an offsetting position in the Eurocurrency market

b. a forward contract that provides a perfect hedge against currency risk

c. a portfolio of renewable one-day forward contracts

d. a portfolio of simultaneous forward contracts of different maturities

e. none of the above.

9. The risk of unexpected change in the relationship between currency futures prices and currency spot prices is called ____.

a. basis risk

b. currency risk

c. exchange rate risk

d. interest rate risk

e. none of the above

10. The ____ provides the optimal amount in a futures hedge per unit of value exposed to currency risk.

a. basis

b. hedge ratio

c. margin requirement

d. omega factor

e. none of the above

Problems (These can be converted into Multiple Choice questions.)

1. Today is April 1. Korea’s LG Electronics (LG) expects to receive ¥160,000,000 from a Japanese customer in 60 days. The current spot exchange rate is Won0.1250/¥. The current futures price for June delivery is Won0.1200/¥. The size of a yen futures contract is ¥10,000,000. How many futures contracts should LG buy or sell in order to hedge its forward obligation? What is LG’s net profit or loss if the spot rate in 60 days is Won0.1400/¥?

2. You work for Hong Kong Telecom and are considering ways to hedge a £10 million cash inflow to be received in three months. The current spot rate is equal to the three-month forward exchange rate at S₀^£/HK$ = F₃^£/HK$ = £0.1000/HK$. The current spot rate for the U.S. dollar is S₀^$/HK$ = $0.1250/HK$.

a. The Hong Kong Exchange (HKEx) trades HK$/£ contracts that expire in five months with a contract size of £50,000. You estimate  = 1.02 based on the regression s_t^HK$/£ =  + fut_t^HK$/£ + e. The r² of this regression is 0.97. How many pound contracts should you sell to minimize the risk of your hedged position?

b. An investment bank offers a HK$-per-$ futures contract with a 3-month maturity. You estimate  = 1.10 based on the regression s_t^HK$/£ =  + s_t^HK$/$ + e. The r² of this regression is 0.42. What should be the dollar size of your futures position to minimize the risk of your hedged position?

c. The Chicago Mercantile Exchange (CME) trades HK$ futures contracts that expire in five months and have a contract size of HK$500,000. You estimate  = 1.06 based on the regression s_t^HK$/£ =  + fut_t^HK$/$ + e. The r² of this regression is 0.36. How many CME HK$ contracts should you sell to minimize the risk of your hedged position?

d. Which of these contracts provides the highest quality hedge?

Problem Solutions

1. LG will need (¥160 million)/(¥10 million/contract) = 16 contracts to cover their forward exposure. Since the underlying position is long yen, LG should sell 16 contracts. A short futures position in yen suffers from an appreciation of the yen. If the spot rate closes at Won0.1400/¥ on the expiration date, then the loss accumulated over the two months of the contract will be (Won0.1200/¥Won0.1400/¥)(¥160,000,000) = Won3,200,000. This will offset the gain on the underlying position.

2. Delta hedges, cross hedges, and delta-cross hedges:

a. The optimal hedge ratio for this delta-hedge is given by:

N_Fut = (amount in futures) / (amount exposed) = 

⇒ (amount in futures) = ()(amount exposed)

= (1.02)(£10 million) = £10.2 million.

This is equivalent to (£10,200,000) / (£50,000/contract) = 204 contracts.

b. The optimal amount in the futures position of this currency cross hedge is:

⇒ (amount in futures) = (1.10)(£10 million) = £11 million.

The $ equivalent is (£11,000,000)/(($0.1250/HK$)/(£0.1000/HK$)) = $13,750,000.

c. The optimal amount in the futures position of this delta-cross hedge is:

⇒ (amount in futures) = (1.06)(£10 million) = £10.6 million.

At current spot rates of exchange, this is equivalent to (£10,600,000)/(£0.1000/HK$) = HK$106,000,000, or (HK$106,000,000)($0.1250/HK$) = $13,515,000. In terms of CME HK$ contracts, this is equivalent to (HK$106,000,000)/(HK$500,000/contract) = 212 contracts.

d. Hedge quality is highest for the delta hedge (r² = 0.97) and lowest for the delta-cross hedge (r² = 0.36). The cross hedge (r² = 0.42) is not much higher quality than the delta-cross hedge, and is likely to be more expensive than the HKEx futures contract for a company based in Hong Kong. The delta-hedge using the HKEx pound sterling futures contract is probably preferred.