On May 1, 2017, an American company bought inventory from a German company for 100,000 euros, with the transfer due in three months. The cash rate on May 1, 2017 was €1 = €1.0899. On the same day, the US company entered into a futures contract to buy €100,000 in three months at 1 = €1.0929. Since the futures contract completely eliminates the cash flow variability of foreign exchange risk, the company can refer to the futures contract as a hedge of the cash flows of the liabilities. Regardless of the euro exchange rate as of July 31, 2017, the company is guaranteed to pay $109,290. The Company may also refer to the futures contract as a fair value hedge because it guarantees that the fair value of the liability will be $109,290. Since the settlement date, currency type and currency amount of the futures contract coincide with the corresponding terms of the liability, hedging should be very effective. The actual effectiveness of the hedging is assessed at any time by comparing the change in the value of the debt with the change in the value of the futures contract. Figure 1 summarizes cash rates, forward rates, valuations, gains and losses, and premium amortization over the life of the contract. Finally, investors should understand that futures derivatives are generally considered to be the basis of futures, options and swap contracts. Indeed, futures contracts are essentially standardized futures contracts that have a formalized exchange and clearing house. Option contracts are essentially futures contracts that offer an investor an option, but not an obligation to close a trade at any given time.
Swap contracts are essentially a linked chain arrangement of futures contracts that investors must take regular action over time. If a transaction that may be affected by exchange rate fluctuations is to take place at a later date, setting the exchange rate allows both parties to budget and plan their other business activities without fear that the future transaction will leave them in a different financial situation than they expected. An adjustment (up or down) of the interest rate differential between the two currencies. Essentially, the country`s currency with a lower interest rate is traded at a premium, while the country`s currency with a higher interest rate is traded at a discount. For example, if the national interest rate is lower than the interest rate of the other country, the bank acting as a counterparty adds points to the spot rate, which increases the cost of the foreign currency in the futures contract. On June 30, 2017, the liability will be adjusted to fair value based on the current cash rate (1.1426) and the corresponding foreign exchange loss of $5,270 will be recognized as net income. Earnings on the futures contract ($5,075) are based on the change in forward prices during the period (0.0510), discounted at an annual rate of 6% until July 31, 2017. Profit or loss is recognised as profit or loss in the same income statement as the foreign exchange loss on the underlying foreign currency liability. The company receives €100,000 from the customer, which corresponds to the current cash rate equivalent to $118,000 (100,000 x 1.18). With this, the company must now settle the debtor`s balance of $120,000 and calculate another foreign exchange loss as follows. In this case, $1,298 would be required to facilitate the transaction. Then the forex trader would determine how many euros are needed to facilitate this trade, which is simply determined by dividing one by one plus the 4% risk-free European annual rate.
To date, serious problems such as systemic defaults have not materialized among parties entering into futures contracts. Nevertheless, the economic concept of « too big to fail » will still be a problem as long as futures contracts are allowed to be adopted by large organizations. This problem becomes even more serious when options and swap markets are taken into account. The calculation of the number of discount or reward points that must be deducted or added from a futures contract is based on the following formula: Importers and exporters typically use forward foreign exchange contracts to hedge against exchange rate fluctuations. Futures are traded on the over-the-counter (OTC) market, which means that they are not traded on an exchange. When a futures contract expires, the transaction is settled in two ways. The first is to go through a process called « physical delivery. » In this type of settlement, the party that has the forward position is long, the part that is short, pays the position when the asset is actually delivered and the transaction is completed. Although the concept of a « delivery » transaction is easy to understand, implementing the provision of the underlying asset can be very difficult for the party holding the short position. Therefore, a futures contract can also be supplemented by a process called « cash settlement ». Suppose an American forex trader works for a company that regularly sells products in Europe for euros, and those dollars eventually need to be converted back into U.S. dollars.
A trader in this type of position would likely know the spot rate and the forward rate between the United States. The dollar and the euro on the open market as well as the risk-free return of both instruments. For example, the forex trader knows that the spot rate of the US dollar per euro on the open market is 1.35 US dollars per euro, the risk-free annualized US rate is 1%, and the european risk-free annual rate is 4%. The one-year foreign exchange futures contract on the open market is quoted at a rate of US$1.50 per euro. With this information, it is possible for the forex trader to determine whether a covered arbitrage opportunity is available and how to build a position that generates a risk-free profit for the company using a futures trade. When a tourist visits Times Square in New York, they are likely to find a bureau de change that publishes foreign currency exchange rates per U.S. dollar. This type of convention is often used.
It is known as an indirect quote and is probably the way most retail investors think in terms of currency exchange. However, when conducting a financial analysis, institutional investors use the direct quote method, which indicates the number of units of national currency per unit of foreign currency. This process was established by securities industry analysts because institutional investors tend to think in terms of how much local currency is required to buy a unit of a particular stock, rather than how many shares can be purchased with a unit of local currency. Given this convention standard, direct quotation is used to explain how a futures contract can be used to implement a hedged interest arbitrage strategy. The mechanism for calculating a forward exchange rate is simple and depends on the interest rate differentials of the currency pair (assuming that both currencies are freely traded in the Forex market). If, in a year, the spot rate is US$1 = C$1.0300 – meaning that the C$was appreciated as expected by the exporter – by setting the forward rate, the exporter received C$35,500 (by selling the US$1 million at C$1.0655 instead of the cash rate of C$1.0300). On the other hand, if the spot rate is C$1.0800 per year (i.e., the Canadian dollar has weakened contrary to the exporter`s expectations), the exporter suffers a notional loss of C$14,500. The journal entries for the fair value coverage and cash flow coverage designations are shown in Figure 2. As of May 1, 2017, the Company records the purchase and related figure at $108,990 using the current cash rate. The futures contract does not require an initial deposit, so no accounting is required on May 1, 2017. The recognition of debits is recognised as an expense in the income statement under the heading Foreign exchange loss.
Credit recording reduces trade receivables to their fair value of 120,000 at the balance sheet date. However, a currency futures transaction has little flexibility and represents a binding commitment, meaning that the buyer or seller of the contract cannot leave if the « blocked » rate ultimately proves detrimental. .