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Futures and Options (Currency Futures (Advantages (No up front premium is…
Futures and Options
Currency Futures
Futures are exchange-traded contracts to buy or sell a standard quantity of foreign currency at an agreed price on an agreed date.
Futures are the trade-able version of a forward and can be bought and sold on secondary markets or exchanges
An initial "margin" amount is paid up-front to the exchange - the "margin account" tracks gains or losses from the contracts on a daily basis - thus removing risk of default
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UK exports hedge against rising exchange rates by buying currency futures to guarentee delivery of foreign currecny
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UK importers hedge against falling exchange rates by selling currency futures to guarantee sale of foreign currency.
Selling a futures contract fixes a future exchange rate for converting £ inot $ for required $ payment
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Disadvantages
Locked into futures rate, so cannot take advantage of favourable changes in exchange rates
Contracts are standardised so difficult to find a perfect hedge in terms of amount and maturity - under or over hedging
Currency options
Give holder or buyer the right but not the obligation to buy or sell foreign currency at a given rate
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Traded options are bought and sold on the financial markets and are equivalent to futures but now with the option to use
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To manage risk - always BUY options - this achieves an effective insurance policy by fixing a maximum or minimum rate
The seller or provider of the option offers the insurance and may be speculating in the hope that the buyer does not exercise - the seller is liable for full compensation
To hedge against exchange rates going up, BUY call option contracts
Buying a call option is an agreement to buy foreign currency £ at agreed rate i.e. deliver $ for exchange into £ in order to convert a future $ receipt
To hedge against exchange rates going down, BUY put option contracts.
Buying a put option contract is an agreement to sell foreign currency £ at agreed rate i.e. deliver £ for exchange into $ in order to meet a future $ payment.
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Advantages
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Holder or buyer has option, but not obligation so can take advantage of favourable rates
Standardised and trade-able, so contracts can be sold on or before expiry at a "fair" market price
Disadvantages
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Cost, since option premium must be paid
REMEMBER, seller has large risk exposure
Derivatives
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Companies or users of these instruments insure themselves against losses due to changes in price currencies, interest rates, commodities, shares
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Futures and options lock in a future price, at a future date, for a standard amount