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Currency Hedging

Currency Hedging
3 minute read
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Currency futures are a special branch of the futures market. In fact, they’re one of its highest volume subsets. Even so they’re vastly different in many aspects compared to other futures, such as commodities for example. The main reason for their prevalence is that nearly every sector of the economy can use them to hedge their risk during export or import activity. Changes in currency prices generally affect a larger segment of traders than price changes for most other commodities. This makes currency futures an attractive option for any company that deals with energies or other natural resources, since the acquisition and sale of these materials typically involves some level of foreign contact. For the purpose of hedging, companies registered in and operating from the US in some ways benefit immensely from the fact that other countries use the dollar both for clearing and as a reserve currency. Their foreign trade partners will often use US dollars for their own acquisition or sales contracts.

Foreign exchange transactions have existed for as long as there have been countries  with their own respective currencies trading with one another. Although its roots stretch back to ancient history, in modern times it has grown into an industry that’s both colossal in size and extremely sophisticated in nature. In a sense it also resembles what economists would call a perfect market in terms of liquidity, access to information and the number of independent participants. The result is a market structure that’s highly resilient to price manipulation, giving the relative prices of currencies a relatively stable and objective value.

This pricing system is further legitimized by the fact that the bulk of it doesn’t happen on the stock market, but outside of it through over-the-counter interbank markets. Banks negotiate so called forward contracts between each other, giving them greater freedom in settling them. While there is some divergence between the prices formed during the interbanking exchange and the futures contract prices, the actual trade and price movement patterns are nearly identical. The primary difference is that in the case of forward transactions the contracts size and expiry can be customized to fit the trader’s needs. Meanwhile the contracts traded on Globex for example are standardized with fixed sizes and expiry.

It’s also worth pointing out that banks use the spot price when trading with each other, meaning they trade the immediate price, then add further interest afterwards. This interest figure comes from the difference in the base interest rates set by the central banks of the two respective currencies in question. To give an example, in the case of the EUR/USD the euro has a base interest rate of -0.31% while the dollar has 2.61%. This 2.92% gap is then divided further to show the interest per day to approximately 0.008002%, which at a EUR/USD spot price of 1.1312 would amount to 0.00009 basis points.

The above numbers should help us determine the prices of future contracts by ourselves based on their expiry dates. The CME offers assets with monthly expiries, allowing us to closely observe what effects time has on the price.

Using the contract expiring on April 15th as our next example we can see that it cost 1.1333 while the spot price was 1.1312. If the time remaining were 20 days, we would multiply it by the 0.0009 daily interest rate difference to get 0.0018 basis points. Adding it to the spot price gives a total of 1.1330. The difference between this result and the official CME price is a mere 3 pips. If we were to repeat the same process for June we’d get 1.1386 compared to the CME’s 1.1391 price.

CME Prices:

Interbank Spot Price:

These calculations are merely meant to showcase that the actual market prices diverge only mildly from the numbers we determined ourselves. It’s also evident that companies Taking a short position on the EUR/USD means the who require dollars and choose to purchase it by selling euros end up getting a good deal. Taking a short position on the EUR/USD means that if the company strikes the hedge deal now and pays with dollars in June, then they can do it at a price of 1.1391. If the spot price remains the same over the following 83 days, then the contract price will eventually reach the spot price, since the interest rate difference is priced out as time goes on. That’s a 74 pip profit for European companies selling in the States. On the US side the idea is to take the contract as close to the expiry as possible as possible, since reducing it’s runtime correlates directly to reducing its costs. This does put US companies at a higher risk, which in turn reduces their competitiveness and potential profits. Although they still benefit from the dollar’s supremacy, it still comes with its own drawbacks.

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