THE HEDGING EFFECTIVENESS OF FOREIGN CURRENCY FUTURES

This study provides an initial analysis of the hedging potential of the foreign currency futures markets. Numerous studies exist on the pricing efficiency and hedging effectiveness of the foreign currency forward markets, but little research exists on the foreign currency futures market. An adequate price history has only recently become available to carry out such an investigation. Minimum risk hedges and hedging effectiveness measures are presented for five currencies: the British pound, German mark, Canadian dollar, Japanese yen and Swiss franc. Analysis indicates the relative desirability of positions in futures contracts to minimize the risk of spot currency exposure. Results also show hedging effectiveness increases with the investment horizon.     

Forward and Futures Prices: Evidence from the Foreign Exchange Markets

Cornell and Reinganum (1981) , hereafter CR, report that price differentials for future contracts and forward contracts are statistically insignificant in foreign exchange markets. Based on this finding, CR conclude that marking-to-market is insignificant in the formulation of currency futures prices. This note identifies two potential concerns with the CR tests. One problem relates to the timing of delivery dates for “matched” contracts. A second problem relates to the time period for the CR study. We show that correcting for these problems does not affect the overall conclusions of the CR study; marking-to-market does not appear to have a significant effect on currency futures prices.     

Currency risk hedging: Futures vs. forward

The objective of this paper is to address the issue of choosing between currency forward and currency futures contracts when hedging against currency risk within a stochastic interest rates environment. We compare between the hedging effectiveness of the two derivative assets both within a narrow sense (i.e., volatility minimization) and within a wide sense (i.e., risk-return trade-off). When judging hedging effectiveness in the narrow sense, forward and futures contracts give identical results even if they do not have identical prices. When judging hedging effectiveness in the wide sense, the choice between the two contracts is determined by the correlation between the domestic and the foreign term structures dynamics.     

海外TRAKRS期货合约发展创新及借鉴

TRAKRS期货合约是国外期货市场于2002年推出的一种追踪商品与商品指数、股票指数与债券指数、货币、汇率和其他金融工具的新型期货品种，是国际商品期货市场和金融期货市场发展到较高程度以后出现的金融创新产品。本文在研究国外TRAKRS期货合约的基础上，探讨我国期货市场创新发展TRAKRS产品的主要途径。     

Risk Premia in Foreign Currency Futures: A Reexamination

This paper reexamines the significant autocorrelation results of foreign currency futures reported by Liu and He [12] in this journal. It argues that extremely thin trading early in the life of individual futures contracts induces unreliable results in [12]. Moreover, the Monte Carlo results clarify the power performance between Lo and MacKinlay's [13] variance ratio tests and Diebold's [3] Q-statistics; both tests are used by Liu and He.     

Risk Premia in Foreign Currency Futures

This paper tests the uncorrelatedness of increments of daily foreign currency futures prices and derives implications for risk premia based on a heteroscedasticity-robust variance ratio test. There is evidence suggesting the existence of a time-varying risk premia. Moreover, the results suggest that currency futures price is not an unbiased predictor of currency spot price on corresponding maturity date of currency futures contract. The paper also applies a heteroscedasticity-adjusted Box-Pierce Q test to the same data set for comparison.     

International tax arbitrage,currency options and put-call parity conditions

Using a finite-horizon general equilibrium model with uncertainty and money, we characterize situations where tax arbitrage opportunities may arise for international portfolio investors in an economy with heterogeneous capital income taxation where foreign currency exposure can be hedged using forward contracts and a set of currency options. We obtain tax-modified option prices similar to the no-tax ones, but augmented by tax-induced “risk-premium” terms; tax-modified put-call parity conditions are derived that revert to their standard (no-tax) format if the respective marginal agents in the bond and option markets are in identical tax brackets.     

Currency futures-spot basis and risk premium

This paper explores the usefulness of currency futures-spot basis in predicting spot rate changes and currency futures returns. We conjecture that the currency risk premium may be an important component of the basis for long-maturity futures contracts, but may not be so for short-maturities. Thus, the basis of long-maturity contracts cannot predict the spot rate changes between now and maturity, rejecting uncovered interest rate parity (UIP), but can predict currency futures returns, which are solely determined by the risk premium. Conversely, the basis of the short-maturity contracts can predict the spot rate changes between now and maturity, validating the UIP, but cannot predict currency futures returns. Empirical tests support these conjectures for the Japanese, British, Swiss, and German currencies over the last two decades. The results are also consistent with Longstaff [Longstaff, F., 2000. The term structure of very short-term rates: new evidence for the Expectation Hypothesis. Journal of Financial Economics 58, 397–415], who shows that the Expectations Hypothesis holds at the very short end of the term structure of interest rates.     

Currency hedging for multinationals under liquidity constraints

This paper examines the impact of liquidity risk on the behavior of a risk-averse multinational firm (MNF) under exchange rate uncertainty in a two-period dynamic setting. The MNF has operations domiciled in the home country and in a foreign country, each of which produces a single homogeneous good to be sold in the home and foreign markets. To hedge the exchange rate risk, the MNF has access to one-period currency futures and option contracts in each period. The MNF is liquidity constrained in that it is obliged to terminate its risk management program in the second period whenever the net loss due to its first-period hedge position exceeds a predetermined threshold level. We show that the MNF optimally sells less (more) and produces more (less) in the foreign (home) country in response to the imposition of the liquidity constraint. We show further that the liquidity constrained MNF optimally uses the currency option contracts in the first period for hedging purposes in general, and opts for a long option position if its utility function is quadratic in particular.     

Currency Denomination of Intercompany Debt and Multinational Taxes

For multinational companies (MNCs) with foreign subsidiaries, the currency denomination of intercompany debt can have important effects on both taxes and financial statements. This paper analyzes the choice between an intercompany loan denominated in the home currency and one denominated in the subsidiary's functional currency. Using U.S. rules for financial accounting and taxes, the author demonstrates the expected impact of the loan's currency denomination on the expected level and variability of an MNCs overall taxes in the case where it has excess foreign tax credits.
The author's analysis shows that the foreign currency loan denomination leads to lower expected tax if the foreign withholding tax rate on interest is higher than the parent's home income tax rate. At the same time, the parent currency denomination leads to lower expected taxes if the parent's home income tax rate is higher than the foreign withholding tax rate on interest. Moreover, if an MNCs excess foreign tax credits are attributable to the subsidiary, the foreign currency loan denomination leads to lower variability in overall taxes. But in cases where the excess foreign tax credits arise from other foreign operations, the parent currency denomination leads to lower variability of overall tax.     

A leader of the world commodity futures markets in the making? The case of China's commodity futures

We use the daily data of 16 commodity futures contracts traded in China and corresponding foreign markets (the US, the UK, Japan, and Malaysia) to analyze the linkages between markets. Several findings are noteworthy. First, trading returns of foreign markets, such as the US, have significant impact on China's overnight (close-to-open) returns and vice-versa. Second, daytime (open-to-close) returns of many Chinese commodity futures contracts are not led by foreign daytime returns. Finally, the close-to-close returns analysis suggests that there are no significant lead-lag relationships between the Chinese and foreign markets. These results suggest that (1) the Chinese commodity futures markets are information-efficient, and (2) they are likely to be driven by local market dynamics occurring during the daytime trading session.     

PRICING CURRENCY OPTIONS UNDER STOCHASTIC INTEREST RATES AND JUMP‐DIFFUSION PROCESSES

We investigate the effects of stochastic interest rates and jumps in the spot exchange rate on the pricing of currency futures, forwards, and futures options. The proposed model extends Bates's model by allowing both the domestic and foreign interest rates to move around randomly, in a generalized Vasicek term‐structure framework. Numerical examples show that the model prices of European currency futures options are similar to those given by Bates's and Black's models in the absence of jumps and when the volatilities of the domestic and foreign interest rates and futures price are negligible. Changes in these volatilities affect the futures options prices. Bates's and Black's models underprice the European currency futures options in both the presence and the absence of jumps. The mispricing increases with the volatilities of interest rates and futures prices. JEL classification: G13     

Exchange traded currency derivatives markets in India: the road ahead

Indian exchanges have recently been permitted to offer currency futures on their platforms to the market participants. The paper outlines the contract, and charts the development and growth of currency futures in India since their inception in 2008. It emphasizes the existing close connectivity between commodity and currency markets. It highlights the increased exchange rate volatility of Indian exchange rate against US dollar (INRUSD) during conventional and non conventional trading hours and argues for the ability of the market to quickly adapt to extended trading hours. The paper recommends some new products and an alternative mechanism to settle the contracts.     

An Investigation into the Equilibrium Structure of the Commodity Futures Market Anomaly

Commodity futures contracts are shown to be characterized by indivisibility problems and tax disadvantages. An empirical test demonstrates that long futures investors were compensated for these drawbacks prior to the mid-1970s. However, compensation for the investment disadvantages of commodity futures ceased to exist after 1974. The year 1974 is significant because barriers to institutional investment in the futures market were removed in that year.     

Foreign exchange and lost opportunity in the US Department of Defense

This paper examines US Department of Defense (DoD) foreign exchange rate exposure in light of the government’s prohibition against foreign currency hedging. Using data from the United States Air Force and Monte Carlo simulation, we evaluate whether the use of forward foreign exchange contracts or currency options might reduce the financial impact of currency fluctuation. The results strongly indicate that these alternatives outperform the current method for dealing with foreign currency exposure in the DoD. Using forward contracts, expected cost reductions are on the order of 3.5% of current outlays. For options, expected cost reductions increase to 6.4% thereby defining an upper bound of 2.9% on acceptable option premium levels.     

Long Memory In Futures Prices

This paper tests for fractional roots in the futures prices for selected commodities, foreign currencies, and stock indexes. The fractional testing method is the spectral regression method suggested by Geweke and Porter-Hudak (1983). The empirical results suggest the presence of a fractional exponent in the differencing process for several commodity and foreign currency futures prices. The returns series for these commodities and currencies exhibit long range positive dependence. However, differencing of exact order one is sufficient for the stock index futures prices. Implications are drawn concerning theoretical and econometric modeling and price forecasting.     

Reducing reporting risk: Designating foreign currency forward contracts as cash flow hedges

We present an example that compares the effects on earnings of designating a foreign currency forward contract as either a cash-flow or fair-value hedge of a foreign currency denominated receivable. Entities engaging in exchange transactions not denominated in their functional currency frequently enter into foreign currency forward contracts in order to mitigate their foreign exchange rate risk exposure. The aggregate effect on earnings of the transaction gain or loss on the foreign currency receivable and the gain or loss on the forward contract is known on the date the forward contract is initiated. The effect on each period’s earnings during the term of a forward contract designated as a cash-flow hedge is also known on the date the contract is initiated; whereas the effect on each periods’ earnings from a fair-value hedge cannot be determined until the respective balance sheet dates. Therefore, designating forward contracts as cash-flow hedges may suppress volatility in reported earnings compared to designating forward contracts as fair-value hedges. In addition, the reporting risk (the amount of uncertainty surrounding the pending measure of an item to be reported in the financial statements) is lower when a forward contract is designated as a cash-flow hedge relative to designating it as a fair-value hedge. This suggests foreign currency forward contracts designated as cash-flow hedges are more consistent with the purpose of hedge accounting: to mitigate the effects on earnings of applying different measurement criteria for the hedge and the hedged item.     

Estimating the bid-ask spread in a heteroskedastic market: The case of foreign currency futures

Because the bid-ask spread often defies direct measurement, a serial covariance-based approach is frequently used to estimate it. We develop a new serial covariance estimator that exploits the relation of time-varying volatility to trading activity to obtain more precise estimates. The performance of Roll's (1984) estimator and the new estimator are compared using intraday data for four foreign currency futures. The new estimator finds currency futures spreads to be of economic significance—usually two to three ticks, or $25.00 to $37.50 per contract. A distinct maturity effect is present, with the lowest spreads occurring one to three months from expiration. While no evidence is found that the intraday spread changes near closing, the spread is larger near opening for some contracts four to six months from expiration.The University of Texas at Austin. We appreciate the comments of Katherine Daigle, Scott Irwin, Dan Quan, Barry Schachter, workshop participants at the University of Houston, and three anonymous referees. Part of this work was completed while Laux was visiting the Commodity Futures Trading Commission, and the support of the Commission is appreciated.     

Price dynamics in foreign currency futures markets

Nested tests of Samuelson's submartingale and martingale models of price behavior in an efficient futures market find significant autocorrelation at low lags in daily changes of log prices for four of ten currency futures contracts satisfying the assumptions of the statistical tests. Negative serial correlation following large price changes is also found. The analysis controls for bias due to institutional limits on daily price movements. Simulated trading based on out-of-sample forecasts suggests the dependencies probably could be exploited by traders who are members of the futures exchange to earn net profits greatly exceeding buy and hold.     

FX counterparty risk and trading activity in currency forward and futures markets

The Global Financial Crisis initiated a period of market turbulence and increased counterparty risk for financial institutions. Even though the Dodd–Frank Act is likely to exempt interbank foreign exchange trading from a central counterparty mandate, market participants have the option to trade currency futures on existing futures markets which standardize counterparty risks. Evidence for the period 2005–11 indicates that the market share of currency futures trading has grown relative to the pre-crisis period. This shift may be the result of a perceived increase in counterparty risk among banks, as well as changes in relative trading costs or changes in other institutional factors.