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Internatioal Financial Management - Bekaert 2e - Solutions - Ch20.doc

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Internatioal Financial Management - Bekaert 2e - Solutions - Ch20

Chapter 20 Foreign Currency Futures and Options questions How does a futures contract differ from a forward contract? Answer: Foreign currency futures contracts, or futures contracts for short, allow individuals and firms to buy and sell specific amounts of foreign currency at an agreed-upon price determined on a given future day. Although this sounds very similar to forward contracts, there are a number of important differences between forward contracts and futures contracts. The first major difference between foreign currency futures contracts and forward contracts is that futures contracts are traded on an exchange, whereas forward contracts are made by banks and their clients. Orders for futures contracts must be placed during the exchange’s trading hours, and pricing occurs in the “pit” by floor traders or on an electronic trading platform where demand is matched to supply. In contrast to forward contracts, where dealers quote bid and ask prices at which they are willing either to buy or sell a foreign currency, for each party that buys a futures contract, there is a party that sells the contract at the same price. The price of a futures contract with specific terms changes continuously, as orders are matched on the floor or by computer. A second major difference is that futures exchanges standardize the amounts of currencies that one contract represents. Thus, futures contracts cannot be tailored to a corporation’s specific needs as can forward contracts. But the standardized amounts are relatively small compared to a typical forward contract, and if larger positions are desired, one merely purchases more contracts. Standardization with small contract sizes makes the contracts easy to trade, which contributes to market liquidity. A third major difference involves maturity dates. In the forward market, a client can request any future maturity date, and active daily trading occurs in contracts with maturities of 30, 60, 90, 180, or 360 days. The stan