Chapter 6
The Market for Currency
Futures
In Part 1 we first studied Interest Rate Parity (or Covered Interest Parity) in perfect
markets, but we soon introduced transaction costs and other market imperfections
that make life more exciting. But spreads, taxes, and information costs are not the
only practical issues that can arise in this context. In this chapter, we start from
two other problems connected to forwards: default risk, and absence of a secondary
market. We discuss how they are handled (or not handled) in forward markets—
traditionally by rationing and up-front collateralizing, nowadays also by periodic
recontracting or variable collateralizing. This is the material for Section 3.
We then describe—Section 4—the institutional aspects of futures contracts. A
crucial feature is that futures contracts address the problem of default risk in a way
of their own: daily marking to market. This is similar to daily recontracting of a
forward contract, except that the undiscounted change in the futures price is paid
out in cash. In Section 5, we then trace the implications of daily marking to market
for futures prices. Especially, we show that the interim cash flows from marking to
market create interest risk, which affects the futures prices. In Section 6 we address
the question how to hedge with futures contracts. We conclude, in the seventh
section, by describing the advantages and disadvantages of using futures compared to
forward contracts. In the appendix we digress on interest-rate futures—not strictly
an international-finance contract, but one that is close to theFRA’s discussed in
Chapter 4 which, you will remember, are very related to currency forwards and
forward-forward swaps.