246 CHAPTER 6. THE MARKET FOR CURRENCY FUTURES
- Given the liquidity of the secondary market for futures, futures positions can be
closed out early with greater ease than forward contracts.
Clearly, there are alsodrawbacksto futures contracts—otherwise, forward markets
would have disappeared entirely:
- One drawback is the standardization of the futures contract. A creditworthy
hedger has to choose between an imperfect but cheap hedge in the futures markets
and a more expensive but exact hedge in the forward market. The standardization
of the futures contracts means that one will rarely be able to find a contract of
exactly the right size or the exact same maturity as that of the underlying position
to be hedged. - Futures contracts exist only for a few high-turnover exchange rates. This is be-
cause futures markets cannot survive without large trading volumes. Thus, for
most exchange rates, a hedger has to choose between forward contracts or money-
market hedges, or a cross-hedge in the futures markets. A cross-hedge is less
effective because the relationship between the currency one is exposed to and the
currency used as a hedge instrument is obscured by cross-rate risk. - Also, marking to market may create ruin risk for a hedger. A firm that expects
to receiveeur100m nine months from now faces no inflows or outflows when
it hedges in the forward market. In contrast, the daily marking to market of a
futures contract can create severe short-term cash flow problems. It is not obvious
that interim cash outflows can always be financed easily. - Assuming that financing of the interim cash flows is easy, marking to market still
creates interest-rate risk. The daily cash flows must be financed/deposited in
the money markets at interest rates that are not known when the hedge is set
up. This risk is not present in forward hedging. The correlation between futures
prices and interest rates is typically rather low, implying that the interest rate
risk is smallon average; but in an individual investment theex posteffect can be
larger. - Lastly, futures markets are available only for short maturities. Maturities rarely
exceed eleven months, and the markets are often thin for maturities exceeding six
months. In contrast, forward contracts are readily available for maturities of up
to one year, and today the quotes for forward contracts extend up to ten years
and more.
We see that the competing instruments, forwards and futures, appear to cater
to two different clienteles. As a general rule, forward markets are used primarily by
corporate hedgers, while futures markets tend to be preferred by speculators. Mark
these words: it’s a general rule, not an exact law.