Investments, tenth edition

 Futures, Swaps, and Risk 

Management 

 CHAPTER TWENTY-THREE 

   The Markets 

 Exchange rates between currencies vary continually and often substantially. This 

variability can be a source of concern for anyone involved in international business. A U.S. 

exporter who sells goods in England, for example, will be paid in British pounds, and the 

dollar value of those pounds depends on the exchange rate at the time payment is made. 

Until that date, the U.S. exporter is exposed to foreign exchange rate risk. This risk can 

     23.1 

Foreign Exchange Futures 

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P A R T   V I

  Options, Futures, and Other Derivatives

be hedged through currency futures or forward markets. For example, if you know you 

will receive £100,000 in 90 days, you can sell those pounds forward today in the forward 

market and lock in an exchange rate equal to today’s forward price. 

 The forward market in foreign exchange is fairly informal. It is simply a network of 

banks and brokers that allows customers to enter forward contracts to purchase or sell 

currency in the future at a currently agreed-upon rate of exchange. The bank market in 

currencies is among the largest in the world, and most large traders with sufficient credit-

worthiness execute their trades here rather than in futures markets. Unlike those in futures 

markets, contracts in forward markets are not standardized in a formal market setting. 

Instead, each is negotiated separately. Moreover, there is no marking to market, as would 

occur in futures markets. Cur-

rency forward contracts call for 

execution only at the maturity 

date. Participants need to con-

sider  counterparty risk,  the pos-

sibility that a trading partner may 

not be able to make good on its 

obligations under the contract if 

prices move against it. For this 

reason, traders who participate in 

forward markets must have solid 

creditworthiness. 

 Currency 

 futures,  

however, 

trade in formal exchanges such as 

the Chicago Mercantile Exchange 

(International Monetary Market) 

or the London International Finan-

cial Futures Exchange (LIFFE). 

Here contracts are standardized by 

size, and daily marking to market 

is observed. Moreover, standard 

clearing arrangements allow trad-

ers to enter or reverse positions 

easily. Margin positions are used 

to ensure contract performance, 

which is in turn guaranteed by the 

exchange’s clearinghouse, so the 

identity and creditworthiness of 

the counterparty to a trade are less 

of a concern. 

  Figure  23.1   reproduces   The 

Wall Street Journal 

 listing of 

foreign exchange spot and for-

ward rates. The listing gives the 

number of U.S. dollars required 

to purchase some unit of foreign 

currency and then the amount of 

foreign currency needed to pur-

chase  $1.   Figure 23.2   reproduces 

futures listings, which show the