The Role of Currency Futures in Risk Management Coursework

Introduction

Exchange rate fluctuations pose a significant threat to operations carried out in the target environment (Kumar 2015). To be more specific, significant losses can be taken while performing different transactions. As a rule, three primary types of exposure are possible: transaction, translation and economic. Herein lies the significance of introducing tools that allow for a reduction in the risks associated with exchange rate fluctuations. Once the certainty of cash flows is increased and the level of cash flow fluctuations is minimized, the threat of taking costs will be reduced and new opportunities for financial growth will be created (Corte, Ramadorai & Sarno 2016).

Currency futures can be viewed as tools for maintaining the certainty of cash flows at a high level. Also known as derivatives, currency futures can be used to make the company’s costs of equity drop gradually. A currency contract can be viewed as a variation of a financial commitment. Furthermore, it creates an environment in which transaction costs can be brought to a minimum. Consequently, it can be assumed that currency futures play a huge role in managing risk levels (Hanly & Morales 2015).

Among other approaches that can be used in finance to manage risks with the help of currency futures, hedging must be mentioned. Typically defined as a way of taking out an insurance policy and, therefore, securing a specific property, hedging plays an important role in the management of risks related to money loss (Campbell 2014). While hedging does not prevent the problem from occurring, it does allow members of the company to retain their financial assets and recover from the financial damage comparatively quickly (Tornell & Yuan 2009).

Literature Review

History

The issues associated with foreign exchange risks used to be overlooked by organizations operating in the global economy, as well as by the authorities that coordinated economic and financial transactions, up until the Bretton Woods system collapsed. Because of the increase in the number of gold outflows in the United States in the late 1960s, attempts to position the US dollar as the reserve currency outside of the United States failed miserably, creating the phenomenon known as dollar glut—and therefore making it clear that the Bretton Woods system was unsustainable due to the overvaluation of the US dollar (Bau & Du 2015). Thus, it became necessary to monitor foreign exchange risks and introduce new tools for addressing the threats associated with global financial transactions (Chang & Shanker 2003).

Due to the necessity to adjust to rapid changes in the global economy, the need to switch to a concept of floating exchange rates emerged. Defined by the supply and demand for a specific currency, the floating exchange rate approach allows for better control over the factors that determine changes in currency rates (Sung, Park & Park 2015). Thus, the concept of the floating exchange rate was coined, and the role of currency as the defining factor that determines changes in the global exchange market was established (Sensoy & Tabak 2016).

At present, central banks can manipulate their national currency so that the exchange rate is adjusted and the target market does not experience a shock due to the effects of negative factors that may emerge unexpectedly. It would be wrong to claim that such currency manipulation is always successful, yet it creates an environment in which risk factors can be spotted at a comparatively early stage and relevant threats can be eliminated (Hau 2014).

Currency Futures and Risk Management

As stressed above, hedging is typically used as a means of managing the risks associated with transactions in foreign currencies (Kotkatvuori-Örnberg 2016). However, hedging is not always viewed as the most appropriate tool for increasing profits and addressing risk. It should be noted that the role of currency futures is often downplayed in the global economic environment since currency is believed to have high volatility rates (Chang & Wong 2003).

Furthermore, currency is usually considered to have a comparatively low average return. Nevertheless, an increasingly large number of investors are choosing to hold indirect positions in foreign currency. As a result, these investors can expect an “excess return on their foreign assets, plus the return on foreign currency” (Campbell 2007, p. 1).

Furthermore, hedging can be viewed as a tool for determining overall tendencies in currency price levels and, thus, for modelling future scenarios. Consequently, the opportunities and threats that the future scenarios hold can be identified, and the most appropriate techniques for handling the expected threats can be designed. In this way, the dangers to which a company may be exposed after a rapid change in exchange rates can be avoided or eliminated successfully (Hill & Schneeweis 1981).

Hedging is also preferred on a range of occasions due to the multiplicative nature of price in the context of the global economy (Chang & Wong 2003). Therefore, currency futures not only affect but also determine the risk management approach that a firm may choose. Currency futures can become a means of illuminating future financial possibilities, isolating current trends, and determining the most efficient strategy to be used in the global market.

Reference List

Bau, Y & Du, Y 2015, ‘An overview of causes for the financial crisis and implications: from the perspective of China’, Journal of Chinese Economics, vol. 3, no. 1, pp. 58-69.

Campbell, JY 2007, Global currency hedging. Web.

Campbell, JY 2014, ‘The fair value of cash flow hedges, future profitability, and stock returns’, Contemporary Accounting Research, vol. 32, no. 1, pp. 243-279.

Chang, JSK & Shanker, L 2003, ‘Hedging effectiveness of currency options and currency futures’, European Economic Review, vol. 47, no. 5, pp. 833-839.

Chang, EC & Wong, KP 2003, ‘Currency hedging with options and futures’, The Journal of Financial and Quantitative Analysis, vol. 38, no. 3, pp. 555-574.

Corte, DP, Ramadorai, T & Sarno, L 2016, ‘Volatility risk premia and exchange rate’, Predictability. Journal of Financial Economics, vol. 120, no. 1, pp. 21-40.

Hanly, J & Morales, L 2015, Volatility and risk management in European electricity futures markets. Web.

Hau, G 2014, ‘The exchange rate effect of multi-currency risk arbitrage’, Journal of International Money and Finance, vol. 47, no. 1, pp. 304-331.

Hill, J & Schneeweis, T 1981, ‘A note on the hedging effectiveness of foreign currency futures’, The Journal of Futures Markets, vol. 1, no. 4, pp. 659-664.

Kotkatvuori-Örnberg, J 2016, ‘Dynamic conditional copula correlation and optimal hedge ratios with currency futures’, International Review of Financial Analysis, vol. 47, no. 1, pp. 60–69.

Kumar, A 2015, ‘Impact of currency futures on volatility in exchange rate: a study of Indian currency market’, Paradigm, vol. 19, no. 1, pp. 95-108.

Sensoy, A & Tabak, BM 2016, ‘Dynamic efficiency of stock markets and exchange rates’, International Review of Financial Analysis, vol. 47, no. 1, pp. 353-371.

Sung, T., Park, D & Park, KY 2015, ‘Short-term external debt and foreign exchange rate volatility in emerging economies: evidence from the Korea market’, Emerging Markets Finance and Trade, vol. 50, suppl. 6, pp. 138-157.

Tornell, A & Yuan, C 2009, Speculation and hedging in the currency futures markets: are they informative to the spot exchange rates. Web.