CHAPTER 7 FUTURES AND OPTIONS ON FOREIGN EXCHANGE
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS

QUESTIONS

1. Explain the basic differences between the operation of a currency forward market and a futures market. Answer: The forward market is an OTC market where the forward contract for purchase or sale of foreign currency is tailor-made between the client and its international bank. No money changes hands until the maturity date of the contract when delivery and receipt are typically made. A futures contract is an exchange-traded instrument with standardized features specifying contract size and delivery date.
Futures contracts are marked-to-market daily to reflect changes in the settlement price. Delivery is seldom made in a futures market. Rather a reversing trade is made to close out a long or short position.

2. In order for a derivatives market to function most efficiently, two types of economic agents are needed: hedgers and speculators. Explain.

Answer: Two types of market participants are necessary for the efficient operation of a derivatives market: speculators and hedgers. A speculator attempts to profit from a change in the futures price. To do this, the speculator will take a long or short position in a futures contract depending upon his expectations of future price movement. A hedger, on-the-other-hand, desires to avoid price variation by locking in a purchase price of the underlying asset through a long position in a futures contract or a sales price through a short position. In effect, the hedger passes off the risk of price variation to the speculator who is better able, or at least more willing, to bear this risk.

3. Why are most futures positions closed out through a reversing trade rather than held to delivery?

Answer: In forward markets, approximately 90 percent of all contracts that