358 PA R T I V The Management of Financial Institutions In two months, when her customer receives the 10 million euros, the forward contract ensures that it is exchanged for dollars at an exchange rate of $1.40 per euro, thus yielding $14 million No matter what happens to future exchange rates, Frivolous Luxuries will be guaranteed $14 million for the goods it sold in Germany Mona calls up her friend Sam to let him know that his company is now protected from any foreign exchange movements, and he thanks her for her help Hedging Foreign Exchange Risk with Futures Contracts As an alternative, Mona could have used the currency futures market to hedge the foreign exchange risk In this case, she would see that the Chicago Mercantile Exchange has a euro contract with a contract amount of 125 000 euros and a price of $1.40 per euro To the hedge, Mona must sell euros as with the forward contract, to the tune of $14 million of the March futures How many of the Chicago Mercantile Exchange March euro contracts must Mona sell in order to hedge the 10 million euro payment due in March? Using Equation with VA + 10 million euros VC + 125 000 euros we have NC + 10 million/125 000 + 80 Thus, Mona can hedge the 10 million euros by selling 80 of the CME euro contracts Given the $1.40 per euro price, the sale of the contract yields 80 * 125 000 euros + $14 million The futures hedge thus again enables her to lock in the exchange rate for Frivolous Luxuries so that it gets its payment of $14 million One advantage of using the futures market is that the contract size of 125 000 euros, worth $175 000, is quite a bit smaller than the minimum size of a forward contract, which is usually $1 million or more However, in this case, the bank manager is making a large enough transaction that she can use either the forward or the futures market Her choice depends on whether the transaction costs are lower in one market than in the other If the First Bank is active in the forward market, that market would probably have the lower transaction costs, but if First Bank rarely deals in foreign exchange forward contracts, the bank manager may better by sticking with the futures market STOC K I N DE X F U TU RE S As we have seen, interest rate futures markets can be useful in hedging interestrate risk However, financial institution managers, particularly those who manage mutual funds, pension funds, and insurance companies, also worry about stock market risk, the risk that occurs because stock prices fluctuate Stock index futures were developed in 1982 to meet the need to manage stock market risk, and they have become among the most widely traded of all futures contracts The futures trading in stock price indexes is now controversial (see the FYI box, Program Trading and Portfolio Insurance: Were They to Blame for the Stock Market Crash of 1987?) because critics assert that it has led to substantial increases in market volatility, especially in such episodes as 1987 s stock market crash