Currency Futures

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 Currency Futures
• Currency futures belong to the family of
financial derivatives, which essentially are:
• Contracts that derive their value from some
underlying asset ( such as a stock, bond or
currency ) or a reference rate ( such as 90-
day treasury bill rate ) or index ( such as the
Sensex)

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 Currency Futures
• First offered in 1972 by the Chicago
Mercantile Exchange, through its
International Monetary Market ( IMM)
division
• Futures exchanges have since been started
in London ( LIFFE ), Singapore ( SIMEX ),
Hong Kong ( HKFE ), TOKYO ( TIFFE )
and also in Frankfurt and Paris
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 Currency Futures
• Futures contracts currently available in the
following currencies :
• Australian dollar, Brazilian Real, British
pound, Canadian Dollar, Euro, Japanese
Yen, Mexican Peso, New Zealand Dollar,
South African Rand, Swiss Franc, and the
US Dollar

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 Market participants
• Hedgers who want to transfer a risk
component of their portfolio
• Speculators who intentionally take the risk
from hedgers in pursuit of profit
• Arbitrageurs who operate in the different
markets simultaneously in pursuit of profit
and eliminate mis-pricing

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 Question
• Assume that, in the futures market, a
speculator wants to buy a contract low in
order to sell high in the future. From who is
he likely to be buying the contract ?

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 Possible answer to question on
previous slide
• The speculator would most likely be buying
the contract from a hedger selling a contract
low in anticipation of declining prices in the
market

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 Market participants
• Unlike the hedger, the speculator does not
actually seek to own the commodity in
question
• Rather he or she will enter the market,
seeking profits by offsetting rising and
declining prices through the buying and
selling of contracts.

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 Market participants
Aim in taking a long Aim in taking a short
position position
Hedgers Secure a price now to Secure a price now to
( those in protect against future protect against future
commodity rising prices declining prices
businesses)
Speculators Secure a price now in Secure a price now in
anticipation of rising anticipation of
prices declining prices

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How currency futures differ from
forward contracts
Forward contracts Futures

Trading Over the counter Exchange -

traded

Regulation Self-regulating Appropriate

regulatory
authority
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How currency futures differ from
forward contracts
Forward Futures
contracts

Delivery More than 90% Less than 1% of

of all forward all futures
contracts are contracts are
settled by actual settled by actual
delivery delivery

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How currency futures differ from
forward contracts
Forward Futures
contracts

Contract size Tailor-made to Standardized

suit the client’s
needs

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How currency futures differ from
forward contracts
Forward Futures
contracts
Delivery Tailor-made Futures contracts are
dates to suit the available for delivery
client’s needs only on dates specified
by the Exchange
Quotes Units of local Dollars per foreign
currency per currency
dollar
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 How currency futures differ
from forward contracts
Forward Futures
contracts
Settlement On the dates Occurs daily at the
agreed Exchange’s clearing
between the house. Gains and losses
bank and are collected daily. This
client process is known as “
marking to market “

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 How currency futures differ
from forward contracts
Forward Futures
contracts
Transaction Cost based on Brokerage fees for buy
costs buy-sell and sell orders
spreads
Margins No margins Margins are required
required of all players in the
futures market

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How currency futures differ from
forward contracts
Forward contracts Futures

Credit risk Credit risk is borne The Exchange

by each party to a becomes the
forward contract counter-party to
every transaction

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 Margins
• The Futures Exchange protects itself
through margins
• Initial Margin = Maintenance Margin +
Variation margin

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 Margins
• The aim of margins is to minimize the risk
of default by either counter-party
• The payment of margin ensures that the risk
is limited to the previous day’s price
movement on each outstanding position

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 Initial Margin
• The basic aim of initial margin is to cover
the largest potential loss in one day.
• Both buyers and sellers have to deposit
margins
• Initial margin is deposited before opening
any position in the futures market
• The margin is calculated by considering the
worst case scenario

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 Variation margin
• Also called volatility margin or mark-to-
market margin
• Exchanges require that all daily losses must
be met by depositing of further collateral,
which is required to be deposited by close
of business the following day
• Any profits on the contract are credited to
the client’s variation margin account

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 Question
• Should margins in the futures market be
necessarily be in the form of cash?

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 Margins
Margins need not necessarily be in the form
of cash. They could be in any of the
following forms :
• Cash
• Commodities
• Securities
• Treasury Bills
• Letter of Credit
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 The settlement price
• The settlement price is fixed by the
Exchange on a daily basis ( as the average
of say the last ten trades )
• Because of the standardized size and
delivery procedures in futures exchanges,
futures do not provide a perfect hedge

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 Marking to market
• A futures trade is market to market at the close of
the day on which it takes place
• It is then marked to market at the close of trading
on each subsequent day
• If delivery period is reached, and delivery is made
by the party with the short position, the price
received is generally the futures price at the time
the contract was last marked to market

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 Marking to market
• The effect of marking to market is broadly as
follows :
• A futures contract is settled daily, rather than at the
end of its life
• At the end of each day, the investor’s gain ( or
loss ) is added to ( or subtracted from ) the margin
account. This brings the value of the contract back
to zero
• A futures contract is, in effect, closed out and
rewritten at a new price each day
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 The Optimal Hedge Ratio
• The optimal hedge ratio is given by the
following equation :
• H = R ( sigma spot / sigma forward )
( see next slide for explanation of symbols)
• This ratio can help in working out the
optimal number of futures contracts to in
for

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 The Optimal Hedge Ratio
Contd. From previous slide:
• H is the optimal hedge ratio
• R is the coefficient of correlation between changes
in spot price and changes in futures price over a
duration equal to the life of the hedge
• Sigma spot is the standard deviation of changes in
the spot price
• Sigma forward is the standard deviation of
changes in the futures price

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 Convergence of futures price to
spot price
• As the delivery month approaches, the
futures price converges to the spot price of
the underlying asset
• At the delivery period, the futures price
equals – or is very close – to the spot price

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 Role of arbitrage in bringing
about convergence
• Question : What kind of arbitrage actions
are likely to take place under the following
scenarios?
• Scenario 1 : The futures price has been
above the spot price
• Scenario 2 : The futures price has been
below the spot price

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 Role of arbitrage in bringing
about convergence
Scenario 1 ( FP > SP ) Scenario 2 ( FP < SP )

Arbitrage action Arbitrage action

Sell a futures contract Buy a futures contract
Buy the spot Take delivery
Make delivery

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 Basis Risk
• Basis = Spot price of the asset to be hedged – the
futures price of the contract used
• Generally, basis should be zero at contract expiry
• Prior to expiry, basis could be either positive or
negative
• Basis risk refers to the uncertainty associated with
the basis at the time of closing out the futures
position

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 Spreads
• Going long and going short are positions
that basically involve the buying or selling
of a contract now in order to take advantage
of rising or declining prices in the future
• Another common strategy used by futures
traders is called “ spreads”

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 Spreads
• Spreads involve taking advantage of the
price difference between two different
contracts of the same commodity.
• Spreading is considered to be one of the
most conservative forms of trading in the
futures market, because it is much safer
than the trading of long / short futures
contracts
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 Spreads
Among the more important types of spreads
are the following :
• Calendar spread
• Inter-market spread
• Inter-exchange spread

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 Calendar spread
• This involves the simultaneous purchase
and sale of two futures of the same type ,
having the same price, but different delivery
dates

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 Inter-market spread
• Here the investor, with contracts of the
same month, goes long in one market and
short in another market.
• For example, the investor may take short
June wheat and Long June pork bellies

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 Inter-exchange spread
• This is any type of spread in which a futures
position is created in different futures
exchanges
• For example, the investor may create a
futures position in the Chicago Board of
Trade ( CBOT ) and the London
International Financial Futures and Options
Exchange ( LIFFE )
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