market for currency futures

8/10/2019 Market for Currency Futures

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SHARAD RAJ SHARMA

ROLL NO: 12MSOM003MBA (4thSemester)

School of Management, NIT Agartala

Market for Currency Futures


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Currency Futures

A transferable futures contract that specifies theprice at which a currency can be bought or sold ata future date. Currency future contracts allowinvestors to hedge against foreign exchange risk.

OR

A currency future is a futures contract toexchange one currency for another at a specifieddate in the future at a price (exchange rate) thatis fixed on the purchase date.


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History of Currency Futures The currency futures came into being in May 16,

1972. The Chicago Mercantile Exchange (CME) set up its

International Monetary Market division for trading ofcurrency futures.

In the year 1978 only 2 million contracts were tradedand in the year 2004 a total of 48 million contractswere traded. (Source: Cheol S Eun and Bruce GResnick, International Financial Management, TMH

Publications, 4th

Edition 2008. Pg- 165). The volume of transactions in currency futures market

is very low compared to that in spot and forwardmarket. The volume of currency futures turnover in2000 came to around 8-13% of the total turnover inthe global spot and forward market. (Source:


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Features of Currency FuturesContract

Size and Maturity of contract

Use of Pits

Transactions through a clearing house

Margin Money Marking to the market

Methods of transaction

Types of Order

Costs in Futures deal

Future Contract vs. Forward Contract


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Maturity of the contract

The date of delivery is also fixed normally on the3rdWednesday of January, March, April, June,July, September, October and December.

The maturity of the Currency Futures deals isfixed and cannot be tailored according to theneeds of individuals.


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Use of Pits In Currency Futures brokers strike the deals

sitting face to face under a trading roof, known aspits.

Locals or Floor traders: The brokers trade forthemselves.

Commission or Floor brokers: The brokerstrade for their customers.

Dual Traders: The brokers trade for themselvesas well as their customers.


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Transactions through a ClearingHouse

Every currency futures deal involves the clearinghouse. It is a part of the system with which thetraders strike the deal.

Long and short position: The buyer of thecurrency acquires a long position with theclearing house whereas the seller of the currencyacquires the short position.

The obligation of the buyer and seller lies with theclearing house and not with each other.

The Clearing house becomes seller to everybuyer and buyer from every seller. This way it

guarantees the performance of every transaction.


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Margin Money

Margin money represents traders deposits with the

clearing house for the adjustment of gain/loss. The traders represent a source of credit risk to the

exchange or the clearing house as long futurestraders may not have sufficient funds to buy theunderlying foreign currency.

In order to cover this risk they are required to depositmargin money with the clearing house.

Margin money has two components- Initial margin: amount of money to be deposited at

the time of signing of contract- Maintenance margin: it is the minimum level towhich the margin is allowed to fall in the sequel ofloss.

What happens if the balance drops below

maintenance margin?


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Marking to the Market Marking to the market involves daily comparison

of spot rate with yesterdays rate up to thematurity for the assessment of loss/gain.

The rates are matched every day with themovements in spot rates and on this basis gainsand losses are settled everyday.

An Example:An importer buys Pound ( 62,500)in the futures market at $1.750/ on 20thSeptember. The maturity date is 27thSeptember.If the spot exchange of US dollar is given find outhow much will be added to/subtracted from themargin money.


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Marking to the MarketDate Spot Rate

exchange(US $/)

Calculation of gains/losses(in $)

21stSeptember 1.752 1.7521.750 = 0.002

22nd September 1.755 1.7551.752 = 0.003

23rdSeptember 1.753 1.7531.755 = - 0.002

24thSeptember 1.753 1.7531.753 = 0

25thSeptember 1.754 1.7541.753 = 0.001

26thSeptember 1.755 1.7551.754 = 0.001

27th

September 1.758 1.7581.755 = 0.003Net Gain/ Loss 0.008

Total Gain = $ 0.008 x 62500 = $ 500 will be added to the Margin M


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Method of Transaction The trader (client) who wants to enter Currency

Futures Contract informs his agent. The agentthen informs the commission broker at

the exchange.

The brokerexecutes the deal in the pit for a fee.

The broker confirms the trade with the agent ofthe trader.

The agent gives the information about thetransaction and the futures price to the trader.

The trader deposits the Margin Money to theclearing house.

Marking to the market takes place everyworking day as a settlement.

Final settlement takes place on the maturity day.


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Method of Transaction

Client/

Trader AgentBroker

(1) Informs (2) Informs

(4) Confirms trade(5) Informs

PitClearin

gHouse

(6) Deposits Margin Money(3) Executes Deal


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Types of Order (placed by trader) Limit Order: It stipulates a particular price at which a

deal is to be made. Fill-or-kill order: In this the commission broker is

instructed to fill an order immediately at a specificprice. The order is cancelled if not transacted quickly.

All-or-none order: The commission broker transactsdifferent parts of the deal at different prices.

On-the-open order: Involves transaction within a fewminutes of opening of the stock exchange.

On-the-close order: Involves transaction during theclosure of the stock exchange.

Stop order: Involves a reversing trade when the pricehits the prescribed limit. It protects against losses on

existing position.


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Costs in Futures deals

Brokerage Commission: It is the cost chargedby the commission brokers

Floor trading and clearing fee: It is charged bythe stock exchange and its associated clearinghouse.

Delivery Cost: Costs related to the delivery ofthe currencies but since actual delivery of thecurrency seldom takes place, such cost is notcommon.


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ContractCharacteristics Forward Contract Futures Contract

Size of Contract Tailored to individual

needs

Standardized

Maturity Tailored to individualneeds

Standardized

Method oftransaction

Over-the-counter deal Dealing on the floor ofthe exchange

Regulation Self-regulating Regulated by the rulesof the stock exchange

Volume ofTransaction

Very large Very low, say around 1per cent of forexmarket

Security Deposit Not required exceptcompensating bankbalances

Margin money to bedeposited to theclearing house

Commission Spread between the banksbuying and selling price

Brokerage fee

Clearing Operation No Clearing House Clearing House for


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Hedging in Currency FuturesMarket

Suppose a person who deals in imports andexports wants to import/export some goods fromUS after 3 months. How will he hedge againstthe change in spot market price of US $ using

Currency Futures?Details IMPORT EXPORT

Contract Type US $ futurescontract

US $ futurescontract

Operation Buy Sell

Result Protection againstloss due to

appreciation of US$

Protection againstloss due to

depreciation of US$


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Problems with hedging in futures The contract size is fixed, and is unlikely to

exactly match the position to be hedged.

The expiration dates of the futures contract rarelymatch those for the currency inflows/outflows that

the contract is meant to hedge.

The currency one wishes to hedge may not havea futures contract.

H d i i C F t


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Hedging in Currency FuturesMarket

Delta Hedge: It exists when the maturity does notcoincide with the hedgers need for the currency.

Cross Hedge: It exists when the amount of thefutures contract does not tally with the actual

amount to be hedged.

Delta Cross Hedge: It is a combination of theDelta hedge and the Cross hedge.


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Speculation with CurrencyFutures Speculators make profits by using currency

futures

If they expect the spot rate to move up beyondthe currency futures contract they buy currencyfutures of that currency. At maturity they get thecurrency at a rate cheaper than the spot rate andthey make profit.

If they expect the spot rate to depreciate belowthe rate mentioned in the futures contract thespeculators sel l cu rrenc y futuresin thatcurrency. At maturity date they sell the currency ata rate higher than the spot rate and make profit.


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Intra-currency Spread This exists when a speculator buys/sells the

same currency for two delivery dates. Suppose pound is expected to appreciate till June

and then depreciate by September at faster ratethan the futures rate. The speculator buys a

pound futures contract for June delivery and sellanother one for September delivery.

Net Gain = (0.0050.002) x 62,500 = $ 187.5

June Delivery September Delivery

Futures Rate $0.650/ $0.640/

Spot Rate $0.655/ $0.642/

Gain/(Loss) $0.005/ ($0.002/)


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Inter-currency Spread This exists when a speculator buys/sells two or

more currencies for the same delivery date. Suppose a speculator buys pound futures contract

and sells Euro futures contract for the same maturity.He expects that pound will appreciate and Euro willdepreciate.

Net Gain = $ 1,875 - $ 625 = $ 1,250

Pound (bought) Euro (sold)Futures Price $ 1.690 $ 1.250

Spot Price $ 1.680 $ 1.235

Gain/(Loss) onfutures contract

1.690-1.680 =($ 0.010 / )

1.250-1.235=$ 0.015/

Total Gain/(Loss) 0.010*62,500=($ 625)

0.015*62,500= $ 1,875


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References Vyuptakesh Sharan, International Financial

Management, PHI Learning Private Ltd, 5thedition 2010.

Cheol S Eun and Bruce G Resnick, InternationalFinancial Management, TMH Publications, 4thEdition 2008.

http://www.investopedia.com/terms/c/currencyfuture.asp

http://en.wikipedia.org/wiki/Currency_future
http://www.investopedia.com/terms/c/currencyfuture.asphttp://www.investopedia.com/terms/c/currencyfuture.asphttp://en.wikipedia.org/wiki/Currency_futurehttp://en.wikipedia.org/wiki/Currency_futurehttp://www.investopedia.com/terms/c/currencyfuture.asphttp://www.investopedia.com/terms/c/currencyfuture.asp


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