Currency futures

1
Currency futures
2
Meaning

• It is a derivative instrument
• Definition is the same as currency forward
• Forwards are traded over the counter
• Futures are traded in organised exchanges
  (separate financial futures exchanges)
• Futures are transacted through brokers
• Traded only in a limited number of currencies

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Features

• Standardised terms
• Clearing house
• Margin system
• Closing of futures

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Standardised terms

• Contract size is standardised
• Example 62,500 Sterling 125,000 Euro 100,000
  Can Dollar Chicago Mercantile exchange
• Date of delivery is predetermined
• Third Wednesday of Jan, March, April, June, July,
  Sept., Oct., Dec.

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Clearing house

• Each exchange has a clearing house
• Clearing house arranges for delivery of asset and
  payment of money
• Clearing house becomes the counter party to the
  original parties
• Original parties buyer and seller
• Clearing house becomes counter party to buyer (to
  deliver the asset)
• Clearing house becomes the counter party to the
  seller (to make payment)

6
Margin system

• There are 3 types of margins
• Initial margin, maintenance margin and variation
  margin
• Initial margin to be paid upfront
• Balance is marked to the market every day
• Maintenance margin to be maintained throughout
  the duration of the contract
• Variation margin (shortfall in margin) to be
  remitted promptly

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Example for margin system

• Can Dollar futures size 100,000 Can D
• Dealer buys one contract at USD 0.75/ Can D
• Value of contract USD 75,000
• Initial margin 10 percent USD 7,500
• Maintenance margin 7.5 percent USD 5,625
• Price moves upto USD 0.755/ Can D dealer gains
  USD 500 (100,000 USD 0.005)
• Price moves down to USD 0.740 dealer loses USD
  1000 (100,000USD 0.010)

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Closing of futures

• Forward contract is settled on delivery date by
  delivery of asset and payment of money
• Futures can be closed
• Exchange of asset and cash on delivery date
• Cash settlement through a reverse trade on any
  day
• Hedgers prefer exchange of asset speculators
  prefer cash settlement

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Hedging with currency futures

• Importer buys the required currency futures
  contract
• Thus locks in a price for the purchase of
  foreign currency
• Hedges (avoids) risk due to exchange rate
  fluctuations
• Exporter sells the expected currency futures
  contract
• locks in a price for the sale
• Hedges risk due to exchange rate fluctuations

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Imperfections in hedging with currency futures

• Maturity mismatch
• Mismatch in maturity date of futures contract and
  date of cash transaction
• Size mismatch
• Mismatch between size of futures contract and
  size of cash transaction
• Maturity and size mismatch
• Hedging with currency futures may not result in
  perfect hedge

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Speculation with currency futures

• Fluctuations in exchange rates used to reap
  speculative profits
• Spot rate USD Rs.46.40
• 1 month future rate USD Rs.46.60
• Expected spot rate on maturity USD Rs. 46.75
• Dealer buys one currency futures contract of size
  100,000 USD
• Value of contract Rs.46,60,000 Margin deposit
  Rs.4,66,000
• If exchange rate move up to Rs.46.75 as
  anticipated, dealer gains profit of Rs.15,000
  (100,000 Re.0.15)
• Rate of return (15000/466,000)(12)(100) 38.63

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Speculation through cash transaction

• Spot rate USD Rs.46.40
• Dealer buys 100,000 USD at spot rate
• Investment required Rs.46,40,000
• If exchange rate moves upto Rs.46.75 within a
  month, dealer gains profit of Rs.35,000 (100,000
  Re.0.35)
• Rate of return (35000/46,40,000)(12)(100)
  9.05
• Speculation with currency futures - larger
  returns on smaller investment