5. Foreign Currency Futures
Futures contracts are designed to minimize the problems arising from default risk and to
facilitate liquidity in secondary dealing.
In the United States, the most important market for foreign currency futures is the
International Money Market (IMM) of Chicago, a division of the Chicago Mercantile
Exchange.
The best way to understand these contracts is to compare them with forward transactions.
Like forward contracts, currency futures contracts are, in principle, contracts to deliver a
given amount of currency on a given date and at a pre-specified price to be paid later on.
Like forward contracts, futures contracts have a zero initial market value: neither the
buyer nor the seller has to pay anything when a contract is initiated at the going market
rate. However, futures contracts differ from forward contracts in many other respects.
5.1 Currency Futures Markets
As we have seen before, forward contracts are held until maturity. At that point, a prespecified amount of currency is delivered at a pre-agreed price.
However, only about 5 % of all futures contracts are settled by the physical delivery of
foreign exchange between buyer and seller. Most often, buyers and sellers offset their
original position prior to delivery date by taking an opposite position. The complete
buy/sell or sell/buy is called a round turn. Customers usually pay a commission to their
broker to execute a round turn and only a single price is quoted.
Organized Markets:
Futures are traded on organized exchanges, with specific rules about the terms of the
contracts, and with an active secondary market. Futures prices are the result of a
centralized, organized, matching of demand and supply.
One method of organizing this matching of orders is the open outcry system, where floor
members are physically present in a trading pit and auction off their orders by shouting
them out: examples include the International Money Market (IMM) in Chicago and the
London International Financial Futures Exchange (LIFFE).
Another method is to centralize the limit orders in a computerized Public Limit Order
Book. A limit order is an order to buy and indicated number of currency units at a price
no higher than a given level or to sell an indicated number of currency units at a price no
lower than a given level. Brokers sit before their screens, and can add or delete their
orders, or fill a limit order posted on the screen.
Clearing Corporation:
Futures contracts are not initiated directly between clients. Rather, each party has a
contract with the futures clearing corporation or clearing house. Consequently, clients
need not worry that a specific counterpart in the market will fail to honor an agreement.
Moreover, the clearing corporation levies a small tax on all transactions, and thus has
reserves that should cover losses from default.
Contract Specifications:
Exact contract specifications are defined by the exchange on which they are traded.
This standardization means that the futures market is not as fragmented by too wide a
variety of contracts as in the forward market. Standardization facilitates the emergence of
a deep, liquid market.
The major features that must be standardized are usually the following.
A Specific Contract Size: For example, a CAD contract is for CAD 100,000 (IMM).
A Standard Quoting Convention: For example, the American terms (USD/CAD) are
used at the IMM.
A Standard Maturity Date: Expirations dates are typically the third Wednesdays of
March, June, September, or December.
A Specified Last Trading Day: Trading stops two business days before the expirations
date. Actual delivery takes place on the second business day after the expiration date.
Specific Collateral: The purchaser must deposit a sum as an initial margin or collateral.
In addition, a maintenance margin is required. The value of the contract is marked to
market daily, and all changes in value are paid in cash daily. The amount to be paid is
called the variation margin.
5.2 Currency Futures Quotations
Following is an example of a quote that appear in The Wall Street Journal on Friday 30
July 1993, showing information on yen futures trading for Thursday 29 July 1993 on the
International Money Market (IMM) of the Chicago Mercantile Exchange (CME).
Open
High
Low
Settle
Change
Lifetime
High
Low
JAPAN YEN (CME)  12.5 MILLION YEN; $ per yen (.00)
Sep
.9458
.9466 .9386 .9389 -.0046 .9540
Dec
.9425
.9470 .9393 .9396 -.0049 .9529
Mr94
….
….
….
.9417 -.0051 .9490
.7945
.7970
.8700
Open
Interest
73,221
3,455
318
Est vol 28,844; vol Wed 36,595; open int 77,028, + 1,820
The first line shows the size of the contract (12.5 m yen) and states that the prices are
stated in USD cents.
The June 1993 contract had expired, so the tree contracts being traded on 29 July 1993
are the September and December 1993 contracts, and the March 1994 contracts. Note that
there was no trading on the March 1994 contracts for that day.
The different headers are:
Open: The price at the start of trading on 29 July.
High and Low: The highest and lowest transaction prices on 29 July.
Settle: The settlement price on 29 July (representative of prices around the close).
Change: The change in the settlement price between 28 July and 29 July.
Lifetime High and Low: The highest and lowest prices during the life of the contract.
Open Interest: The number of outstanding contracts (note: trading is concentrated in the
nearest maturity contract).
The last line gives an estimate of the volume traded that day and the previous day
(Wednesday 27 July 1993). Also shown is the total open interest across the three
contracts and the change in open interest relative to the day before.
5.3 Marking to Market and Margin Requirements
Marking to Market:
The futures contract stipulates that the buyer pays the initially agreed-upon amount later
on. With a forward contract, later on means at the value date. With a futures contract,
however, the exact details of how much is paid at what time depend on the day-to-day
movements of the futures price.
Consider the following sequence of ex post daily cash flows in a three-day contract (dates
0,1,2,3) to purchase foreign currency:
Day:
Settlement Price (Settle):
Marking to Market:
Final Payment for Delivery:
0
100
1
98
Pay 2
2
96
Pay 2
3
97
Receive 1
Pay 97
The table shows the cash flows to the buyer. The cash flows to the seller are the reverse.
Ignoring the time value of money, the cumulative payment from the buyer is equal to
2+2-1+97=100 units of home currency.
Marking to market is the most crucial difference between forward and futures contracts.
It means that if an investor defaults, the gain from defaulting is simply the avoidance of a
one-day marking to market outflow. All previous losses have already been settled in cash.
Compared to a forward contract, the incentive to default on a futures contract is small.
For a forward contract, defaulting means that the investor saves the amount lost over the
entire life of the contract. The counterpart of this statement is that if an investor fails to
make the required margin payment, the loss to the clearing-house is simply the day's
price change.
Finally, note the futures price for delivery of a currency today must be equal to the
relevant spot rate (convergence property):
f T ,T = S T
Margin Requirements:
There are two types of margin requirements when trading in futures markets. These are
called initial margin and maintenance margin. The idea behind the margin
requirements is that the margin should cover virtually all of the one-day risk. This, of
course, further reduces both the incentives to default as well as the loss to the clearinghouse if there is default.
If one takes a position in the futures market, an initial margin is required. Futures price
changes generate either positive or negative cash flows via marking to market. To avoid
the cost and inconvenience of frequent but small payments, losses are deducted from the
initial margin until a lower bound, the maintenance margin, is reached. At this stage, a
margin call is issued, requesting the investor to bring the margin back up to the initial
level. This payment is called a variation margin.
Example 8.1:
The initial margin on a GDP 62,500 contract may be USD 3,000 and
the maintenance margin USD 2,400. As long as the investor's loss due
to marking to market do not exceed USD 600, the initial equity (USD
3,000) in your account does not go below the maintenance margin of
USD 2,400. If her losses were USD 1,000, the value of the equity
would drop to USD 2,000, which is below the maintenance margin of
USD 2,400. At this point a margin call is issued, and the investor must
add a variation margin of USD 1,000 to restore the equity to USD
3,000.
5.4 Hedging with Futures Contracts
Hedge: The purchase of a contract or tangible good that will rise in value and offset a
drop in value of another contract or tangible good. Hedges are undertaken to reduce risk
by protecting an owner from loss.
Because of its low cost, a hedger may prefer the currency futures market to the forward
market. There are, however, problems that arise with hedging in the futures market:
• The contract size is fixed, and is unlikely to exactly match the position to be hedged.
• The expiration dates of the futures contract rarely match those for the currency
inflows/outflows that the contract is meant to hedge.
• The choice of underlying assets in the futures market is limited, and the currency one
wishes to hedge may not have a futures contract.
That is, whereas in the forward market we can tailor the amount, the date, and the
currency to a given exposed position, this is not always possible in the futures market.
Cross-Hedge: An imperfect hedge is called a cross-hedge when the currencies do not
match.
Delta-Hedge: An imperfect hedge is called a delta-hedge when the maturities do not
match.
Delta-Cross-Hedge: An imperfect hedge is called a delta-cross-hedge when both
currencies and maturities do not match.
The problems of currency and maturity mismatch mean that, at best, only an approximate
hedge can be constructed when hedging with futures. The standard rule is to look for a
futures position that minimizes the variance of the hedged cash flow.
The Perfect Match:
Consider the case of US firm in the import/export business. The firm will receive a
payment of CAD 500,00 on December 21.
It happens that there are CAD 100,000 futures contracts available for a maturity of
December 21. To hedge its future payment, the firm sells 5 futures contract of CAD
100,000 with a maturity of December 21.
The firm can hedge that amount by engaging in a forward contract to sell CAD 100,000.
5.5 Comparing Futures Contracts and Forward Contracts
Characteristic
Currency Futures
Forward Contracts
Contract Size:
Standardized per currency
Any contract size
Maturity:
Standard fixed maturity
Any maturity
Location:
Floor of organized exchange
No specific physical location
Pricing:
Open outcry in the pit
Bid and ask quotes
Collateral:
Initial margin and marking to
market
No collateral, but standing
relations with bank
Settlement:
Rare delivery on settlement
Normal delivery at settlement
Commissions:
Single commission covers round
trip (purchase and sale)
Commissions through bid-ask
spread
Trading Hours:
During exchange hours
24 hours a day
Counterparts:
Client and clearing house
Direct relations
Liquidity:
Liquid (secondary market)
Liquid and large volume
Advantages of Using Futures Contracts over Forward Contracts:
• The default risk of futures contracts is low. As a consequence, relatively unknown
players without established reputation can trade in futures market.
• Because of standardization, futures markets have low transaction costs. Commissions
tend to be lower than in forward markets.
• Futures positions can be closed out with great ease, because of the liquidity in the
secondary market.
Drawbacks of Using Futures Contracts over Forward Contracts:
• Standardization of futures contracts makes it difficult to find a perfect hedge.
Creditworthy hedgers have to choose between an imperfect but cheap hedge in the
futures market and a perfect but expensive hedge in the forward market.
• Marking to market creates ruin risk for a hedger. The daily marking to market can
create severe short-term cash flow problems.
• Marking to market creates an interest rate risk. The daily cash flows must be
financed/deposited in the money markets at interest rates that are not known when the
hedge is set up.
• Futures contracts exist only for a few high-turnover exchange rates. Thus, for most
exchange rats, a hedger has to choose between a forward contracts or money market
hedges, or a cross-hedge in the futures market.
• Futures contracts are available only for a number of short maturity.
5.6 Summary
•
Like forward contracts, currency futures contracts are, in principle, contracts to
deliver a given amount of currency on a given date and at a pre-specified price to be
paid later on.
•
Currency futures contracts are standardized contracts (size and maturity) traded on an
organized market between a client and the clearing corporation.
•
Currency futures contracts are subject to marking to market. That is, the daily
variations in futures prices give rise to daily cash flows. The inception of these
contracts requires an initial margin. In addition, a maintenance margin is required.
•
Hedging refers to the purchase of an asset that rises in value and offset a drop in value
of another asset. Hedges are undertaken to reduce risk by protecting an owner from
loss.