1. 1 Derivatives(2) Futures Market Dr. J. D. Han King’s College University of Western Ontario

2. 2 I. FX Futures 1. Rationales: 1) To overcome Lack of Liquidity of Forward Market, which is mostly O.T.C. -> Futures Market has Standardized Transactions, and is (all the time) Standing Exchanges -> Futures are Common men’s Forward Contract 2) To overcome the Credit/Default Risk -> Third Party Market clears daily with Performance Bonds(Margin); there is no risk of one party declaring default(breaking or not carrying out the contract at t+1). 3) Leverage -> Leverage in futures trading means that the performance deposit or ‘margin’ (deposit) for futures (transactions) is small in comparison to the amount of product it will control. The required deposit is only 3- 5% of the underlying asset value.

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5. Futures are ‘Derived’ from: -Commodities soft commodities, such as FCOJ-A, coffee, sugar, grains, (cooking) oil, live stocks, dried milk - metals - energy, such as crude oil, gas - FOREX or FX - Interest (Rates) 5

6. Equivalency between Forward and a succession of Futures: The sum of all daily changes in futures prices are exactly equal to the difference between the price at the expiry/delivery date and the price at the commence/trade date of forwards contract. 6

7. For Banks, the most relevant for risk management are: FX Futures Interest Rate Futures 7

8. 8 History and Currents of the FX Futures Market: Chicago Mercantile Exchange started FOREX Future Trading in 1972 Daily average trading volume exceeds US $ 100 billion Website of FX futures in CME http://www.cmegroup.com/trading/fx/

9. FX Futures: Standardized Contract Size in CME British Pound(GBP)62,500 Euro125,000 Swiss Franc125,000 Australian Dollar100,000 Canadian Dollar100,000 Chinese Yuan1,000,000 Japanese Yen12,500,000 Russian rubles2,500,000 Brazilian reals100,000 Mexican pesos500,000 Chinese Reminbi1,000,000 9

10. 10 Operation of Futures Market: Daily Reconstructed/Settled Forward market You have to make Margin Deposit (=performance bonds=Initial Deposit Requirement) Buy (take long-position) if you expect/need the price of a currency to rise; Sell (take short-position) if you expect/need it to fall. Futures settlement price changes every day If the price rises, the buyer wins; if the price falls, the seller wins. Profits or Losses are calculated by multiplying the price change (quoted per one unit of the asset) time the contract size(how many units of the assets in one future contract). Profits/Losses are settled on a daily basis from a mandatory margin account -> The transfer of losses/profits are called “Marking to Market”

11. Numerical Example 1 For example, John buys 10 (units of) September CME Euro FX Futures (contract) at $1.2713/€. One contract has €125,000 in it. Suppose that at the end of the day, the futures close at $1.2784/€. The change in price is $0.0071 per each €. As the price has gone up, he as a buyer wins. His profits today are $0.0071 times 125,000 per unit = 887.5 dollars per unit. As he has 10 units, his total profits are 8875 dollars. This amount is credited to his account immediately. 11

12. Numerical Example 2: ‘GBP/USD Futures’ One unit contains 62,500 pounds How much is the Initial Margin = Performance Bond? Usually 3-5% of the value: 62,500 pounds are roughly equivalent to U.S. $ 100,000. In reality, the initial margin required is US $ 1,850, about 2% of the value. 12

13. Now Suppose you buy a unit at 1.4444 US $ per Sterling Pound. Initial Margin Requirement by CME = $1,850. Suppose Actual Initial Margin Deposited = $2000. Next day, the price/quote of GBP Futures falls to 1.4433 You as a buyer have lost 11 points or 0.0011 dollar per Sterling Pound. - For one unit of Sterling Pound/U.S. $ or GBP/USD has 62,500 pounds in it.,0 - You have lost the total amount of 0.0011 dollar x 62,500 pounds=687.5 US dollars per unit. Lost 687.5 dollars has “Marking to the Market” now. It will be transferred from you to the market, and finally to the seller. Your (remaining) Margin Balance (will fall to) = 2000 – 687.5 = $ 1313.5 Maintenance Margin set by CME = $ 1850 You have to refill by the Variation Margin Requirement to refill = $536.5. 13

14. *comments When the price goes up, a Futures buyer(Long) wins. - This is for a hedger needing protection from Price Increases through Futures. When the price goes down, a Futures seller(Short) wins. - This is for a hedger needing protection from Price Falls through Futures. 14

15. Numerical Example 2 You are a Canadian exporter to U.S. and are to receive U.S. 1 mil in 3 months, that is, June 2010(t+1). How would you do FX Hedging in the CME? 15

16. To start: Performance bond = U.S. $ 3300 for a hedger Mindset: You have to put on the U.S. shoes-Act and think like you are a U.S. citizen for S U.S $./C$ What to do? You are (buying/selling) Canadian Dollar Futures (CD) in CME, which will expire/deliver on March 2010. How much? Each unit = C $100,000 So you buy 1/S = 1/0.82 =about 12 units of CD for $100,000 for the corresponding rate = 0.8159 at 10:25:30 AM CST 2/09/2009. Thus you pay 0.8159 x 100,000 x 12 = U.S. $ 978,900. You have to get it from Spot Market at the current Spot rate S t. 16

17. Interest Rate Products in Futures Interest Rate Products are not directly on Interest Rate, but on the related short-term bonds, such as the certificate of deposits. For instance, Eurodollar Futures are about “(the amount of) Eurodollar Interbank Deposit having approximately $1 million face(principal value), for three-month term(90 days) to maturity, for spot settlement on the 3rd Wednesday of the contract month”. The Quote or Price is given as 100 minus Interest Rates. 17

18. How do we use the Interest Rate Products in Futures Exchanges such as CME for the purpose of hedging against Interest Rate Risk? For a fully explained Example, click here.click here. 18