1. CURRENCY FUTURES A futures contract, like a forward contract is an agreement between two parties to exchange one asset for another, at a specified date in the future, at a rate of exchange specified up front. However, there are a number of significant differences. Major Features of Futures Contracts Organized Exchanges not OTC markets. Standardization : Amount of asset, expiry dates, deliverable grades etc. Clearing House: A party to all contracts. Guarantees performance. Mitigates/Eliminates Credit Risk Daily mark-to-market and a system of margins. Actual delivery is rare.

2. Foreign Currency Futures Contract specifications are established by the exchange on which futures are traded. Major features that are standardized are: –Contract size –Method of stating exchange rates –Maturity date –Last trading day –Collateral and maintenance margins –Settlement –Commissions –Use of a clearinghouse as a counterparty

3. FUTURES CONTRACTS Global Futures Exchanges: 1)IMM: International Monetary Market 2)LIFFE: London International Financial Futures Exchange 3)CBOT: Chicago Board of Trade 4) SIMEX: Singapore International Monetary Exchange 5)DTB: Deutsche Termin Bourse 6)HKFE: Hong Kong Futures Exchange

4. FUTURES CONTRACTS B.Forward vs. Futures Contracts Basic differences: 1) Trading Locations 2) Regulation 3) Frequency of delivery 4) Size of contract 5) Transaction Costs 6) Quotes 7) Margins 8) Credit Risk

5. FUTURES CONTRACTS Advantages of Futures: 1) Easy liquidation 2) Well- organized and stable market. 3) No credit risk Disadvantages of Futures: 1) Limited to a few currencies 2) Limited dates of delivery 3) Rigid contract sizes

6. FUTURES CONTRACTS ON IMM Available Futures Currencies/Contract Size: 1) British pound / 62,500 2) Canadian dollar /100,000 3) Euro / 125,000 4) Swiss franc / 125,000 5) Japanese yen / 12.5 million 6) Mexican peso / 500,000 7) Australian dollar / 100,000

7. Exchange traded currency futures were launched in India on August 29, 2008. As of now only USD-INR contracts have been permitted with contract size of USD 1000 with monthly maturities upto twelve months. The contracts will be cash settled in INR. Contracts will expire on the last working day of the month. Quotations will be given in rupee terms. Unlike OTC forwards, no underlying exposure is required to trade in USD-INR futures. Individuals can also trade for purely speculative purposes. Margins will be calculated using a VAR framework. Contracts have started trading on NSE. Eventually, they will also be traded on MCX and BSE. Contracts between INR and other currencies will be introduced later based on perception of market interest.

8. FUTURES CONTRACTS Transaction costs: Commission payment to a floor trader; Brokerage, Bid-Offer Spreads Leverage is high Initial margin required is relatively low (less than 2% of contract value).

9. FUTURES CONTRACTS: SAFEGUARDS Maximum price movements 1) Contracts set to a daily price limit restricting maximum daily price movements. 2) If limit is reached, a margin call may be necessary to maintain a minimum margin.

10. System of Margins Initial margin : When position is opened Variation Margin: Settlement of daily gains and losses Maintenance Margin : Minimum balance in margin account. Balance falls below this, margin call issued. If not met, position liquidated. Regulators specify minimum margins between clearing members and clearinghouse. Margins at other levels negotiated Margins can be deposited in cash or specified securities such as T-bills. Interest on securities continues to accrue to owner. Margin is a performance bond. Levels of margins may be changed if volatility increases.

11. System of Margins With clearing house guarantee, buyer-seller need not worry about each other’s creditworthiness. Standardized contracts with margin system increase liquidity. Protects clearing house; enhances financial integrity of the exchange. Credit risk issues almost eliminated

12. CLEARING HOUSE CLEARING MEMBER A CLEARING MEMBER B NON-CLEARING MEMBER CUSTOMER NON-CLEARING MEMBER CUSTOMER

13. TYPES OF ORDERS IN FUTURES MARKETS Market Orders : Execute at best available price Limit Orders: Sell above or buy below stated limits Market If Touched or MIT Orders: Become market orders if price touches a trigger Stop-Loss Orders : Sell if price falls below a limit; buy if it rises above a limit. Used to limit losses on existing positions Stop Limit Orders : Stop loss plus limit Time of Day Orders, Day Orders, Good Till Canceled(GTC) Orders Participants : Brokers, Floor Traders, Dual Traders, Futures Commission Merchants. Hedgers and speculators both participate.

14. CONTRACT OPEN HIGH LOW CLOSE OP.INT NOTIONAL VALUE OCT 09 47.90 47.99 47.78 47.86 300000 522288.06 NOV 09 48.03 48.10 47.89 47.96 95700 139438.45 DEC 09 48.11 48.18 47.99 48.05 4800 1482.95 JAN 10 48.19 48.19 48.10 48.10 2000 15.01 USD/INR CONTRACT TRADED ON MCX-SX OCTOBER 1, 2009 QUOTES CONTRACT SIZE : USD 1000 TICK SIZE : Rs.0.25 NOTIONAL VALUE: VALUE OF CONTRACTS TRADED RS.LAKH EXPIRY DATE: 2 BUSINESS DAYS BEFORE THE LAST WORKING DAY OF THE CONTRACT MONTH Source: BUSINESS STANDARD

15. FUTURES PRICES, SPOT PRICES AND EXPECTED SPOT PRICES Basis = (Spot Price – Futures Price) Normal Backwardation : Hedgers net short. Speculators must be net long; they would do so if they expect futures price to rise. Futures price rises as maturity approaches. Contango : Hedgers net long. Speculators net short. Futures price expected to fall as maturity approaches Net Hedging Hypothesis Risk Aversion and behaviour of futures prices Futures Price = Expected Spot Price ?

16. Backwardation Contango FUTURES PRICE EXPECTED SPOT PRICE FUTURES PRICE Time Expiry Time

17. FUTURES PRICES AND FORWARD PRICES DETERMINISTIC INTEREST RATES: FUTURES PRICES EQUAL FORWARD PRICES STOCHASTIC INTEREST RATES : FUTURES PRICES DIFFER FROM SPOT PRICES DUE TO DAILY GAINS AND LOSSES SPOT PRICE AND INTEREST RATE POSITIVELY CORRELATED : FUTURS PRICE EXCEEDS FORWARD PRICE NEGATIVE CORRELATION: FUTURES PRICE LESS THAN FORWARD PRICE

18. FUTURES PRICE AND SPOT PRICE CASH-AND -CARRY ARBITRAGE Spot Price of a dollar : Rs.44.00 3-month Futures Price : 45.75 Rupee interest rate : 6% p.a. Dollar interest rate : 4% p.a. Borrow rupees, buy dollars and deposit, sell futures. 3 months later, deliver, get rupees, repay loan.

19. Suppose contract size is $50000. Must deposit $(50000)/(1.01) = $49504.95 Must borrow Rs.(49504.95)(44.0) = Rs.2178217.82 Must repay (2178217.82)(1.015) = 2210891.09 On expiry, liquidate deposit, deliver on futures collect Rs.2275000. Net profit: 64108.91 Futures Price “too high” : Buy asset in spot market, store, pay storage cost, sell futures, deliver at expiry. Futures Price too low (e.g.44.60) Reverse cash-and- carry arbitrage. Borrow dollars, convert to rupees and deposit, buy futures. Take delivery at expiry and repay dollar loan. Nothing but Covered Interest Arbitrage

20. Arbitrage and Theoretical Futures Price Let C denote the present value of carrying costs, S t the spot price, r the interest rate, and FU t,T the futures price for delivery at T, Then theoretical futures price is given by FU t,T = (S t + C)[1 + r(T-t)] Actual futures price higher : cash-and-carry arbitrage Actual futures price lower: reverse cash-and-carry arbitrage For currency futures, futures prices are almost identical to forward prices. A similar relation will hold between FU t,T1 and Fu t,T2, T2>T1>t

21. In practice futures price does not exactly equal theoretical futures price. Reasons: 1 Transaction costs – bid-offer spreads, brokerage 2 In some cases, restrictions on short sales (Does not apply to currency futures) 3 Non-constant interest rates 4 Mark-to-market gains/losses. 5 “Convenience yield” (Commodity futures) A band of variation around theoretical price.

22. Hedging with Currency Futures A corporation has an asset e.g. a receivable in a currency A. To hedge it should take a futures position such that futures generate a positive cash flow whenever the asset declines in value. The firm is long in the underlying asset, it should go short in futures i.e. it should sell futures contracts on A against its home currency. When the firm is short in the undelying asset – a payable in currency A – it should go long in futures. Cash Position: Receive A; Futures Position: Deliver A Cash Position: Deliver A; Futures Position: Receive A If no futures between A and HC, use futures between A and a currency closely correlated with HC.

23. Futures Hedge : An Example January 30. A UK firm has $250000 payable due on August 1. £/$ spot:1.7550. GBP Futures: September: 1.7125 December: 1.6875 Decides to hedge with September futures. GBP value of USD payable at futures price: (250000/1.7125) = £145985.40. Each GBP futures contract is for £62500. Sells (145985.40/62500) = 2.3357 rounded off to 2 contracts. Could be rounded off to 3 contracts.

24. On July 30 the rates are: July 30: £/$ spot: 1.6850 September futures: 1.6750 Firm buys USD spot. It has to pay GBP(250000/1.6850) = £148367.95 Compared to the GBP value of payable at the spot rate at start this represents a loss of GBP 5917.81. Buys 2 September futures contracts at $1.6750 to close out the futures position. Gain on futures : $(1.7125-1.6750)(2)(62500) = £4687.50. Not a perfect hedge. Basis narrowed.

25. Futures Hedge : Example (contd) Choice of contract underlying was obvious. Firm chose a contract expiring immediately after the payable was to be settled. Is this necessarily the right choice? The number of contracts chosen was such that value of futures position equaled the value of cash market exposure, aside from the unavoidable discrepancy due to standard size of futures contracts. Is this the optimal choice? Futures hedge involves three considerations: Underlying, expiry date of the contract, number of contracts. The latter two problems do not arise with forwards. Why?

26. Three Decisions (1) Which contract should be used i.e. the choice of "underlying". Home currency A; exposure in B; futures on B against A available – Direct hedge. Home currency A; exposure in C; no futures on C against A. B and C are highly correlated; use futures on B – Cross Hedge (2) Choice of expiry date : In February A UK firm books a USD payable maturing on June 3. To hedge, must sell GBP futures (Buy USD futures). Which month? June or later? (3) How many contracts? Choice of “hedge ratio”. Value of futures position = Value of underlying exposure?

27. Choice of expiry date: As expiry date approaches, basis narrows. On expiry date futures price equals spot price. This is known as “Convergence”. Does convergence help you or hurt you? If convergence helps, choose near contract If convergence hurts, choose far contract. However, liquidity less in far contracts; bid-offer spreads are higher; basis volatility more. Thumb rule followed by practitioners: Choose expiry date immediately after underlying exposure is to be settled.

28. Choice of Expiry Date Basis at the start Positive Negative Nature of hedge Long F A Short A F Long Hedge: You must take delivery of underlying in your futures position. You have bought futures contracts. Short Hedge : You must make delivery of underlying in your futures position. You have sold futures. F: Convergence favours you. A: Convergence against you. Positive Basis: Spot price > Futures Price

29. Choosing the Number of Contracts A Swiss firm has a USD payable of $500,000, maturing November 15. It decides to sell December contracts priced at $0.74/CHF. At this price, the CHF equivalent of $500,000 is CHF 675675.68. Since one CHF contract is for CHF 125,000, it should sell : (675675.68/125000) = 5.4054 rounded off to 5 or 6 contracts. Sounds logical but is it necessarily correct? What is the objective of hedging? To minimize the variance of the hedged position? Define the "Hedge Ratio"(HR) as : V F /V H = (Value of futures position/Value of cash position) Should HR = 1.0 always?

30. Direct Hedge with a Timing Mismatch Choosing Hedge Ratio A Swiss firm on February 28 has a USD 500,000 payable to be settled on July 1. Cash market position short USD. Must buy USD futures or short CHF futures. It chooses to hedge by selling September CHF contracts. This contract matures on September 18. The spot rate is USD/CHF 1.3335 or CHF/USD 0.7499 September futures price is USD/CHF 1.4518 or CHF/USD 0.6888 Each CHF contract is for CHF 125000. Determine the number of contracts it should short..

31. Choosing Hedge Ratio …. V C : The value of the cash market position measured in the foreign currency. S t : The spot rate at the start stated as units of home currency(HC) per unit of foreign currency(FC). T 1 : The date when the cash position has to be settled. T 2 : The date when the futures contract expires, T 2 > T 1 V F : The value of the futures position measured in US dollars. F t,T2 : The price at time t of the futures contract maturing at T 2 stated as units of HC per unit of FC. In the example HC: CHF FC: USD V c = $500000 S t = 1.3335 T 1 : July 1 T 2 : September 18 F t,T2 = 1.4518

32. Choosing Hedge Ratio…. F ~ T1,T2 : The price of the same contract at time T1 (a random variable) S ~ T1 : The spot rate at time T1 when the hedge is lifted. Stated as units of HC per unit of FC. (Random variable) The value of the hedged cash flow at time T1 is given by V˜ H,T1 = - V C S ˜ T1 + V F (F t,T2 – F ~ T1,T2 ) The variance of V˜ H,T1 is (V C ) 2  2 (S˜ T1 ) + (V F ) 2  2 (F˜ T1T2 ) – 2V C V F COV(S˜ T1 F ~ T1,T2 ) Let H = V F /V C be the hedge ratio

33. Then (V C ) 2  2 (S˜ T1 ) + (V F ) 2  2 (F˜ T1T2 ) – 2V C V F COV(S˜ T1 F ~ T1,T2 ) = (V C ) 2 [  2 (S˜ T1 ) + H 2  2 (F˜ T1T2 ) – 2H COV(S˜ T1 F ~ T1,T2 )] To minimize this w.r.t. H 2 H  2 (F˜ T1T2 ) – 2 COV(S˜ T1 F ~ T1,T2 ) = 0 This leads to H = V F /V C = COV(S ~ T1, F ~ T1T2 ) / VAR(F ~ T1T2 ) We need forward-looking estimates of these parameters. Using past data estimate a regression equation: S ~ T1 =  +  F ~ T1T2 + u The estimate of  can be used as hedge ratio. But this would be a historical estimate.

34. Let us apply this result to the Swiss firm's case. Assume that we have somehow obtained estimates of the covariance of S˜ T1 and F˜ T1,T2 and the variance of F˜ T1,T2. Their ratio is 0.90. Then the USD value of the futures position must be (500,000  0.90) = USD 450,000. At the futures price of $0.6888/CHF this translates into CHF 653310.10. With each contract being CHF 125,000 this is equivalent to 5.23 contracts rounded off to 5 or 6 contracts.

35. The interest parity relation tells us that [1 + r B (T-t)] F t,T2 (A/B) = S t (A/B) ----------------- = k S t (A/B) [1 + r A (T-t)] [1 + r B (T-t)] where k = ----------------- [1 + r A (T-t)] If the factor k remains constant, then (F T1,T2 -F t,T2 ) = k(S T1 - S t ) and a hedge ratio V F /V C = 1/k =  would give a perfect hedge. But k does not remain constant. Optimal hedge ratio keeps changing

36. Dynamic hedging: As interest rates and spot rate keep changing, recalculate the optimal hedge ratio and rebalance the hedge by selling more futures or buying futures. How frequently? Transaction costs must be considered. Any gain from frequent rebalancing must be weighed against increased transaction costs. Large position, long duration of hedge, more frequent rebalancing warranted. Standard-size problem cannot be circumvented.

37. SPECULATION WITH CURRENCY FUTURES Open Position Trading In April Spot EUR/USD: 1.5750 June Futures : 1.5925 September Futures: 1.6225 You do not think EUR will rise. It will fall. You do not think EUR will rise so much. How to profit from this view? Sell September.

38. SPECULATION WITH CURRENCY FUTURES On September 10 the rates are : Spot EUR/USD: 1.5940 September futures: 1.5950 Close out by buying a September contract. Profit USD(1.6225-1.5950) per EUR on 125000 EUR = USD 3437.50 minus brokerage etc. First view was wrong; EUR did appreciate but not as much as implied by futures price.

39. SPREAD TRADING Intercommodity Spread In April : Spot EUR/USD : 1.5500 GBP/USD: 1.9000 September Futures: EUR: 1.5800 GBP: 1.8580 Your view: GBP is going to rise against EUR. What should you do? Intracommodity Spread: June EUR: 1.5800 September EUR : 1.7500 Your view: Between June and September EUR will not rise so much. What should you do?

40. INTEREST RATE FUTURES Treasury Bill Futures A futures contract on US treasury bills is traded on the CME. Its specifications are as follows: Product and Trading unit: 13 WEEK TREASURY BILL FUTURES 3-month (13-week) U.S. Treasury Bills having a face value at maturity of $1,000,000 Point Description: ½ point =.005 = $12.50. A point here is one basis point or (1/100) th of 1 percent.

41. CME 13 WEEK US T-BILL Trade Unit3-month (13-week) U.S. Treasury Bills having a face value at maturity of $1,000,000 Settle MethodCash Settled Point Descriptions ? point =.005 = $12.50 Contract Listing Mar, Jun, Sep, Dec, Four months in March quarterly cycle plus 2 months not in the March cycle (serial months). Current Listings Current Listings Strike Price Interval N/A Product Code Clearing=T1 Ticker=TB GLOBEX=GTB Trading Venue: Floor HoursHours 7:20 a.m.-2:00 p.m LTD(12:00 p.m.)^7:20 a.m.-2:00 p.m LTD(12:00 p.m.)^ Li st e d Alllisted seriesAlllisted series S tr ik e N/AN/A Li m it s No LimitNo Limit Mi ni mu m Flu ctu ati on Regul ar 0.005=$12. 50 Mi ni mu m Flu ctu ati on Regul ar 0.005=$12. 50

42. T-Bill Futures Contract on CME…. The dollar value of a point represents interest at 0.01% p.a. on $1 million for a period of 3 months, which works out to $25. Contract Listings: Mar, Jun, Sep, Dec, Four months in March quarterly cycle plus 2 two months not in the March cycle (serial months). The short must deliver a US T-bill with face value USD 1 mio, with 90, 91 or 92 days to maturity. Futures price stated as: 100.000-Discount yield Rates rise, price falls; rates fall, price rises.

43. Three Month Euro (EURIBOR) Interest Rate Futures Contract (LIFFE) Unit of trading: €1,000,000 Delivery months: March, June, September, December, and four serial months, such that 25 delivery months are available for trading, with the nearest six delivery months being consecutive calendar months Quotation: 100.00 minus rate of interest Minimum price movement (tick size and value): 0.005 (€12.50) Last trading day: Two business days prior to the third Wednesday of the delivery month Delivery day: First business day after the Last Trading Day Trading hours: 07:00 – 21:00

44. THE EURODOLLAR DEPOSIT CONTRACT The underlying asset is a 3-month Eurodollar deposit of USD 1 million beginning on expiry date of futures. Contract price is stated as (100-Implied Interest Rate) May be cash settled only or both cash settled and physical delivery. If latter, long is actually assigned a deposit at a eurobank. As interest rate rises, contract price falls. As rates fall, contract price rises. To hedge against falling rates, buy futures; to hedge against rising rates sell futures

45. CME Eurodollar Futures Trade Unit : Eurodollar Time Deposit having a principal value of $1,000,000 with a three-month maturity. Settle Method : Cash Settled Point Size :1 point = 0.01 = $25.00 Tick Size (Min Fluctuations) SGX : Half Tick 0.005=$12.50 Quarter 0.0025=$6.25 for nearest expiring month. FLOOR : Half Tick 0.005=$12.50 Quarter 0.0025=$6.25 for nearest expiring month. GLOBEX : Half Tick 0.005=$12.50 Quarter 0.0025=$6.25 for nearest expiring month.

46. DECEMBER 3, 2008

47. INTEREST RATE FUTURES DECEMBER 3, 2008

48. LONG TERM INTEREST RATE FUTURES The CBT contract on US T-bonds and T-notes; LIFFE contract on UK guilts. DTB contract on German Bunds etc. The short must deliver a long term bond from among a set of eligible bonds -”Basket Delivery” The CBT contract on US T-bonds: Underlying is a notional T-bond with 15 years to maturity and 8% YTM. Exchange calculates a conversion factor for all eligible bonds.

49. LONG TERM INTEREST RATE FUTURES For US T-bond futures, price stated as % of face value with minimum 1/32% e.g. Price : 103-18 means 103 and (18/32) percent of $100000 Long pays: Settlement Price × Conversion factor + Accrued Interest Conversion Factor necessary because different bonds have different coupons and maturities. An eligible bond has CF of 1.5 - Each of these bonds equals 1.5 of notional bonds.

50. 30 Year U.S. Treasury Bonds Futures Contract Size One U.S. Treasury bond having a face value at maturity of $100,000 or multiple thereof. Deliverable Grades U.S. Treasury bonds that, if callable, are not callable for at least 15 years from the first day of the delivery month or, if not callable, have a maturity of at least 15 years from the first day of the delivery month. The invoice price equals the futures settlement price times a conversion factor plus accrued interest. The conversion factor is the price of the delivered bond ($1 par value) to yield 6 percent. Tick Size Minimum price fluctuations shall be in multiples of one-half of one thirty second point per 100 points ($15.625 per contract) except for intermonth spreads, for which minimum price fluctuations shall be in multiples of one-fourth of one thirty-second point per 100 points ($7.8125 per contract). Par shall be on the basis of 100 points. Contracts shall not be made on any other price basis. Price Quote Points ($1,000) and one-half of 1/32 of a point; i.e., 80-16 equals 80-16/32, 80-165 equals 80-16.5/32. Contract Months Mar, Jun, Sep, Dec Last Trading Day Seventh business day preceding the last business day of the delivery month. Trading in expiring contracts closes at noon, Chicago time, on the last trading day. Last Delivery Day Last business day of the delivery month. Trading Hours Open Auction: 7:20 am - 2:00 pm, Chicago time, Monday - Friday Electronic: 5:30 pm - 4:00 pm, Chicago time, Sunday - Friday Trading in expiring contracts closes at noon, Chicago time, on the last trading day

51. 30-YEAR T-BOND FUTURES QUOTES Thursday, 4 December ContractLastChangeOpenHighLowPrev. Stl. Dec '08132-310+0-245132-090132-310132-010132-065 Mar '09131-305+0-230130-315131-315130-150131-075 Jun '09)130-250+0-2300-000130-250130-020 Sep '09129-135+0-2300-000129-135128-225 Dec '09128-015+0-2300-000128-015127-105

52. Hedging a Commercial Paper Issue. In January a corporation finalises its plans to make an issue of $50 million 90-day commercial paper around mid May. Paper of comparable quality is now yielding 12.05%. At this yield the company hopes to realise $48,493,750. To protect itself against the possibility that rates may rise before its issue hits the market decides to hedge using EURO$ futures. June futures currently quoted at 88.75 What should it do?

53. SPECULATION WITH INTEREST RATE FUTURES Open Position Trading On September 1, December eurodollar futures on the IMM is trading at 89.25. A trader believes that short term interest rates are going to fall very soon. He buys a December contract at 89.25. On subsequent days, the prices and consequent losses/gains are : Day 1: 89.35 (+$250) Day 2: 89.32 (-$75) Day 3: 89.45 (+$325) Day 4: 89.47 (+$50) Day 5: 89.45 (-$50) Day 6: 89.50 (+$125) Liquidates position. Total gain: $625 minus brokerage commissions.

54. An Intra-Contract Spread Trade On February 25 the following prices are quoted for T-bill futures on the IMM : March : 96.02 June : 95.25 September : 94.50 December : 93.00 A trader feels that the yield curve is going to become flatter. He has no particular ideas about how interest rates as a whole are going to change but he is confident that long term rates will be lower relative to short-term rates than they are now.

55. Intra-Contract Spread Trade….. If his prediction comes true the spread between near and far contracts will narrow. To profit from this he must sell a near contract and buy a far contract. (”sell a spread"). He sells a September contract at 94.50 and buys a December contract at 93.00. By August 10, rates have fallen, yield curve is flatter: September: 95.50 December: 94.75 Close out. Buy September sell December. Net gain 75 ticks or USD 1875 minus brokerage. Better strategy: Sell T-bill futures buy T-bond futures.