Currency Futures Introduction and Example

2 Financial instruments Future contracts: –Contract agreement providing for the future exchange of a particular asset at a currently determined price. A contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a pre-determined price in the future. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while mostly others are settled in cash. –Long position: A commitment to purchase (buy) the asset on the delivery date. –Short position: A commitment to deliver (sell) the asset at contract maturity date.

3 Future contracts The cash is not required until the delivery or settlement date. “good faith deposit” called the initial margin, is required to reduce the chance of default by either party.

4 Currency Futures A derivative instrument. Very low cost on each contract Traded on centralized exchanges (illustrated in Figure 1 later). Highly standardized contracts (£62,500, SFr 125,000). Clearinghouse perform as counter-party. High leverage instrument (margin requirement is on average less than 2% of the value of the future contract). The leverage assures that investors fortunes will be decided by tiny swings in exchange rates.

5 Currency Futures Initial Margin: The customer must put up funds to guarantee the fulfillment of the contract. Or That part of a transaction’s value a customer must pay to initiate the transaction, with the remainder borrowed. Maintenance Margin: The minimum amount the margin account can fall to. Or The percentage of a security’s value that must be on hand all times as equity. Mark-to-the-market: A daily settlement procedure that marks profits or losses incurred on the futures to the customer’s margin account.

6 Margin Account Margin: –The investor’s equity in a transaction, with the remainder borrowed from a brokerage firm. Initial margin: –That part of a transaction’s value a customer must pay to initiate the transaction, with the remainder borrowed. Maintenance margin: –The percentage of a security’s value that must be on hand all times as equity. Margin call: –A demand from the broker for the additional cash or securities as a result of the actual margin declining below the maintenance margin.

7 Example If the maintenance margin is 30% and initial margin requirement is 50% on a transaction $10,000 (100 shares at $100/share), the customer must pay up $5000, borrowing $5000 from the broker to purchase security. Assume that after purchase transaction the price of the stock declines to $90. what would be the actual margin now? And does it require margin call? Actual margin = market value of securities – amount borrowed market value of securities 44.44% = ($9,000 - $5000)/$9,000 the actual margin is b/w 30% to 50% therefore no margin call is required yet

8 Example Using the data, for 100 shares, $5000 borrowed, and a maintenance margin of 30%, a margin call will be issued when the price gets below: MC price = $ ( ) = $71.43

9 Difference B/w Future and Forward Contracts Forward contracts are traded in a close environment Forward market is self regulating Forward contract are normally settled with physical delivery or assets Forward contracts are individually tailored to the demand of respective party Banks offer forward contracts for delivery on any date Costs of forward contracts are based on bid-ask spread Margins are not required in the forward market Future contracts are traded in a competitive arena Money market or the market in which future trades regulate the contracts Normally Future contracts not settled by physical delivery of assets Future contracts are standardized in terms of currency amount Future contracts are available for delivery on only a few specified dates e.g. a year Future contracts entail brokerage fees for buy and sell order Margins are required of all participants in the future market

10 Future Trading 1.Tuesday morning, an investor takes a long position (commitment to purchase SFr against $) in a Swiss franc futures contract that matures on Thursday afternoon. The agreed-on price is $0.75 for SFr 125, To begin, the investor must deposit into his account a performance bond of $1,452. At the close of trading on Tuesday, the futures price has risen to $ At Wednesday close, the price has declined to $ At Thursday close, the price drops to $0.74, and the contract matures. The investor pays his $375 loss to the other side and takes delivery of the Swiss francs, paying the prevailing price of $0.74. Tuesday end margin call required = $1452+$625=$2077 (No) Wednesday end margin call required = $2077-$1500=$577 (Yes). Margin call of $875 is required to have the initial margin of $1452. Thursday end margin call required $1452-$375=$1077 (No) because the maintenance margin is $1075

11 Future Hedging Futures can be used either to hedge or to speculate on the price movement of the underlying asset (currency). For example, a producer of corn could use futures to lock in a certain price and reduce risk (hedge). On the other hand, anybody could speculate on the price movement of corn currency by going long or short using futures.

12 Hedging What Does Hedge Mean? Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations. Investors use this strategy when they are unsure of what the market will do.

13 Long Hedge and Short Hedge A situation where an investor has to take a long position in futures contracts in order to hedge against future price volatility is: A long hedge is beneficial for a company that knows it has to purchase an asset in the future and wants to lock in the purchase price. A long hedge can also be used to hedge against a short position (The sale of a borrowed security, commodity or currency with the expectation that the asset will fall in value) that has already been taken by the investor. Short hedging is often seen in the agriculture business, as producers are often willing to pay a small premium to lock in a preferred rate of sale in the future.

14 Long Hedge Example For example, assume it is January and an aluminium manufacturer needs 25,000 Kg ($1.5 per kg - spot rate) of copper from America to manufacture aluminium and fulfil a contract in May. The manufacturer has to pay the money in $ to his counter part. The current spot price is $1.50/£1, but the May futures price is $1.4/£1. In January the aluminium manufacturer would take a long position in 1 May futures contract on copper. This locks in the price the manufacturer will pay and save himself from currency exposure. If not hedge then in May the spot price of copper is $1.45 per pound the manufacturer has benefited from taking the long position, because the hedger is actually paying $0.05/kg of copper compared to the current market price. However if the price of copper was anywhere below $1.40 per kg the manufacturer would be in a worse position than where they would have been if they did not enter into the futures contract.

15 Example 1 1 st Jan company X: (British co) has to pay $2000 on 30 th Jan Spot currency price is £0.80/$1, whereas forward rate for one month now will (speculating) be £0.90/$1 £0.80/$1 x $2000 =£1600 (our company has to pay £1600 to settle the transaction according to spot rate 1 st Jan) £0.90/$1 x $2000 =£1800 (if not our company will have to pay £1800 to settle the transaction according to forward rate 30 th Jan) In short there is a fear of loss of - £200 (£ £1800) on settlement date Company wants to hedge this loss Our asset (£-home currency) is getting devalue against foreign asset ($). Therefore the recommendations are to take a long position for $2000 (commitment to purchase $) or short position for £1600 (commitment to sell £). Therefore company X purchases 30 th Jan future contract at £0.80/$1. At maturity the price is £0.90/$1 as we have speculated. £1600/£0.80/$1= $2000 (the company will have $2000 against £1600) Company x will immediately convert these $2000 into £’s at 30 th Jan spot rate which assumed to be £0.90/$1 i.e. $2000 x £0.90/$1 = £1800 Therefore the company will make the profit of £200 (£ £1600) on settlement date Therefore company hedged the above mentioned loss perfectly through future contract

16 Example 2 1 st Jan company X (British co) has to pay $2000 on 30 th Jan Spot currency price is £0.80/$1, whereas forward speculating rate for one month now will be £0.90/$1 Our asset (£-home currency) is getting devalue against foreign asset ($). Therefore the recommendations are to take a long position for $2000 (commitment to purchase $) £0.80/$1 x $2000 =£1600 (our company has to pay £1600 to settle the transaction according to the rate decided £0.80/$1 at 1 st Jan) – Actual settlement £0.90/$1 x $2000 =£1800 (Forward rate at maturity - if future contract were not have been taken our company has to pay £1800 to settle the transaction according to 30 th Jan rate) In short we have made a profit of £200 (£ £1600) on settlement date 30 th Jan At the same time company X also takes a short position for $’s (means commitment to sell $). Therefore to sell $’s against £’a Company X need to have $2000 in advance for the settlement on 30 th Jan. company will buy $2000 at the rate £0.80/£1 and will retain it till maturity date. $2000 x £0.80/$1= £1600 (the company will have £1600 against $2000) -Actual $2000 x £0.90/$1 = £1800 (Whereas in market the price of these $2000 is £1800) Therefore the company will have the made the loss of - £200 (£ £1800) on settlement date Therefore the long position of the company has offset by short position Now what if, the adverse happens to our speculation means the £ (home currency – our asset) gets appreciated against $ (foreign currency)

17 Example 2 ………….. If, the adverse happens to our speculation means the £ (home currency – our asset) gets appreciated against $ (foreign currency) 1 st Jan rate was £0.80/$1, whereas after month 30 th Jan rate is £0.70/$1 £0.80/$1 x $2000 =£1600 (our company has to pay £1600 to settle the transaction according to the rate decided £0.80/$1 at 1 st Jan) – Actual settlement £0.70/$1 x $2000 =£1400 (Forward rate at maturity - if future contract were not have been taken our company would have paid £1400 to settle the transaction according to 30 th Jan rate) In short we would have made the loss of -£200 (£ £1600) on settlement date 30 th Jan At the same time company X also has taken a short position for $’s (means commitment to sell $). Therefore $2000 x £0.80/$1 = £1600 (the company will have £1600 against $2000) -Actual $2000 x £0.70/$1 = £1400 (Whereas in market the price of these $2000 is £1400) Therefore the company have made the profit of £200 (£ £1400) on settlement date Therefore the long position of the company has offset by the short position This what we call a perfect hedge.

18 Arbitrage between future and forward contract Suppose the inter-bank forward bid for June 18 on pounds sterling is $ at the same time price of IMM sterling futures for delivery on June 18 is $ one contract is of £62,500. How could the dealer use arbitrage to profit from the situation? First take a long position for £ contract Then sell the £ on forward rate You will have the benefit of $75 Try yourself

19 Arbitrage between future and forward contract Take long position for June 18 pound contract –$1.2915/£1 x £62,500 = $80, You will pay $80, and get £62,500 in return Sell £62,500 at forward rate of $1.2927/£1 –$1.2927/£1 x £62,500 = $80, $80, $80, = $75 (benefit) Therefore as we have seen above arbitrage play an important role. Therefore future rates are translated into inter-bank forward rates by realising profit opportunities, so that to keep futures rates in line with bank forward rates