The Currency Futures Market The Futures Market is nothing but an organized forward market for selected currencies.

The Futures Market exists only for 8 currencies including the following: The Aussie$, BP Sterling, Euro, Canadian$, JYen, and SF. All are in American Terms. The Chinese Yuan, however, is calculated via cross-rates of exchange against the Dollar, Euro, and Yen. Exchanges may add/delete currencies depending on demand. A few fixed trading locations exist for these currencies IMM (International Monetary Market, Chicago) Part of the Chicago Mercantile Exchange LIFFE (London International Financial Futures Exchange, London, UK; not London, Ontario) MATIF (France) SIMEX (Singapore) (Only the first two are the major futures markets for currencies) Only limited maturities are available - the second business day before the third Wednesday of January, March, April, June, July, September, October and December Contracts can only be bought in fixed 'lot sizes' British Pound: 1 contract = 62,500 pounds Japanese Yen: 1 contract = 125,000 Yen.

Mexican Peso: 1 contract= 500,000 new Mexican Pesos. Unlike a forward market, prices quoted are market prices, and do not include the transaction cost. American terms are used i.e. $/1.00 Foreign Currency. Unlike a forward market, prices on futures contracts change daily till maturity Futures contracts can be bought on margin (approximately 3-4 % of the value of the contract) Two Types of Margin Requirements: Initial margin } All depend on the currency Maintenance margin } For example, Initial margin on BPounds is $ 2,000 per contract; Maintenance margin is $ 1,500 per contract (that is, when the contract is bought, the buyer must make a 'down payment' of $ 2,000. If the value of the contract goes down such that the margin account dips below $ 1,500 (say $ 1,200) on any day before maturity, then buyer must deposit and additional $ 300 to bring the margin up-to $ 1,500. Otherwise, the Exchange will come after you.

The Exchange (IMM or LIFFE) charges a $15/Contract/Round Trip, Fixed Fee. This is not

refundable. (Remember that the quoted prices are market prices) Round Trip: A buy and a sell of the contract = 1 -Round Trip The Exchange enters into such contracts both with the buyer and the seller. The exchange guarantees both sides of the contract Contracts can be liquidated before maturity ONLY BY BUYING AN OPPOSITE CONTRACT For example, if you bought one contract on February 1, 2010 to buy 62,500 BPs (maturity date: 2 business days prior to the 3rd Wednesday in March, 2010), up front, you need to pay: $ 2,700 (Initial Margin) $ 15, (IMM Exchange fee; nonrefundable), Round Trip Suppose you want to liquidate your BUY Pound Sterling contract on February 10, 2010. You will buy an OPPOSING Contract to SELL 62,500 BP with the maturity date same as your buy contract. This opposing contract will be bought at the MARKET price ON FEBRUARY 10, 2010. You do not have to pay exchange fees again for this transaction. By doing so, you have 'liquidated' your position.

The Futures market has a daily mark to market feature See Example below The Futures Market is most often used by currency speculators..mostly large institutional investing and money management firms such as hedge funds. Example of how the Futures Market works (illustrating the daily settlement feature called mark to the market. Suppose an investor buys 1 SF contract today (February 15) to buy SF 2 business days before the third Wednesday in March, 2010. (From the IMM, Chicago) The investor has agreed (after signing the contract) to buy 125,000 SF during the third week in March Day 0 (today). She pays $ 15 to the exchange (non-refundable) She pays the initial margin $ 4,050 Maintenance margin $3,000 The price fixed: $ 0.75/SF The value of the contract = $ 93, 750 What happens on day 1? Suppose the futures price of SF (for March delivery) rises to $ 0.755/SF. Is this good news for the buyer? Yes! The exchange tears up the old contract for $ 0.75/SF The exchange gives the investor a new contract for $

0.755/SF The exchange credits the margin account of the investor with the daily profits: Profit: = 125,000 * (0.755 - 0.75) = $ 625. At this point, the investor can buy an opposing contract at 0.755/SF (no exchange fees to be paid, since this is the counterpart of the round trip transaction), take her profit of $ 625, and go to Las Vegas! No one will come after her! Is this legalized gambling or what? But what if the investor decides to stay? (She does not buy the opposing contract) Day 2 Suppose the new SF price for March delivery is 0.70/SF The investor has lost!. How much? (0.70 - 0.755)* 125,000 = -$ 6,875 (wow) How much will be there in her margin account? She has: $ 4,050 + 625 - 6,875 = - 2,200. The maintenance margin required by the exchange is +$3,000. Hence the investor will be asked to deposit $ 5,200 if she wants to continue to maintain her position

If she decides to stay, she will be issued a new contract to buy 125,000 SF at 0.70/SF. This is how the daily mark to market (or daily settlements feature) works. This process will continue till 2 days before the third Wednesday in March. If she still has not closed out her position, then on the third Wednesday in March, she must take physical delivery of SF. 1. The Futures Market- how it can function as a forward market. How can the futures market function as a forward market ? Suppose you bought 1 SF Futures Contract to BUY SFs today, February 22, 2010, (Maturity Date = 2 business days before the third Wednesday in March 2010; This date is Monday, March 18, 2010). Price = $ 0.75/SF; February 22, 2010: You pay: $ 4,050 (Initial Margin) $ 15 (Exchange Fee) You have purchased: 1 SF Contract (= 125,000 SF) to BUY SF at Maturity February 23, 2010 New Price for SF : 0.80/SF Have you made money? Yes! Profit: (0.80 - 0.75) * 125,000 = $6,250 You can take this profit and get out of the futures contract if you

BUY an OPPOSING CONTRACT to SELL 125,000 at Maturity (March 18,2010). No exchange fee is due here (already paid) However, you want to maintain your contract to BUY SF at Maturity (i.e., you want to use the futures contract as a forward contract) you receive the $ 6,250 in your margin account and now you receive a new contract to BUY SF at maturity at $ 0.80/SF (the new price) The total amount in your margin account = $ 4,050 + $ 6,250 = $ 10,300 Note that despite the new price of $ 0.80/SF, you will still pay only $ 0.75/SF for each SF. The extra $ 6,250 in your margin account can be used to pay the extra 5 cents required (0.80 0.75) for each SF February 23, 2010 New Price = 0.55/SF She has lost! How much? -$25,000 How much will this leave her in the margin account? $ 10,300 - 25,000 = -$ 14,700. Maintenance margin required is $ 3,000. Hence the exchange will ask her to put 17,700 more in her margin account. Hence she has put in a total of $ 4,050 + 17,700 = $ 21,750 so far. The exchange also gives her a new contract to BUY SF at $

0.55/SF This process takes place daily till 2 days prior to maturity (March 18, 2010) Lets say that the next change in price is to $0.60/SF, on Feb 25, and lets assume that the price for March delivery of SF will remain at 0.60/SF from February 23 till March 18, 2010. What happens on March 18, 2010 ? (This is two days before maturity) Under the assumption that the Price of SF futures remains at 0.60/SF from February 25, 2010 till March 18,2010, the following set of events will take place at maturity: The exchange will give the investor 125,000 SFs (Deliver SFs) The investor will pay 0.60 * 125,000 - $ 3,000 (in her margin account) = $ 72,000 to the exchange The actual delivery will take place on Wednesday, March 20, 2010 (2 business days later) since the exchange has to tally up all of the BUY and SELL SF Futures Contracts, and it takes two days to do this. Effectively, how much has the investor paid for the 125,000 SF? She has paid in total: $ 21, 750 (the money needed to maintain her margin account)

+ $ 72,000 = $ 93,750. Hence, how much did she pay per SF? $ 93,750/125,000 = $ 0.75/SF. This was (if you recall) the original price she paid for the SF Futures (on February 22, 2010). Hence, no matter what happens to the price between the time the investor buys the SF Futures and the Maturity Date, if she stays in the contract and collects delivery of the SF Futures, she will pay the original price she paid for it (in this case, $ 0.75/SF). Thus, the Futures market can be used as a Forward market. 2. Cross Rates Suppose you call up a broker in the US and ask him the spot rates for the SF and DM. He says: 0.65/SF; and 0.40/DM. Ignore bid - ask spreads here. Can you find out the rate between SF and DM from these? 0.65 $ = 1 SF; 1$ = 1.5385 SF; 0.40 $ = 1 DM; 1$ = 2.5 DM; Hence, 1.5385 SF = 2.5 DM;, or 1SF = 1.6250 DM This is the cross rate between SF and DM. This rate is obtained through an intermediary currency, namely the US $. Note that you can also obtain a direct rate between SF and DM