Currency Futures

Introduction and Example

 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.
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 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.

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 Currency Futures
• A derivative instrument.
• Very low cost on each contract
• 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.
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 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.

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 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 below6 the
maintenance margin.
 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 call7 is

required yet
 Difference B/w Future and Forward
Contracts
• Forward contracts are traded in a close • Future contracts are traded in a
environment competitive arena
• Forward market is self regulating • Money market or the market in which
future trades regulate the contracts

• Forward contract are normally settled • Normally Future contracts not settled by
with physical delivery of assets physical delivery of assets
• Forward contracts are individually • Future contracts are standardized in
tailored to the demand of respective terms of currency amount
party
• Banks offer forward contracts for • Future contracts are available for
delivery on any date delivery on only a few specified dates
e.g. quarterly in a year
• Costs of forward contracts are based on • Future contracts entail brokerage fees
bid-ask spread for buy and sell order
• Margins are not required in the forward • Margins are required of all participants
market in the future market

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 Future Trading

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
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 125,000.
2. 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 $0.755.
3. At Wednesday close, the price has declined to $0.743.
4. 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
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the prevailing price of $0.74.
 Hedging
• What Does Hedge Mean?
Making an investment to reduce the risk of
adverse price movements in an asset.

• 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.
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 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, by going long or
short using future contract.
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 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
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future. 
 Long Hedge Example
• For example, assume it is January and a British alloy
manufacturer needs 25,000 Kg ($1.5/kg-deal) of
copper from America to manufacture alloy 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 in the May

future expected exchange rate will be $1.4/£.

• In January the alloy manufacturer would take a long

position for 1st May futures contract on $. This locks
the price at $1.5/£ that the manufacturer will pay £ and
will get $. This will save him from currency exposure
and loss of $0.1/Kg. 13
 Example 1
• 1st Jan company X: (British co) has to pay $2000 on 30th Jan 2009.
• 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 1st Jan)
• £0.90/$1 x $2000 =£1800 (if not our company will have to pay £1800 to settle the
transaction according to forward rate 30th Jan)
• In short there is a fear of loss of - £200 (£1600 - £1800) on settlement date
• Company wants to hedge this expected loss
• Our asset (£-home currency) is getting devalue against foreign asset ($).
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 30th Jan future contract at £0.80/$1. At
maturity the exchange rate 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 exchange rate
which assumed to be £0.90/$1 i.e.
• $2000 x £0.90/$1 = £1800
• Therefore the company has hedged the expected loss of £200 (£1800 - £1600) on
settlement date
• Therefore company hedged the above mentioned loss perfectly through
future contract
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 Example 2
• 1st Jan company X (British co) has to pay $2000 on 30th Jan 2009.
• 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 1st 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 made a profit of £200 (£1800 - £1600) on settlement date 30th Jan
• If, the adverse happens to our speculation means the £ (home currency – our asset)
gets appreciated against $ (foreign currency)
• 1st Jan rate was £0.80/$1, whereas after month 30th 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 1st 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 (£1400 - £1600) on settlement date 30th 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 (£1600 - £1400) on settlement date
• Therefore the long position of the company has offset by the short position
• This what we call a perfect hedge.
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 Arbitrage between future and
forward contract
• Suppose the inter-bank forward rate for June
18th on pounds sterling is $1.2927, at the same
time price of IMM sterling futures for delivery on
June 18th is $1.2915. 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

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 Arbitrage between future and
forward contract
• Take long position for June 18 pound contract
– $1.2915/£1 x £62,500 = $80,718.75
• You will pay $80,718.75 and get £62,500 in return
• Sell £62,500 at forward rate of $1.2927/£1
– $1.2927/£1 x £62,500 = $80,793.75
• $80,793.75 - $80,718.75 = $75 (benefit)

• Therefore as we have seen above arbitrage play an

important role. Therefore inter-bank forward rates are
translated in future rates by realising profit opportunities,
so that to keep futures rates in line with bank forward
rates
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 Sample question
• 1st Jan Royal Company (British co) has to pay $9000 on
15th Jan 2009.
• Spot currency price is $1.25/£, whereas your speculation
about forward rate for 15th Jan would be $1.1111/£1
– Do the company needs to hedge its exposure if yes; produce the
necessary calculations to hedge the loss perfectly.

• Now what if, the adverse happens to your speculation

once after taking a position based on prior speculation
i.e. the forward rate for 15th Jan rate is now expected to
be $1.4285/£1
– What will be your strategy to offset the initial position perfectly,
produce calculation with supporting statements

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 Sample question

1. Tuesday morning, an investor takes a long position for a 4

GBP futures contracts that matures on Thursday afternoon.
The agreed-on price is $1.25/£.
2. Tuesday evening, the futures price has risen to $1.35/£.
3. At Wednesday close, the price has declined to $1.3/£
4. At Thursday close, the price drops to $1.4/£, and the
contract matures.
5. What would be profit and loss position for the investor using
mark to the market method. 19