Foreign Currency Futures Contract

Market Background

In 1972 the International Monetary Market (IMM), a division of the CME, was formed to offer futures contracts in foreign currencies: British pound, Canadian dollar, West German mark, Japanese yen, Mexican peso, and Swiss franc.

In 1973 Western economies allowed currency exchange rates to float free. Trading in foreign currency futures contracts became even more attractive.

Currency Future markets developed at Philadelphia (Philadelphia Board of Trade), London (London International Financial Futures Exchange (LIFFE)), Tokyo (Tokyo International Financial Futures Exchange), Sydney (Sydney Futures Exchange), and Singapore International Monetary Exchange (SIMEX).

Definition of Foreign Currency Futures Contract

  • Foreign Currency Futures Contract refers to standardized and easily transferable obligation between two parties to exchange currencies at a specified rate during a specified delivery month; standardized contract on specified underlying currencies, in multiples of standard amounts. Purchased and traded on a regulated exchange on which margins are posted.
  • Foreign Currency Futures Contract is a contract specifying a standard volume of a particular currency to be exchanged on a specific settlement date.

Features of Foreign Currency Futures

1. Trade on an organized exchange

2. Futures contracts are standardized with regard to the following

  • The asset on which you trade a futures contract
  • The contract size – Contract size is standardized in terms of currency amount.
  • Delivery arrangements

3. Expiration dates: typically 4/year (the 3rd Wednesday of March, June, September, or December). Traditionally, only the three nearest contracts are traded.

4. Trading stops two business days before the expiration date, and actual delivery takes place on the second business day after the expiration date.

5. Mark to Market on a daily basis

Futures contracts are revalued daily depending on the daily settlement price (ex-rate).  Every futures contract involves a buyer (long) and a seller (short).  Buyer (seller) will gain (lose) when the settlement price rises (falls).  Futures trading is a “zero-sum” game, every gain is exactly offset by a loss of the same amount.

Forward Contract versus Currency Futures Contract

Feature Forward Contracts Futures Contracts
Size of contract An informal arrangement between a forex dealer and a cutomer.The terms are highly flexible. Contract size is standardized in terms of currency amount.
Trading They are traded by telephone or telex. They are traded in a competitive arena (on the exchange floor) by ‘open outcry’ of bids, offers and amounts.
Regulation Self-regulating International Monetary Market(IMM) are regulated by the Commodity Futures Trading Commission (CFTC).
Maturity The contracting parties may choose any maturity desired but maturities are commonly in multiples of 30 days. The contracts are only for a limited number of dates (four dates, the 3rd Wednesday of March, June, September and December)
Final Settlement Over 90% of forward contracts are settled by delivery. Less than 1% of currency futures contracts are settled through delivery. Normally, they are settled through contract reversal.
Margins Margins are not required in the forward market. Margins are required of all participants in the futures market.
Default risk Since there is no daily settlement substantial loss occurs if a party defaults. For this reason, banks need high credit ratings in order to maintain strong positions as forward dealers. Daily settlement assures that the default risk is small in magnitude. All contracts are cleared by the exchange are guaranteed by the clearing house. Some default risk exists between brokers and their customers.
Price Quotes Prices are quoted in European terms except for British Pounds, & some commonwealth currencies. Prices are quoted in American terms.
Variety of currencies Forward contracts are available in all the currencies of developed countries & in some currencies of LDC’s. Offerings are limited to a small number of currencies.
Price fluctuations There is no daily limit. Daily limit is imposed by the exchange with a rule providing for expanded daily price limits.
Market Liquidity Offsetting with the other banks. Forward positions are not easily offset or transfer to other participants. There is public offset/ arbitrage offset. All positions whether long or short can be liquidated easily.

Components of Currency Futures Trade

1. Futures Players – These players are:-

  • Hedgers – Traders/ Parties wishing to manage their risks are called hedgers. Hedgers use futures to reduce price risk.
  • Speculators – Speculators are people who take positions in the market & want to assume risks to profit from exchange rate fluctuations. Speculators assume risk in the hope of making a profit.
  • Arbitrageurs – They are market participants who thrive on market imperfections & are in the business to take advantage of a discrepancy between prices in two different markets. They provide liquidity for the marketplace.

2. Clearing Houses – Every organized futures exchange has a clearing house that guarantees   performance to all of the participants in the market. Every trading party in the futures markets has obligations only to the clearing house. Futures exchanges like CME act as third party “clearinghouses” to facilitate futures trading. The Clearing Members guarantee the trades monitor and maintain the margin accounts, and individual traders are protected from default.

It is an independent corporation and its stockholders are its member clearing firms. All futures traders maintain an account with member clearing firms either directly or through a brokerage firm.

3. Margin Requirements – Each trader is required to post a margin to insure the clearing house against credit risk. Upon completion of the futures contract, the margin is returned. When one opens a futures contract, one is required pay a fee to the broker and to post a margin. The margin is posted to ensure that deals are honored. When the equity position falls, then this margin must be supplemented by additional cash to bring it up to the maintenance level.

Example of margin and maintenance level: Suppose the margin on a futures contract on the £ is $3000 and the maintenance level is $2500. Then as long as the the decline in the futures position is less than $500 you need not take any action, but once the futures position declines by more than $500 you need to post additional margin equal to the full decline in value in the futures position.

4. Transaction Costs – The costs incurred are-

  • Floor trading & clearing fees – These are small fees charged by the exchange & its associated clearing house.
  • Commissions – A commission broker charges a commission fees to transact a public order.
  • Delivery Costs – Those are incurred in case of actual delivery.

NB:

In futures contracts, only 1% of contracts are settled with the underlying asset, 99% are “settled with cash” by a “reversing trade.” Because of daily settlement, the contract is actually settled in cash continually throughout the contract.  Like buying insurance, you get a cash settlement from your auto insurance company, not a new car or body work.  Futures contracts are like “side bets.”  90% of forward contracts involve an exchange of currency, the person who is short (seller) actually delivers FX to the long (buyer).

Reversing Trade involves taking an offsetting position, which closes out, neutralizes, your futures position, and you exit the market.  If you are long (buy), you take a short (sell) position to close out – you are then selling to yourself, neutralizes your contract.

Execution of Futures Trade

  1. Trading is done on trading floor.
  2. A party buying or selling future contracts makes an initial deposit of margin amount.
  3. If the rate moves in its favour, it makes a gain. This amount (gain) can be immediately withdrawn or left in the account.
  4. However, in case the closing rate has moved against the party, margin call is made and the amount of ‘loss’ is debited to its account.
  5. As soon as the margin account falls below the maintenance margin, the trading party has to make up the gap so as to bring the margin account again to the original level.

Source: Docstoc.com

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