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7.ForeignCurrencyFutures.pptx

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Foreign Currency Futures

International Finance

Learning Objectives

Introduce two categories of derivatives: foreign currency futures and foreign currency options

Illustrate how foreign currency futures differ from forward contracts

Describe the exchanges on which futures trade and their contract specifications

Learn to use foreign currency futures for:

Speculation

Hedging

Foreign Currency Derivatives

These derivatives, so named because their values are derived from the underlying asset, are a powerful tool used for two distinct objectives:

Speculation – the financial manager takes a position in the expectation of profit

Hedging – the financial manager uses the instruments to reduce the risks of the corporation’s cash flow

Financial management in the 21st century needs to consider the use of financial derivatives

The financial manager must first understand the basics of the market structure and pricing of these tools

In the wrong hands, derivatives can cause a corporation to collapse (Barings, Allied Irish Bank), but used wisely they allow a financial manager the ability to plan cash flows

Foreign Currency Futures

A foreign currency futures contract is an alternative to a forward contract

It calls for future delivery of a standard amount of foreign exchange at a fixed time, place and price (but, actually, the physical delivery is rare—see below)

Currency futures are similar to futures contracts that exist for commodities such as cattle, lumber, interest-bearing deposits, gold, etc.

Futures trade on exchanges; whereas, forwards are over-the-counter instruments offered by banks

Globally, as of March 2017, currency futures have notional principal outstanding of US$ 240 B and average daily trading volume of US$ 121 B

http://www.bis.org/statistics/r_qa1409_hanx23a.pdf

http://www.bis.org/statistics/r_qa1409_hanx23b.pdf

http://www.bis.org/statistics/extderiv.htm

Some major foreign exchange futures exchanges are:

Chicago Mercantile Exchange (CME)

Chicago Mercantile Exchange (CME) is the largest futures exchange in the United States and the second largest in the world after Eurex for the trading of futures contracts and options on futures

London International Financial Futures and Options Exchange (LIFFE), now part of part of NYSE Euronext

Singapore International Monetary Exchange (SIMEX)

NASDAQ OMX PHLX (PHLX)

Formerly known as the Philadelphia Stock Exchange (PHLX)

NASDAQ OMX Futures Exchange (NFX)

Formerly known as the Philadelphia Board of Trade (PBOT))

ICE Futures US (a wholly owned subsidiary of the Intercontinental Exchange (ICE))

Formerly known as the New York Board of Trade (renamed in September of 2007)

US Dollar Index Futures trade here

https://www.theice.com/publicdocs/ICE_USDX_Brochure.pdf

www.theice.com/publicdocs/futures_ us /ICE_ Dollar _ Index _FAQ.pdf

Trading & Settlement

In the US, the most important market for foreign currency futures is the International Monetary Market (IMM), a division of the Chicago Mercantile Exchange

Traditionally trades were in open outcry trading. Traders stand in a trading pit and call out prices and quantities that indicate their willingness to buy or sell

They use hand signals to convey the same information since it can be difficult to hear if everyone is shouting at once

Open outcry is an efficient means of "price discovery," allowing buyers and sellers to arrive at the best prices given the supply and demand for a given futures (or options on futures) contract

Its speed and efficiency have been further enhanced by the introduction of a variety of trading floor technologies

In June 1992, CME® Globex® was launched, CME's global electronic trading platform for the trading of futures and options on futures products

CME Globex is available nearly 23 hours a day, five+ days a week

The CME open outcry platform and trading floor systems are linked to the CME® Globex® electronic trading platform

The CME announced February 4, 2015, that it will close most of its futures trading pits by July 2

Note: One area that has seen consistent levels of floor trading is options. Many traders say the nature of options trading has yet to transition properly to the screen. Witter says that many options trades rely on contract combinations that are often times complex

Euronext.LIFFE is the international derivatives business of Euronext

Euronext resulted from the merger of the Amsterdam, Brussels, Lisbon, London and Paris exchanges

Euronext then acquired LIFFE in 2001 (the NYSE acquired Euronext in 2006 and ICE acquired the NYSE in 2013)

LIFFE stands for the London International Financial Futures Exchange (Options Exchange was then added to the name)

LIFFE CONNECT® is the world’s most advanced electronic trading platform, with considerable speed of execution and flexibility, according to LIFFE

It was designed and developed by the London International Financial Futures and Options Exchange (LIFFE) to replace its open outcry trading floor

Following the success of initial product migrations, LIFFE became a fully electronic exchange in 2000, with its entire product range traded on LIFFE CONNECT®

A clearing house is the counterparty to futures

All contracts are agreements between the client trader and the exchange clearing house (all clearing members also contribute to a pool called the guarantee fund, which can be accessed in case of default)

Consequently clients need not worry about the performance of a specific counterparty

Settlement – only 5% of futures contracts are settled by physical delivery, most often buyers and sellers offset their position prior to delivery date

The complete buy/sell or sell/buy is termed a round turn

Moreover, some contracts are only “cash-settled.” Examples: Two cash-settled contracts are the Brazilian real and the Russian ruble

Commissions – customers pay a commission to their broker to execute a round turn and only a single price is quoted

Trade futures for as low $1.95 per side flat.

Contract Specifications

Size of contract – called the notional principal, trading in each currency must be done in an even multiple of size

Maturity date

Most currency contracts at the CME are traded on the March quarterly cycle and (would) go through a physical delivery process four times a year on the third Wednesday of March, June, September and December

Exceptions: The Mexican peso and the South African rand are traded on all 12 calendar months

Method of stating exchange rates – Traditionally, American terms are used to express exchange rates for futures trading on US exchanges. For an American trader, these are also known as direct quotes

Note: the CME also trades other currency pairs such as EUR/AUD, EUR/GBP, EUR/CAD, GBP/JPY, GBP/CHF, CZK/EUR, HUF/EUR, which clearly cannot be in American terms

Collateral, initial & maintenance margins

At contract initiation, the trader must deposit an initial margin or collateral; this requirement is similar to a performance bond

At the end of each trading day, the account is marked to market such that the balance in the margin account is:

Credited if value of the contracts increases

Debited if value of contracts decreases

If the margin account falls below a maintenance margin threshold, funds must be contributed to the account to bring it back to its initial margin

Margin is another reason clients need not worry about the performance of a specific counterparty

Last trading day – contracts may be traded through the second business day prior to maturity date

Foreign Currency Futures Versus Forward Contracts

or electronic trading platform

Relative preferences of financial managers and speculators

Some Contracts & Specifications

Contract	Exchange	Delivery Months	Contract Size	Price Quoted In	”Tick Size”	Initial Margin	Maint Margin
Australian Dollar	CME		100,000 AUD	$/AUD	.01¢ = $10	$2,035	$1,850
British Pound	CME		62,500 GBP	$/£	.01¢ = $6.25	1,650	1,500
Canadian Dollar	CME		100,000 CND	$/CND	.01¢ = $10	1,265	1,150
Euro	CME		125,000 Euros	$/Euro	.01¢ = $12.50	2,475	2,250
Japanese Yen	CME		12,500,000 JPY	¢/JPY	.0001¢ =$12.50	3,465	3,150
Swiss Franc	CME		125,000 SF	$/SF	.01¢ = $12.50	2,530	2,300
US Dollar Index (USDX)	ICE		1,000 x USD Index	100ths/pt	.005 = $5	1,650	1,500

March

June

September

December

Notes: Margins are subject to change without notice (Update: March 31, 2014). CME also trades E-micro contracts of smaller size

http://www.cmegroup.com/trading/fx/g10/australian-dollar_performance_bonds.html#sortField=exchange&sortAsc=true&sector=FX&exchange=CME

Using Futures

Futures speak:

Long = Buy

Short = Sell

How are positions in futures contracts settled?

Rarely, physical delivery is made at a specified location

Far, far more commonly, an offsetting position in the same contract is taken

To close a long position, take a new short position

To close a short position, take a new long position!

Example: Consider a position in a Gold future (contract size: 100 oz)

June 5

F0 = $1,400 = futures price per ounce of September gold

You long 200 oz. (= 2 contracts) of September gold

July 29

F1 = $1,380 = futures price per ounce of September gold

You close out by shorting 200 oz. of September gold

Payoff = 2(100) (1,380 – 1,400) = –$4000

Combined effect of a long followed by a short position where Ft is the futures price at time t:

Position	Initial Futures Price	Payoff at Time t
Long 2 Contracts	$1,400/oz	2(100)(Ft−1,400)

Short 2 Contracts	$1,380/oz	2(100)(1,380−Ft)

		2(100)(1,380−1,400) = −$4,000

Long position value: 2(100)(Ft−1,400)

Short position value: 2(100)(1,380−Ft)

If the margin cannot be maintained due to insufficient funds, the broker will close out the position on behalf of the customer and return any remaining monies back to the client

In general, payoffs if contract is closed out before expiration are:

Payoff to closing out an original long position:

Payoff to closing out an original short position:

In general, Ft is the price of a futures as of any time t. In these formulas:

F0 is the futures price at t=0, the time the initial position is entered into

Ft is the futures price at time t in the future

Convergence property

As the expiration date closes, the futures price and spot price must converge:

Where St is the spot price at any time t and ST is the spot price at t=T, contract maturity

Similarly, FT is the futures price at t=T, contract maturity

Discussion: can you provide an explanation of the convergence property?

Ft  St as t T

At expiration: FT = ST

Payoffs if positions are held until expiration—there are two possibilities:

No offsetting transaction and physical delivery is made with spot value ST, or

A closing transaction is made right at maturity*

The “formulas” are the same however:

Remember, ST=FT at contract maturity T by the convergence property!

Initial Long: (ST – F0) x Contract Size

Initial Short: (F0 – ST) x Contract Size

* As the last trading day usually precedes the maturity date, this would typically not be possible in practice

Marking to Market

Example: Long One Euro Future Contract

-0.0006$/ € x 125,000€

A margin call for $712.50 to bring the margin call back up to its initial margin

-0.0011$/ € x 125,000€

+0.0032$/ € x 125,000€

Hedging with Currency Futures

Example: Carnival Cruise Line offers Alaskan Inner Passage Cruises in the summer. Suppose Carnival contracts the use of a pier with the Vancouver Port Authority in Canadian dollars at a rate of CAD1,000,000 for the summer due in June. Passengers pay Carnival in USD and the dollar is Carnival’s currency of operation

Currently, the expected June spot exchange rate is 0.80 USD per CAD implying an obligation of 1M x 0.80 = USD 800,000

What happens if the USD depreciates relative to CAD such that next summer the exchange rate becomes 0.90 USD per CAD? The cost rises to 1M x 0.90 = USD 900,000

Relative to the line’s revenues in USD, its costs for docking have risen and its profits have fallen!

To reduce exposure to changes in the exchange rate, Carnival may take an offsetting financial position—a hedge

When a firm is hedged using a future relative to an exchange rate, its net financial position—core business activity plus hedge—is invariant to changes in the value of the currency

Recognizing the contract size on the Canadian dollar is CAD100,000, Carnival Cruise Line could long 10 Canadian dollar June futures contracts and lock in an exchange rate

Suppose the futures price for the June contract now is F = 0.80 USD per CAD

Carnival can now lock in a docking cost of 0.80 x 1M = USD 800,000 and avoid the risk of a fluctuating exchange rate!

June Spot Exchange USD per CAD	Cost of Pier (USD)	Gain/Loss on Future (USD)	Net Cost (USD)
0.70	–700,000	–US$ 100,000	–US$ 800,000
0.80	–800,000	US$ 0	–US$ 800,000
0.90	–900,000	+ US$ 100,000	–US$ 800,000

(0.90USD/CAD - 0.80USD/CAD) x CAD100,000 x 10

Regardless of the spot exchange rate next June, Carnival will be obligated to pay only US$ 800,000, NET

(0.70USD/CAD - 0.80USD/CAD) x CAD100,000 x 10

Problems with Futures Hedges

Standardized contract sizes

If the contract size does not perfectly match the need for FX, the hedge will be off and some exchange rate risk will remain

Relatively low number of delivery dates implies “basis risk”—suppose Carnival needed to make payment in May not June!

If the maturity of the futures contract does not perfectly match the transaction date, the hedge will be off by the difference between the then-prevailing spot price and the futures price—convergence will be imperfect

Speculating with Currency Futures

Example: Vicky believes that Mexican peso will fall in value against the US dollar before next March and looks at quotes and contract specs for Mexican peso futures on the CME (today is October 9, 2014)

Contract Size: 500,000 MXN

“Tick Size”: USD 0.00001 per MXN

Contract Months: Thirteen consecutive calendar months plus 2 deferred March quarterly cycle contract months

http://www.cmegroup.com/trading/fx/emerging-market/mexican-peso_contract_specifications.html

http://www.cmegroup.com/trading/fx/emerging-market/mexican-peso_quotes_globex.html

Mexican Peso Futures Quotes Globex 09 Oct 2014

Month	Last	Change	Prior Settle	Open	High	Low	Volume
OCT 2014	-	-	0.074390	-	-	-	0
NOV 2014	-	-	0.074210	-	-	-	0
DEC 2014	0.074130	+0.000060	0.074070	0.074570	0.074980	0.074050	59,751
JAN 2015	-	-	0.073930	-	-	-	0
FEB 2015	-	-	0.073800	-	-	-	0
MAR 2015	0.073730	+0.000080	0.073650	-	0.074540	0.073650	0
APR 2015	-	-	0.073520	-	-	-	0
MAY 2015	-	-	0.073340	-	-	-	0
JUN 2015	0.073580 b	+0.000380	0.073200	-	0.073580 b	-	0

Vicky’s Stategy

She believes that the value of the peso will fall, so she takes a short position in one March futures contract

By taking a short position on the Mexican peso, Vicky sells a contract for 500,000 Mexican pesos at a set price

Specifically, Vicky sells one March contract for 500,000 pesos at a price of USD 0.073730 per MXN

Vicky’s Payoff

To calculate the value of Vicky’s position at time t, we use the following formula:

As Vicky predicted, by February 2015, the futures price on the March contract falls

Specifically, it falls to USD 0.070000 per MXN

Vicky closes out her position for a payoff of:

(0.073730 – $0.070000 ) x 500,000 MXN = USD 1,865

Example: Now let’s suppose Vicky believes that the Mexican peso will rise in value before next March, so she takes a long position in one peso futures contract (today is October 9, 2014)

To calculate the value of her position, we use the following formula:

Again as Vicky predicted, by February 2015, the futures price on the March contract rises

Specifically, it rises to USD 0.080000 per MXN

Vicky closes out her position for a payoff of:

(0.080000 – 0.073730 ) x 500,000 MXN = USD 3,135

Foreign Currency Futures Versus Forward Contracts

Financial managers typically prefer foreign currency forwards over futures

With forward contracts, margin calls can be avoided

Forward contracts are better for hedging in that they are tailored to meet the specific maturity and contract size needs of the client, typically a business*

Speculators prefer futures over forwards because of the liquidity of the market and ability to easily take offsetting positions

Moreover, speculators often do not have access to the forward market

Interesting article: Derivative contracts that are marked to market (such as futures contracts) are subject to margin calls that create liquidity risk. The need to meet margin calls on the futures positions can be a significant source of risk and even lead to financial distress despite the firm being "hedged". http://www.bis.org/publ/work109.htm

* Banks are also involved in the foreign currency futures market in part to offset positions that they may have taken in the forward markets as dealers

Foreign currency futures are standardized contracts that lend themselves well to speculation purposes but less so for hedging purposes

The standardized nature of the futures contract makes it easy to trade futures and to make bets about general changes in the value of currencies

Summary

A foreign currency futures contract is an exchange-traded agreement calling for future delivery of a standard amount of foreign currency at a fixed time, place and price

Foreign currency futures contracts are very similar to standardized forward contracts except, unlike forward contracts, futures:

Trade on the floor of an organized exchange (or on an electronic platform of the exchange)

Require collateral/margin be posted

Are normally settled through the taking of an offsetting position (long/ short or short/long)

Have standardized sizes and maturities

Financial managers typically prefer foreign currency forwards over futures because of customizable maturities and contract sizes and the avoidance of margin calls

Speculators prefer futures over forwards because of the liquidity of the market

Appendix: Margin & Clearing

The InterContinental Exchange on Margin & Clearing Houses

We collect original margin, aka initial margin, for all open positions based on a risk model that takes into account a broad range of stress and / or historically observed scenarios. The amount of original margin required is driven by the historical price fluctuations for the given contract. The margin requirement for each contract is regularly adjusted in line with changes in market volatility

Variation Margin (the amount of cash or collateral that brings the account up to the initial margin amount once it drops below the maintenance margin). All positions are marked-to-market on a daily basis in order to ensure adequate margin. End-of-day variation payments are typically due the following business day.

Throughout the trading day our clearing houses monitor the positions and market exposure of each clearing member to ensure that there are enough funds on deposit to cover their risk

Our clearing houses maintain the ability to make intra-day margin calls, both scheduled and unscheduled, as determined by market circumstances. For example, in times of significant price volatility or changes in position, an intra-day variation payment may be required

Back-Testing — We conduct daily back-testing in order to ensure the adequacy of our margin requirements. This includes verifying that losses on a per product basis are consistent with our projections and that our calculations meet a confidence level of 99%.

Position Limits — Limits can be established to restrict the size of the total positions that can be carried by each clearing member. If a clearing member exceeds their limit, a margin surcharge is levied. Clearing houses can increase or reduce a clearing member’s position limits as warranted by circumstances

Guaranty Funds — In addition to the margin collected, each of our clearing houses maintains guaranty funds that provide further protections in the event of a clearing member default. Each clearing member is required to contribute to the guaranty fund based on the risk they bring to the clearing house and on the utilization of the clearing services.

Default Waterfall — In order to ensure that our economic and risk interest is aligned with that of our clearing members, ICE has contributed more than $200 million in capital to our clearing house guaranty funds which could be drawn upon in the event of a default

https://www.theice.com/publicdocs/How_Clearing_Works.pdf