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Currency futures

11/17/16

Currency futures - Kevin

Meaning
It is a derivative instrument
Definition is the same as currency forward
Forwards are traded over the counter
Futures are traded in organised exchanges
(separate financial futures exchanges)
Futures are transacted through brokers
Traded only in a limited number of
currencies
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Currency futures -

Features
Standardised terms
Clearing house
Margin system
Closing of futures

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Currency futures -

Standardised terms
Contract size is standardised
Example: 62,500 Sterling; 125,000
Euro; 100,000 Can Dollar Chicago
Mercantile exchange
Date of delivery is predetermined
Third Wednesday of Jan, March,
April, June, July, Sept., Oct., Dec.
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Currency futures -

Clearing house
Each exchange has a clearing house
Clearing house arranges for delivery of
asset and payment of money
Clearing house becomes the counter
party to the original parties

Original parties: buyer and seller


Clearing house becomes counter party to
buyer (to deliver the asset)
Clearing house becomes the counter party
to the seller (to make payment)

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Currency futures -

Margin system
There are 3 types of margins
Initial margin, maintenance margin and
variation margin
Initial margin to be paid upfront
Balance is marked to the market every day
Maintenance margin to be maintained
throughout the duration of the contract
Variation margin (shortfall in margin) to be
remitted promptly
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Example for margin


system
Can Dollar futures: size = 100,000 Can D
Dealer buys one contract at USD 0.75/ Can D
Value of contract: USD 75,000
Initial margin: 10 percent = USD 7,500
Maintenance margin: 7.5 percent = USD
5,625
Price moves upto USD 0.755/ Can D: dealer
gains USD 500 (100,000 * USD 0.005)
Price moves down to USD 0.740: dealer loses
USD 1000 (100,000*USD 0.010)
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Closing of futures
Forward contract is settled on delivery
date by delivery of asset and payment
of money
Futures can be closed:

Exchange of asset and cash on delivery date


Cash settlement through a reverse trade on
any day

Hedgers prefer exchange of asset;


speculators prefer cash settlement
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Currency futures -

Hedging with currency


futures
Importer buys the required currency futures
contract
Thus locks in a price for the purchase of
foreign currency
Hedges (avoids) risk due to exchange rate
fluctuations
Exporter sells the expected currency futures
contract
locks in a price for the sale
Hedges risk due to exchange rate fluctuations
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Imperfections in hedging
with currency futures
Maturity mismatch

Mismatch in maturity date of futures


contract and date of cash transaction

Size mismatch

Mismatch between size of futures contract


and size of cash transaction

Maturity and size mismatch


Hedging with currency futures may not
result in perfect hedge
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Currency futures -

Speculation with currency


futures

Fluctuations in exchange rates used to reap


speculative profits
Spot rate: USD = Rs.46.40
1 month future rate: USD = Rs.46.60
Expected spot rate on maturity: USD = Rs. 46.75
Dealer buys one currency futures contract of size
100,000 USD
Value of contract: Rs.46,60,000; Margin deposit:
Rs.4,66,000
If exchange rate move up to Rs.46.75 as anticipated,
dealer gains profit of Rs.15,000 (100,000* Re.0.15)
Rate of return: (15000/466,000)(12)(100) = 38.63%

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Speculation through cash


transaction
Spot rate: USD = Rs.46.40
Dealer buys 100,000 USD at spot rate
Investment required: Rs.46,40,000
If exchange rate moves upto Rs.46.75
within a month, dealer gains profit of
Rs.35,000 (100,000* Re.0.35)
Rate of return: (35000/46,40,000)(12)(100)
= 9.05%
Speculation with currency futures larger returns on smaller investment
11/17/16

Currency futures -