Currency futures

MEANING
Currency future contracts are contracts specifying a

standard volume of a particular currency to be

exchanged on a specific settlement date, at predetermined price in future. Like a forward contract, a future contract is an agreement between two parties to buy or sell an asset (currency, Stock, commodities etc.)

at a certain time in the future for certain price.

Meaning
It is a derivative instrument 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

Features
Standardised terms Clearing house Margin system Closing of 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.

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)

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

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)

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

Hedging with currency futures

Importer buys the required currency futures
contract for payables when he expects upward movement in the price of currency in which payables are due Thus locks in a price for the purchase of foreign currency Hedges (avoids) risk due to exchange rate fluctuations

Hedging with currency futures

Exporter sells the expected currency
futures contract for receivable when he expect downward movement in the price of the currency in which he is expecting his payment locks in a price for the sale Hedges risk due to exchange rate fluctuations

Imperfections in hedging with currency futures

Maturity mismatch

Mismatch in maturity date of futures contract and date of cash transaction Mismatch between size of futures contract and size of cash transaction

Size mismatch

Maturity and size mismatch Hedging with currency futures may not result in perfect hedge

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%

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