The Derivatives - Currency Futures

Similar to forward contracts but are exchange traded rather than OTC and is marked to market on a daily basis.

The price of currency futures change continuously in response to market conditions and expectations about future price movements. The largest exchange for currency futures is Chicago Mercantile Exchange where major contracts are for $ against Yen, Euro, and GBP. The futures are traded for four delivery days each year in - March, June, Sept and Dec. The contracts are referred to by delivery day e.g Dec Yen Futures

The standardization of the contract means the amount of contracts are rounded to a whole number which causes some inaccuracies in hedging (see below). The market price for each contract fluctuates, with each minimum price movement refereed to a 'tick'. Each contract has a fixed tick value. e.g Suppose value of tick was $10. If the contract goes up by 16 ticks there will be a gain $160 for a long position in the contract or
loss of $160 for someone in a short position.

Hedging with Futures Contract

To hedge with futures contract, the question needs to be asked are:

a) To buy or sell the contract?

(Seen in with a Importer)

If you need to buy a currency (e.g SF) on future date with $ then
- Buy the appropriate futures contract (SF) now
- On the date you buy the currency (SF), you close out by selling the same number of future contracts.

(Seen in with a Exporter)
If you need to sell a currency (e.g SF) on future date for $ then
- Sell the appropriate futures contract (SF) now
- On the date you sell the currency (SF), you close out by buying the same number of future contracts.

 

Note - Special case: $ futures do not exist on the exchange, so we need to restate the requirements:

(Seen in with a Importer)
If you need to buy $ on future date with domestic currency (SF) then
- Sell the appropriate futures contract (SF) now
- You close out by buying the same number of future contracts.

(Seen in with a Exporter)
If you need to sell $ on future date for for domestic currency (SF) then
- Buy the appropriate futures contract (SF) now
- You close out by selling the same number of future contracts.


b) How many contracts ?

 

 Futures can be bought and sold as a whole number of contracts. Normally the problem of contract comes if the receipt or payment is in $ (see Special case above). The method used in convert the other currency using today's futures rate.

 

 c) Which settlement month ?

 

To hedge currency receipts or payments a future contract must have a settlement date AFTER the date that is actual currency is received or needed. So one needs to select a contract which matures AFTER actual cash is needed or received.

Inefficiencies in Hedging

 

 Basis Risk : Its is difference between the future price and spot price. The basis will move towards 0 on settlement date.The risk is that futures price might move by a different amount from the price of the underlying currency.

Rounding problem: Amounts are rounded to a whole number of contracts.

Advantage or Disadvantage of Futures against Forwards

 

Advantage 

- Lower transaction cost.

- Exact date of reciept or payment of currency does not need to be known (equivalent to option forward)

- Does not take bank credit lines.

Disadvantage

- Cannot be tailored to users exact requirement

- Hedge inefficiencies due to contract size and basis risk

- Limited number if currencies on exchange.

Speculations with Futures

 

 If 3 December £ future contract is $1.68/£ (contract size is £62,500) and you know that in Dec the spot rate, and therefore the Dec futures price, will be $1.73/£ (i.e £ appreciates and $ depreciates), you can enter the contract to sell £ on the expiry of contract.

                        1) buy the £187,500 (3 contracts) @ $1.68/£ 
                          
  i.e. On expiry 2) sell £187,500 @ $1.73/£  as per the spot rate
                          

The profit is $0.05/£, hence the overall profit is $9,375 in total.