I.

CURRENCY FUTURES CONTRACT

1. Definition of Currency Futures Contract

Currency futures are contracts specifying a standard volume of a particular currency to be

exchanged on a specific settlement date.

A currency futures contracts are similar to forward contracts in terms of their obligation:
A certain currency will be exchanged for another at a specified time in the future at prices
specified today.

However, it differs from forward contracts in the way they are traded: Futures are
standardized contracts trading on organized exchanges with daily resettlement through a
clearing house.

They are commonly used by MNCs to hedge their foreign currency positions. In addition,
they are traded by speculators who hope to capitalize on their expectations of exchange
rate movements. A buyer of a currency futures contract locks in the exchange rate to be
paid for a foreign currency at a future point in time. Alternatively, a seller of a currency
futures contract locks in the exchange rate at which a foreign currency can be exchanged
for the home currency. (1)

2. The participants in the Futures market

These investors can be divided into two main types: Speculators and Hedgers.

Speculators attempt to profit from a change in the futures price. They willing to take
risks from the fluctuation of spot rate and futures price to gain big profits. (2) To do this,
the speculator will take a long or short position in a futures contract depending upon his
expectations of future price movement.(3) Speculators prefer using Futures contract due to
profit arising from this will be received in cash and among the same day from their
deposit accounts. Beside that, Futures contract has very low transaction costs. (4)
EX: Forward Forex transaction costs have 10 points SPREAD. The value of a Forward
contract is $ 100,000 and $100 transaction costs, whereas with the same value of a
Futures contract, the costs fluctuate only from $ 20 to $ 40.

Hedgers are investors who take steps to reduce risks of an investment by making an
offsetting investment. They maximize profits by minimizing risks through Futures
contract. Unlike Speculators, they want to avoid price variation by locking in a purchase
price of the underlying asset through a long position in the futures contract or a sales
price through a short position. In effect, the hedger passes off the risk of price variation to
the speculator, who is better able, or at least more willing, to bear this risk.
Besides two main types mentioned above, there are brokers who represent financial
investment companies to get commission.(5)
3. Features of Currency Futures Contract

 Provides protection against exchange rate fluctuations in investment portfolios.

 Allows the holder to fix prices for import and export purposes.

 Allows investors to take advantage of price movements in the exchange rate

because they can take a view as to whether the exchange rate will strengthen or
weaken.

 Individual investors can trade over and above their foreign allocation.

 Standardized contracts traded on a regulated exchange eliminate counterparty risk.

 Highly liquid market.

 Are traded based on margins that change based on the underlying currency’s
volatility. This means that investors may be required to make additional payments on
a daily basis should their initial margin payment become insufficient because of
movements in the underlying currency.

 The main risk associated with CFs trading results from the effect that gearing or
leverage has on a position. A geared transaction is simply the deposit of a smaller
amount of cash, but being exposed to the full value of the transaction. Investors
deposit the initial margin amount but are exposed to the full nominal value of the
contracts traded. This means that investors can end up losing much more than the
initial margin they paid to open a Futures Contract. The profits and losses on the
underlying currency can be up to ten times more than on the Future.(6)

4. Clearing House

A clearing house is an agency or separate corporation of a futures exchange responsible

for settling trading accounts, clearing trades, collecting and maintaining margin monies,
regulating delivery and reporting trading data. Clearing houses act as third parties to all
futures and options contracts - as a buyer to every clearing member seller and a seller to
every clearing member buyer.(7)

5. Currency Futures Contract Standardized Specifications

5.1 Contract size

Contract size determines the amount of currency that can be transferred on a contract.
This determination is very important for the market. If the size of the contract is too big,
many investors will want to hedge and relatively small speculators can not afford to
participate in the market. Conversely, if the contract is too small, the transaction can be
costly because each contract get an amount of fee. Contract size is standardized according
to the foreign currency amount.

Currency Contract size

Australian Dollar AUD 100,000
British Pound GBP 62,500
Canadian Dollar CAD 100,000
Deutsch Mark DEM 125,000
Mexican Peso MXN 500,000
Japanese Yen JPY 12,500,000
Swiss Franc CHF 125,000
Euro EUR 125,000
Brazilian reals BRL 100,000
South African rand ZAR 500,000
Russian rubles RUR 2,500,000
Norwegian krone NOK 2,000,000
Swedish krona SEK 2,000,000
Czech koruna CZK 4,000,000
Hungarian forint HUF 30,000,000
Polish zloty PLN 500,000
Israeli Shekelim ILS 1,000,000
Korean Won KPW 125,000,000
5.2 Futures Price Quotations
Future prices are quoted conveniently and easily to understand. The minimum level
of price movement may occur in the transaction must be consistent with the quoting
price.

Some specific terms used in Currency Futures quotation:

- Month: Month maturity.
- Open: Opening price (price of the contracts were traded immediately after opening).
- High: Highest price during the trading day.
- Low: Lowest price during the trading day.
- Settle: Settlement price - the average price that contracts were traded right before the
market is closed.
- Change: The difference between the settlement price of the previous day and trading
day.

- High and Low Lifetime: Futures highest and lowest price since the contract was formed
until the current time.

- Open Interest: The number of outstanding contracts (note: trading is concentrated in the
nearest maturity contract).

5.3 Minimum price variation

Transaction centers may stipulate limitations of future price movements among a day
(price limits), by regulating how much today’s settlement price increases or decreases
compared to the previous day's settlement price. This is also the difference from forward
contracts. Currently, a number of transaction centers apply limitations on the futures
exchange rate fluctuation while some are not. Thus, when the transact exchange rate
reaches the critical point of today’s exchange rate, most transactions would be
temporarily stopped until the limitation is adjusted.
5.4 Daily price amplitude

Transaction centers stipulate minimum and maximum of shifting price with most of
contracts. If the price dropped down equal to the limited daily price, the contract is
mentioned reaching limit down. If the price rises up equal to the limited daily price, the
contract is mentioned reaching limit up. Typically, the transactions of the day will be
stopped when the contract reached lowest or highest limit. However, in some cases,
centers have the right to intervene and change the limits.

The purpose of price limits is to prevent dramatic variation due to speculation. However,
this can also become a barrier to trading activities when the asset price increases or
decreases too quickly. In general, the price limits is good for Futures markets which are
controlled.

5.5 Trading Hours

Trading hours are usually 4-8 hours / day. Transaction centers are connected together to
create a global market.

5.5 Delivery months

Delivery Month will be specified clearly in the Futures contract. Futures contracts are
normally named after the delivery month. Transaction centers have to determine period of
time during the month to deliver. With a big amount of Futures contracts, the delivery
time is the entire month.

Month delivery may vary depending on each contract and will be selected by the
transaction center in order to meet the requirements of participants in market. For
example, currency futures contracts at market IMM (International Monetary Market) has
the delivery months of 3, 6, 9 and 12. At any given time, the contract has the nearest
delivery month and some next delivery months will be transacted. The transaction center
determines when contracts and delivery month begin and also determine the last day to
conduct transactions for a specific contract. The transaction usually ends a few days
before the final delivery date.

5.6 Delivery date

Due dates are standardized, usually on Wednesday of the 3rd week of March, June,
September and December (Used at Market CME).

There are 3 special days in Futures contract: The first notice day, the last notice day, the
last trading day.
  The first notice day: the first day delivery notification is submitted to the Clearing
house.
 The last notice day: Is the last day to submit delivery notification. This notification
will be submitted to the clearing house during the period from the first notice to
the last notice day. Clearing house will select partners in the” long” position to
accept the transfer (2 to 3 days after the notification).
 The last trading day: A few days before the last notice day.

5.7 The transaction steps

1. Open trading account with the broker

2. Send trading order to broker
3. The broker start to trading asset
4. After the transaction made, margin procedures are conducted with clearing house.
5. Clearing house become partners of the transaction parties.(8)

6. Margin Requirement

There are two types of margin requirements when trading in futures markets. These are
called initial margin and maintenance margin. The idea behind the margin
requirements is that the margin should cover virtually all of the one-day risk. This, of
course, further reduces both the incentives to default as well as the loss to the
clearinghouse if there is default.

If one takes a position in the futures market, an initial margin is required. Futures price
changes generate either positive or negative cash flows via marking to market. To avoid
the cost and inconvenience of frequent but small payments, losses are deducted from the
initial margin until a lower bound, the maintenance margin, is reached. At this stage, a
margin call is issued, requesting the investor to bring the margin back up to the initial
level. This payment is called a variation margin.

- Initial margin: Initial margin is the percentage of the purchase price of future
contract (that can be purchased on margin) that the investor must pay for his or her
own cash or marginable future contract. This margin is about 4% of the contract
value.
- Maintenance margin: is the minimum amount of equity that must be maintained
in a margin account (normally by about 70% - 75% of the initial margin).

EX: The initial margin on a GDP 62,500 contract may be USD 3,000 and the
maintenance margin USD 2,400. As long as the investor's loss due to marking to market
do not exceed USD 600, the initial equity (USD 3,000) in your account does not go
below the maintenance margin of USD 2,400. If her losses were USD 1,000, the value of
the equity would drop to USD 2,000, which is below the maintenance margin of USD
2,400. At this point a margin call is issued, and the investor must add a variation margin
of USD 1,000 to restore the equity to USD 3,000.(9)

7. Daily settlement
- At the end of each trading day, clearing house will determine the payment of the
contract price.
- The price payment is normally the average exchange rate of the last transactions in
day or the end of the day's closing price.
- With this price, each margin accounts will be adjusted according to market prices.
(10)

8. Hedging with Futures Contracts

Hedge: The purchase of a contract or tangible good that will rise in value and offset a
drop in value of another contract or tangible good. Hedges are undertaken to reduce risk
by protecting an owner from loss.

Because of its low cost, a hedger may prefer the currency futures market to the forward
market. There are, however, problems that arise with hedging in the futures market:

 The contract size is fixed, and is unlikely to exactly match the position to be
hedged.
 The expiration dates of the futures contract rarely match those for the currency
inflows/outflows that the contract is meant to hedge.
 The choice of underlying assets in the futures market is limited, and the currency
one wishes to hedge may not have a futures contract.

That is, whereas in the forward market we can tailor the amount, the date, and the
currency to a given exposed position, this is not always possible in the futures market.

 Cross-Hedge: An imperfect hedge is called a cross-hedge when the currencies do

not match.
 Delta-Hedge: An imperfect hedge is called a delta-hedge when the maturities do
not match.
 Delta-Cross-Hedge: An imperfect hedge is called a delta-cross-hedge when both
currencies and maturities do not match.

The problems of currency and maturity mismatch mean that, at best, only an
approximate hedge can be constructed when hedging with futures. The standard rule
is to look for a futures position that minimizes the variance of the hedged cash flow.
 9. Advantages and Drawbacks of Using Futures Contracts over Forward
Contracts

9.1 Advantages
 The default risk of futures contracts is low. As a consequence, relatively
unknown players without established reputation can trade in futures market.
 Because of standardization, futures markets have low transaction costs.
Commissions tend to be lower than in forward markets.
 Futures positions can be closed out with great ease, because of the liquidity
in the secondary market.

9.2 Drawbacks
 Standardization of futures contracts makes it difficult to find a perfect
hedge. Creditworthy hedgers have to choose between an imperfect but cheap
hedge in the futures market and a perfect but expensive hedge in the forward
market.
 Marking to market creates ruin risk for a hedger. The daily marking to
market can create severe short-term cash flow problems.
 Marking to market creates an interest rate risk. The daily cash flows must
be financed/deposited in the money markets at interest rates that are not known
when the hedge is set up
 Futures contracts exist only for a few high-turnover exchange rates. Thus,
for most exchange rates, a hedger has to choose between a forward contract or
money market hedges, or a cross-hedge in the futures market.
 Futures contracts are available only for a number of short maturity.(11)

II. CURRENCY FORWARD CONTRACTS

1. What is Currency Forward Contract

Currency Forward Contract is a binding contract in the foreign exchange rate that locks in
the exchange rate for the purchase or sale of a currency on a future date .(12)

2. Benefits of Currency Forward Contract

A currency forward contract is essentially a hedging tool that dose not involve any
upfront payment.

The other major benefit of currency forward is that it can be tailored to a particular
amount and delivery period, unlike standardized currency future contract.

3. Functions of Currency Forward Contract

Currency forward settlement can either be on cash or delivery basis, provided that the
option is mutually acceptable and has been specified beforehand in the contract.

It is also an over-the-counter (OTC) instrument, as they do not trade on a centralized

exchange. They have also known as an “outright forward”.

Different from currency future and optional contracts, which require an upfront payment
for margin requirement and premium payments, currency forward contract typically do
not require an upfront payment. Foreign currency forwards contracts may have different
contract sizes, time periods and settlement procedures than futures contracts.

However, it has a little flexibility and represents a binding obligation, which means that
the contract buyer and seller cannot walk away if the “locked in” rate eventually proves
to be adverse. Therefore, to compensate for the risk of non-delivery or non-
settlement, financial institutions that deal in currency forwards may require a deposit
from retail investors or smaller firms with whom they do not have a business relationship.

4. Determining currency in Currency Forward Contract

The mechanism for determining a currency forward rate is straightforward, and depends
on interest rate differentials for the currency pair.

Assuming both currencies are freely traded on the Forex market. Assume a current spot
rate for the Canadian dollar of US$1 = C$1.0500, a one-year interest rate for Canadian
dollars of 3%, and one-year interest rate for US dollars of 1.5%.

After one year, based on interest rate parity, US$1 plus interest at 1.5% would be
equivalent to C$1.0500 plus interest at 3%.

Or, US$1 (1 + 0.015) = C$1.0500 x (1 + 0.03).

So US$1.015 = C$1.0815, or US$1 = C$1.0655.

As well, the actual spot rate of the Canadian dollar one year from now has no correlation
on the one-year forward rate at present. The currency forward rate is merely based on
interest rate differentials, and does not incorporate investors’ expectations of where the
actual exchange rate may be in the future.

EX: Assume a Canadian export company is selling US$1 million worth of goods to a
U.S. company and expects to receive the export proceeds a year from now. The exporter
is concerned that the Canadian dollar may have strengthened from its current rate (of
1.0500) a year from now, which means that it would receive fewer Canadian dollars per
US dollar. Therefore the Canadian exporter enters into a currency forward contract to sell
$1 million a year from now at the forward rate of US$1 = C$1.0655.

If a year from now, the spot rate is US$1 = C$1.0300, which means that the C$ has
appreciated as the exporter had anticipated – by locking in the forward rate, the exporter
has benefited to tune of C$35,500 (by selling the US$1 million at C$1.0655, rather than
at the spot rate of C$1.0300). On the other hand, if the spot rate a year from now is
C$1.0800 (the C$ weakened contrary to the exporter’s expectations), the exporter has a
notional loss of C$14,500.

5. Some Definitions
5.1. Outright Forward

An outright forward is a forward currency contract with a locked-in exchange

rate and delivery date. An outright forward contract allows an investor to buy or sell a
currency on a specific date or within a range of dates. Foreign exchange forward contracts
function in a very similar fashion to standard forward contracts.

5.2. Forward Discount

Forward discount is where the domestic current spot exchange rate is trading at a higher
level then the current domestic futures spot rate for a maturity period. A forward discount
is an indication by the market that the current domestic exchange rate is going to
depreciate in value against another currency.
 III. Comparing Futures Contracts and Forward Contracts

Characteristic Currency Futures Forward Contracts

Contract Size: Standardized per currency Any contract size
Maturity: Standard fixed maturity Any maturity
Location: Floor of organized
No specific physical
exchange location
Pricing: Open outcry in the pit Bid and ask quotes
Collateral: Initial margin and markingNo collateral, but standing
to market relations with bank
Settlement: Rare delivery on settlement
Normal delivery at
settlement
Commissions: Single commission covers Commissions through bid-
round trip (purchase and ask spread
sale)
Trading Hours: During exchange hours 24 hours a day
Counterparts: Client and clearing house Direct relations
Liquidity: Liquid (secondary market) Liquid and large volume
 REFERENCES
(1), (3), (5): Cheol S. Eun & Bruce G. Resnick (2012). International Financial
Management (6th Ed). McGraw-Hill Publications.

(2), (4), (8), (10): Future Forex Transaction (Part 2)

Available: kdtqt.duytan.edu.vn/

(6): Currency Derivatives

Available: jse.co.za/

(7): Clearing house

Available: investopedia.com/

(9), (11): Foreign Currency Futures

Available: is.vsfs.cz/el/6410/leto2012/N_IFS_2/um/Futures_v_pdf.pdf

(12): Derivatives - Currency Forward Contracts

Available: investopedia.com/