Currency Derivatives:

Futures

Ebru Reis
İstanbul Bilgi University
Outline
• Forward Contracts
• Futures Contracts
• Forwards vs. Futures
• Daily Resettlement of Futures Contracts
• Reading Currency Futures Quotes
• Basic Currency Futures Relationships
Forward Contract
• An agreement between a corporation and a financial
institution (or between two financial institutions) to exchange
a specified amount of a currency at a specified exchange rate
(called the forward rate) on a specified date in the future.
– Not traded on an exchange
– Specifies the currencies to be traded
– Specifies the exchange rate – forward rate
– Specifies a date for the exchange – delivery date
– This is an obligation – NOT an option
– No money/currency changes hands except on the delivery
date
Forward Contract
• The spot rate is the exchange rate for
immediate exchange.
• The forward rate is the exchange rate
agreed to in the contract.
• The spot rate on the delivery date is the
future spot rate – not known at the time
the contract is written.
Forward Contract
Why enter into such a contract?
• Speculation:
– You think the future spot rate will be higher
than the forward rate.
• Hedging:
– An MNC wishes to fix the exchange rate on
cash flow coming in December.
Forward Contract: An Example
• Suppose you enter into a forward contract to
buy C$1M at the forward rate of $0.75/C$.
– What is your profit (or loss) if the future spot rate is
$0.70/C$? $0.80/C$?
– If spot rate $0.70/C$ : (0.7-0.75) *1 M = $50,000 loss
– If spot rate $0.80/C$ : (0.8-0.75) *1 M = $50,000 gain
– What is the largest possible loss? Profit?
– Max loss : $750,000, max profit: Unlimited
Forward Contract :
Premium/Discount
• As with the case of spot rates, there is a bid/ask
spread on forward rates.
• Forward rates may also contain a premium or
discount.
– If the forward rate exceeds the existing spot rate, it
contains a premium.
– If the forward rate is less than the existing spot rate, it
contains a discount.
Forward Premium/Discount:
An Example
• annualized forward premium/discount
forward rate – spot rate 360
= 
spot rate n
where n is the number of days to maturity
• Example: Suppose £ spot rate = $1.681,
• 90-day £ forward rate = $1.677.
$1.677 – $1.681 360
x = – 0.95%
$1.681 90
So, forward discount = 0.95%
Forward Premium/Discount:

• The forward premium/discount reflects the

difference between the home interest rate
and the foreign interest rate, so as to
prevent arbitrage.
Futures Contracts
• A futures contract is like a forward contract:
– It specifies that a certain currency will be
exchanged for another at a specified time in the
future at prices specified today.
• A futures contract is different from a forward
contract:
– Futures are standardized contracts trading on
organized exchanges with daily resettlement
through a clearinghouse.
Futures Contracts
• Standardizing Features:
– Contract Size
– Delivery Month and date (typically the third
Wednesdays in March, June, September, and
December (delivery dates are standardized).
– Daily resettlement
• Initial performance bond (about 2 percent
of contract value, cash or T-bills held in a
street name at your brokerage).
Futures Contract:
Daily Resettlement
• Margin Account:
– Investor has to deposit funds in this account
• Initial Margin:
– Amount that must be deposited when the contract is first
entered into
• Maintenance Margin:
– Funds in the margin account cannot fall below this
• Marking to Market:
– At the end of each trading day, the margin account is either
credited (or debited) with the profit (or loss) on the contract
based on the settlement futures price at the end of each day.
Daily Resettlement:
An Example
• Consider a long position in the CME U.S. Dollar/Euro
contract.
• It is written on €125,000 and quoted in $ per €.
• The strike price is $1.30 the maturity is 3 months.
• At initiation of the contract, the long posts an initial
performance bond of $6,500.
• The maintenance performance bond is $4,000.
Daily Resettlement:
An Example
• Recall that an investor with a long position gains from
increases in the price of the underlying asset.
• Our investor has agreed to BUY €125,000 at $1.30 per
euro in three months time.
• With a forward contract, at the end of three months, if
the euro was worth $1.24, he would lose $7,500 =
($1.24 – $1.30) × 125,000.
• If instead at maturity the euro was worth $1.35, the
counterparty to his forward contract would pay him
$6,250 = ($1.35 – $1.30) × 125,000.
Daily Resettlement:
An Example
• With futures, we have daily resettlement of gains an
losses rather than one big settlement at maturity.
• Every trading day:
– if the price goes down, the long pays the short
– if the price goes up, the short pays the long
• After the daily resettlement, each party has a new
contract at the new price with one-day-shorter
maturity.
Daily Resettlement:
An Example
• Each day’s losses are subtracted from the
investor’s account.
• Each day’s gains are added to the account.
• In this example, at initiation the long posts an initial
performance bond of $6,500.
• The maintenance level is $4,000.
– If this investor loses more than $2,500 he has a decision
to make: he can maintain his long position only by
adding more funds—if he fails to do so, his position will
be closed out with an offsetting short position.
Daily Resettlement:
An Example
• Over the first 3 days, the euro strengthens then
depreciates in dollar terms:
Settle Gain/Loss Account Balance

$1.31 $1,250 = ($1.31 – $1.30)×125,000

$7,750 = $6,500 + $1,250

$1.30 –$1,250 $6,500

$1.27 –$3,750 $2,750 + $3,750 = $6,500

• On third day suppose our investor keeps his long

position open by posting an additional $3,750.
Daily Resettlement:
An Example
• Over the next 2 days, the long keeps losing money and
closes out his position at the end of day five.

Settle Gain/Loss Account Balance

$1.31 $1,250 $7,750

$1.30 –$1,250 $6,500

$1.27 –$3,750 $2,750 + $3,750 = $6,500

$1.26 –$1,250 $5,250 = $6,500 – $1,250

$1.24 –$2,500 $2,750

Totaling Up
• At the end of his adventures, our investor has three ways of
computing his gains and losses:
– Sum of daily gains and losses
– $7,500 = $1,250 – $1,250 – $3,750 – $1,250 – $2,500
– Contract size times the difference between initial contract
price and last settlement price.
– $7,500 = ($1.24/€ – $1.30/€) × €125,000
– Ending balance on account minus beginning balance on
account, adjusted for deposits or withdrawals.
– $7,500 = $2,750 – ($6,500 + $3,750)
Daily Resettlement:
An Example
Settle Gain/Loss Account Balance
$1.30 –$– $6,500

$1.31 $1,250 $7,750

$1.30 –$1,250 $6,500

$1.27 –$3,750 $2,750 + $3,750

$1.26 –$1,250 $5,250

$1.24 –$2,500 $2,750

Total loss = – $7,500 = $2,750 – ($6,500 + $3,750)

= ($1.24 – $1.30) × 125,000
Currency Futures Markets
• The Chicago Mercantile Exchange (CME) is by far the largest.
• The Singapore Exchange offers interchangeable contracts.
• There are other markets, but none are close to CME and SIMEX
trading volume.
• Others include:
– The Philadelphia Board of Trade (PBOT)
– The MidAmerica Commodities Exchange
– The Tokyo International Financial Futures Exchange
– The London International Financial Futures Exchange
Forwards vs Futures
Forward Markets Futures Markets
Location Interbank Exchange Floor
Contract size Negotiated. Standardized.
Delivery date Negotiated. Standardized.

Participants Banks, brokers, Banks, brokers,

MNCs. Public MNCs. Qualified
speculation not public speculation
encouraged. encouraged.

Security Compensating Small security

deposit bank balances or deposit required.
credit lines needed.
Forwards vs Futures
Forward Markets Futures Markets
Location Interbank Exchange Floor
Contract size Negotiated. Standardized.
Delivery date Negotiated. Standardized.

Participants Banks, brokers, Banks, brokers,

MNCs. Public MNCs. Qualified
speculation not public speculation
encouraged. encouraged.

Security Compensating Small security

deposit bank balances or deposit required.
credit lines needed.
Forwards vs Futures
Forward Markets Futures Markets
Regulation Self-regulating Commodity
Futures Trading
Commission,
Natural Futures
Association.

Liquidation Mostly settled by Mostly settled by

actual delivery. offset.

Clearing Handled by Handled by

operation individual banks exchange
& brokers. clearinghouse.
Daily settlements
to market prices.
Forwards vs Futures
Forward Markets Futures Markets

Transaction Bank’s bid/ask Negotiated

Costs spread. brokerage fees.
Forwards vs Futures
• Forwards are typically used by hedgers
– Illiquid
– End with the exchange of currency
• Futures are used by hedgers and speculators
– Can reverse position
– Marked to market daily
– Most end with offsetting transaction
– May be imperfect: delivery date many not coincide with
hedger’s FX cash flow
 Reading Currency Futures
Quotes
LIFETIME OPEN INT
OPEN HIGH LOW SETTLE CHG HIGH LOW

Euro/US Dollar (CME)—€125,000; $ per €

Mar 1.3136 1.3167 1.3098 1.3112 -.0025 1.3687 1.1363 159,822
Jun 1.3170 1.3193 1.3126 1.3140 -.0025 1.3699 1.1750 10,096

Closing price Highest and lowest

Expiry month
prices over the life
Daily Change
Opening price Lowest price that day of the contract.
Highest price that day Number of open contracts
Basic Currency
Futures Relationships
• Open Interest refers to the number of contracts
that are not closed or delivered on a particular
day.
• Open interest is a good proxy for demand for a
contract.
• Some refer to open interest as the depth of the
market.
Reading Currency Futures
Quotes

LIFETIME
OPEN HIGH LOW SETTLE CHG HIGH LOWOPEN INT

Euro/US Dollar (CME)—€125,000; $ per €

Mar 1.3136 1.3167 1.3098 1.3112 -.0025 1.3687 1.1363 159,822
Jun 1.3170 1.3193 1.3126 1.3140 -.0025 1.3699 1.1750 10,096
Sept 1.3202 1.3225 1.3175 1.3182 -.0025 1.3711 1.1750 600
Notice that open interest is greatest in the nearby contract, in this case March,
2005.
In general, open interest typically decreases with term to maturity of most
futures contracts.
Basic Currency
Futures Relationships

LIFETIME OPEN INT

OPEN HIGH LOW SETTLE CHG HIGH LOW

Euro/US Dollar (CME)—€125,000; $ per €

Mar 1.3136 1.3167 1.3098 1.3112 -.0025 1.3687 1.1363 159,822

Notice that if you had been smart or lucky enough to open a long position at
the lifetime low of $1.1363 by now your gains would have been
$21,862.50 = ($1.3112/€ – $1.1363/€) × €125,000
Bear in mind that someone was unfortunate enough to take the short position
at $1.1363!
Basic Currency
Futures Relationships

LIFETIME
OPEN HIGH LOW SETTLE CHG HIGH LOW OPEN INT

Euro/US Dollar (CME)—€125,000; $ per €

Mar 1.3136 1.3167 1.3098 1.3112 -.0025 1.3687 1.1363 159,822
If you had been smart or lucky enough to open a short
position at the lifetime high of $1.3687 by now your gains
would have been:
$7,187.50 = ($1.3687/€ – $1.3112/€) × €125,000
 Basic Currency
Futures Relationships
LIFETIME OPEN INT
OPEN HIGH LOW SETTLE CHG HIGH LOW

Euro/US Dollar (CME)—€125,000; $ per €

Mar 1.3136 1.3167 1.3098 1.3112 -.0025 1.3687 1.1363 159,822
Jun 1.3170 1.3193 1.3126 1.3140 -.0025 1.3699 1.1750 10,096
Sept 1.3202 1.3225 1.3175 1.3182 -.0025 1.3711 1.1750 600
 Basic Currency
Futures Relationships
LIFETIME OPEN INT
OPEN HIGH LOW SETTLE CHG HIGH LOW

Euro/US Dollar (CME)—€125,000; $ per €

Mar 1.3136 1.3167 1.3098 1.3112 -.0025 1.3687 1.1363 159,822
Jun 1.3170 1.3193 1.3126 1.3140 -.0025 1.3699 1.1750 10,096
Sept 1.3202 1.3225 1.3175 1.3182 -.0025 1.3711 1.1750 600

From June 15 to September 21, 2005 (the actual

delivery dates of these contracts) we should expect 1 + i$ F($/€)
higher interest rates in dollar denominated accounts: =
if we find a higher rate in a euro denominated 1 + i€ S($/€)
account, we may have found an arbitrage.