Currency Derivatives Guide

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1 Currency Derivatives Guide What are Futures? In finance, a futures contract (futures) is a standardised contract between two parties to buy or sell a specified asset of standardised quantity and quality for a price agreed upon today (the futures price) with delivery and payment occurring at a specified future date. The contracts are negotiated on a futures exchange, which acts as an intermediary between the two parties. What are Options? In finance, an option is a contract which gives the buyer (the owner) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date. The strike price (or exercise price) of an option is the fixed price at which the owner of the option can buy (in the case of a call) or sell (in the case of a put) the underlying security or commodity). The seller incurs a corresponding obligation to fulfil the transaction that is to buy or sell if the owner elects to "exercise" the option prior to expiration. The buyer pays a premium to the seller for this right. An option which conveys to the owner the right to buy something at a specific price, is a call; an option which conveys the right of the owner to sell something at a specific price, is a put. What are Currency Futures? Currency Futures are derivative contracts that are traded on the JSE s YieldX Exchange -they allow the investor to trade an exchange rate at some specified date in the future. An investor that buys a Dollar and sells a Rand at R9.00 is going long of the currency future - he wants the Dollar to appreciate and therefore wants the Rand to go from R9.00 to R9.50. An investor that sells a Dollar and buys a Rand at R9.00 is going short of the currency future, wants the Dollar to depreciate, and therefore wants the rand to go from R9.00 to R8.50. Castle Walk Office Park Block E, Cnr of Nossob & Swakop Str Erasmuskloof 0048 Postnet Suite 578 Private Bag X10 Elarduspark 0047 Pretoria South Africa Website Copyright BVG Commodities (Pty) Ltd 2013 All Rights Reserved

2 Why trade Currency Futures? Currency future contracts allow investors to hedge against foreign exchange risk or currency risk. Companies whose business processes entail receiving/settling transactions in a foreign currency can use this instrument to lock in a specific rate. Currency future contracts allow investors to speculate on the future movements of the exchange rates. What is the difference between spot, forward and futures rate? Spot: Is today s exchange rate for the physical exchange of currencies. Forward: The forward rate is a fixed price based on a future date s rate as stipulated in a private agreement. These private agreements are not as rigid in their terms and conditions as exchange traded contracts. Futures: Fundamentally, forward and futures contracts have the same function: both types of contracts allow people to buy or sell a specific type of asset at a specific time at a given price. However, it is in the specific details that these contracts differ. First, futures contracts are exchangetraded and, therefore, are standardized contracts. Because forward contracts are private agreements, there is always a chance that a party may default on its side of the agreement. Futures contracts have clearing houses that guarantee the transactions. Secondly, the specific details concerning settlement and delivery are quite distinct. For forward contracts, settlement for forward contracts occurs at the end of the contract. Futures contracts are mark-to-market daily, which means that daily changes are settled day by day until the end of the contract. Furthermore, settlement for futures contracts can occur over a range of dates. Forward contracts, on the other hand, only have one fixed settlement date. Lastly, speculators who bet on the direction in which an asset s price will move, frequently use futures contracts. Usually futures contracts are closed out prior to maturity and delivery usually never occurs. On the other hand, forward contracts are mostly used by hedgers that want to eliminate the volatility of an asset's price, and delivery of the asset or cash settlement will usually take place. There are four categories of participants in the currency derivatives market: Hedgers use currency futures or options to protect against possible adverse currency movements and foreign exchange risk. Hedgers therefore seek to reduce risk. Hedgers have a real interest in the underlying currency and use futures or options as a way of preserving their performance. Arbitrageurs profit from price differentials of similar products in different markets, e.g. price differentials between the spot exchange rate and futures or options price. Investors use currency futures or options to enhance the long-term performance of a portfolio of assets. Speculators can be any person who uses currency futures or options, in the hope of making a profit on short-term movements in prices. Speculators therefore seek to enhance risk with the aim of making a profit. Speculators have no interest in the underlying currency other than taking a view on the future direction of the currency s price.

3 Currency Futures quotes Yield-X quotes all currency futures prices in the same way as the underlying spot rate, quoted to four decimal places. A currency quote is always against a base currency followed by the quoted currency. The reason all currencies are quoted in pairs is that in every foreign exchange transaction, you are simultaneously buying one currency and selling another. Here is an example of a foreign exchange rate for the US dollar versus the South African rand. Example: The quote in the sample shows the US Dollar as the base currency and the Rand as the quoted currency. The terminology used is the Rand is trading at R against the US Dollar. This sample shows that you need R Rand to purchase $1 US Dollar, and this is the exchange rate, i.e. to exchange R for $1US Dollar. If you want to buy (which means buy the base currency and sell the quote currency), you want the base currency to increase. This is going long or taking a long position : Long = Buy If you want to sell (which actually means sell the base currency and buy the quote currency), you want the base currency to decrease. This is going short or taking a short position. Short = sell } Am I long OR short?

4 Bid / Ask All forex quotes are quoted with two prices: the bid and ask. Bid: is the price at which you are willing to buy the base currency in exchange for the quote currency. This means the bid is the best available price at which you (the trader) will sell to the market. Ask: is the price at which you are willing to sell the base currency in exchange for the quote currency. *Another word for Ask is the offer price Ask price: is the best available price at which you will buy from the market. Spread: the difference between the bid and the ask price is known as the spread. *As viewed on the Swordfish platform On the September 2013 contract USD/ZAR quote above, the bid is at R and ask is at R Bid: If you want to sell rand (in other words you expect the rand to weaken against the dollar), then you click Bid to go long at R Ask: If you want to buy rand (in other words you expect the rand to strengthen against the dollar), then you click "Sell" to go short at R Example: The US Dollar / Rand was trading at R10.00 yesterday and today it is trading at R this means that the base currency which is the US Dollar (left in the equation), increased or strengthened from R10.00 to R10.30 and the quoted currency which is the Rand (right in the equation), decreased or weakened from R to R Therefore, in this example we can say that the Rand weakened against the dollar, which is good news for exporters because they get more Rands for their goods, while importers have to pay more. In the reverse example the US Dollar / Rand was trading at R10.30 yesterday and today it is trading at R this means that the base currency which is the US Dollar (left in the equation), decreased or weakened from R10.30 to R10.00 and the quoted currency which is the Rand (right in the equation), increased or strengthened from R10.30 to R Therefore, in this example we can say that the Rand strengthened against the Dollar, which is good news for importers because they pay less Rands for their goods, while exporters get less money for their goods. Expiry months and date The currency futures and options contracts expire two business days before the third Wednesday of each expiry month. In the months where this day is not a business day, the contract will expire the first business day before the allocated day. March June September December Settlement The foreign currency futures contracts are cash settled in Rand. In other words, no physical delivery of the underlying currency or base currency will ever take place. Margins Initial Margin is required when a Currency Future and options is opened i.e. when a contract is purchased (long) or sold (short). The client will deposit cash into the (clearing) bank and they will then deposit it with the JSE clearing house. The Initial Margin is on average 5% of the nominal value of the contract opened. This margin amount earns a market related interest.

5 The Mark-to-Market (MTM) process entails calculating the price movement from the close of yesterday to the close of today. The difference in the closing prices determines the profit or loss of the position. If the difference is positive then the profit is paid to the investor. If the difference is negative then the investor has to pay the JSE clearing house the amount owed. Closing out or rolling over a Position Currency Future contracts can be bought or sold, any time during the JSE YieldX Exchange hours: 09H00-17H00 during workdays, or left to expire on the date the contract ends or rolled over to the next contract month. Closing out a contract entails the investor taking an equal and opposite position to his existing position. For example, if an investor has entered a long position i.e. buys 1 contract in the Currency Futures contract he would need to sell 1 contract. The net of the two positions will be zero thus closing out the initial contract position. The futures contract can also be rolled over. This means that the investor can choose to keep the same position past the expiry date of the contract, that is: he can roll the position over to the next expiry date. The exchange offers a discounted fee for all positions that are rolled over. The investor benefits from rolling his position over because the same hedge is preserved. Options contracts can t be rolled over and they expire at the end of their duration. Alternatively, the investor can let the contract automatically expire on the date of expiry. Here, the exchange closes out the position and charges a fee for doing so. On the expiry day the contract position is Mark-to-Marketed for the last time and the initial margin is returned. Yield-X offers the following currency futures contracts: Symbol Country Currency ZAR South Africa Rand EUR Euro zone members Euro JPY Japan Yen GBP Great Britain Pound (Sterling) CHF Swiss Franc Franc AUD Australia Dollar CAD Canada Dolar CNY China Yuan

6 Benefits of trading currency futures via the Yield-X exchange Currency futures equalise the playing field for all investors The product allows for individuals to access the currency market generally reserved for institutions and allows for smaller corporate entities to access favourable rates generally reserved for the larger corporates The Johannesburg Securities Exchange regulates transactions Allows for transparent pricing Less administration - no reporting to SARB required and no firm and ascertainable commitment required (i.e. no SARB documentation required to hedge: only a YieldX Client Agreement and FICA) No penalties for adjusting your position excluding basic cost Low brokerage Low margin requirements Daily summary and research Low barriers to entry online software platform available i.e. Swordfish High liquidity - you can instantaneously buy and sell at will as there will usually be someone in the market willing to take the other side of your trade Leverage - a small deposit can control a much larger total contract value. Leverage gives the trader the ability to make nice profits, and at the same time keep risk capital to a minimum. Currency Futures Details Contract size: 1 futures contract exposes you to 1000 of the foreign underlying currency or the base currency: US$ 1000 or 1000 or 1000 Price movement: 1c = R10 Profit or Loss per contract Contracts quoted to 4 decimal places in the currency markets one unit is called a tick or a pip and it refers to the minimum price movement, i.e to = 1 tick or pip movement Price movement from R to R = 1 tick = R0.10 per contract Price movement from R to R =1c = R10 per contract (1c = 100 ticks) Price movement from R9.05 to R9.06 = 1c = R10 per contract Cash settlement in Rand No physical delivery of foreign currency Example: If you buy 1 US Dollar / Rand contract at R10.00 and you sell your 1 contract at R10.30 to close-out the position (the base currency increases or strengthens while the quoted currency decreases or weakens) then you have made a profit minus the brokerage and exchange fees. R10.30 R10.00 = 30c price movement. Therefore, 0.30*1000 (contract size)*1 contract = R300 profit. If you bought 2 contracts then the equation is, 0.30*1000*2 contracts = R600 profit. This example only shows the gross profit. The net profit equals gross profit minus brokerage and exchange fees: Total costs (brokerage and exchange fees) are R12.50 per contract or c price movement per contract. Therefore, the breakeven level would be at R (costs charged on opening and closing of position). The net profit is: R R = *1000 (contract size)*1contract = R275. The net profit for 2 contracts is: *1000*2 contracts = R550.

7 Examples: Hedging a transaction for importers Currency Future example 1. How to place an order: John believes the Rand will weaken against the US Dollar, but is not sure how to benefit from this. John calls his broker and explains his views. His broker advises John to buy (go long) a future on the US$/R contract (enabling John to buy $ and sell Rand), or to buy a call option. Importers risk is Rand weakness : R10.00 to R10.30 equal rand weakness. Hedge by buying the 10.00, therefore you buy the US$ and sell the Rand R 1,000 Day 1 Day 2 Day 3 Day Market to Market Price Profit/Loss for the day Profit/Loss * Multiplier Initial margin per contract R R R Nett Cashflow for the day R R R R Portfolio Value R 1, R 1, R 1, R 1, Hedge or protection was entered at R10.00 and the hedge was closed at R10.30 which made R0.30 or R275, which offsets the loss made in the spot market. Currency Future example 2. R 1,000 Day 1 Day 2 Day 3 Day Market to Market Price Profit/Loss for the day Profit/Loss * Multiplier Initial margin per contract R R R Nett Cashflow for the day R R R R Portfolio Value R 1, R 1, R 1, R Hedge or protection was entered at R10.00 and the hedge was closed at R9.80 which lost R0.20 or R225, which offsets the profit made in the spot market.

8 Currency Option example Buy At The Money call R 1,000 Day 1 Day 2 Day 3 Day Premium Market to Market Price Profit/Loss for the day Profit/Loss * Multiplier Initial margin per contract R R R - Nett Cashflow R R R R Portfolio Value R R R R 1, The call option was entered at strike R10.00 and the option expired at in the money i.e made a profit of R Examples: Hedging a transaction for exporters Currency Future example 1. How to place an order: John believes the Rand will strengthen against the US Dollar, but is not sure how to benefit from this. John calls his broker and explains his views. His broker advises John to sell (go short) a future on the US$/R contract (enabling John to sell $ and buy Rand), or to buy a put option. Exporters risk is Rand strength : R10.30 to R10.00 equal rand strength. Hedge by selling the 10.30, therefore you sell the US$ and buy the Rand R 1,000 Day 1 Day 2 Day 3 Day Market to Market Price Profit/Loss for the day Profit/Loss * Multiplier Initial margin per contract R R R Nett Cashflow for the day R R R R Portfolio Value R 1, R 1, R 1, R 1, Hedge or protection was entered at R10.30 and the hedge was closed at R10.00 which made R0.30, which offsets the loss made in the spot market.

9 Currency Future example 2. R 1,000 Day 1 Day 2 Day 3 Day Market to Market Price Profit/Loss for the day Profit/Loss * Multiplier Initial margin per contract R R R Nett Cashflow for the day R R R R Portfolio Value R 1, R 1, R 1, R Hedge or protection was entered at R10.30 and the hedge was closed at R10.50 which lost R0.20, which offsets the profit made in the spot market. Currency Option example Buy At The Money put R 1,000 Day 1 Day 2 Day 3 Day Premium Market to Market Price Profit/Loss for the day Profit/Loss * Multiplier Initial margin per contract R R R - Nett Cashflow R R R R Portfolio Value R R R R The put option was entered at strike R10.30 and the option expired at which makes the option worthless. The loss is the premium plus the brokerage and the margin is return. Disclaimer: USE & COPYRIGHT Use of this website and any services offered is at the sole risk of the user. The various market reports are intended to provide general information regarding the financial markets. The products and services of the BVG group of companies ( BVG ) and are not intended to constitute investment or other professional advice. It is prudent to consult your own professional advisor before making any investment decision or taking any action which might affect your personal finances or business. The information, views and opinions expressed in these reports/communications are compiled from or based on trade and statistical services or other third party sources believed to be reliable and are therefore provided and expressed in good faith. The views and opinions do not necessarily represent the views and opinions of BVG and consequently BVG does not accept responsibility for such views and opinions, nor does any report and/or commentary in itself constitute binding terms and conditions. Content displayed on the Website is provided by BVG, its affiliates or subsidiaries, or other third party owners of the content ( Content ). All the proprietary works, and the compilation of the proprietary works, belong to BVG, its affiliates or subsidiaries, or any third party owners of the rights, and the Content is protected by South African and international copyright laws.

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