5. Foreign Currency Futures

Transcription

1 5. Foreign Currency Futures Futures contracts are designed to minimize the problems arising from default risk and to facilitate liquidity in secondary dealing. In the United States, the most important market for foreign currency futures is the International Money Market (IMM) of Chicago, a division of the Chicago Mercantile Exchange. The best way to understand these contracts is to compare them with forward transactions. Like forward contracts, currency futures contracts are, in principle, contracts to deliver a given amount of currency on a given date and at a pre-specified price to be paid later on. Like forward contracts, futures contracts have a zero initial market value: neither the buyer nor the seller has to pay anything when a contract is initiated at the going market rate. However, futures contracts differ from forward contracts in many other respects. 5.1 Currency Futures Markets As we have seen before, forward contracts are held until maturity. At that point, a prespecified amount of currency is delivered at a pre-agreed price. However, only about 5 % of all futures contracts are settled by the physical delivery of foreign exchange between buyer and seller. Most often, buyers and sellers offset their original position prior to delivery date by taking an opposite position. The complete buy/sell or sell/buy is called a round turn. Customers usually pay a commission to their broker to execute a round turn and only a single price is quoted. Organized Markets: Futures are traded on organized exchanges, with specific rules about the terms of the contracts, and with an active secondary market. Futures prices are the result of a centralized, organized, matching of demand and supply. One method of organizing this matching of orders is the open outcry system, where floor members are physically present in a trading pit and auction off their orders by shouting them out: examples include the International Money Market (IMM) in Chicago and the London International Financial Futures Exchange (LIFFE). Another method is to centralize the limit orders in a computerized Public Limit Order Book. A limit order is an order to buy and indicated number of currency units at a price no higher than a given level or to sell an indicated number of currency units at a price no

2 lower than a given level. Brokers sit before their screens, and can add or delete their orders, or fill a limit order posted on the screen. Clearing Corporation: Futures contracts are not initiated directly between clients. Rather, each party has a contract with the futures clearing corporation or clearing house. Consequently, clients need not worry that a specific counterpart in the market will fail to honor an agreement. Moreover, the clearing corporation levies a small tax on all transactions, and thus has reserves that should cover losses from default. Contract Specifications: Exact contract specifications are defined by the exchange on which they are traded. This standardization means that the futures market is not as fragmented by too wide a variety of contracts as in the forward market. Standardization facilitates the emergence of a deep, liquid market. The major features that must be standardized are usually the following. A Specific Contract Size: For example, a CAD contract is for CAD 100,000 (IMM). A Standard Quoting Convention: For example, the American terms (USD/CAD) are used at the IMM. A Standard Maturity Date: Expirations dates are typically the third Wednesdays of March, June, September, or December. A Specified Last Trading Day: Trading stops two business days before the expirations date. Actual delivery takes place on the second business day after the expiration date. Specific Collateral: The purchaser must deposit a sum as an initial margin or collateral. In addition, a maintenance margin is required. The value of the contract is marked to market daily, and all changes in value are paid in cash daily. The amount to be paid is called the variation margin.

3 5.2 Currency Futures Quotations Following is an example of a quote that appear in The Wall Street Journal on Friday 30 July 1993, showing information on yen futures trading for Thursday 29 July 1993 on the International Money Market (IMM) of the Chicago Mercantile Exchange (CME). Lifetime Open Open High Low Settle Change High Low Interest JAPAN YEN (CME) 12.5 MILLION YEN; $ per yen (.00) Sep ,221 Dec ,455 Mr Est vol 28,844; vol Wed 36,595; open int 77,028, + 1,820 The first line shows the size of the contract (12.5 m yen) and states that the prices are stated in USD cents. The June 1993 contract had expired, so the tree contracts being traded on 29 July 1993 are the September and December 1993 contracts, and the March 1994 contracts. Note that there was no trading on the March 1994 contracts for that day. The different headers are: Open: The price at the start of trading on 29 July. High and Low: The highest and lowest transaction prices on 29 July. Settle: The settlement price on 29 July (representative of prices around the close). Change: The change in the settlement price between 28 July and 29 July. Lifetime High and Low: The highest and lowest prices during the life of the contract. Open Interest: The number of outstanding contracts (note: trading is concentrated in the nearest maturity contract). The last line gives an estimate of the volume traded that day and the previous day (Wednesday 27 July 1993). Also shown is the total open interest across the three contracts and the change in open interest relative to the day before.

4 5.3 Marking to Market and Margin Requirements Marking to Market: The futures contract stipulates that the buyer pays the initially agreed-upon amount later on. With a forward contract, later on means at the value date. With a futures contract, however, the exact details of how much is paid at what time depend on the day-to-day movements of the futures price. Consider the following sequence of ex post daily cash flows in a three-day contract (dates 0,1,2,3) to purchase foreign currency: Day: Settlement Price (Settle): Marking to Market: Pay 2 Pay 2 Receive 1 Final Payment for Delivery: Pay 97 The table shows the cash flows to the buyer. The cash flows to the seller are the reverse. Ignoring the time value of money, the cumulative payment from the buyer is equal to =100 units of home currency. Marking to market is the most crucial difference between forward and futures contracts. It means that if an investor defaults, the gain from defaulting is simply the avoidance of a one-day marking to market outflow. All previous losses have already been settled in cash. Compared to a forward contract, the incentive to default on a futures contract is small. For a forward contract, defaulting means that the investor saves the amount lost over the entire life of the contract. The counterpart of this statement is that if an investor fails to make the required margin payment, the loss to the clearing-house is simply the day's price change. Finally, note the futures price for delivery of a currency today must be equal to the relevant spot rate (convergence property): f = S T, T T Margin Requirements: 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

5 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. Example 8.1: 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, 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.

6 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. The Perfect Match: Consider the case of US firm in the import/export business. The firm will receive a payment of CAD 500,00 on December 21. It happens that there are CAD 100,000 futures contracts available for a maturity of December 21. To hedge its future payment, the firm sells 5 futures contract of CAD 100,000 with a maturity of December 21. The firm can hedge that amount by engaging in a forward contract to sell CAD 100, 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 exchange No specific physical location Pricing: Open outcry in the pit Bid and ask quotes Collateral: Initial margin and marking to market No collateral, but standing relations with bank Settlement: Rare delivery on settlement Normal delivery at settlement Commissions: Single commission covers round trip (purchase and sale) Commissions through bid-ask spread Trading Hours: During exchange hours 24 hours a day Counterparts: Client and clearing house Direct relations Liquidity: Liquid (secondary market) Liquid and large volume

7 Advantages of Using Futures Contracts over Forward Contracts: 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. Drawbacks of Using Futures Contracts over Forward Contracts: 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 rats, a hedger has to choose between a forward contracts or money market hedges, or a cross-hedge in the futures market. Futures contracts are available only for a number of short maturity. 5.6 Summary Like forward contracts, currency futures contracts are, in principle, contracts to deliver a given amount of currency on a given date and at a pre-specified price to be paid later on. Currency futures contracts are standardized contracts (size and maturity) traded on an organized market between a client and the clearing corporation. Currency futures contracts are subject to marking to market. That is, the daily variations in futures prices give rise to daily cash flows. The inception of these contracts requires an initial margin. In addition, a maintenance margin is required. Hedging refers to the purchase of an asset that rises in value and offset a drop in value of another asset. Hedges are undertaken to reduce risk by protecting an owner from loss.