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CURRENCY AND INTEREST RATE FUTURES

CURRENCY AND INTEREST RATE FUTURES. CURRENCY FUTURES.

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CURRENCY AND INTEREST RATE FUTURES

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  1. CURRENCY AND INTEREST RATE FUTURES

  2. CURRENCY FUTURES • A futures contract, like a forward contract is an agreement between two parties to exchange one asset for another, at a specified date in the future, at a rate of exchange specified up front. However, there are a number of significant differences. • Major Features of Futures Contracts • Organized Exchanges not OTC markets. • Standardization : Amount of asset, expiry dates, • deliverable grades etc. • Clearing House: A party to all contracts. Guarantees • performance. Mitigates/Eliminates Credit Risk • Daily mark-to-market and a system of margins. • Actual delivery is rare.

  3. Foreign Currency Futures • Contract specifications are established by the exchange on which futures are traded. • Major features that are standardized are: • Contract size • Method of stating exchange rates • Maturity date • Last trading day • Collateral and maintenance margins • Settlement • Commissions • Use of a clearinghouse as a counterparty

  4. FUTURES CONTRACTS • Global Futures Exchanges: • 1) IMM: International Monetary Market • 2) LIFFE: London International Financial Futures Exchange • 3) CBOT: Chicago Board of Trade • 4) SIMEX: Singapore International • Monetary Exchange • 5) DTB: Deutsche Termin Bourse • 6) HKFE: Hong Kong Futures Exchange

  5. FUTURES CONTRACTS • B. Forward vs. Futures Contracts • Basic differences: • 1) Trading Locations • 2) Regulation • 3) Frequency of delivery • 4) Size of contract • 5) Transaction Costs • 6) Quotes • 7) Margins • 8) Credit Risk

  6. Comparison of the Forward & Futures Markets Forward MarketsFutures Markets Contract size Customized Standardized Delivery date Customized 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. Clearing Handled by Handled by operation individual banks exchange & brokers. clearinghouse. Daily settlements to market prices.

  7. Comparison of the Forward & Futures Markets Forward MarketsFutures Markets Marketplace Worldwide Central exchange telephone floor with worldwide network communications. Regulation Self-regulating Commodity Futures Trading Commission, National Futures Association. Liquidation Mostly settled by Mostly settled by actual delivery. offset. Transaction Bank’s bid/ask Negotiated Costs spread. brokerage fees.

  8. FUTURES CONTRACTS • Advantages of Futures: • 1) Easy liquidation • 2) Well- organized and • stable market. • 3) No credit risk • Disadvantages of Futures: • 1) Limited to a few • currencies • 2) Limited dates of • delivery • 3) Rigid contract sizes

  9. FUTURES CONTRACTS ON IMM • Available Futures Currencies/Contract Size: • 1) British pound / 62,500 • 2) Canadian dollar /100,000 • 3) Euro / 125,000 • 4) Swiss franc / 125,000 • 5) Japanese yen / 12.5 million • 6) Mexican peso / 500,000 • 7) Australian dollar / 100,000

  10. Exchange traded currency futures were launched in India on August 29, 2008. As of now only USD-INR contracts have been permitted with contract size of USD 1000 with monthly maturities upto twelve months. The contracts will be cash settled in INR. Contracts will expire on the last working day of the month. Quotations will be given in rupee terms. Unlike OTC forwards, no underlying exposure is required to trade in USD-INR futures. Individuals can also trade for purely speculative purposes. Margins will be calculated using a VAR framework. Contracts have started trading on NSE. Eventually, they will also be traded on MCX and BSE. Contracts between INR and other currencies will be introduced later based on perception of market interest.

  11. FUTURES CONTRACTS • Transaction costs: • Commission payment to a floor trader; Brokerage, Bid-Offer Spreads • Leverage is high • Initial margin required is relatively low (less than 2% of contract value).

  12. FUTURES CONTRACTS: SAFEGUARDS • Maximum price movements • 1) Contracts set to a daily price limit restricting maximum daily price movements. • 2) If limit is reached, a margin call may be necessary to maintain a minimum margin.

  13. System of Margins • Initial margin: When position is opened • Variation Margin: Settlement of daily gains and losses • Maintenance Margin : Minimum balance in margin account. Balance falls below this, margin call issued. If not met, position liquidated. • Regulators specify minimum margins between clearing members and clearinghouse. Margins at other levels negotiated • Margins can be deposited in cash or specified securities such as T-bills. Interest on securities continues to accrue to owner. Margin is a performance bond. • Levels of margins may be changed if volatility increases.

  14. System of Margins • With clearing house guarantee, buyer-seller need not worry about each other’s creditworthiness. • Standardized contracts with margin system increase liquidity. • Protects clearing house; enhances financial integrity of the exchange. Credit risk issues almost eliminated

  15. CLEARING HOUSE CLEARING MEMBER A CLEARING MEMBER B NON-CLEARING MEMBER CUSTOMER CUSTOMER NON-CLEARING MEMBER CUSTOMER CUSTOMER

  16. TYPES OF ORDERS IN FUTURES MARKETS Market Orders : Execute at best available price Limit Orders: Sell above or buy below stated limits Market If Touched or MIT Orders: Become market orders if price touches a trigger Stop-Loss Orders : Sell if price falls below a limit; buy if it rises above a limit. Used to limit losses on existing positions Stop Limit Orders : Stop loss plus limit Time of Day Orders, Day Orders, Good Till Canceled(GTC) Orders Participants : Brokers, Floor Traders, Dual Traders, Futures Commission Merchants. Hedgers and speculators both participate.

  17. Currency Futures Contract Specifications Exchange: IMM at Chicago Mercantile Exchange(CME) British Pound Japan Yen Size: £625000 ¥12,500,000 "Tick": $ 0002 per £ $0.000001 per ¥ (Per Contract) ($12.50) ($12.50) Expiry Months: January, March, April, June, July, September, October, December, & Spot Month (Both GBP and JPY) Limit: NO LIMIT FOR THE FIRST 15 MINUTES OF TRADING. A schedule of expanding price limits will be in effect when the 15-minute period is ended. (Both GBP and JPY) “Tick” : Minimum size of price movement.

  18. PRICE QUOTES OCTOBER 1, 2009 JAPANESE YEN (CME) USD PER 100 JPY ContractOpen High Low Settle Chg Op Int Dec 09 1.1153 1.1189 1.1095 1.1146 -.0016 117663 Mar 10 1.1140 1.1194 1.1109 1.1153 -.0017 107 Jun 10 1.1120 1.1185 1.1120 1.1167 -.0018 9 SOURCE : WALL STREET JOURNAL

  19. OCTOBER 1, 2009 BRITISH POUND (CME) Contract Open High Low Settle Chg Op Int Dec 09 1.6005 1.6024 1.5920 1.5946 -.0056 102389 Mar 10 1.5992 1.6009 1.5923 1.5945 -.0056 97 SOURCE : WALL STREET JOURNAL

  20. OCTOBER 1, 2009 SWISS FRANC (CME) ContractOpen High Low Settle Chg OP INT Dec 09 0.9658 0.9678 0.9571 0.9608 -.0052 45156 SOURCE : WALL STREET JOURNAL

  21. USD/INR CONTRACT TRADED ON MCX-SX OCTOBER 1, 2009 QUOTES CONTRACT OPEN HIGH LOW CLOSE OP.INT NOTIONAL VALUE OCT 09 47.90 47.99 47.78 47.86 300000 522288.06 NOV 09 48.03 48.10 47.89 47.96 95700 139438.45 DEC 09 48.11 48.18 47.99 48.05 4800 1482.95 JAN 10 48.19 48.19 48.10 48.10 2000 15.01 CONTRACT SIZE : USD 1000 TICK SIZE : Rs.0.25 NOTIONAL VALUE: VALUE OF CONTRACTS TRADED RS.LAKH EXPIRY DATE: 2 BUSINESS DAYS BEFORE THE LAST WORKING DAY OF THE CONTRACT MONTH Source: BUSINESS STANDARD

  22. MCX-SX USD/INR FUTURES, November 25, 2008 The MCX-SX INR December futures opened stronger and made a high of 49.96 on the back of overnight strength seen in US markets coupled with strong Asian markets in the morning. US rescue package of around $306 billion to Citigroup saw support being provided to stock markets. One-month offshore Non-Deliverable Forward contracts were quoting at 50.62/77, weaker than the onshore spot rate, indicating the outlook for the currency continues to be bearish in the near term. MCX-SX INR December futures towards the end of the session closed towards 50.33. Supports are at 50 followed by 49.7, while the resistances are seen around 50.60 followed by 50.95 levels.MCX-SX INR January futures closed towards 50.52 and registered a volume of 13.02cr and the open interest increased by 52.03% from the previous session.

  23. Mumbai, Dec 2 The December futures contract today ended higher at 50.43 on the currency derivatives segment of the MCX Stock Exchange (MCX-SX). The December contract resumed lower due to sharp losses seen in Asian stock markets. Looses in the market would see more outflows of funds, which would continue to pressure rupee in the near term. RBI intervention was seen around 50.50 to arrest the rupee fall. But the inflows into the system are very less compared to outflows by the FIIs. Foreign fund outflows have been a key factor for the rupee's decline this year, which is 22 per cent down. One-month offshore Non-Deliverable Forward contracts were quoting at 51.35/50, weaker than the onshore spot rate, indicating a bearish outlook for the currency. Supports for December contract are at 50.15 followed by 4990, while the resistance are seen around 50.95 followed by 5120 levels and January futures closed towards 50.65 and registered a volume of 96.385 crore Spot rupee closed stronger during the session. Supports hold between 49.55/65 followed by crucial support at 49.10, Resistance are around 50.90 followed by 5130 levels The MCX-SX active December contract registered volume increase of around 21.16 per cent over the previous session.

  24. FUTURES PRICES, SPOT PRICES AND EXPECTED SPOT PRICES • Basis = (Spot Price – Futures Price) • Normal Backwardation : Hedgers net short. Speculators must be net long; they would do so if they expect futures price to rise. Futures price rises as maturity approaches. • Contango : Hedgers net long. Speculators net short. Futures price expected to fall as maturity approaches • Net Hedging Hypothesis • Risk Aversion and behaviour of futures prices • Futures Price = Expected Spot Price ?

  25. Backwardation Contango EXPECTED SPOT PRICE FUTURES PRICE FUTURES PRICE Expiry Expiry Time Time

  26. FUTURES PRICES AND FORWARD PRICES • DETERMINISTIC INTEREST RATES: FUTURES PRICES EQUAL FORWARD PRICES • STOCHASTIC INTEREST RATES : FUTURES PRICES DIFFER FROM SPOT PRICES DUE TO DAILY GAINS AND LOSSES • SPOT PRICE AND INTEREST RATE POSITIVELY CORRELATED: FUTURS PRICE EXCEEDS FORWARD PRICE • NEGATIVE CORRELATION: FUTURES PRICE LESS THAN FORWARD PRICE

  27. FUTURES PRICE AND SPOT PRICE • CASH-AND -CARRY ARBITRAGE • Spot Price of a dollar : Rs.44.00 • 3-month Futures Price : 45.75 • Rupee interest rate : 6% p.a. • Dollar interest rate : 4% p.a. • Borrow rupees, buy dollars and deposit, sell futures. • 3 months later, deliver, get rupees, repay loan.

  28. Suppose contract size is $50000. Must deposit $(50000)/(1.01) = $49504.95 Must borrow Rs.(49504.95)(44.0) = Rs.2178217.82 Must repay (2178217.82)(1.015) = 2210891.09 On expiry, liquidate deposit, deliver on futures collect Rs.2275000. Net profit: 64108.91 Futures Price “too high” : Buy asset in spot market, store, pay storage cost, sell futures, deliver at expiry. Futures Price too low (e.g.44.60) Reverse cash-and- carry arbitrage. Borrow dollars, convert to rupees and deposit, buy futures. Take delivery at expiry and repay dollar loan. Nothing but Covered Interest Arbitrage

  29. Arbitrage and Theoretical Futures Price Let C denote the present value of carrying costs, St the spot price, r the interest rate, and FUt,T the futures price for delivery at T, Then theoretical futures price is given by FUt,T = (St + C)[1 + r(T-t)] Actual futures price higher : cash-and-carry arbitrage Actual futures price lower: reverse cash-and-carry arbitrage For currency futures, futures prices are almost identical to forward prices. A similar relation will hold between FUt,T1 and Fut,T2, T2>T1>t

  30. In practice futures price does not exactly equal theoretical futures price. Reasons: 1 Transaction costs – bid-offer spreads, brokerage 2 In some cases, restrictions on short sales (Does not apply to currency futures) 3 Non-constant interest rates 4 Mark-to-market gains/losses. 5 “Convenience yield” (Commodity futures) A band of variation around theoretical price.

  31. Hedging with Currency Futures • A corporation has an asset e.g. a receivable in a currency A. • To hedge it should take a futures position such that futures generate a positive cash flow whenever the asset declines in value. • The firm is longin the underlying asset, it should go short in futures i.e. it should sell futures contracts on A against its home currency. • When the firm is short in the undelying asset – a payable in currency A – it should go long in futures. • Cash Position: Receive A; Futures Position: Deliver A • Cash Position: Deliver A; Futures Position: Receive A • If no futures between A and HC, use futures between A and a currency closely correlated with HC.

  32. Futures Hedge : An Example January 30. A UK firm has $250000 payable due on August 1. £/$ spot:1.7550. GBP Futures: September: 1.7125 December: 1.6875 Decides to hedge with September futures. GBP value of USD payable at futures price: (250000/1.7125) = £145985.40. Each GBP futures contract is for £62500. Sells (145985.40/62500) = 2.3357 rounded off to 2 contracts. Could be rounded off to 3 contracts.

  33. On July 30 the rates are: July 30: £/$ spot: 1.6850 September futures: 1.6750 Firm buys USD spot. It has to pay GBP(250000/1.6850) = £148367.95 Compared to the GBP value of payable at the spot rate at start this represents a loss of GBP 5917.81. Buys 2 September futures contracts at $1.6750 to close out the futures position. Gain on futures : $(1.7125-1.6750)(2)(62500) = £4687.50. Not a perfect hedge. Basis narrowed.

  34. Futures Hedge : Example (contd) • Choice of contract underlying was obvious. • Firm chose a contract expiring immediately after the payable was to be settled. Is this necessarily the right choice? • The number of contracts chosen was such that value of futures position equaled the value of cash market exposure, aside from the unavoidable discrepancy due to standard size of futures contracts. Is this the optimal choice? • Futures hedge involves three considerations: Underlying, expiry date of the contract, number of contracts. The latter two problems do not arise with forwards. Why?

  35. Three Decisions (1) Which contract should be used i.e. the choice of "underlying". Home currency A; exposure in B; futures on B against A available – Direct hedge. Home currency A; exposure in C; no futures on C against A. B and C are highly correlated; use futures on B – Cross Hedge (2) Choice of expiry date : In February A UK firm books a USD payable maturing on June 3. To hedge, must sell GBP futures (Buy USD futures). Which month? June or later? (3) How many contracts? Choice of “hedge ratio”. Value of futures position = Value of underlying exposure?

  36. Choice of expiry date: As expiry date approaches, basis narrows. On expiry date futures price equals spot price. This is known as “Convergence”. Does convergence help you or hurt you? If convergence helps, choose near contract If convergence hurts, choose far contract. However, liquidity less in far contracts; bid-offer spreads are higher; basis volatility more. Thumb rule followed by practitioners: Choose expiry date immediately after underlying exposure is to be settled.

  37. Choice of Expiry Date Basis at the start Positive Negative Nature of hedge Long F A Short A F Long Hedge: You must take delivery of underlying in your futures position. You have bought futures contracts. Short Hedge : You must make delivery of underlying in your futures position. You have sold futures. F: Convergence favours you. A: Convergence against you. Positive Basis: Spot price > Futures Price

  38. Choosing the Number of Contracts • A Swiss firm has a USD payable of $500,000, maturing November 15. • It decides to sell December contracts priced at $0.74/CHF. • At this price, the CHF equivalent of $500,000 is CHF 675675.68. • Since one CHF contract is for CHF 125,000, it should sell : (675675.68/125000) = 5.4054 rounded off to 5 or 6 contracts. • Sounds logical but is it necessarily correct? • What is the objective of hedging? • To minimize the variance of the hedged position? • Define the "Hedge Ratio"(HR) as : VF/VH • = (Value of futures position/Value of cash position) • Should HR = 1.0 always?

  39. Direct Hedge with a Timing Mismatch • Choosing Hedge Ratio • A Swiss firm on February 28 has a USD 500,000 payable to be settled on July 1. • Cash market position short USD. Must buy USD futures or short CHF futures. • It chooses to hedge by selling September CHF contracts. This contract matures on September 18. • The spot rate is USD/CHF1.3335 or CHF/USD 0.7499 • September futures price is USD/CHF 1.4518 or CHF/USD 0.6888 • Each CHF contract is for CHF 125000. • Determine the number of contracts it should short. • .

  40. Choosing Hedge Ratio …. VC : The value of the cash market position measured in the foreign currency. St : The spot rate at the start stated as units of home currency(HC) per unit of foreign currency(FC). T1 : The date when the cash position has to be settled. T2 : The date when the futures contract expires, T2 > T1 VF : The value of the futures position measured in US dollars. Ft,T2 : The price at time t of the futures contract maturing at T2 stated as units of HC per unit of FC. In the example HC: CHF FC: USD Vc = $500000 St = 1.3335 T1: July 1 T2: September 18 Ft,T2 = 1.4518

  41. Choosing Hedge Ratio…. F~T1,T2 : The price of the same contract at time T1 (arandom variable)  S~T1: The spot rate at time T1 when the hedge is lifted. Stated as units of HC per unit of FC. (Random variable) The value of the hedged cash flow at time T1 is given by V˜H,T1 = - VCS˜T1 + VF (Ft,T2 – F~T1,T2) The variance of V˜H,T1is (VC)22(S˜T1) + (VF)22(F˜T1T2)– 2VCVF COV(S˜T1 F~ T1,T2) Let H = VF/VC be the hedge ratio

  42. Then (VC)2 2(S˜T1) + (VF)22(F˜T1T2)– 2VCVF COV(S˜T1 F~T1,T2) = (VC)2 [2(S˜T1)+ H2 2(F˜T1T2)– 2H COV(S˜T1 F~ T1,T2)] To minimize this w.r.t. H 2 H 2(F˜T1T2)– 2 COV(S˜T1 F~T1,T2) = 0 This leads to H = VF/VC = COV(S~T1, F~T1T2) / VAR(F~T1T2) We need forward-looking estimates of these parameters. Using past data estimate a regression equation: S~T1 =  +  F~T1T2 + u The estimate of  can be used as hedge ratio. But this would be a historical estimate.

  43. Let us apply this result to the Swiss firm's case. • Assume that we have somehow obtained estimates of the covariance of S˜T1 and F˜T1,T2 and the variance of F˜T1,T2. • Their ratio is 0.90. • Then the USD value of the futures position must be (500,0000.90) = USD 450,000. • At the futures price of $0.6888/CHF this translates into CHF 653310.10. • With each contract being CHF 125,000 this is equivalent to 5.23 contracts rounded off to 5 or 6 contracts.

  44. The interest parity relation tells us that [1 + rB(T-t)] Ft,T2(A/B) = St(A/B) ----------------- = k St(A/B) [1 + rA(T-t)]   [1 + rB(T-t)] wherek = ----------------- [1 + rA(T-t)] If the factor k remains constant, then (FT1,T2-Ft,T2) = k(ST1 - St) and a hedge ratio VF/VC = 1/k =  would give a perfect hedge. But k does not remain constant. Optimal hedge ratio keeps changing

  45. Dynamic hedging: As interest rates and spot rate keep changing, recalculate the optimal hedge ratio and rebalance the hedge by selling more futures or buying futures. How frequently? • Transaction costs must be considered. Any gain from frequent rebalancing must be weighed against increased transaction costs. • Large position, long duration of hedge, more frequent rebalancing warranted. • Standard-size problem cannot be circumvented.

  46. SPECULATION WITH CURRENCY FUTURES • Open Position Trading • In April Spot EUR/USD: 1.5750 • June Futures : 1.5925 • September Futures: 1.6225 • You do not think EUR will rise. It will fall. • You do not think EUR will rise so much. • How to profit from this view? Sell September.

  47. SPECULATION WITH CURRENCY FUTURES On September 10 the rates are : Spot EUR/USD: 1.5940 September futures: 1.5950 Close out by buying a September contract. Profit USD(1.6225-1.5950) per EUR on 125000 EUR = USD 3437.50 minus brokerage etc. First view was wrong; EUR did appreciate but not as much as implied by futures price.

  48. SPREAD TRADING • Intercommodity Spread • In April : Spot EUR/USD : 1.5500 GBP/USD: 1.9000 • September Futures: EUR: 1.5800 GBP: 1.8580 • Your view: GBP is going to rise against EUR. • What should you do? • Intracommodity Spread: • June EUR: 1.5800 September EUR : 1.7500 • Your view: Between June and September EUR will not rise so much. What should you do?

  49. INTEREST RATE FUTURES Treasury Bill Futures A futures contract on US treasury bills is traded on the CME. Its specifications are as follows: Product and Trading unit: 13 WEEK TREASURY BILL FUTURES 3-month (13-week) U.S. Treasury Bills having a face value at maturity of $1,000,000  Point Description: ½ point = .005 = $12.50. A point here is one basis point or (1/100)th of 1 percent.

  50. CME 13 WEEK US T-BILL

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