Futures FX Market

1. Futures FX Market Dr. J. D. Han King’s College University of Western Ontario

2. I. FX Futures 1. Rationales: 1) To overcome Lack of Liquidity of Forward Market, which is mostly O.T.C. -> Futures Market has Standardized Transactions, and is Standing Market -> Futures are Common men’s Forward Contract 2) To overcome the Credit/Default Risk -> Third Party Market, Performance Bonds(Margin), etc. 3) Leverage -> Leverage in futures trading means that the amount you need to deposit is small in comparison to the amount of product it will control.

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4. 3. History and Currents of the Futures Market: • Chicago Mercantile Exchange started FOREX Future Trading in 1972 • Daily average trading volume exceeds US $ 100 billion • Website of FX futures in CME http://www.cmegroup.com/trading/fx/

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6. Standardized Contract Size • British Pound 62,500 • Euro 125,000 • Swiss Franc 125,000 • Australian Dollar 100,000 • Canadian Dollar 100,000 • Chinese Yuan 1,000,000 • Japanese Yen 12,500,000

7. 6. Operation of Futures Market: Daily Reconstructed/Settled Forward market • Margin Deposit (=performance bonds=Initial Deposit Requirement) • Buy (take long-position) if you expect/need the price of a currency to rise; Sell (take short-position) if you expect/need it to fall. • Futures settlement price changes every day • Profits or Losses are settled on a daily basis from a mandatory margin account -> “Marking to Market”

8. Numerical Example 1. • British Pound 625,000 pounds • Initial Margin = Performance Bonds -$ 2,900 for hedgers • Maintenance Margin = $ 2,6\900

9. Suppose you buy a unit at 1.4444 $ per Sterling Pound. • Initial Margin Requirement by CME = $2900 for a hedger • Suppose Actual Initial Margin Deposited =3000 • Next day, the rate of GBP Futures falls to 1.4334 • You have lost 11 points or 0.0110 dollar per Sterling Pound. - For one unit has 62,500 pounds. - You have lost 0.0110 dollar x 62,500 pounds for a unit of GBP Futures = 687.5 dollars = Marking to the Market • Margin Balance = 3000 – 687.5 = 2313.5 • Maintenance Margin set by CME = 2900 • Variation Margin Requirement to refill = 587.5

10. Numerical Example 2 • You are a Canadian exporter to U.S. and are to receive U.S. 1 mil in 3 months, that is, June 2010(t+1). • How would you do FX Hedging in the CME?

11. To start: Performance bond = U.S. $ 3300 for a hedger • Mindset: You have to put on the U.S. shoes-Act and think like you are a U.S. citizen for SU.S $./C$ • What to do? You are (buying/selling) Canadian Dollar Futures (CD) in CME, which will expire/deliver on March 2010. • How much? Each unit = C $100,000 So you buy 1/S = 1/0.82 =about 12 units of CD for $100,000 for the corresponding rate = 0.8159 at 10:25:30 AM CST 2/09/2009. Thus you pay 0.8159 x 100,000 x 12 = U.S. $ 978,900. You have to get it from Spot Market at the current Spot rate St.

12. Forward Contract Suppose that at the expiry date in June 2009, the CD M06 is 0.8400. You win the net of (0.8400-0.8159) x 100,000 x 12 U.S. dollars. (St+1 – F) times 1 million -(a) • Initial FX Risk Exposure of Business However, that forward rate is close to the spot rate in June 2009. You have lost (St+1 –St ) times 1 million –(b) • (a) makes up the whole or part of (b). -When F = St, then F-St = 0, it is a perfect coverage.. F- St is inevitable change not to be covered. ,