Foreign
Exchange Futures
The name gives you
a clue about its meaning. It is a contract to buy or sell a foreign currency at
a “future” date.
It has the same
definition with a forward contract. The main difference is that futures are
standardized contracts.
2.
Standardised
contract
The amount of the
foreign currency you want to buy/sell and the future date are fixed. The future date can either be
March, June, September or December.
Therefore, futures
are not as flexible as forward contracts.
3.
Market
The market for
shares is the stock exchange. Likewise, the market for futures is the future
exchange.
The futures
exchange fixes the future exchange rate. So, there is nothing the you can do to negotiate the rate.
4.
Futures
exchange’s roles
i.
It regulates the futures market
ii.
It eliminates counterparty risk.
5.
Other
party
A forward contract
is agreed with a bank. On the other hand, you can just walk into any futures
exchange to buy futures.
6.
Default
This occurs when
you don’t what you promised. If you promised to sell Naira to a bank today and
you didn’t actually sell, then, you have defaulted.
It is harder to
default on a future compared to a forward contract. This is because future
exchanges have clearing houses that will force you to honour your obligation.
7.
Dollars
It must be the currency
that you are buying or selling. If not, you will need to perform some complex
calculations.
8.
Close-out
forward contract
If I buy a loaf of
bread and I sell it before eating it, it’s just as if I didn’t buy the bread at
all.
The same thing applies to futures. To close out futures that you have sold, you will buy similar
futures with a similar maturity date.
9.
Tick
The value of a
future can either rise or fall. Tick is the minimum change in the exchange
rate. The lowest possible movement of the
exchange rate for a pound/dollar future is $ 0.0001. This means that ANY movement in
the exchange rate must be at least a $0.0001 increase or decrease.
10.
Total
tick
=Size of Futures
Contract*Tick size
11.
Basis
This is the
difference between spot rate and futures price.
12.
Expectation
The future price
is seen as a prediction of the future spot price.
For example, Today is Monday. The spot dollar rate is N200, while Wednesday’s futures price
is N300.
It is expected
that spot rate will be N300 on Wednesday. Spot rate will not just jump to N300,
it will increase gradually.
To compute the gradual
increase, the following formula will be used
(Futures Rate-Spot
Rate)/time to maturity of futures
=
(300-200)/2days=N50 increase/day
So, spot rate is expected to increase to N250 on Tuesday and it’s expected to be N300 on Wednesday.
13.
Basis
risk
The above scenario
is what is expected to happen, but, life
can not meet our expectations 100% of the time. Basis risk is the risk that spot rate
will not move how you expect it to move. E.g Spot rate was actually N235 on Tuesday.
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14. Unexpired basis
This arises when
you cancel a future before its maturity
date. E.g you canceled the above futures on Tuesday.
15.
Managing
Basis Risk
Futures with the
closest maturity to the actual transaction should be chosen. This will minimize any unexpired basis and
basis risk. The smaller the unexpired basis, the smaller the basis risk.
In other words,
the closer the spot price is to the futures price, the lower the basis risk.
E.g This table relates to two futures you sold
Future
1
|
Future
2
|
Spot rate on date sold- N2
|
Spot rate on date sold- N40
|
Futures price- N50
|
Futures Price- N50
|
Unexpired basis- N48 (50-2)
|
Unexpired basis- N10 (50-40)
|
Futures 1 is more
risky because it is harder to predict whether the futures price will be equal
to the spot rate on the maturity date.
16.
Hedging
Futures contracts may not provide a perfect hedge because a whole number of futures have to be
bought or sold. A future is like a live chicken. You cant buy half of a live chicken
in the market. You either buy 0,1,2.....
Basis risk may
also lead to an imperfect hedge.
17.
Initial
Margin
If you trade in
futures, you will actually pay/receive the money on the fixed future date. This
means that you can decide not to pay on the D-day.
The future
exchange will prevent this by collecting initial margin when you trade in a future. This is a form of deposit to the futures exchange. This means that you
cant just walk away scott-free.
It is paid into a ”Margin
account”.
18.
Variation
Margin
This is an
additional margin collected by the futures exchange when a trader is making
significant losses. The exchange uses a “margin call” to demand for it.
19.
Trade
When you buy
dollar futures, you want to buy dollars at a future date and vice versa. An easy way to
understand this is to pretend that I didn’t say futures in the last sentence.
To buy dollars, you have to use Naira. Since,
you are giving Naira away to get dollar, this means that you are selling Naira.
The currency you give away is the one that you are selling.
20.
Number
of contracts
=(Transaction
amount/Standard size of futures contract)*(Hedging Period/ 3months)
Hedging period is
divided by 3 months because futures mature every 3 months.
21. Aim
Hedging with
futures aims to achieve a break even position whereby losses are cancelled out
by gains. You trade in futures to profit from what is seen as a risk.
22.
Buy/Sell?
Always think about this
in terms of the currency of the futures. This can either be the home currency/
foreign currency.
Example 1
You expect to
receive $1m in 3 months time and you want to hedge the risk using Dollar futures.
Risk: the risk is
that the value of dollar will fall, so, you will receive a lower amount of
Naira
Response: Sell
Dollar futures. You are afraid that dollar will fall in value, so, you choose to
sell when it has a high value. This will cancel out the above risk.
Example 2
You expect to
receive $1m in 3 months time and you want to hedge the risk using Naira futures.
Risk- Value of
Naira will rise, so, the nominal value of dollars received will be lower
Response- buy
Naira futures to gain from any rise in value.
23.
Gain/Loss
This is the
difference between the amount the futures are bought and sold. You can either
buy now and sell later or sell now and buy later
24.
Total
Gain/loss
= Gain/loss*Number
of Contracts*Standard size of a futures contract
25.
Gain
A gain is a good
thing. If you are receiving foreign currency, that is also good. So, the gain
will be added to the receipt.
A foreign payment
is bad because you are losing money, but a gain is good. So, the gain the
reduce the foreign payment.
Bad things add up-
Loss+payment
Good things add
up- Gain+Receipt
A bad thing
reduces a good thing- Receipt-Loss
A good thing
reduces a bad thing- Payment-Gain
26.
Net
outcome of futures payment
=Spot rate payment or receipt
adjusted by gain a loss
Spot rate payment
or receipt is what you’ll have paid or received if you didn’t hedge using a
futures contract. A gain is realized or a loss is made due to hedging the
transaction using futures
27.
Effective
rate
The formula depends on the rate used in the question.
If the rate used was Dollar/Naira, use that and vice versa.
28.
Advantages
of futures
i.
They can be sold before their maturity date
unlike forward contracts. You might want to sell either because you need the
money or you have achieved your hedging objective.
ii.
Lower transaction costs compared to forward
contracts
29.
Disadvantages
of futures
i.
May not lead to exact hedging
ii.
Need to incure costs to use futures exchange e.g
broker fees.
iii.
Complex calculations are needed when dollar is
not involved
iv.
Not suitable for long term hedging
v.
Only major currencies have futures. Naira futures have just been introduced
30.