The Chicago Mercantile Exchange (CME) provides an outlet for currency speculators and for those looking to reduce their currency risks. Trade takes place in currency futures, which are contracts for specific quantities of given currencies; the exchange rate is fixed at the time the contract is entered into, and the delivery date is set by the board of directors of the International Monetary Market (IMM). These contracts are patterned after those for grain and commodity futures contracts, which have been traded on Chicagos exchanges for more than 100 years.
Currency futures contracts are currently available for the Australian dollar, Brazilian real, British pound, Canadian dollar, Chinese renminbi, Czech koruna, Hungarian forint, Israeli shekel, Japanese yen, Korean won, Mexican peso, New Zealand dollar, Norwegian krone, Polish zloty, Russian ruble, South African rand, Swedish krona, Swiss franc, and the euro. The CME is continually experimenting with new contracts. Those that meet the minimum volume requirements are added, and those that do not are dropped. For example, the CME added a number of cross-rate contracts, such as EC/JY and AD/SF cross-rate contracts, while dropping contracts in the Dutch guilder (before it was replaced by the euro). By taking the U.S. dollar out of the equation, cross-rate futures allow one to hedge directly the currency risk that arises in dealing with nondollar currencies. The number of contracts outstanding at any one time is called the open interest.
Private individuals are encouraged, rather than discouraged, to participate in the market. Contract sizes are standardized by the amount of foreign currency—for example, £62,500, C$100,000, and SFr 125,000. Exhibit 8.1 shows contract specifications for some of the currencies traded. Leverage is high; margin requirements average less than 2% of the value of the futures contract. The leverage assures that investors’ fortunes will be decided by tiny swings in exchange rates.
The contracts have minimum price moves, which generally translate into about $10 to $12 per contract. At the same time, most exchanges set daily price limits on their contracts that restrict the maximum daily price move. When these limits are reached, additional margin requirements are imposed and trading may be halted for a short time.
Instead of using the bid-ask spreads found in the interbank market, traders charge commissions. Though commissions will vary, a round trip—that is, one buy and one sell—costs as little as $15. This cost works out to less than 0.02% of the value of a sterling contract. The low cost, along with the high degree of leverage, has provided a major inducement for speculators to participate in the market. Other market participants include importers and exporters, companies with foreign currency assets and liabilities, and bankers.
Exhibit 8.1 Contract Specifications for Foreign Currency Futures 1
1 Effective as of July 17, 2008.
Source: Data collected from Chicago Mercantile Exchange’s Web site at www.cme.com
Although volume in the futures market is still small compared with that in the forward market, it can be viewed as an expanding part of a growing foreign exchange market. As we will see shortly, the different segments of this market are linked by arbitrage.
The CME is still the dominant trader, but other exchanges also trade futures contracts. The most important of these competitors include the London International Financial Futures Exchange (LIFFE), the Chicago Board of Trade (CBOT), the New York Mercantile Exchange, the Philadelphia Stock Exchange (PHLX), the Singapore International Monetary Exchange (SIMEX), Deutsche Termin Borse (DTB) in Frankfurt, the Hong Kong Futures Exchange (HKFE), the Marché à Termes des Instruments Financiers (MATIF) in Paris, and the Tokyo International Financial Futures Exchange (TIFFE).
A notable feature of the CME and other futures markets is that deals are struck by brokers face to face on a trading floor rather than over the telephone. There are other, more important distinctions between the futures and forward markets.
Forward Contract versus Futures Contract
One way to understand futures contracts is to compare them with forward contracts. Futures contracts are standardized contracts that trade on organized futures markets for specific delivery dates only. In the case of the CME, the most actively traded currency futures contracts are for March, June, September, and December delivery. Contracts expire two business days before the third Wednesday of the delivery month. Contract sizes and maturities are standardized, so all participants in the market are familiar with the types of contracts available, a situation that facilitates trading. Forward contracts, on the other hand, are private deals between two individuals who can sign any type of contract they agree on. For example, two individuals may sign a forward contract for €70,000 in 20 months to be paid in Swiss francs. However, CME contracts trade only in round lots of €125,000 priced in U.S. dollars and with a limited range of maturities available. With only a few standardized contracts traded, the trading volume in available contracts is higher, leading to superior liquidity, smaller price fluctuations, and lower transaction costs.
Once a trade is confirmed, the exchange’s clearing house—backed by its members’ capital—becomes the legal counterparty to both the buyer and seller of the futures contract. The exchange members, in effect, guarantee both sides of a contract, largely eliminating the default risks of trading. Members of the futures exchange support their guarantee through margin requirements, marking contracts to market daily (explained later), and maintaining a guarantee fund in the event a member defaults. In contrast, a forward contract is a private deal between two parties and is subject to the risk that either side may default on the terms of the agreement.
The contract specifications in Exhibit 8.1 show the margin requirements (now called performance bonds by the CME) for speculators (members have different margin requirements). The initial performance bond shows how much money must be in the account balance when the contract is entered into. This amount is $1,890 in the case of the pound. A performance bond call is issued if—because of losses on the futures contract—the balance in the account falls below the maintenance performance bond, which is $1,400 for the pound. At that time, enough new money must be added to the account balance to bring it up to the initial performance bond. For example, suppose you start with an initial balance of $2,050 ($160 in excess of the initial performance bond of $1,890) in your account on a pound futures contract and your contract loses, say, $780 in value. It is now $1,270, which is $130 below the maintenance performance bond of $1,400. Hence, you must add $490 to your account to meet the initial performance bond requirement ($2,050 − $780 + $620 = $1,890).
The CME periodically revises its performance bond requirements in line with changing currency volatilities using a computerized risk management program call SPAN, which stands for Standard Portfolio Analysis of Risk. Note also that the performance bond requirements set by the CME are minimums; brokers often require higher performance bonds on more volatile currency contracts.
Profits and losses of futures contracts are paid over every day at the end of trading, a practice called marking to market. This daily-settlement feature can best be illustrated with an example. On Tuesday morning, an investor takes a long position in a Swiss franc futures contract that matures on Thursday afternoon. The agreed-on price is $0.95 for SFr 125,000. To begin, the investor must deposit into his account an initial performance bond of $2,700. At the close of trading on Tuesday, the futures price has risen to $0.955. Because of daily settlement, three things occur. First, the investor receives his cash profit of $625 (125,000 × 0.005). Second, the existing futures contract with a price of $0.95 is canceled. Third, the investor receives a new futures contract with the prevailing price of $0.955. Thus, the value of the futures contracts is set to zero at the end of each trading day.
At Wednesday close, the price has declined to $0.943. The investor must pay the $1,500 loss (125,000 × 0.012) to the other side of the contract and trade in the old contract for a new one with a price of $0.943. At Thursday close, the price drops to $0.94, and the contract matures. The investor pays his $375 loss to the other side and takes delivery of the Swiss francs, paying the prevailing price of $0.94, for a total payment of $117,500 (125,000 X $0.94). The investor has had a net loss on the contract of $1,250 ($625 − $1,500 − $375) before paying his commission. Exhibit 8.2 details the daily settlement process.
Daily settlement reduces the default risk of futures contracts relative to forward contracts. Every day, futures investors must pay over any losses or receive any gains from the day’s price movements. These gains or losses are generally added to or subtracted from the investor’s account. An insolvent investor with an unprofitable position would be forced into default after only one day’s trading rather than being allowed to build up huge losses that lead to one large default at the time the contract matures (as could occur with a forward contract). For example, if an investor decided to keep his contract in force, rather than closing it out on Wednesday, he would have had a performance bond call because his account would have fallen below the maintenance performance bond of $2,000. His performance bond call would be for $875 ($2,700 + $625 − $1,500 + $875 = $2,700) at the close of Wednesday trading in order to meet his $2,700 initial performance bond; that is, the investor would have had to add $875 to his account to maintain his futures contract.
Futures contracts can also be closed out with an offsetting trade. For example, if a company’s long position in euro futures has proved to be profitable, it need not literally take delivery of the euros when the contract matures. Rather, the company can sell futures contracts on a like amount of euros just prior to the maturity of the long position. The two positions cancel on the books of the futures exchange, and the company receives its profit in dollars. Exhibit 8.3 summarizes these and other differences between forward and futures contracts.
Exhibit 8.2 An Example of Daily Settlement with a Futures Contract
Exhibit 8.3 Basic Differences between Forward and Futures Contracts
Application Computing Gains, Losses, and Performance Bond Calls on a Futures Contract
On Monday morning, you short one CME yen futures contract containing ¥12,500,000 at a price of $0.009433. Suppose the broker requires an initial performance bond of $4,000 and a maintenance performance bond of $3,400. The settlement prices for Monday through Thursday are $0.009542, $0.009581, $0.009375, and $0.009369, respectively. On Friday, you close out the contract at a price of $0.009394. Calculate the daily cash flows on your account. Describe any performance bond calls on your account. What is your cash balance with your broker as of the close of business on Friday? Assume that you begin with an initial balance of $4,590 and that your round-trip commission was $27.
Cash Flow on Contract
Sell one CME yen futures contract. Price is $0.009433.
Futures price rises to $0.009542. Contractis marked to market.
You pay out
12,500,000 × (0.009433 − 0.009542) − $1,362.50
Futures price rises to $0.009581. Contract is marked to market.
You pay out an additional
12,500,000 × (0.009542 − 0.009581) = − $487.50
Futures price falls to $0.009375. Contractis marked to market.
12,500,000 × (0.009581 − 0.009375) = +$2,575.00
Futures price falls to$0.009369. Contract ismarked to market.
You receive an additional
12,500,000 × (0.009375 − 0.009369) = +$75.00
You close out your contract at a futures price of $0.009394.
You pay out
12,500,000 × (0.009369 − 0.009394) = − $312.50
You pay out a round-trip commission = − $27.00
Net gain on the futures contract
Your performance bond calls and cash balances as of the close of each day were as follows:
With a loss of $1,362.50, your account balance falls to $3,227.50($4,590 −$1,362.50). You must add $772.50 ($4,000 −$3,227.50) to your accountto meet the initial performance bond of $4,000.
With an additional loss of $487.50, your balance falls to $3,512.50($4,000—$487.50). Your balance exceeds the maintenance performance bond of $3,400 so you need add nothing further to your account.
With a gain of $2,575, your balance rises to $6,087.50.
With a gain of $75, your account balance rises further to $6,162.50.
With a loss of $312.50, your account balance falls to $5,850. After subtracting the round-trip commission of $27, your account balance ends at $5,823.