FOREX External Hedging Techniques - Currency Futures

ACCA Director Author

Currency Futures

FOREX External Hedging Techniques (Part Two) - Currency Futures

Contents:

• Currency futures

Referenced syllabus: E. 2 (b) (iii)

Sketch

Currency futures first emerged in 1970 at the International Commercial Exchange in New York. This is an exchange-traded equivalent to a forward contract.

How futures work?

Speculation or hedge?

• Speculation - only buy and sell futures contract
• Hedge – buy or sell hedged item, and buy or sell futures contract (same direction)

Characteristics of currency futures:

1. Fixed contract:

• There are usually March, June, September and December contracts to be chosen and if the contract is chosen, the contract needs to be closed out on the agreed date.

2. Buy and sell futures:

• Buy (Long) futures – buy goods, buy futures (base currency)
• Buy goods – afraid price increases – buy futures – then sell futures as futures are not usually close out until the maturity date but before the maturity date, ie to cancel it before on the transaction date.
• If price increases, loss in the spot market but gain in the futures market
• Sell (Short) futures – sell goods, sell futures (base currency)
• Sell goods – afraid price falls – sell futures, then buy futures as futures are not usually close out until the maturity date but before the maturity date, ie to cancel it before on the transaction date.
• If price falls, loss in the spot market but gain in the futures market

Tutorial note: - Buy (Go Long)/Sell (Go Short):

• Receipt:

Example, if you are based in UK and you will receive US$

• The action is to sell the US $ and to buy £
• If the contract currency is $, - sell futures (Going short)
• If the contract currency is in £, - buy futures (Going Long)
• Payment:

Example, if you are based in UK and you will pay US$

• The action is to buy US $ before making the payment, ie to sell the £ and buy US$
• If the contract currency is $ - buy futures (Going long)
• If the contract currency is £ - sell the futures (Going short)

3. Standardised contracts on organized exchanges:

• Different from the OTC forward contract.
• Organised exchanges such as Chicago Mercantile Exchange (CME), Tokyo Financial Exchange, Intercontinental Exchange and London International Financial Futures and Options Exchange would bear losses if parties default.

4. Margin system:

• To reduce default risks from involved parties, initial and maintenance margins are needed. Profits and losses from futures contracts are accumulated and if accumulated profits are under margins requirement, additional cash needs to be topped up, otherwise the contract will be closed out.
• Unlike forward contract where no cash needs to be input until when the contract is exercised at a future date.

5. Gearing or leverage:

• Because of the margin system is used, investors generally use small amount of money to conduct the trading.

6. Ticks:

• A tick is the smallest movement in the exchange rate and is normally four decimal places. Tick size is usually 0.01%.
• Tick value = Futures contract size x Tick size

Tutorial note:

• For every $0.0001 movement in the price, company will make a profit or loss of $6.25.
• If the exchange rate moves by $0.004 in the company’s favour – which is 40 ticks (0.004/0.0001) – the profit made will be 40 x $6.25 = $250 per contract.
• If £2 million needs to be hedged, 32 contracts are needed (£2m/£62,500). If the number of contracts can not be rounded, we are likely to enter into another hedging contract to hedge against the remaining balance. Total gain would therefore be $250 x 32 = $8,000.

7. Spot and futures price:

• Spot price will be the same as the futures price when the contract matures.

8. Basis:

• Basis is the difference between spot and futures price.
• The reason for the basis could be the future estimate about foreign exchange rates taking into account monetary policies and government intervention.
• For commodities, futures price is usually higher than the spot rate as additional (future) transport and storage costs are considered.

9. Basis risk:

• Basis risk is the changes in spot price does not equal to changes in futures price.
• For example, the commodity futures price increases by $10, however, the cash price increases by $13. Therefore, to buy the commodity, we use $10 gain from the futures market and to offset against losses of $13 in the cash market, leaving a $3 net loss position.
• This usually arises when the contract is closed out before its maturity date, ie the contract maturity date is 30^th June but closes out on 15^th June.
• Basis risk creates an imperfect hedge as the business may suffer extra losses.

10. Contract dates:

• Futures contract maturity date include 31st March; 30th June; 30th September and 31st December.

11. Imperfect hedge:

• To conclude, the imperfect hedge arises from basis risk, and the contract size, ie if we need to hedge $70,000, we may only be able to enter into a $62,500 agreement, leaving the difference of $7,500 unhedged.

Case study – Currency futures:

Source: https://www.cmegroup.com/

• This is a EUR/USD currency futures contract.
• Up – EUR appreciates against USD
• Down – EUR depreciates against USD

Steps in currency futures: (CPA)

W1: Profit or loss from futures market: (PNS; or TTN)

P/L per futures contract (W2) x number of contracts (W3) x Contract size = Total P/L

Or

Ticks (P/L per futures contract (W2)/0.0001 or 0.000001(Japanese yen))

x number of contracts (W3)

x tick value (0.0001 or 0.000001(Japanese yen) x contract size)

= Total P/L

W2: P/L per futures contract (Table):

Date:

• “Now” – when futures contract is entered

• “Settlement” – when futures contract is settled

• We can buy or sell futures in March, June, September, and December.

Rate:

• “Now” - the rate agreed to buy/sell the future contract

• “Settlement” – the rate where futures contract is closed

• Future rate will be equal to the actual spot rate when it is settled

W3: Number of contracts

If the amount is in contract currency:

No of contracts = Amount (Contract currency)

Contract Size

If the amount is not in contract currency:

No of contracts = Amount (not contract currency)/ Opening futures price

Contract Size

Categories: : Advanced Financial Management (AFM)