Author
Keywords
Currencies, Derivatives, Foreign Exchange Rates
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Unreviewed
Definition
A future represents a binding obligation to buy or sell a particular asset at a designated price on a specified later date. In practice, futures are in fact quite a similar instrument to forward agreements, at least in terms of the end result. They do have however specific features, in particular their standardization and their payoff procedure that distinguish them from forwards.
When a new contract is developed, several terms need to be specified by the exchange house prior to any transaction:
- the underlying asset: whether it is a commodity such as corn, or a financial instrument such as foreign exchange rates
- the size of the contract: the amount of the asset which will be delivered
- delivery date and delivery arrangements
- the quoted price
Let us imagine a corn producer is interested in fixing his sale price of corn for July next year. He could contact a broker in order to short sell corn futures, therefore fixing the price of the corn and the delivery date. When entering into such a contract, he is binding himself to the delivery of corn (the underlying asset which he is selling) to the other part (which will be arranged by the exchange house) at that contracted price on that contracted date. The number of contracts to short depends on the quantity per contract: if each contract corresponds to 5,000 bushels of corn and he is interested in selling 10,000 bushels, then he would sell 2 contracts. In practice however, the majority of the contracts do not reach delivery date, they are closed out before — investors enter into the opposite type of agreement for the same delivery date.
The role of the margin
Margins have a very important role in the trading of futures. They are at the same time an attractive of the market and a way of minimizing contract defaults. When buying a contract, the investor must open a margin account, where he will deposit an initial margin. This initial margin does not correspond to the entire value of contract that he just acquired but only to a certain percentage of that contract, between 5-10%. At the end of each trading day, the margin account of the investor is adjusted upwards/downwards according to the movement of the futures price, reflecting the investor gain/loss. This is what is known as ‘marking to market’.
As the futures contract reaches its maturity, its price converges to the spot price of the underlying asset. At the delivery date the price of the futures contract is equal to the spot price. If this was not the case, arbitrage opportunities would arise thus forcing, by the action of the agents in the market, the price of the futures to move upwards/downwards.
Currency Futures
Futures are a common instrument used for hedging, which generally work by offsetting losses(gains) in the spot market with gains(losses) in the futures market. Let us briefly explain how it works. In March next year, a certain company in the USA is expecting to receive Eur 500,000 and in order to protect itself against fluctuations of the exchange rate Eur/USD, decides to short sell futures for that amount. Given that each future contract represents Eur 125,000, the company will sell 4 contracts at the price of $1.2888 per Eur. In March, when the company receives the amount in Eur, it will close the position in the futures market by going long on 4 contracts with delivery date for March and price of $1.2750 per Eur. The gain in the futures market is therefore $1.2888-1.2750 = 0.0138$ USD cents per Eur, and the foreign exchange rate was successfully fixed at $1.2888. Theoretically, as the futures price converges to the spot price at maturity, the loss(gain) occurring in the cash market, the difference $(S_{t+1} - S_t)$ in the spot market, is offset by a gain(loss) in the futures market, $(Fu - S_{t+1})$, where $Fu$ is the futures price contracted. Net gain(loss) for the investor is therefore $(Fu - S_t)$, fixing the exchange rate at $Fu$.
For the common investor wishing to hedge a part or all of his/her expected returns however, futures can pose several disadvantages or work less than perfectly in practice. As mentioned, futures are a standardized instrument in terms of maturity date and more importantly in terms of amount per contract. While the maturity date obstacle can be overcome by closing the position earlier, having an amount to hedge which is not a multiple of the value of each contract may cause the hedge to be below 100%. Furthermore, currency futures are not such a common instrument as one may wish and they are only against the USD as the base currency. Hedges in other currencies would have to be made by cross hedging which might increase significantly transaction costs.
Although in the case of currencies and other financial instruments as the underlying asset, this may not be such a serious problem due to the arbitrage mechanisms mentioned above, the spot price of the asset at maturity date may differ from the futures price. This is known as the basis risk:
basis = spot price of the hedged asset - futures price of contract used
Comparison with forward agreements
If futures and forwards have the same price, then this approach is not any different from using forwards. In fact, and according to the futures-forward equivalence, Luenberger [3], “If interest rates are known to follow expectations dynamics, then the theoretical futures and forward prices of corresponding contracts are equivalent”. The main difference would be on the cash-flows processes associated with forwards (which occur only at delivery date) and with futures (which occur every trading day).
Luenberger [3] shows also that it is possible to recreate a hedging strategy in futures using forward exchange rate contracts, assuming intermediate cash flows from the futures market are reinvested at the discount rate $r$.
The table below summarizes the main differences between forward agreements and futures contracts, Hull [2].
| Forwards | Futures |
|---|---|
| Private contract | Traded on an exchange |
| Not standardized | Standardized |
| Limited range of delivery dates | Wide range of delivery dates |
| Settled at maturity date | Settled daily |
| Final cash settlement | Closed out before maturity |
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External links
| References |
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1. Garman, M.; and Kohlhagen, S. Foreign Currency Option Values. Journal of International Money and Finance, 2, 231-237, 1983.
2. Hull, John C. Options, Futures and Other Derivatives. Pearson International Edition, 2006.
3. Luenberger, D. Investment Science. Oxford University Press, 1998.
4. Wystup, U. FX options and structured products. Wiley Finance, 2006.
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