1 Forward v futures
Forwards and futures contracts are both agreements to buy or sell a quantity of a financial or physical commodity (known as the underlying asset) at given price, on a specific future date.
• A forward contract is a private over-the-counter transaction between counterparties known to each other, on terms agreed between themselves.
A futures contract is a forward contract that is traded on a public exchange like the International Money Market (IMM) division of the Chicago Mercantile Exchange (CME), the New York Board of Trade (NYBOT) and Finex, its Dublin-based division. Private investors transact through brokers who are members of the exchange, but the counterparties will not be known to one another
A futures contract will have standardised features (e.g. units of trading, delivery and settlement dates, minimum price increments etc.). The futures exchange itself acts as a counterparty through the provision of clearance and settlement facilities to safeguard the interests of the parties.
Futures and forward contracts are binding on both parties at expiry, where one party receives and the other delivers. However, investors can buy or sell back their contracts before expiry at the prevailing offer and bid prices respectively.
1.1 Advantages
Forwards and futures have a vital role in the mitigation of currency risk. The main beneficiaries are international corporations who use them to hedge against adverse changes in exchange rates that affect the profitability of projects.
For example, a European manufacturer importing raw materials priced in US dollars would suffer a financial loss if the euro fell against the US dollar. Likewise, a conspicuously-consuming British importer of a luxury European car would be severely out of pocket if sterling were to fall against the euro before payment. Both would benefit from buying their respective US dollars and euros in advance at guaranteed exchange rates.
Private investors might also take a purely speculative interest in currency forwards and futures. Investors would be attracted by the ability to profit in both rising and falling market, by the opportunity to leverage profits through margin trading and the ability to close out contracts before delivery.
1.2 Pricing forwards and futures
Because a forward or futures contract involves the delivery and the settlement of a currency trade in the future, the forward/futures and spot exchange rates will be numerically different, albeit related to one another.
The relationship between the spot and the forward/futures rate is determined by the difference in the rates of interest earned on the respective currencies in the pair (the net “cost of carry”). The “fair” price is the rate that prevents an investor from making a riskless profit by “round tripping” and exploiting the interest rate differential.
Assume that a private investor has 100,000 USD. He has a choice of (a) putting it on deposit at 1.25% p.a. for 3 months or (b) converting it into GBP, investing it at 4% p.a. for 3 months and simultaneously entering into a forward or futures contract for delivery and settlement in 3 months.
If the spot and the forward/futures rates are the same, then our investor could: -
• Borrow USD at 1.5% for 3 months
• Sell USD for GBP at the spot rate
• Enter into a forward/futures contract to buy back USD for GBP at the same rate
• Invest the GBP at 4% p.a. for 3 months
• Buy back the USD with sterling after 3 months and repay the USD loan
• Pocket a riskless profit roughly equal to the interest differential over 3 months.
Generally speaking, the forward and futures exchange rate should trade at a discount to the spot rate for the currency with a positive interest rate differential For example, GBP/USD futures should trade at a discount to GBP/USD spot where sterling base rate is, say, 4% vis-a-vis USD base at 1.25%. Conversely, USD/GBP futures should trade at a premium to USD/GBP spot.
1.3 Risk
Since the currency futures rates are related to spot rates by the cost of carriage, it follows that the risks are comparable.
The same range of stop loss, limit and OCO orders are available for the control of risk in the futures market as in the spot market (Refer to the relevant section of The Spot Market in Part I.)
1.4 Trading costs
The charging regime for futures dealing will typically be a blend of fixed and transaction costs. For example, Easy2Trade operates a two- tariff system for futures trades, depending on intended volume and whether they are classified as frequent or infrequent traders
Low volume private investors pay no monthly basic charge but incur higher transactions costs than frequent traders. Other than a one-off set-up charge of £50 there are no further overheads for “light trading screen” use. Monthly transactions costs are £4 per lot for 1 to 800 lots and £2 per lot thereafter.
2 Practical futures trading
We can now look at some examples of forwards/ futures trading. The basic principles are the same for forwards and futures.
With a futures or forward contract, the rate you pay is related to the spot rate by the net interest differential on the currency pair. For a forward contract, that is the end of the matter, save only for receipt and delivery at the future date. With futures contracts, the exchange will declare an exchange delivery settlement price at expiry.
The future and forward rate will converge towards the spot rate as the contract approaches expiry, as the net cost of carry decreases towards zero over time. If investors want to close out before expiry, they can do so at the prevailing bid or offer price.
2.1 Speculating on a rise
Assume that GBP/USD = 1.5847/52 (spot). If the US base rate is 1.25% p.a. and UK base is 4% p.a.
• You think that the GBP/USD rate will rise over the next 3 months, so you buy 2 futures contracts on the CME International Money Market (IMM) through your UK margin broker. The standard unit of trading for sterling is 62,500 GBP.
• The GBP/USD futures rate with 90 days to delivery should be about 1.5741/46
• The value of your purchase is:
2 X 62,500 X 1.5746 = 196,825 USD
• You don’t have to pay all of this up front. Your margin will be determined by the IMM minimum plus any supplement charged by your broker.
• As expiry approaches, the spot and futures prices converge. Let us say that the settlement price turns out to be 1.6100. Your gain will be:
(1.6100 – 1.5746) X 62,500 X 2 = 4,425 USD
• Had the settlement price been 1.5650, your loss would have been:
(1.5746 – 1.5650) X 62,500 X 2 = 1,200 USD
2.2 Insuring against a fall (hedging)
You are the finance director of a British manufacturer that has just negotiated a purchase of raw materials to be delivered and paid for in US dollars 90 days hence. At the time of closing the deal, the GBP/USD spot rate is 1.5847/52. The contract is worth 500,000 USD or 315,517 BP at the bid spot rate.
• You fear that the deal could be unprofitable if sterling falls, so you decide to enter into a forward contract to sell GSB/USD for receipt and delivery 90 days hence.
• The 90-day forward rate for GBP/USD is, say, 1.5741/46. You buy sell 317,642 GBP at the bid rate, i.e.
317,642 GBP X 1.5741 = 500,000 USD
This represents an “insurance premium” of (317,642 – 315,517) = 2,125 GBP
• Your fears turn out to well founded. Spot GBP/USD falls to 1.5219/24 thirty days later and the forward GBP/USD rate falls to, say, 1.5151/56 at the end of 90 days. Had you not hedged, the consignment of raw materials would have cost the company £328,537 (13,020 GBP more).
• You have saved the company 13,020 – 2,125 = 10,895 GBP. You are tipped for higher things.
• Had GBP/USD spot risen to say 1.6100/06 after 30 days, the cost of the raw materials would have fallen to 310,559 GBP. Had you done nothing, the company would have saved 4,958. Instead, the company has paid 317,642 GBP, a difference of 7,083 GBP.
• You are demoted to internal auditor. That’s insurance, kid.
2.3 Closing out before delivery
GBP/USD spot is trading at 1.5847/52. You feel that the rate will rise over the next 90 days and buy a futures contract for 1.5746 valued at:
62,500 X 1.5746 = 98,412
After 30 days, spot has risen to 1.6100/06 and the futures rate has risen to 1.6028/34. If I were to close out now I would earn:
62,500 X 1.6028 = 100,175 USD, a profit of 1,763 USD or 1,095 GBP when converted back at the spot offer rate.
Had GBP/USD spot fallen to 1.5219/24 after 30 days, the futures rate would have been, say 1.5156/62. Had you closed out, you would have lost:
62,500 X 1.5156 = 94,725 USD, a loss of 3,687 USD or 2,432 GBP when converted back.
