FUTURES The foreign exchange market we have discussed (spot, forward, and swap

transactions) is a global market. Commercial banks, business firms, and governments in various locations buy and sell foreign exchange using telephone and computer systems with no centralized geographical market location. However, additional institutions exist that have not yet been covered, one of which is the foreign exchange futures market. The futures market is a market where foreign currencies may be bought and sold for delivery at a future date. The futures market differs from the forward market in that only a few currencies are traded; moreover, trading occurs in standardized contracts and in a specific geographic location, such as the International Monetary Market (IMM) of the Chicago Mercantile Exchange (CME), which is the largest currency futures market.

CME futures are traded on the British pound, Canadian dollar, Japanese yen, Swiss franc, Australian dollar, Mexican peso, and euro. The contracts involve a specific amount of currency to be delivered at specific maturity dates. Contracts mature on the third Wednesday of March, June, September, and December. In the forward market, contracts are

92 International Money and Finance

Feb.

Month Open

Lifetime Lifetime Open Int

Low British Pound (CME)-62,500 Pounds; $ per Pound

Swiss Franc (CME)-CHF 125,000; $ per CHF Mar

Jun 1.0787 1.0809 1.0756 1.0777 1.0839 0.8780 705 ’11

Figure 4.2 Futures markets.

The futures table shows the dollar prices quoted for each unit of the contract. In Figure 4.2 the columns for each contract are: Month Month that the contract matures Open

The price that contract had at the beginning of the trading day High

The highest price the contract reached during the day Low

The lowest price the contract reached during the day Settle The price the contract had at closing of the day Lifetime High

The highest price the contract has reached at any point during the contract life Lifetime Low

The lowest price the contract has reached at any point during the contract life

Forward-looking Market Instruments 93

and the September futures contract is currently priced at $1.6220 (the settle price), we would buy a September contract. To buy a British pound contract we need to pay 1.6220 3 62,500 5 $101,375. However, we are only obligated to pay that when the contract matures in September. The seller of the contract is likely to want some security to ensure that the contract will be honored (in forward contracts the bank will know the participants and might not require any security). For example, the seller might ask for 10 percent of the contract value, or $10,137.50 as a security or margin. The margin is a cushion for potential losses that you may incur on the contract, to make sure you will honor your contract.

Each day the futures market will quote the September contract that we now own, until the maturity date, so the value of the contract changes on a daily basis. At maturity each pound will cost $1.6220, but the contract does not have to be kept until maturity. For example, assume that the price of the pound contract goes to $1.65 in August. We can now sell our contract for $1.65 3 62,500 5 $103,125 for a profit of $1,750 (less transactions costs), or we can wait and hope that the September rate will

be even more favorable. In contrast, a fall in the value of the pound in August will hurt our financial position. If the pound falls to $1.60 then our pound position is only worth $100,000. If we still believe that the pound price will go up in September then it makes sense to wait and hold onto the contract. But the seller might be worried that we will not be able to honor the position in September. Therefore, they might ask for more security, for example an extra $1,375 to make the total margin $11,512.50. This is called a margin call.

As the preceding examples show, the futures contracts may not be held to maturity by the initial purchaser. Only the last holder of the contract has to take delivery of the foreign exchange. Thus, the futures market can be used to hedge risk, but can also be used by speculators. The speculators can take ownership of a fairly large contract with a small initial investment. Thus, speculators can be highly leveraged and have futures contracts worth lots more than the net worth of the indi-

94 International Money and Finance

In comparing the types of participants in the futures market and forward markets, we have already concluded that futures markets can be used for speculation as well as hedging. In addition, the futures contracts are for smaller amounts of currency than are forward contracts, and therefore serve as a useful hedging vehicle for relatively small firms. Forward contracts are within the realm of wholesale banking activity and are typically used only by large financial institutions and other large business firms that deal in very large amounts of foreign exchange.

The financial crisis of 2008 highlighted another important difference between forwards and futures. When one trades a forward, the counter- party is a bank. As became evident with the failure of Lehman Brothers in 2008, banks are subject to credit risk. If the bank that is the counter- party to your forward contract fails during the life of the contract, then the contract will not be honored, leaving you with a foreign exchange risk exposure. In contrast, futures contracts are traded on an exchange and the exchange guarantees the performance of each contract. So to the extent that bank credit risk is important, futures may be attractive relative to forwards.

FUTURES The foreign exchange market we have discussed (spot, forward, and swap