FOREX Types ( All Types with full detail )
Currency futures
Futures Contract is a legally binding agreement to buy or sell a commodity or financial instrument at a later date. Futures contracts are standardized according to the quality, quantity and delivery time and location for each commodity. Futures contracts have secondary markets, can be traded many times during life of contract, like a bond (vs. bank loan).
A futures contract is a standardized commitment that describes the key features of a transaction:
The quantity and quality of the commodity being exchanged
The date on which the exchange is to take place
The method of delivery
The price at which the commodity will be purchased
Examples: Yen contracts: ¥12.5m (approx $116,000), Pound: £62,500 (approx. $112,500), Euro: 125,000 (approx $160,000), SF: 125,000 (approx $104,000), etc. Expiration dates: March, June, Sept, Dec. on the 3rd Wednesday.
Currency futures started trading in 1972 at the Chicago Mercantile Exchange (CME), which opened in 1898 (largest futures exchange in U.S., 4 product areas: stock indexes, interest rates, currency, commodities) Why then? Actually, trading in many derivative markets started to explode in the 70s. Why?
Fixed exchanges rates until 1973 meant no currency risk.
Interest rates were fixed by federal law for savings accounts (Reg. Q) and checking accounts (i = 0%), and some mortgages (led to "points").
Inflation was low and stable, 2-3% in the 50s, 60s and early 70s.
Interest rates on T-bills were low and stable 1-2%.
Price of oil was low and stable stable.
Economic and financial volatility increased dramatically in the 1970s. Fixed ex-rates were abandoned, started to float. Req Q was eventually repealed. Inflation and int. rates rose and became volatile in the 1970s. Oil prices doubled and tripled in the two oil shocks of the 1970s (74-75 and 79-80). Led to an explosion in the derivative markets for futures contracts.
Unlike the purchase or sale of a security, no price is paid or received upon the purchase or sale of a futures contract. Initially, the Account will be required to deposit in a custodial account an amount of cash, United States Treasury securities, or other permissible assets equal to approximately 5% of the contract amount. This amount is known as “initial margin.” The nature of initial margin in futures transactions is different from that of margin in security transactions in that futures contract margin does not involve the borrowing of funds by the customer to finance the transactions. Rather, the initial margin is in the nature of a performance bond or good faith deposit on the contract, which is returned to the Account upon termination of the futures contract assuming all contractual obligations have been satisfied.
The initial investment required to establish a futures position, usually 3-5% of the contract value. To buy one U.K. pound contract, you would have to put up about $4500 ($112,500 x 4%). You would also have to keep a "maintenance margin" usually about 75% of the initial margin. In this case, you could never let your account go below $3375 (75% of $4500). If you can't make margin call, your contract is liquidated by broker.
There are two types of futures contracts, those that provide for physical delivery of a particular commodity and those that call for an even tual cash settlement. The commodity itself is specifically defined, as is the month when delivery or settlement is to occur. A July futures contract, for example, provides for delivery or settlement in July.
It should be noted that even in the case of delivery-type futures contracts, very few actually result in delivery. Not many speculators want to take or make delivery of 5,000 bushels of grain or 40,000 pounds of pork. Rather, the vast majority of both speculators and hedgers choose to realize their gains or losses by buying or selling an offsetting futures contract prior to the delivery date.
Selling a contract that was previously pur chased liquidates a futures position in exactly the same way that selling 100 shares of IBM stock liquidates an earlier purchase of 100 shares of IBM stock. Similarly, a futures contract that was initially sold can be liquidated by making an offsetting purchase. In either case, profit or loss is the difference between the buying price and the selling price, less transaction expenses.
Cash settlement futures contracts are precisely that, contracts that are settled in cash rather than by delivery at the time the contract expires. Stock index futures contracts, for example, are settled in cash on the basis of the index number at the close of the final day of trading.
Participants of currency futures market
Speculators - pure speculative bet/investment, with no business interest in the underlying commodity/currency.
Hedgers - someone with a business/personal interest in the underlying currency, and is using futures trading to minimize, eliminate or control currency risk, e.g., MNCs, banks, exporters, importers, etc.
If a hedger is short (long) and a speculator is long (short), the hedger is "selling" their risk to the speculator.
Hedgers
The details of hedging can be somewhat complex but the principle is simple. By buying or selling in the futures market now, individuals and firms are able to establish a known price level for something they intend to buy or sell later in the cash market. Buyers are thus able to protect themselves against—that is, hedge against—higher prices and sellers are able to hedge against lower prices. Hedgers can also use futures to lock in an acceptable margin between their purchase cost and their selling price.
A jewelry manufacturer will need to buy additional gold from its supplier in six months to produce jewelry that it is already offering in its catalog at a published price. An increase in the cost of gold could reduce or wipe out any profit margin. To minimize this risk, the manufacturer buys futures contracts for delivery of gold in six months at a price of $300 an ounce.
If, six months later, the cash market price of gold has risen to $320, the manufacturer will have to pay that amount to its supplier to acquire gold. But the $20 an ounce price increase will be offset by a $20 an ounce profit if the futures contract bought at a price of $300 is sold for $320.
The hedge, in affect, provided protection against an increase in the cost of gold. It locked in a cost of $300, regardless of what happened to the cash market price. Had the price of gold declined, the hedger would have incurred a loss on the futures position but this would have been offset by the lower cost of acquiring gold in the cash market.
Whatever the hedging strategy, the common denominator is that hedgers are willing to give up the opportunity to benefit from favorable price changes in order to achieve protection against unfavorable price changes.
Risk Minimizing Hedge strategy
As stated earlier, the objective of hedging is to minimize risk, not to maximize profits from currency speculation. Using futures contracts, this is typically accomplished by taking a short position in the futures market to offset any gains or losses in the spot market. From a portfolio perspective, the hedger would have a portfolio consisting of a long position in the cash market, and a short position in the futures market. The return on the portfolio is equal to the return on the spot position (denoted S) plus the return on the futures position (denoted F):
Return = S + hFwhereh - denotes the number of futures contracts held in the portfolio, or the 'hedge ratio'. In most instances, h will be negative, depicting a short position. The optimal value for h is the one that minimizes the variance of the portfolio:Var(S + hF) = Var(S) + h2Var(F) + 2hCov(S,F)Taking the first derivative with respect to h and setting it equal to zero yields the hedge ratio that minimizes the portfolio variance:2hVar(F) + 2Cov(S,F) = 0h* = -2Cov(S,F)/Var(F)whereh* - is the variance-minimizing hedge ratio. Because spot prices and futures prices are highly correlated, h* should be fairly close to –1.
The hedge ratio is calculated using historical returns in the cash and futures market. Since exchange rate levels exhibit non-stationarity (i.e. they can deviate from their long-term mean level for prolonged periods of time), means and variances are not meaningful unless returns are used. The covariance between cash returns and futures returns is assumed to be relatively stable over the hedging horizon, although hedge ratios can be dynamically updated over the hedging horizon if one wants a more precise hedge.
Speculators
Were you to speculate in futures contracts by buying to profit from a price increase or selling to profit from a price decrease, the party taking the opposite side of your trade on any given occasion could possibly be a hedger or it might be another speculator, someone whose opinion about the probable direction and timing of prices differs from your own.
Buying futures contracts with the hope of later being able to sell them at a higher price is known as "going long." Conversely, selling futures contracts with the hope of being able to buy back identical and offsetting futures contracts at a lower price is known as "going short." An attraction of futures trading is that it is equally as easy to profit from declining prices (by selling) as it is to profit from rising prices (by buying).
The difference between the price of a commodity in the cash (or 'spot') market and the currency futures market is called the 'basis', and is determined by relative interest rates for financial futures. The price is established by an arbitrage argument which asserts that the payoff from converting a unit of domestic currency at the spot rate, lending in another currency and converting the proceeds in the forward market should yield the same profit as lending the unit of domestic currency at home – provided he or she can borrow and lend at the risk-free rate. Using S as the spot rate, F as the forward rate – both in terms of domestic currency per unit of foreign currency – r as the domestic effective interest rate and rf as the foreign effective interest rate, the above equality produces the identity:
(1+r) = (1/S)*(1+rf)*F, orF = S*(1+r)/(1+rf)
If this condition does not hold, then arbitrageurs would take advantage of the opportunity by borrowing unlimited amounts in the country with low interest rate, investing in the country with the high interest rate and converting at the forward rate for a risk-free profit. This would lead to an adjustment in the exchange rate until the opportunity was no longer profitable. This relationship is more commonly known as 'interest rate parity'. Slight deviations from parity may be apparent in the market due to transaction costs.
Currency forwards:
Forward (Cash) Contract is a cash contract in which a seller agrees to deliver a specific cash commodity to a buyer sometime in the future. Forward contracts, in contrast to futures contracts, are privately negotiated and are not standardized.
Many market participants want to exchange currencies at a time other than two days in advance but would like to know the rate of exchange now. Forward foreign exchange contracts are generally used by importers, exporters and investors who seek to lock in exchange rates for a future date in order to hedge their foreign currency cash flows.
For example, if a company had contracted to purchase equipment for the price of GBP 1 million payable in 3 months time but was concerned that the GBP would rise against the Australian dollar in the interim, the company could agree today to buy the USD for delivery in 3 months time. In other words, the company could negotiate a rate at which it could buy GBP at some time in the future, setting the amount of GBP needed, the date needed etc. and hence be sure of the Australian Dollar purchasing price now.
There are two components to the price in forward transaction and they are the spot price and the forward rate adjustment.
The spot rate is simply the current market rate as determined by supply and demand. The forward rate adjustment is a slightly more complicated calculation that involves the applicable interest rates of the currencies involved.
Forward Exchange Contracts, both Buying and Selling, may be either fixed or optional term contracts.
Fixed Term Contracts:
With a Fixed Term Contract the customer specifies the date on which delivery of the overseas currency is to take place. An earlier delivery can be arranged but it may involve a marginal adjustment to the Forward Contract Rate.
Optional Term Contracts:
Optional Term Contracts can be entered into for a specific period, and the customer states the period within which delivery is to be made (normally for periods not more than one month) eg. a contract may be entered into for a six month period with the customer having the option of delivery at anytime during the last week.
In each case there is a firm contract to effect delivery by both the Bank and the customer. An optional delivery contract does not give the customer an option to not deliver the Forward Exchange Contract. It is only the period during which delivery may occur that is optional.
Forward rates are quoted for transactions where settlement is to take place more than two business days after the transaction date. Forward Contract rates consist of the Spot rate for the currency concerned adjusted by the relative Forward Margin.
Forward Margins are a reflection of the interest rate differentials between currencies, and not necessarily a forecast of what the spot rate will be at the future date.
The Forward rate may be expressed as being at parity (par), or at a Premium (dearer) or at a Discount (cheaper), when related to the spot rate. It follows therefore that premiums are deducted from the spot rate and discounts are added to the spot rate.
Forward Rates incorporating a 'Premium' are more favourable to exporters and less favourable to importers than the relative spot rates on which they are based. Similarly, Forward rates incorporating a 'Discount' are more favourable to importers and less favourable to exporters that the relative spot rates on which they are based.
The general rule in determining whether a currency will be quoted at a premium or a discount is as follows:
The currency with the higher interest rate will be at a discount on a forward basis against the currency with the lower interest rate.
The currency with the lower interest rate will be at a premium on a forward basis against the currency with the high interest rate.
As the interest differential between the currencies widens then the premium or discount margin increases (i.e. moves farther from parity) and similarly as the interest differential narrows then the premium or discount margin decreases (ie moves towards parity).
Differences/similarities between futures and forward contracts:
Similarities:
1. Both are derivative securities for future delivery/receipt. Agree on P and Q today for future settlement or delivery in 1 week to 10 years.
2. Both are used to hedge currency risk, interest rate risk or commodity price risk.
3. In principal they are very similar, used to accomplish the same goal of risk management.
Differences:
1. Forward contracts are private, customized contracts between a bank and its clients (MNCs, exporters, importers, etc.) depending on the client's needs. There is no secondary market for forward contracts since it is a private contractual agreement, like most bank loans (vs. bond).
2. Forward contracts are settled at expiration, futures contracts are continually settled, daily settlement.
3. Most (90%) of forward contracts are settled with delivery/receipt of the asset. Most futures contracts (99%) are settled with cash, NOT the commodity/asset.
4. Futures markets have daily price limits.
Forward Exchange Contract is a bilateral contract between two counterparties, and therefore each party is responsible for assessing the credit standing and capacity of the other party, before entering into a transaction.
The deals are totally flexible as to the maturity date, the size of the transaction and the currency involve
