CHAPTER 7
Foreign Exchange Futures
BACKGROUND
Leo Melamed, former chairman of the Chicago Mercantile Exchange (CME), has documented, in two fascinating accounts, the beginnings and development of the market for foreign exchange futures contracts.1 In the late 1960s, there was pressure on the fixed exchange rate system of Bretton Woods and an anticipation of the impending floating foreign exchange environment. Milton Friedman, at the invitation of the CME, published a paper in 1971 advocating a “futures market in foreign currencies”—“as broad, as deep, as resilient” as possible “in order to facilitate foreign trade and investment.”2 With the additional endorsement of government, which Melamed noted was surely desirable though not legally necessary, the CME set up the International Monetary Market (IMM) as a separate entity and it was within its markets that FX futures first traded. Foreign exchange currency futures contracts emerged as a trading vehicle on May 16, 1972—the date identified as the birth of FX futures. Merton Miller, a distinguished finance professor at the University of Chicago, later praised futures contracts as “the most significant financial innovation of the last twenty years” and stated in 1986, this was, and is, singularly high praise indeed. The CME Clearing House currently processes more than 80% of all futures (not just FX futures) traded in the United States.
Just as an FX forward contract involves an agreement to buy/sell a certain amount of a certain currency for a previously-agreed-upon amount of another currency (where this ratio, properly quoted, is known as the forward price) at some well-defined point in the future, so too does an FX future contract involve an agreement to buy/sell a certain amount of a certain currency (in exchange for another currency) for a predetermined price (known as the future price) at some point later in time (known as the maturity date).
FUTURES VERSUS FORWARDS
There are four primary differences between forward contracts (or simply forwards) and future contracts (or simply futures).
1. The first has to do with where they trade (and this expression is used loosely); forwards are, by definition, over-the-counter (OTC) contracts, whereas futures are, by definition, “exchange-traded” contracts or exchange-traded derivatives (ETDs).
2. Forwards are individually negotiated agreements between two counterparties. As such they may be tailored in any way that the two parties see fit. This means that they may (and actually must) specify the amount (or notional or face), the (forward) price, the type, nature, quality of the underlying, the mechanism for delivery (timing, location), and possibly some additional features as part of the contract. Futures contracts are standardized contracts; that is, they specify the amount, typically quote the price in certain minimum increments, identify the nature or quality of the deliverable asset, have set maturities and delivery dates (or delivery windows), and well-defined delivery processes. Some exchanges have attempted to mitigate the replacement of their exchange-traded contracts with the more flexible OTC contracts, which might better suit the end users’ financial, economic, or accounting needs by allowing some relaxation of the standardized features of the exchange-listed contracts especially when it comes to exchange-listed options contracts: these are sometimes identified as “flex” contracts. As an example, a flex contract might allow for endof-month settlement (to accommodate financial statement reporting considerations) as opposed to the exchange convention, which does not coincide with the final day of the calendar month. Another variation might involve physically settling a cash-settled contract.
3. The third difference between forwards and futures has to do with cash flows. When one buys or sells a future, the transaction is actually done between members of the exchange. These may involve brokers acting on behalf of customers, locals trading their own financial capital, or any of the members of the exchange (which could represent larger banks and broker/dealers). Once a transaction is agreed upon, executed, and confirmed, though, the exchanges and clearing houses act as the counterparties to both sides of the trade. In the words of the Chicago Mercantile Exchange,
Although many different customers trade at CME, all trades are ultimately conducted between CME and a clearing member. CME serves as the buyer to every seller and the seller to every buyer, with a clearing member assuming the opposite side of each trade. In so doing, clearing members essentially vouch that the financial obligation will be met for all trades matched and executed in CME facilities.3
What this means is that the buyer of the future contract (that is, the individual who has agreed to buy the underlying asset at some point in the future) is effectively long the asset from the exchange, and the seller of the future (the individual who has agreed to sell the underlying asset in the future) is short the asset to the exchange. The implication is that, once the trade is done (“I thought I bought it; you thought you sold it—for a specific asset, for a specific time in the future and at a specific price”), the exchange takes on the role of the counterparty to both sides of the transaction. The attractiveness of this feature is that the exchange and clearing houses assume the counterparty or credit risk associated with every trade and ensure the performance for that agreed upon transaction. Because the exchange and the clearing houses don’t trust either of the counterparties to the trade, though, they ask both the buyer and seller to “post margin”; margin is simply a collateral deposit (of cash and sometimes, in part, negotiable securities), which provides a buffer should the future’s buyer or seller disappear (as in “go bankrupt,” fail to deliver/purchase, etc.). Forward contracts, while some broker/dealers may request “collateral,” especially from leveraged money clients (i.e., hedge funds), do not necessarily require “marking-to-market.”4 We go into more detail on margin later.5
4. The fourth difference between forwards and futures is an empirical one; while, for the most part, both forwards and futures are agreements to purchase/sell an underlying asset in the future, the majority of forward contracts actually result in delivery while the majority of the futures contracts that trade (over 95%) are closed out prior to the settlement date and, therefore, do not result in physical delivery.
These differences between forwards and futures are summarized in Table 7.1.
Are there any significant differences between forward prices and futures prices? There have been numerous academic studies on this topic and, in the case of foreign exchange, the general consensus is no.6 A statistically significant difference between forward prices and futures prices does not seem to exist for many products, like gold, commodities, and FX, but there are well-understood and well-documented differences for interestrate-related forward contracts (such as OTC forward (interest) rate agreements or FRAs) and their exchange-traded counterparts, such as EuroDollar future contracts.7 And even where there are a differences, as the time frame becomes small (one month, one week, one day), the differences tend to disappear.
TABLE 7.1 Forwards versus Futures
| Forwards | Futures |
|---|---|
| Over-The-Counter (OTC) | Exchange-Traded Derivative (ETD) |
| Individually Tailored | Standardized Terms |
| No Cash Flows | Marked-To-Market Daily |
| Usually Result in Delivery | Vast Majority Do Not Result in Delivery |
| Counterparty Exposure | Exchange and Clearing House Exposure |
FOREIGN EXCHANGE FUTURES CONTRACT SPECIFICATIONS
The International Monetary Market, a division of the Chicago Mercantile Exchange, lists futures contracts on 16 non-USD currencies (Euro, Japanese Yen, British Pound, Swiss Franc, Canadian Dollar, Australian Dollar, New Zealand Dollar, Mexican Peso, Brazilian Real, South African Rand, Swedish Krona, Norwegian Krone, Polish Zloty, Czech Koruna, Hungarian Florint, and Russian Ruble), a USD Index, and a number of Cross (Exchange) Rate Contracts (such as Euro-Japanese Yen).
Most of these contracts “mature” on the second business day before the third Wednesday of the month. Note, we use the words “mature” and “maturity” to refer to the termination and the longevity of a future contract, but we will use the words “expire” and “expiration” for options. With the exception of the crosses, on the Merc, all prices are quoted in U.S. Dollars (what we referred to earlier as American quotes). For the most part, these are quarterly contracts that settle in March (H), June (M), September (U), and December (Z). The mnemonic used by some floor traders is marcH, juMe, septUmber, and deZember. At any given time, there are usually six of these futures contracts listed and trading. The majority of these contracts are physically settled; that is, unless the trade is “reversed,” or “closed out,” or “unwound” prior to maturity, then these futures will result in the delivery of the underlying currency. As always in foreign exchange, there are exceptions. The Russian Ruble future contract, which, at any given time, is only listed out four quarters is “cash settled”—resulting, not in a delivery of Rubles, but in the U.S. Dollar equivalent of the Ruble payoff that would otherwise have been associated with that future. Another exception is the Brazilian Real, which, along with Mexican Peso and South African Rand, has monthly futures contracts listed—as opposed to quarterly contracts—and is also cash settled.
TABLE 7.2 Chicago Mercantile Exchange Futures Contract Specifications for Some of the Major Currency Futures
The contract specifications for the major non-U.S. Dollar currencies are summarized in Table 7.2.
A typical day’s currency futures price quotes as seen in the Wall Street Journal are shown in Figure 7.1.
MARGIN
Every traded future requires that “margin” be posted by the two counterparties to that transaction in order to ensure the performance of the agreement inherent in the future contract. Margin is an expression used in a variety of ways in the financial community and on the exchanges.
FIGURE 7.1 Wall Street Journal Currency Futures
Source: Wall Street Journal.
What was once described as “a good faith deposit” is now officially identified as a “performance bond” on the Merc’s web site. Two brief things to note: First, the margin requirements are different depending on whether your position is (1) “naked” or “speculative” or (2) “an offset against another position” or a “hedge.” Second, there are two margin numbers reported by the exchange: “initial” and “maintenance.” The first is what must be placed with the clearing house (working with the futures exchange) once a position (long or short) is taken on. The second is the level which must be maintained given the daily “adjustments” (or variation margin) for the movements in the futures price(s). The futures clearing house in conjunction with the exchange monitors all trades and “marks the position to market” daily. This involves tracking all outstanding positions and crediting or debiting the margin accounts based on the daily price movements in the future contracts. Most futures contracts are “marked” at the end of the trading day; some futures contracts and other futures exchanges, though, may require marking-to-market a couple of times during the trading day.
Three of the most common questions about margin:
1. “What happens if my account drops below the maintenance level?”
2. “If my margin account is in excess of the minimum required, can I take the excess cash out?”
3. “Do I get interest on my money?”
The answers actually depend on the particular exchange. For many futures exchanges, if your margin account falls below the maintenance margin level, you must replenish it by depositing or wiring additional money into your account to satisfy the margin requirement, which, most commonly, involves returning the margin balance to the original level. Bank accounts are established to facilitate this process, which is a necessary part of doing business on a futures exchange. The notion of a “margin call” for a delinquent margin account, if not properly resolved, will generally result in the termination of one’s position by the exchange. Often, margin balances over the initial level can be withdrawn. At one time, getting interest on the cash in your margin account was the exception as opposed to the rule. Nowadays, the exchanges offer interest earning facilities (IEFs), sweep accounts, and similar cash management arrangements, which do afford some return on your money. Interest is less an issue if one realizes that a number of high quality securities (like Treasury bills), letters of credit, and so on may be (and generally are) used to satisfy a portion of one’s margin requirement, with an appropriate discount or “haircut” in recognition of the fact that the market value of the acceptable securities can themselves change. Also, for the record, the exchange reserves the right to revise these performance bond requirements as they see fit at any time, depending principally on the price level at which the underlying is trading and the historical volatility of that underlying price and to mark positions intraday given unusual market circumstances. One last point about margin: The performance bond required by the exchange of the clearing house may be less than that required by the clearing house of its clearing members, which may differ from what they require of their brokers, which in turn may differ from what brokers may impose on the ultimate end user or customer.
As an example of how futures’ margining works, assume a member of the exchange purchases 20 Swiss Franc futures contracts at a future price of F = USD .8000 (per Swiss Franc) for a delivery in three months. One must post the required initial margin, which, if speculative, is USD 1,890 per contract for a total initial margin requirement of USD 37,800. Let’s say that the trade occurred at a price of F = USD .8000 and that the future closed that day at the same price. Then there would not be a need for a daily adjustment to the initial margin in the account at the end of the day. If the next day the future closed at F = USD .8010, then this contract has moved USD .0010 per Swiss Franc (which translates into a cash flow of USD .0010 × CHF 125,000 per contract × 20 contracts = USD 2,500 or more simply + 10 points × USD 12.50 per point (from Table 7.2) × 20 contracts. This cash would appear in the margin account of the trader who bought these futures (for a new total margin deposit of USD 40,300). Where does this money come from? It comes out of the account (s) of the member(s) who sold these contracts. Assume that on the next day, the future closes at F = .7995. This is a one-day drop of 15 points (and so – .0015 × 125,000 × 20 = – USD 3,750 for a running margin balance to the futures purchaser of USD 36,550). This process continues through the last day of trading. If the member who bought these futures was not required to post any additional margin between the trade date and the maturity or delivery date, and if the future closes on the final day of trading at, say, F = .8012, then that person’s margin account should contain USD 40,800 (the initial margin of USD 37,800 and the net USD .0012 per Swiss Franc × 125,000 Swiss Francs per contract × 20 contracts = USD 3,000).
When delivery is made, the purchaser of the Swiss Franc futures will receive the CHF 2,500,000 (CHF 125,000 per contract × 20 contracts) and pay USD 2,003,000 [CHF 125,000 × F, (which, at maturity = USD .8012) × 20 ]. Hey, wait a minute! Didn’t the future buyer agree to pay a price of F = USD .8000 per CHF? So shouldn’t the buyer be paying USD 2,000,000? The answer is “Yes, sort of.” Indeed, we agreed to buy CHF 2,500,000 at a price of USD .8000 per Swiss Franc for a total of USD 2,000,000. Why are we paying USD 2,003,000? Because, when the futures contract matures, we no longer need to have money in our margin account, and so can take home both our initial margin (USD 37,800) and the accumulated variation margin (USD 3,000). In effect we pay USD .8000, but the cumulative daily movements in the futures price have been accounted for in the margin account, so, when we actually pay USD 2,003,000 and get back our initial margin plus USD 3, 000, we effectively realize the trade price of USD .8000 per CHF 1.
The most important question here is, “What is USD .8012?” If we recall our spot-forward pricing relationship (Equation [6.8]), then on the final day (when t = 0), the futures price (F) should equal the spot price (S). And, in effect, what happens when there is a futures delivery is that there is a spot transaction at the current spot price. Through the process of daily marking-to-market, the exchange and clearing houses have reduced their counterparty exposure to a one-day window.
WHY USE FUTURES?
Although the pricing of FX forwards and FX futures is similar, some reasons have been postulated to explain a possible preference on the part of an individual or institution for FX futures contracts (as opposed to FX forwards).
• A fund’s prospectus may allow for the use of futures but not forwards.
• A market participant’s creditworthiness may preclude their ability to enter into OTC contracts, whereas, given sufficient margin, they can trade futures.
• The individual or institution may be unwilling or unable to take the credit/counterparty risk associated with forwards (whether this reluctance is justified for every possible counterparty or not).
• The transparency of the futures markets (with readily available daily closing prices) might be highly valued (though, again, liquidity in the OTC market and the access to marks has never been greater, given the explosion in the availability of market data—OTC and otherwise).
George Stigler, one of my professors at the University of Chicago, was always inclined to turn to the market itself to assess the value attached to any given product or contract; the market in FX forwards is significantly larger than the volume traded via FX futures.
OPTIONS ON FX FUTURES
Although we discuss options in Chapter 9, we simply note here that there are options on many of the FX futures traded on the exchanges. These option contracts, like the underlying futures, have standardized features (premium quotes, expiration dates, listed strike prices, and contract sizes—where each option typically “covers” one future). Also, exchange-traded options on FX futures typically involve American-style exercise, which allows the option buyer the opportunity to exercise the option at any point in time. Note, though, that this results in a long or short FX futures position, not in the acquisition or delivery of the underlying currency. To some market participants, options are viewed as an alternative to forwards or futures.
CURRENCY FUTURES EXERCISES
1. If a U.S. corporation had a firm commitment of two billion in Japanese Yen receivables arriving in December of that year
What futures contracts could they use to “hedge”?
Would they buy or sell them?
How many would they want to trade?
Would they buy or sell them?
How many would they want to trade?
2. In what ways do FX futures contracts differ from FX forward contracts?
SUMMARY
In essence, although we have emphasized the difference between FX forwards and futures and the idiosyncrasies of the futures contracts, they are very similar in that they both afford opportunities to buy or sell currency at some point in the future at a previously agreed upon (i.e., “locked in”) price. Differences involve where they trade (OTC versus exchange), whether they are individually tailored versus standardized, the nature of the cash flow associated with these trading vehicles (possibly none versus daily—or even intraday—marking-to-market through a margin account), and, empirically, the likelihood of delivery. Volume in the OTC FX forward market greatly exceeds volume traded through FX futures, but the latter can provide a useful source of market data, which explains the number of academic studies that have utilized the available information on these exchange-traded instruments. There is one additional difference between futures and forwards: Currency futures trading is overseen by the Commodity Futures Trading Commission (versus the relatively unregulated OTC FX forward market). Finally, as mentioned, there are options on FX futures, typically traded side-by-side with the underlying futures contracts (on CFTC-regulated exchanges in the United States).
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