1. 1 Futures FX Market Dr. J. D. Han King’s College University of Western Ontario

2. 2 I. FX Futures 1. Rationales: 1) To overcome Lack of Liquidity of Forward Market, which is mostly O.T.C. -> Futures Market has Standardized Transactions, and is Standing Market -> Futures are Common men’s Forward Contract 2) To overcome the Credit/Default Risk -> Third Party Market, Performance Bonds(Margin), etc. 3) Leverage -> Leverage in futures trading means that the amount you need to deposit is small in comparison to the amount of product it will control.

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4. 4 3. History and Currents of the Futures Market: Chicago Mercantile Exchange started FOREX Future Trading in 1972 Daily average trading volume exceeds US $ 100 billion Website of FX futures in CME http://www.cmegroup.com/trading/fx/

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6. Standardized Contract Size British Pound62,500 Euro125,000 Swiss Franc125,000 Australian Dollar100,000 Canadian Dollar100,000 Chinese Yuan1,000,000 Japanese Yen12,500,000 6

7. 7 6. Operation of Futures Market: Daily Reconstructed/Settled Forward market Margin Deposit (=performance bonds=Initial Deposit Requirement) Buy (take long-position) if you expect/need the price of a currency to rise; Sell (take short-position) if you expect/need it to fall. Futures settlement price changes every day Profits or Losses are settled on a daily basis from a mandatory margin account -> “Marking to Market”

8. Numerical Example 1. British Pound 625,000 pounds Initial Margin = Performance Bonds -$ 2,900 for hedgers Maintenance Margin = $ 2,6\900 8

9. Suppose you buy a unit at 1.4444 $ per Sterling Pound. Initial Margin Requirement by CME = $2900 for a hedger Suppose Actual Initial Margin Deposited =3000 Next day, the rate of GBP Futures falls to 1.4334 You have lost 11 points or 0.0110 dollar per Sterling Pound. - For one unit has 62,500 pounds. - You have lost 0.0110 dollar x 62,500 pounds for a unit of GBP Futures = 687.5 dollars = Marking to the Market Margin Balance = 3000 – 687.5 = 2313.5 Maintenance Margin set by CME = 2900 Variation Margin Requirement to refill = 587.5 9

10. Numerical Example 2 You are a Canadian exporter to U.S. and are to receive U.S. 1 mil in 3 months, that is, June 2010(t+1). How would you do FX Hedging in the CME? 10

11. To start: Performance bond = U.S. $ 3300 for a hedger Mindset: You have to put on the U.S. shoes-Act and think like you are a U.S. citizen for S U.S $./C$ What to do? You are (buying/selling) Canadian Dollar Futures (CD) in CME, which will expire/deliver on March 2010. How much? Each unit = C $100,000 So you buy 1/S = 1/0.82 =about 12 units of CD for $100,000 for the corresponding rate = 0.8159 at 10:25:30 AM CST 2/09/2009. Thus you pay 0.8159 x 100,000 x 12 = U.S. $ 978,900. You have to get it from Spot Market at the current Spot rate S t. 11

12. Forward Contract Suppose that at the expiry date in June 2009, the CD M06 is 0.8400. You win the net of (0.8400- 0.8159) x 100,000 x 12 U.S. dollars. (S t+1 – F) times 1 million -(a) Initial FX Risk Exposure of Business However, that forward rate is close to the spot rate in June 2009. You have lost (S t+1 –S t ) times 1 million –(b) (a) makes up the whole or part of (b). -When F = S t, then F-S t = 0, it is a perfect coverage.. F- S t is inevitable change not to be covered., 12