Understanding FX Futures


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A number of factors have coalesced in the early 21st century to promote free trade across distance and political boundaries, meaning today's corporation frequently conducts business outside its native country and earns revenues or incurs liabilities denominated in currencies apart from its native currency.

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Understanding FX Futures

  1. 1. CURRENCIESUnderstandingFXFuturesAPRIL 22, 2013John W. Labuszewski Sandra Ro David GibbsManaging Director Executive Director DirectorResearch & Product Development312-466-7469jlab@cmegroup.comResearch & Product Development44-203-379-3789Sandra.ro@cmegroup.comProduct Marketing312-207-2591David.gibbs@cmegroup.com
  2. 2. 1 | Understanding FX Futures | April 22, 2013 | © CME GROUPIt is often said that the world is getting smaller andnowhere is this more apparent than in theincreasingly globalized world of internationalcommerce.A number of factors have coalesced in the early 21stcentury to promote free trade across distance andpolitical boundaries. Political advances promotingfree trade include reduction or elimination ofrestrictive tariffs, capital controls and subsidizationof local businesses. Technical advances includereduced transportation costs promoted bycontainerization of products for ocean shipping, andadvanced telecommunication systems lead by theemergence of the World Wide Web.Thus, today’s modern corporation frequentlyconducts business outside its native country and, inthe process, earns revenues or incurs liabilitiesdenominated in currencies apart from their nativecurrency. In the process, these corporations maybecome exposed to the risk that foreign exchangerates are unpredictable and can fluctuate in adversedirections. These uncertainties may make it difficultto manage current cash flows, plan future businessexpansion or to succeed in a competitive marketenvironment.CME has offered FX futures and options dating backto the breakdown of the post WWII Bretton Woodsagreement in 1972 that imposed fixed exchangerates between the world’s currencies. Thesecontracts provide an ideal tool to accept FX riskexposure or manage those risks in an uncertainworld.Spot Exchange Rates(as of Friday, April 12, 2013)CurrencyISOCODEIn USD per USDAMERICASArgentina peso ARS 0.1943 5.1461Brazil real BRL 0.5077 1.9697Canada dollar CAD 0.9866 1.0135Chile peso CLP 0.002128 470.00Colombia peso COP 0.0005475 1,826.50Ecuador US dollar USD 1.0000 1.0000Mexico peso MXN 0.0828 12.0780Peru new sol PEN 0.3868 2.585Uruguay peso UYU 0.05299 18.8705Venezuela fuerte VEF 0.157480 6.3500ASIA-PACIFICAustralian dollar AUD 1.0507 0.95171-mth forward 1.0483 0.95393-mth forward 1.0435 0.95836-mth forward 1.0366 0.9647China yuan CNY 0.1614 6.1947Hong Kong dollar HKD 0.1288 7.7620India rupee INR 0.01834 54.5200Indonesia rupiah IDR 0.0001030 9,712Japan yen JPY 0.010162 98.411-mth forward 0.010164 98.393-mth forward 0.010168 98.356-mth forward 0.010177 98.26Malaysia ringit MYR 0.3287 3.0427New Zealand dollar NZF 0.8588 1.1644Pakistan rupee PKR 0.01018 98.245Phillippines peso PHP 0.0242 41.349Singapore dollar SGD 0.8085 1.2369South Korean won KRW 0.0008855 1,129.25Taiwan dollar TWD 0.03337 29.965Thailand baht THB 0.03441 29.062Vietnam dong VND 0.00004797 20,848EUROPECzech Rep koruna CZK 0.05060 19.762Denmark krone DKK 0.1758 5.6869Euro area euro EUR 1.3111 0.7627Hungary forint HUF 0.004438 225.33Norway krone NOK 0.1751 5.7108Poland zloty PLN 0.3195 3.1296Russia ruble RUB 0.03218 31.075Sweden krona SEK 0.1573 6.3566Switzerland franc CHF 1.0783 0.92741-mth forward 1.0786 0.92713-mth forward 1.0794 0.92646-mth forward 1.0808 0.9252Turkey lira TRY 0.5592 1.7882UK pound GBP 1.5344 0.65171-mth forward 1.5341 0.65183-mth forward 1.5336 0.65206-mth forward 1.5331 0.6523MIDDLE EAST/AFRICABahrain dinar BHD 2.6523 0.3770Egypt pound EGP 0.1455 6.8739Israel shekel ILS 0.2760 3.6236Jordan dinar JOD 1.4123 0.7081Kuwait dinar KWD 3.5082 0.2851Lebanon pound LBP 0.0006614 1,511.95Saudi Arabia riyal SAR 0.2667 3.7501South Africa rand ZAR 0.1118 8.9436UAE dirham AED 0.2723 3.6728Source: Wall Street Journal, April 15, 20130100,000200,000300,000400,000500,000600,000700,000800,000900,0001,000,0002000200120022003200420052006200720082009201020112012FX Futures & OptionsAverage Daily Volume
  3. 3. 2 | Understanding FX Futures | April 22, 2013 | © CME GROUPProduct innovation, liquidity and financial surety arethe three pillars upon which CME Group has built itsworld class derivatives market. CME Group providesproducts based on a wide range of frequentlytransacted currencies; liquidity offered on the state-of-the-art CME Globex® electronic trading platform;and, financial sureties afforded by its centralizedclearing system.This document is intended to provide a perspectiveon the FX trading landscape, including interbank orover-the-counter (OTC) products, as well asexchange-traded structures such as CME FX futuresand options on futures. We dig in by explaining howFX futures are priced relative to spot rates and howthey may be used as an effective risk-managementvehicle.Spot FX TransactionsCurrencies are typically identified by reference totheir “ISO 4217” codes as established by theInternational Standards Organization (ISO) andillustrated in our table.A spot or outright currency transaction is simply theexchange of one currency for another currency, atthe current or spot rate, or a “currency pair.” Whilethe transaction may be concluded immediately in avariety of interbank markets, sometimes viatelephone, or increasingly via electronic tradingsystems, payment or settlement typically isconcluded two business days hence.It is possible, if mutually agreed, to settle or value atransaction on a one business day basis, as is thestandard convention with transactions between theCanadian dollar (CAD) and U.S. dollar (USD).Quotes may be in either “American terms” or“European terms.”E.g., consider the Swiss franc (CHF) vs. U.S. dollar(USD) currency pairing. Conventionally, one quotesthis currency pair in interbank markets in Europeanterms, or in terms of Swiss francs per one (1) U.S.dollar. Thus, one may quote 0.9274 CHF per 1 USDas of April 12, 2013. The American terms quote issimply the reciprocal of the European terms quote. =1 Thus, one may quote the currency pair in Americanterms, or USD per CHF, as 1.0783 USD per 1 CHF.1.0783 1 =10.9274 1 Since 1978, convention has been to quote mostcurrencies in European terms. There are somenotable exceptions to this rule such as the EUR, theGBP and other British commonwealth currenciessuch as the AUD and NZD, which are generallyquoted in American terms.Most currencies are quoted to the 4thplace past thedecimal or 0.0001, also known as a “pip” or a “tick.”However, practices may vary with respect tocurrencies whose values are very small or very largein relative terms.Select Spot Cross Rates(As of April 12, 2013)USD EUR GBP CHF JPY CADUSD - 1.3111 1.5344 1.0783 0.010162 0.9866EUR 0.7627 - 1.1703 0.8224 0.007750 0.7525GBP 0.6517 0.8545 - 0.7027 0.006622 0.6430CHF 0.9274 1.2159 1.4230 - 0.009424 0.9150JPY 98.41 129.028 151.005 106.114 - 97.091CAD 1.0135 1.3289 1.5553 1.0929 0.010300 -It is also, of course, possible to trade “cross-rates”or transactions which do not involve U.S. dollars andare not quoted as such. For example, one maytrade the GBP/EUR rate. Either currency might beutilized as the base rate but there are someconventions that tend to prevail in the interbankmarkets. For example, one normally quotes thepairing of the Euro and Japanese yen (EUR/JPY) asso many Japanese yen per 1 unit of Euro currency.The British pound and Swiss franc pairing (GBP/CHF)is normally quoted in Swiss francs per 1 unit ofBritish pounds. 1The quote may readily beinterpreted by noting that the base currency ismentioned first.Outright ForwardsAn outright forward contract is almost identical inoperational terms to a spot transaction with thesignificant difference that the value or settlement1Note that British pounds are also frequently referred toas “pounds sterling,” “sterling” or “cable.”
  4. 4. 3 | Understanding FX Futures | April 22, 2013 | © CME GROUPdate is deferred. Rather than settle two days hence,outright forwards are typically traded for settlementin 1 week, 2 weeks, 1 month, 2 months, 3 months,6 months, 12 months forward … also referred to as“straight dates.”While the outright forward contract may be settledsome days, weeks or months later, no considerationis necessarily passed between buyer and seller whenthe transaction is consummated. However, manydealers will demand that customers post someacceptable collateral to cover market risks in theinterim, particularly if a trade goes “underwater.”OTC instruments may be configured to the demandsof the moment. Thus, one may closely match thequantity traded and the value date to one’s specificneeds. Of course, dealers may make theircustomers pay a price for such customization in theform of a wider bid/ask spread.The value of an outright forward relative to the spotvalue of the currency may be modeled by taking intoconsideration the costs and benefits associated withpurchasing and carrying the currency over the life ofthe forward transaction.Consider the prospect of purchasing one currencywith another currency on a forward basis. Theforward price may be calculated as follows, whereRterm represents the short-term rate at which onemay effectively borrow the “term” currency; Rbaserepresents the short-term rate that may be earnedby investing in the “base” currency; and, drepresents the number days until the settlementdate. 2! " = " # $1 + &()*+ # ,-./01 21 + &345) # ,-./01 26E.g., find the 3-month forward price for theEUR/USD currency pair where the spot price =1.313700, U.S. 3-month rates = 0.2780%; and,2The “terms” currency is also sometimes referred to asthe “counter” or the “quoted” currency in the sense thatthe transaction is quoted in so many units of the termscurrency per 1 unit of the base currency.Euro 3-month rates = 0.1290%. The 90-dayforward price is calculated at 1.314189 as follows.3 4! " = 1.313700 # $1 + &0.002780 # ,70./01 21 + &0.001290 # ,70./01 26= 1.314189One may calculate the appropriate forward price, or“fair value,” as illustrated above and compare it toprevailing forward prices. If the prevailing forwardprice exceeds the fair value of the forward price bysome margin, presumably, one might execute anarbitrage by selling the forward and buying spotcurrency. Or, if the prevailing forward price weremuch less than its fair value, one might buy theforward and sell spot. This arbitrage activity mayhave the impact of enforcing fair pricing in themarketplace.But another way of analyzing the situation is tocalculate the implicit terms or base interest rate andcompare it to prevailing rates. This is readilyaccomplished by solving our forward pricingequation above for the base rate as follows.345) = 8360!: # ; " # ,1 + &()*+ # ,-./0121! − 1= E.g., find the implicit 3-month base interest rate forthe EUR/USD currency pair. The observed 3-monthforward price = 1.314500; the spot price =1.313700; and, the terms rate = 0.27800%.345) = 836090: # ;1.313700 # ,1 + &0.002780 # ,70./01211.314500− 1== 0.0344%Thus, the implicit base rate is calculated at 0.0344%while the observed base rate = 0.1290%. Thus, themarket is pricing a base rate that is 0.0946%3When referring to a currency pair, the “base” currencyis always referred to first, following by a reference tothe “terms” currency. Thus, if we quote the EUR/USDpairing, the Euro represents the base currency and theU.S. dollar represents the terms currency.4The convention in most markets is to calculate short-term rates based on a 360-day count assumption, butsome short-term rate markets, including the U.K.,employ a 365-day count.
  5. 5. 4 | Understanding FX Futures | April 22, 2013 | © CME GROUP(=0.1290% - 0.0344%) lower than the observedbase rate.This is consistent with an observation that the fairvalue or calculated 3-month forward price =1.314200 while the observed 3-month forward price= 1.314500. Thus, the market appears to betrading 3 “pips” (=1.314500 – 1.314200) above itsfair value.This suggests that one might consider selling theforward EUR/USD contract and buying spotEUR/USD. This implies a possible arbitrage profit of3 pips or the possibility of effectively borrowingEuros at an implicit rate that is lower than prevailingrates.Some central banks impose restrictions on foreignownership or usage of their national currencies incapital or current accounts. These currencies aresaid to be “inconvertible” or “non-deliverable.”Some of the most significant currencies thatgenerally are not deliverable include the CNY, INRand RUB. 5Still, these currencies may be traded as “Non-Deliverable Forwards” (NDFs). Rather thanculminating in a delivery of currency, NDFs aresettled with a cash payment for the net profit or lossdenominated in the readily negotiable currency.FX SwapsAn FX swap may be thought of as a combination oftwo offsetting currency transactions separated bytime and constitute the largest segment of the FXmarketplace in terms of daily turnover. An FX swapis executed when you swap one currency for anotheron a nearby value date (“near date”) only to reversethe transaction on a subsequent value date (“fardate.”)A large proportion of FX swaps entail a spot trade asthe near date transaction - a “short dated FX swap.”Frequently, the far date transaction occurs within aweek. But dealers often quote FX swaps with the5Note that the People’s Bank of China (PBOC) has takensteps over the past several years to liberalize the CNY.Thus, an offshore market in Chinese yuan is nowavailable in Hong Kong where the currency is oftenreferred to as “CNH.”full range of straight dates, i.e., 1-week, 2-weeks,1-month, 2-months, etc., as the far date. Dealersoften offer a high degree of flexibility and may bewilling to quote prices for odd dates and forwardswaps where the near-term leg is executed as aforward rather than a spot transaction.A “spot-next” FX swap is executed by delivering acurrency one day and reversing the trade on thesubsequent business day. Note that the spottransaction is typically settled two business dayssubsequent to the deal date. A “tom-next” swap istransacted by executing the spot transaction on a“pre-spot” basis or one day earlier than normalconvention, i.e., tomorrow as opposed to twobusiness days hence, reversing the trade on thesubsequent business day.Or, one may execute a “spot-week” or “spot-2week” FX swap. A “forward FX swap” is generallyconsidered one where the near date transaction issettled, not on a spot basis two days hence, but onsome forward date.A “buy-sell” swap implies the purchase of a fixedquantity of the base currency on the near date onlyto be offset with the sale of a fixed quantity of thebase currency on the far date. Conversely, a “sell-buy” swap implies the opposite … the sale of a fixedquantity of the base currency subsequently offsetwith its re-purchase.FX swaps may be thought of as akin to repurchaseor repo agreements in fixed income markets whereone borrows or lends cash on a temporary basiscollateralized with an equivalent value of a fixedincome item, most often a U.S. Treasury security.Like a repo or an FX forward transaction, the valueof an FX swap reflects an interest rate, or moreaccurately, the interest rate differential between thetwo currencies.FX swaps are typically quoted in terms of pips asfollows, where Rterm represents the short-term ratethat may be earned by investing the “term”currency; Rbase represents the short-term rateassociated with the “base” currency; and, drepresents the number of days between the far andnear dates.
  6. 6. 5 | Understanding FX Futures | April 22, 2013 | © CME GROUP " @ = " # ;$1 + &()*+ # ,-./01 21 + &345) # ,-./01 26 − 1=E.g., find the swap points associated with a 90-dayEUR/USD swap. Let us refer to our previousexample where the spot EUR/USD rate is quoted at$1.313700; U.S. 3-month rates = 0.2780%; and,European 3-month rates = 0.1290%. A three-month or 90-day swap rate may be calculated as4.89 pips as follows. " @ = 1.313700 # ;$1 + &0.002780 # ,70./01 21 + &0.001290 # ,70./01 26 − 1== 0.000489 4.89 @ Thus, we expect the 3-month swap to be trading at0.000489 or 4.89 pips above the spot rate of$1.313700.FX swap transactions are often used to manageone’s currency positions on a short-term basis.They may also be deployed to speculate onfluctuations in the interest rate differentials betweentwo countries.An FX swap must be distinguished from a so-called“currency swap” transaction. A currency swapentails an element of an FX swap as well as anelement of an interest rate swap. Parties to acurrency swap will initially exchange two currencieson a spot basis, swap a series of periodic floatinginterest rate payments denominated in therespective currencies involved in the transaction andultimately conclude the transaction by re-exchanging the two currencies.Currency swaps differ from interest rate swaps (IRS)to the extent that an interest rate swap typicallyimplies the periodic exchange of a stream of fixedvs. floating rate payments in a single currencyrather than in two different currencies. But like anIRS, there are many variations on the themeincluding fixed vs. fixed rate; fixed vs. floating rate;or, floating vs. floating rate currency swaps.OTC Currency OptionsThe interbank FX markets had become quiteaggressive and inventive with respect to the use ofoptions beginning in the early 1980s. Optionsprovide a very flexible structure that may be tailormade to meet the risk management or speculativeneeds of the moment.Options may generally be categorized as either callsor puts. Call options convey the right, but not theobligation, to buy a specified quantity currency at aparticular strike or exercise price on or before anexpiration date. One may either buy a call option,paying a negotiated price or premium to the seller,writer or grantor of the call; or, sell, write or grant acall, thereby receiving that premium.Put options convey the right, but not the obligation,to sell a specified quantity currency at a particularstrike or exercise price on or before an expirationdate. Again, one may buy or sell a put option,either paying or receiving a negotiated premium orprice.Options may be configured as European or Americanstyle options. A European style option may only beexercised on its expiration date while an Americanstyle option may be exercised at any time up to andincluding the expiration date.The purchase of a call option is an essentially bullishtransaction with limited downside risk. If the marketshould advance above the strike price, the call isconsidered “in-the-money” and one may exercisethe call by purchasing currency at the exercise priceeven when the exchange rate exceeds the exerciseprice. This implies a profit that is diminished only bythe premium paid up front to secure the option. Ifthe market should decline below the strike price, theoption is considered “out-of-the-money” and mayProfitLossMarket PriceProfit/Loss for Call OptionBuy Call Option Sell Call Option
  7. 7. 6 | Understanding FX Futures | April 22, 2013 | © CME GROUPexpire, leaving the buyer with a loss limited to thepremium.The risks and potential rewards which accrue to thecall seller or writer are opposite that of the callbuyer. If the option should expire out-of-the-money, the writer retains the premium and counts itas profit. If, the market should advance, the callwriter is faced with the prospect of being forced tosell currency when the exchange rate is muchhigher, such losses cushioned to the extent of thepremium received upon option sale.The purchase of a put option is essentially a bearishtransaction with limited downside risk. If the marketshould decline below the strike price, the put is in-the-money and one may exercise the put by sellingcurrency at the exercise price even when theexchange rate is less the exercise price. If themarket should advance above the strike price, theoption is out-of-the-money, implying a loss equal tothe premium.The risks and potential rewards which accrue to theput writer are opposite that of the put buyer. If theoption should expire out-of-the-money, the writerretains the premium and counts it as profit. If, themarket should advance, the put writer is faced withthe prospect of being forced to buy currency whenthe exchange rate is much lower, such lossescushioned to the extent of the premium receivedupon option sale.While one may dispose of an option through anexercise or abandonment (expiration sans exercise),there is also the possibility that one may liquidate along/short option through a subsequentsale/purchase.As such, option traders utilize a variety ofmathematical pricing models to identify appropriatepremium values not the least of which is the Black-Scholes option pricing model. Several factorsincluding the relationship between market andexercise price, term until expiration, marketvolatility and interest rates impact the formula.Frequently, options are quoted in terms of volatilityand converted into monetary terms with use ofthese formulae.By combining options of varying types (puts orcalls), exercise prices and expiration dates, one maycreate an almost infinite variety of strategies whichmay be tailored to suit one’s unique needs.Currency Futures FundamentalsCurrency futures were developed in 1972 by ChicagoMercantile Exchange Chairman Leo Melamed,working in concert with the Nobel Prize winningeconomist Milton Friedman. This development maybe considered a direct response to the breakdown ofthe Bretton Woods Accord and represented the firstfinancial futures contract ever successfullyintroduced.Over the years, many currency contracts have beenadded and the listings now include contracts onEuros vs. U.S. dollars (EUR/USD), Japanese yen vs.U.S. dollars (JPY/USD), British pounds vs. U.S.dollars (GBP/USD), Swiss francs vs. USD(CHF/USD), Canadian dollars vs. USD (CDN/USD),Australian dollars vs. USD (AUD/USD), Mexicanpesos vs. USD (MXN/USD), New Zealand dollars vs.USD (NZD/USD), Russian ruble vs. USD (RUB/USD),South African rand vs. USD (ZAR/USD), Brazilianreal vs. USD (BRL/USD), and many others.Most recent additions to the line-up include Chineserenminbi vs. USD (RMB/USD) and Korean won vs.USD (KRW/USD). Further, CME lists smaller sized or“E-mini” versions of several of our more popular FXfutures contracts. The aforementioned contracts aregenerally quoted vs., and denominated in, the U.S.dollar.Profit/LossMarket PriceProfit/Loss for Put OptionBuy Put Option Sell Put Option
  8. 8. 7 | Understanding FX Futures | April 22, 2013 | © CME GROUPMajor cross-rate contracts included EUR/GBP,EUR/JPY, EUR/CHF, GBP/CHF, GBP/JPY and manyothers. CME Group further offers options on manyof these currency futures contracts.Options on CME Currency FuturesIn addition to operating the primary venue for thetrade of FX futures, CME also offers optionsexercisable for futures, commencing in 1982. Notethat upon exercise, rather than delivering actualcurrency, these contracts contemplate theestablishment of a currency futures position. Thesecontracts are accessible through the CME Globexelectronic trading platform and are offered on anAmerican style and European style basis.Exchange traded options are similar to exchangetraded futures with respect to their relatively highdegree of standardization. And like currencyfutures, trading volumes in options on currencyfutures have been growing very quickly in recentyears.Mechanics of Currency FuturesFutures may be considered akin to a forwardcontract, and typically are priced as such, exceptthat they are traded on a regulated futuresexchange subject to standardized terms andconditions. Exchange traded currency futures havehistorically been distinguished from OTC FXtransactions by their standardization vs. flexibility orcustomization inherent in working with a dealer. Butexchanges are introducing greater degrees offlexibility in their trading practices.FX futures are traded on the CME Globex®electronictrading platform and on the floor of the Exchange inan open outcry environment, although thepredominant mode of trade is electronic. Thesecontracts generally call for delivery of a specifiedquantity of a specified currency, or a cashsettlement, during the months of March, June,September and December (the “March quarterlycycle”). 66Table 1 in our appendix below includes contractspecifications for four of the most popularly traded CMEGroup currency futures contracts including theEUR/USD, JPY/USD, GBP/USD and CHF/USD pairings.Thus, one may buy or sell 12,500,000 JPY fordelivery on the third Wednesday of June 2013; or,125,000 Euros for delivery on the third Wednesdayof September 2013. Traders who "go long" or buyJPY/USD futures are committed to take or acceptdelivery of 12,500,000 JPY while, traders who "goshort” or sell EUR/USD futures are committed tomake delivery of 125,000 Euros. The short makingdelivery is compensated by the buyer acceptingdelivery by an amount equal to the futuressettlement price quoted in USD on the last day oftrading.Noting that the JPY/USD futures contract is based on12,500,000 yen, this means that the June 2013contract was valued at $126,475.00 (=12,500,000yen x 0.010118 dollars/yen). The minimumallowable price fluctuation or “tick” in JPY/USDfutures is $0.000001 yen per dollar or $12.50(=$0.000001 x 12,500,000 yen). 7Digging in a bit more deeply, the table belowillustrates how JPY/USD futures may be quoted. Thecontract is quoted in "American" terms, i.e., in termsof dollars per foreign unit. This is at variance fromthe typical interbank practice of quoting foreignexchange transactions in terms of foreign unit perU.S. dollar.One may readily convert these quotes from dollarsper foreign unit to foreign units per dollar by simplytaking the reciprocal. E.g., if June 2013 JPY/USDfutures close at 0.010118 dollars per yen, this mayreadily be converted into 98.8338 Japanese yen perone U.S. dollar (= 1/0.010118).American vs. European Term Quotes(As of April 12, 2013)CME QuotesAmericanTermsEuropeanTermsUSD per EUR 1.3085 0.7642USD per JPY 0.010118 98.8338USD per GBP 1.5338 0.6520USD per CHF 1.0763 0.92917Table 2 in our appendix below illustrates quotationpractices in four of the most popular CME Groupcurrency futures markets. Table 3 depicts how thecontract and minimum price increment (or “tick” size)translates into monetary values.
  9. 9. 8 | Understanding FX Futures | April 22, 2013 | © CME GROUPThese popular currency futures tend to be sizedsmaller than most typical institutional interbankcurrency transactions in the range of perhaps$100,000 to $200,000 in notional value. This isintended to render the contracts accessible to retailin addition to institutional traders and thereby addanother element of liquidity to the marketplace,noting that one might readily trade in multiples of asingle standard contract size.Like any futures contract, FX futures are secured byperformance bonds that are posted by both buyersand sellers. The performance bond or marginrequirement will reflect one day’s maximumanticipated price movement. Subsequently, thesepositions are marked-to-market (MTM) daily by theExchange clearing house. I.e., any profits or lossesare posted to the trader’s account on a daily basis.Thus, there are no paper profits or losses in futures.Deliverable vs. Non-Deliverable FuturesThe four major currency futures highlighted abovecall for the actual delivery of these currencies ondeposit at designated foreign financial institutionsthrough the Continuous Linked Settlement (CLS)system. CLS may be thought of as essentially anescrow service ensuring that payment of onecurrency is made vs. the other currency.But often it becomes impractical to provide for suchdelivery when, for example, exchange restrictionsare in force with respect to a particular currency.Under such cases, the currency may trade as non-deliverable forward (NDF) in the over-the-counter orinterbank currency markets as described above.There are in fact some currency futures contractsbased on non-deliverable currencies which aresettled in cash upon futures contract expiration.This provision allows CME to extend the futuresproduct line to currencies including the RMB, BRLand other generally inconvertible currencies. Thesecontracts are cash settled vs. a representative pricesurveyed from the interbank NDF markets.The BasisFutures are most closely compared to outright FXforward transactions and are priced in accordancewith so-called cost of carry considerations. Futuresmarket participants refer to “the basis” or therelationship between futures and spot prices. Thebasis may be thought of as the futures price less thespot price of the currency pairing.A @ @ = @ " − "The basis may be either positive or negativecontingent upon the relationship between short-terminterest rates prevailing with respect to the so-called“base” and “terms” currencies. 8The appropriatelevel for the futures contract, or the “fair marketvalue,” is precisely analogous to the calculation of aforward price as follows.@ " = " # $1 + &()*+ # ,-./01 21 + &345) # ,-./01 26Where the terms rate exceeds the base rate, futuresshould trade at premium to the spot price of thecurrency and the basis (of futures less spot) may bequoted as a positive number. This is a conditionknown as “negative carry” in futures marketsbecause costs are incurred to buy and carry basecurrency.But when the terms rate is less than the base rate,futures should trade at a discount to spot and thebasis may be quoted at a negative number. This isa circumstance known as “positive carry” becauseearnings accrue from buying and carrying the base8As discussed above, CME FX futures are generallyquoted in terms of U.S. dollars (USD) per the namedcurrency. Thus, USD is generally considered the termscurrency and the other currency in the pairing is thebase currency.-60-40-200204060t+0 t+1 t+2 t+3 t+4 t+5 t+6 t+7Positive and Negative CarryPositive CarryBase Rate > Terms RateNegative CarryBase Rate < Terms Rate
  10. 10. 9 | Understanding FX Futures | April 22, 2013 | © CME GROUPcurrency. Thus, the futures basis is analogous to“forward points” as quoted in interbank or OTCcurrency markets.E.g., consider the basis for June 2013 EUR/USDfutures as of April 16, 2013. The spot value of theEUR/USD was quoted at 1.3137 while the June 2013EUR/USD futures contract was quoted at 1.3143.Thus, the basis is calculated as 0.0006 or 6.0 pips.A @ @ = 1.3143 < 1.3137 0.0006 6.0 @I.e., the consolidated futures and forward EUR/USDcurve is trading at higher and higher levels insuccessively deferred maturities or settlement dates,as depicted in Table 4 and our graphic below. Thisreflects a condition of negative carry because short-term EUR denominated interest rates are less thanshort-term USD interest rates. I.e., U.S. rates(“terms rate”) exceed Euro rates (“base rate”).Note that we apply different short-term rates todifferent terms in recognition of the shape of theU.S. and Euro denominated short-term yield curvesas illustrated in Table 4.But the impact of these carry considerations isdiminished over time as we approach the expirationof the futures or forward contract. This is intuitiveto the extent that interest costs and expensediminish as a function of a diminished term toexpiration.As a result, the basis or differential of futuresrelative to spot prices is said to “converge” towardszero as expiration approaches. By the time thefutures contract becomes deliverable, the futurescontract becomes a direct proxy for the spot deliveryof the currency in question and the basis is expectedto converge to essentially zero.We may observe this effect by examining therelationship of the spot EUR/USD exchange rate vs.the March 2013 futures. Note that the two valuesfluctuate in close parallel one to the other. But if weisolate the basis as illustrated below, we see that itgenerally converged rather steadily towards zero bythe time the March delivery occurred.This graphic suggests that basis relationships arereally quite predictable as dictated by therelationship between short-term interest ratesassociated with the two currencies that comprise thetransaction. That is, of course, attributable to thefact that arbitrageurs monitor and promptly act upon1.31301.31351.31401.31451.31501.31551.31601.31651.3170Spot1-Mth2-Mth3-Mth4-Mth5-Mth6-Mth7-Mth8-Mth9-MthEUR/USD Futures/Forward Curve(April 18, 2013) EUR-USD vs. Mar-13 FuturesSpot EUR-USD Mar-13 EUR/USD Futures-1001020304050607/2/127/23/128/13/129/3/129/24/1210/15/1211/5/1211/26/1212/17/121/7/131/28/132/18/133/11/13InPIPsMar-13 EUR/USD Futures BasisBasisAdvancesBasisConvergesQuickly
  11. 11. 10 | Understanding FX Futures | April 22, 2013 | © CME GROUPsituations where futures and spot prices aremisaligned.But there are two interesting “wiggles” in the valueof the basis observed in July 2012 and in September2012. The basis advanced a bit in July 2012 andsubsequently converged or declined rather quickly inSeptember 2012. Both of these occasions wereprompted by the relative movement in the relevantU.S. and European short-term interest rates.We see that European rates declined rather sharplyin July 2012 as the European sovereign debt crisisflared up and easy money policies were enacted inresponse. Subsequently in September 2012 we seeU.S. rates declining as well. Thus, the interest ratedifferential increased in July and converged inSeptember, accounting for the slight spike andsubsequent swift convergence of the March 2013EUR/USD futures basis.Fair Value and ArbitrageAssume that futures prices are trading above theirfair value. Under those circumstances, anarbitrageur may sell futures and buy an equivalentamount of the spot currency, eventually makingdelivery of the currency in satisfaction of the futurescontract.E.g., if Mar-13 EUR/USD futures were priced abovetheir fair value of 1.3142, as illustrated in ourcalculation below, one might buy 125,000 Euros inthe spot markets (or the equivalent of one futurescontract) at the spot value of 1.3137 Euros per U.S.dollar on April 16th(for value April 18th) andeventually make delivery against the futurescontract some 64 days later on June 19th.If one leverages the transaction by borrowing atprevailing short-term U.S. rates to purchase theEuros, holding the position over the next 64 daysuntil futures contract expiration, one would incur$79 in associated USD finance costs at a rate of0.277%.Presumably, one invests those Euros over the next64 days at 0.055%, earning $16. The net costassociated with buying and carrying EUR over the 64day period equals $164,275 or 1.3142.Any excess over that 1.3142 at which one might beable to sell EUR/USD futures represents a potentialprofit. By buying and carrying spot Euros andselling EUR/USD futures, arbitrageurs’ tradingactivities may be expected to bid up the spotcurrency and/or push down futures to reestablishequilibrium pricing levels.Buy 125,000 EUR @ 1.3137 EUR/USD -$164,212Finance USD @ 0.277% over 64 days -$79Invest EUR @ 0.055% over 64 days $16Net cost over 64 days -$164,275Divided by 125,000 EUR 1.3142Expected futures price 1.3142If, on the other hand, futures prices were to tradebelow their fair value, one might buy futures and sellan equivalent amount of the currency in the spotmarkets, eventually taking repossession of thecurrency by accepting delivery of the currency insatisfaction of the futures contract.Of course, by selling spot EUR for USD, one enjoysthe opportunity to invest those dollars at theprevailing U.S. denominated rate of 0.277%,foregoing the opportunity to invest in EUR at0.055%. Any amount under fair value of 1.3142 atwhich one might be able to buy futures represents apotential profit on the part of an arbitrageur.Sell 125,000 EUR @ 1.3137 EUR/USD $164,212Invest USD @ 0.277% over 64 days $79Finance EUR @ 0.055% over 64 days -$16Net cost over 64 days $164,275Divided by 125,000 EUR 1.3142Expected futures price 1.31420.00%0.05%0.10%0.15%0.20%0.25%0.30%0.35%0.40%0.45%0.50%7/2/128/2/129/2/1210/2/1211/2/1212/2/121/2/132/2/133/2/134/2/133-Mth EUR & USD LIBOR RatesBBA LIBOR USD 3-Mth BBA LIBOR EUR 3-MthRate GapIncreasesthenNarrows
  12. 12. 11 | Understanding FX Futures | April 22, 2013 | © CME GROUPBy selling spot EUR and buying futures, this mayhave the effect of pushing down spot EUR and/orbidding up EUR/USD futures to establish anequilibrium price level at the fair value. In otherwords, arbitrage activity essentially enforces fairvalue pricing.As a practical matter, of course, one must alsoconsider costs attendant to arbitrage, i.e., slippage,commissions, fees, etc. As such, futures tend totrade within a “band” above and below its theoreticalfair value and the width of that band is a reflectionof the amount of those costs. B C − D E @ @ < @ "< B C + D E @ @Thus, when futures fall below that band,arbitrageurs may be recommended to buy futuresand sell spot. When futures rise above that band,arbitrageurs may be recommended to sell futuresand buy spot. In the context of currency futures,that band tends to be rather tight as the arbitrage israther straightforward and the attendant costs arelow.Hedging with FX FuturesA firm faced with the risk of volatile exchange rateshas many alternate means to address those risks.One of the most efficient and effective riskmanagement tools in this regard is found in the formof CME currency futures contracts. Let’s explore thepossibilities.The first thing that must be considered whenconstructing a hedging strategy is the amount of riskexposure to which one is subject. That is intuitive tothe extent that the purpose of a hedge is to offsetpossibly adverse price fluctuations in one marketwith an (ideally) equal and opposite exposure in thehedging vehicle such as futures.The identification of a “hedge ratio” (HR) in thecontext of currencies is a simple function of therelationship between the exposure to be hedged andthe futures contract size.!E G H = B C I @J # @ ÷ @ LE.g., assume that a company, domiciled in the U.S.and whose financial statements are denominated inU.S. dollars, agrees to sell goods to be delivered acouple of months later for a future payment of€50,000,000. As a result, the firm is exposed to therisk of a declining EUR vs. USD.!E = €50,000,000 ÷ €125,000= 400 / P @The appropriate strategy might be to sell EUR/USDfutures to address the risk exposure. The hedgeratio is found by comparing that €50,000,000 riskexposure with the €125,000 futures contract size.Short HedgeIn other words, the appropriate hedge ratio is asimple linear function of the amount of the riskexposure.E.g., it February 1, 2012 and the spot value of theUSD/Euro rate is at $1.3158 per one EUR. Thisimplies that the current value of that forthcomingpayment of €50,000,000 was worth $65,790,000.The company wishes to protect this anticipated cashflow by selling futures. Thus, the firm sells 400 Sep-12 EUR/USD futures at 1.3173. Note that the basisat the time was quoted at 15 pips (= 1.3173 less1.3158).By August 1, 2012, the spot value of the EUR hadfallen vs. the U.S. dollar to 1.2237. As a result, thevalue of those 50,000,000 EUR had declined some$4,605,000 to $61,185,000. That decline might wellrepresent the difference between a profit and a losson the sale.SpotRate€50MM inUSDSep-12FuturesBasis2/2/12 1.3158 $65,790,000Sell 400 @1.317315 pips8/1/12 1.2237 $61,185,000Buy 400 @1.22436 pips-$4,605,000 +$4,650,000 +9 pipsNet Gain of $45,000But by selling those 400 futures contracts, thecompany would have generated a profit that offsetspot market losses. September 2013 futuresdeclined from 1.3173 to 1.2243. This translated intoa futures market profit of $4,650,000 for thecompany. This profit offset the spot market losses
  13. 13. 12 | Understanding FX Futures | April 22, 2013 | © CME GROUPplus added another $45,000 or 9 pips to the bottomline.Why did the transaction result in a net profit? Theanswer is found in basis fluctuation. Note that thefutures/spot basis declined from its original level of -15 pips to 9 pips (= 1.3173 – 1.2243). Ourcompany was effectively “short the basis” because itwas short EUR in the futures market and long EUR inthe spot market.Long HedgeOur prior example focused on a situation involvingthe sale of futures to offset the possibility that theEUR might decline relative to the USD, or a “shorthedge.” But we might likewise examine theopposite situation involving the purchase of futures(short cash) or a “long hedge.”E.g., consider the plight of a U.S. based importerwho has contracted to purchase goods from aMexican firm and agreed to pay 250,000,000Mexican pesos (MXN) in return. In this case, theimporter must be wary about the possibility that thevalue of the MXN will strengthen vs. the USD in theinterim between the time the contract is executedand the payment is due.Our first order of business is to identify theappropriate hedge ratio. CME MXN/USD futures callfor the delivery of 500,000 Mexican pesos and isquoted in USD per JPY. Thus, the appropriate hedgeratio is calculated at 500 futures contracts asfollows.!E = 250,000,000 QPR ÷ 500,000 QPR= 500 QPR/ @On January 15, 2013, spot USD/MXN was quoted inEuropean terms at 12.6103 MXN per 1 USD. ButCME MXN/USD futures are quoted in Americanterms. Thus, taking the reciprocal of that number,we may quote the rate at $0.079300 per MXN.Thus, 250,000 MXN equates to $19,825,000 and it isthat value that our company wishes to “lock-up” bybuying MXN/USD futures contracts.By April 15, 2013, the exchange rate fluctuates to12.2820 MXN per USD or $0.081420 per USD.Thus, that 250 million MXN payment now translatesinto $20,355,000. This implies an unhedged loss of$530,000.SpotRate250 milMXN inUSDDec-08FuturesBasis1/15/1312.6103or0.079300$19,825,000Buy 500 @0.078050-12.50pips4/15/1312.2820or0.081420$20,355,000Sell 500 @0.0819004.8pips-$530,000 +$962,500+17.30pipsNet Gain of $432,500Our company executes a long hedge by buying 500June 2013 MXN/USD futures at the prevailing priceof 0.078050. By April 15, 2013, the value of theJun-13 contract advanced to 0.081900 whichtranslates into a profit of $962,500 in the futuresmarket, for a net gain of $432,500.This attractive net gain was facilitated by anadvance in the basis. Note that by being effectivelyshort spot and long futures, you are “long the basis”and positioned to benefit from the 17.30 pipadvance in the basis (=4.8 pips less -12.50 pips).Concluding NoteTo learn more about this product, visitwww.cmegroup.com/fx.
  14. 14. 13 | Understanding FX Futures | April 22, 2013 | © CME GROUPTable 1: Specifications of Popular CME FX FuturesEUR/USDFuturesJPY/USDFuturesGBP/USDFuturesCHF/USDFuturesTrade Unit 125,000 EUR 12,500,000 JPY 62,500 GBP 125,000 CHFMinimum PriceFluctuation (Tick)$0.0001 per EUR($12.50)$0.000001 per JPY($12.50)$0.0001 per GBP($6.25)$0.0001 per CHF($12.50)Price Limits No LimitsContract Months 1st 6 months in March quarterly cycle (March, June, Sep & Dec)CME Globex® HoursSundays thru Thursdays: 5:00 pm to 4:00 pmthe following day (Chicago time)Trading Ends On 2nd business day before 3rd Wednesday of contract monthDelivery Thru Continuous Linked Settlement (CLS) FacilitiesPosition Limits No LimitsTicker “6E” “6J” “6B” “6S”Table 2: Select FX Futures Pricing(as of April 12, 2013)Settle-mentReci-procalRTHVolumeGlobexVolumeOpenInterestEUR/USD Futures (125,000 EUR)Jun-13 1.3085 0.7642 3,177 239,944 214,401Sep-13 1.3094 0.7637 241 1,609Dec-13 1.3106 0.7632 21 235Mar-14 1.3116 0.7624 13Jun-14 1.3129 0.7617 12JPY/USD Futures (12,500,000 JPY)Jun-13 0.010118 98.8338 2,164 204,326 209,005Sep-13 0.010125 98.7654 325 1,863Dec-13 0.010136 98.6582 14 130Mar-14 0.010149 98.5319 22Jun-14 0.010163 98.3961 2 2Sep-14 0.010179 98.2415 1 1GBP/USD Futures (62,500 GBP)Jun-13 1.5338 0.6520 6,826 75,947 204,539Sep-13 1.5332 0.6522 10 276Dec-13 1.5329 0.6524 1 33Mar-14 1.5327 0.6524 33CHF/USD Futures (125,000 CHF)Jun-13 1.0763 0.9291 6,734 29,290 51,004Sep-13 1.0777 0.9279 23Note: “B” stands for bid; “A” for ask
  15. 15. 14 | Understanding FX Futures | April 22, 2013 | © CME GROUPTable 3: Sizing Select FX Futures(as of April 12, 2013)ContractSizeJun-13ContractContractValueTickSizeTickValueEUR/USD Futures 125,000 1.3085 $163,562.50 $0.0001 $12.50JPY/USD Futures 12,500,000 0.010118 $126,475.00 $0.000001 $12.50GBP/USD Futures 62,500 1.5338 $95,862.50 $0.0001 $6.25CHF/USD Futures 125,000 1.0763 $134,537.50 $0.0001 $12.50Table 4: EUR/USD Futures and Forward Curve(Intra-Day Observation on April 16, 2013)Maturity Days PriceBasis(Pips)Spot 4/18/13 2 1.3137001-Mth Forward 5/20/13 34 1.313950 2.52-Mth Forward 6/18/13 63 1.314200 5.0Jun-13 Futures 6/19/13 64 1.314300 6.03-Mth Forward 7/18/13 93 1.314500 8.0Sep-13 Futures 9/18/13 155 1.315400 17.06-Mth Forward 10/18/13 185 1.315400 17.0Dec-13 Futures 12/18/13 246 1.316000 23.09-Mth Forward 1/21/14 280 1.316600 29.0Copyright 2013 CME Group All Rights Reserved. Futures trading is not suitable for all investors, and involves the risk of loss. Futures are a leveraged investment, and because only apercentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for a futures position. Therefore, traders should only use funds that theycan afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. All examples inthis brochure are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience.”Swaps trading is not suitable for all investors, involves the risk of loss and should only be undertaken by investors who are ECPs within the meaning of section 1(a)18 of the CommodityExchange Act. Swaps are a leveraged investment, and because only a percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited fora swaps position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one tradebecause they cannot expect to profit on every trade.CME Group is a trademark of CME Group Inc. The Globe logo, E-mini, Globex, CME and Chicago Mercantile Exchange are trademarks of Chicago Mercantile Exchange Inc. Chicago Board ofTrade is a trademark of the Board of Trade of the City of Chicago, Inc. NYMEX is a trademark of the New York Mercantile Exchange, Inc.The information within this document has been compiled by CME Group for general purposes only and has not taken into account the specific situations of any recipients of the information.CME Group assumes no responsibility for any errors or omissions. Additionally, all examples contained herein are hypothetical situations, used for explanation purposes only, and should notbe considered investment advice or the results of actual market experience. All matters pertaining to rules and specifications herein are made subject to and are superseded by official CME,NYMEX and CBOT rules. Current CME/CBOT/NYMEX rules should be consulted in all cases before taking any action.