Derivatives

1. What is a Currency Future?
Currency Futures are traded in the same manner as any other form of futures contract. However, instead
of dealing in a tangible product like pork bellies or wheat, the exchange rate between two given
currencies serves as the commodity for the underlying contract.
There are two ways to settle a currency futures contract – you can hold it until maturity at which point you
receive a cash settlement at the rate specified in the contract, or you can buy and sell currency contracts
prior to maturity on an established exchange. There are several exchanges that specialize in currency
futures including the Chicago Mercantile Exchange (CME), Euronext, and the Tokyo Financial Exchange
to name a few of the larger currency futures trading centers. See Settlement and Delivery of Currency
Futures Contracts for more information how to settle a currency future contract.
History of Currency Futures
Currency futures were introduced by the Chicago Mercantile Exchange (CME) after the United States
abandoned the Bretton Woods agreement in the early 1970s. Bretton Woods was implemented after
World War II and was intended to help European countries devastated by years of warfare to rebuild their
economies. The central element of the Bretton Woods agreement was to tie the U.S. dollar to the value of
gold and then force other currencies to maintain their rates within a narrow operating band of plus or
minus one percent, in relation to the value of the U.S. dollar.
In 1971 – in an attempt to deal with surging stagflation in the U.S. economy, President Richard Nixon
dropped the gold standard and devalued the U.S. dollar to 1/35th of an ounce of gold. This effectively
ended the Bretton Woods restrictions leading ultimately to a market-based valuation for individual
currencies.
Investors soon saw an opportunity to speculate on exchange rate fluctuations, but currency trading at the
time was the exclusive domain of large banks. These institutions operated in a closed, inter-bank market,
forcing outsiders to pay high service fees in order to conduct currency transactions.
CME traders – eager for a market in which they could themselves trade currencies – challenged the
banks by launching the International Monetary Market (IMM) in December of 1971. Initially, the IMM
trading facility offered currency futures in seven different currency pairs, but the IMM’s major contribution
was that it created a market for CME traders to deal in standardized contracts where traders could be
assured of high liquidity levels and a matching / clearing service to ensure that trades were promptly
executed. The IMM continues today as a division of the CME.
Pricing Currency Futures Contracts
Contract prices for currency futures are determined by the interest rate for the country of origin for the
currencies listed in the futures contract as well as the spot rates for each currency. By incorporating the
spot rates in the contract price calculation, the ability to profit solely on arbitrage differences is eliminated
as the contract price moves in tandem with fluctuations in the spot rate of either currency.
Note:
Arbitrage occurs when the same currency or commodity is listed on more than one exchange at the same
time. If the price changes on one exchange but lags behind the other, an opportunity exists to profit on
the difference between the two exchanges – this is known as arbitrage trading.

2. For example, if the value of the Euro were to rise in the spot currency market but the increase was not
reflected in the futures market, an arbitrage opportunity would result as the futures price would still be
based on the weaker Euro valuation. Traders could use this information to buy futures contracts that, in
effect, were priced on stale data. By updating futures prices with changes in the spot market, the ability to
exploit market arbitrage is greatly reduced.
The following formula is used to set the price for a contract for a given currency pair:
F = S (1 + RQ x T) ÷ (1 + RB x T)
Where:
F = the price for the currency futures contract
S = the spot rate for the currency pair
RQ = the interest rate of the quote currency
RB = the interest rate of the base currency
T = the tenor or time to maturity (in days)
Because contract prices are determined – i.e. derived – from the underlying currencies, currency futures
are considered a derivatives product. Currency futures contracts are similar to forward rate agreements
(FRAs) and can also be used for hedging and speculation purposes. However, unlike FRAs which are
agreements between two parties with terms as agreed to by both parties, currency futures have standard
maturity dates and are offered in fixed amounts only.
Minimum Price Change
Price changes in currency futures are expressed as pips or somewhat less commonly, as ticks. A pip –
short for percentage in point – is the smallest unit of measure at which the currency pair trades. For
example, if the current exchange rate for AUD/USD is quoted at 0.9750 and then moves to 0.9755, this is
an increase of five pips (0.9755 – 0.9750). In addition, note that this currency pair trades in $100,000
AUD lots, so with a leverage ratio of 1:100, this means that each pip is worth $10 AUD for each AUD /
USD currency pair you hold ($100,000 x 0.0001 = $10.00). Thus, a five-pip change is a $50 AUD swing in
the price of one AUD / USD contract.
It is important to note however, that not all currency pairs are expressed to four decimal places – some
like the USD / JPY pair for example, list only two decimal places while others are expressed to three.
Some brokers are even offering quote spreads to five decimal places (known as fractional pips or
pipettes). The important thing to remember however, is that it is the last number – whether it be two, four,
or five places after the decimal – that represents a single pip for that currency pair.
Mark-to-Market Price Fix
A Mark-to-market price fix is a theoretical valuation of all your open positions if they were settled at the
current market prices. At the end of each day’s trading, your account will be marked-to-market to ensure
that you are still within the margin limits imposed by the exchange and your broker. See below for more
information on margin and margin-based lending.

3. Margin
There are two types of margin you need to know about prior to trading currency futures. The first is initial
margin – this is the money you deposit in your trading account to establish an account with your broker. If
you incur losses and the amount in your account falls below a certain threshold amount as mandated by
the exchange and your broker, you will then be required to deposit additional money – this threshold is
known as maintenance or variation margin. If the balance in your account falls below the required
maintenance margin levels, your broker will notify you through a margin call that you must bring your
maintenance margin back to compliance levels; failure to do so will result in your broker liquidating your
holdings.
Buying on margin – or leveraged buying – allows you to submit trades for values considerably more than
the amount you have available in your account. To illustrate the power of leveraged buying, consider a
margin ratio of just 20:1 coupled with a trading account containing $10,000. This means that you could
trade amounts up to $200,000 ($10,000 x 20) thus enabling you to secure greater profits on even small
price movements.
Of course, this can work against you as well. If you have committed all your available cash to a trade and
the value of the trade falls below your maintenance margin level, you will receive a margin call requiring
you to deposit additional margin to your account.
For example, consider the following scenario where an investor intends to buy a single USD / CAD
currency futures contract:
USD / CAD currency futures contracts are listed in $100,000 CAD lots
One contract is currently valued at $0.9500 CAD per U.S. dollar, or $95,000 USD
Initial margin required is 10% - therefore, you need at least $9,500 USD margin available in your
account (let’s assume that you have exactly this amount available in your account)
Maintenance margin required by your broker is 7.5% - assuming that you have no other
transactions in your account, you need to maintain at least $7,125 USD in your account in either cash or
marked-to-market value
Based on this information, if the single dollar price moves up to 0.9550 CAD per U.S. dollar – a gain of
fifty pips – the value of the single contract is now worth $500 more than you paid. You can calculate this
in one of two ways:
1. A single CAD pip is equal to $10 CAD per contract – therefore, 50 pips x $10 = $500, or
2. 0.0050 (fifty pips) x $100,000 CAD = $500 CAD
How about if instead of gaining fifty pips, you lose 300 pips? – again, we are assuming that you have only
one order in your account:
1. 300 pips x $10 CAD = ($3,000 CAD) – remember this is a loss. You can also calculate in this manner -
2. 0.0300 (300 pips) x $100,000 = ($3,000 CAD)

4. When your broker performs the mark-to-market evaluation and takes into account this loss, your available
margin will fall from $9,500 to $6,500 CAD. This is obviously below the $7,125 USD threshold you are
required to maintain so this will trigger a margin call from your broker requesting you to deposit sufficient
funds to bring your account back to compliance.
Settlement and Delivery of Currency Futures Contracts
Because currency futures are based on the exchange rate between two currencies, no physical
underlying commodity exists. With a wheat futures for example, the contract holder does have the option
to take physical delivery of the wheat, although physical delivery is quite rare as most commodity futures
are settled in cash – taking this concept one step further, currency futures are always settled in cash.
Like most forms of futures trading, there are two types of investors – hedgers looking to protect a future
transfer of funds, and speculators looking to profit on fluctuations in the price of the contract.
Individuals and firms that have either a future payment due or expect to receive a future payment, may
use currency futures to look in a rate if they have concerns that interest rate changes prior to the payment
date could move against them. In other words, by buying currency futures contracts, hedgers want to
make sure that a change in exchange rates won’t cause them to receive less if they expect a future
payment, or cause them to pay more if making a future payment. See Hedging with Currency Futures for
more information.
Speculators on the other hand, are not interested in holding a currency futures contract until it matures.
These investors are looking to profit on fluctuations in the contract price and may sell and buy several
positions a day (so-called day traders). Unlike hedgers that have a large transfer of funds due in the
future, speculators, through the buying power of margin, move in and out of contract positions
continuously and rarely hold any single contract for an extended period of time.
Currency Futures in India: Only USD-INR contracts are allowed to be traded; the size of each contract
shall be $1000; the contracts shall be quoted and settled in Indian Rupees; the maturity of contracts shall
not exceed 12 months; the settlement price shall be the Reserve Bank’s Reference Rate on the last
trading day.