Main Instruments - Traded Market

EXCHANGE-TRADED FUTURES

In the U.S. exchanges, a foreign exchange futures contract is an agreement between two parties to buy/sell a particular (non-U.S. dollar) currency at a particular price on a particular future date, as specified in a standardized contract common to all participants in that currency futures exchange. (See Box 6-1 on the evolution of foreign exchange futures.) When entering into a foreign exchange futures contract, no one is actually buying or selling anything—the participants are agreeing to buy or sell currencies on pre-agreed terms at a specified future date if the contract is allowed to reach maturity, which it rarely does.

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A foreign exchange futures contract is conceptually similar to an outright forward foreign exchange contract, in that both are agreements to buy or sell a certain amount of a certain currency for another at a certain price on a certain date. However, there are important structural and institutional differences between the two instruments:.

• Futures contracts are traded through public “open outcry” in organized, centralized exchanges that are regulated in the United States by the Commodity Futures Trading Commission. In contrast,forward contracts are traded “over-thecounter” in a market that is geographically dispersed, largely self-regulated, and subject to the ordinary laws of commercial contracts and taxation.

• Futures contracts are standardized in terms of the currencies that can be traded, the amounts, and maturity dates, and they are subject to the trading rules of the exchange with respect to daily price limits, etc. Forward contracts can be customized to meet particular customer needs.

• Futures contracts are “marked to market” and adjusted daily; there are initial and maintenance margins and daily cash settlements. Forward contracts do not require any cash payment until maturity (although a bank writing a forward contract may require collateral). Thus, a futures contract can be viewed as a portfolio or series of forwards, each covering a day or a longer period between cash settlements.

• Futures contracts are netted through the clearinghouse of the exchange, which receives the margin payments and guarantees the performance of both the buyer and the seller in every contract. Forward contracts are made directly between the two parties, with no clearinghouse between them.

The differences between the two instruments are very important. The fact that futures contracts are channeled through a clearinghouse and “marked to market” daily means that credit risk is reduced. The fact that the clearinghouse is guaranteeing the performance of both sides also means that a contract can be canceled (or “killed”) simply by buying a second contract that reverses the first and nets out the position.

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Thus, there is a good “secondary market.” In a forward contract, if a holder wanted to close or reverse a position,there would have to be a second contract, and if the second contract is arranged with a different counterparty from the first, there would be two contracts and two counterparties, with credit risk on both.

Because of the differences in the two markets, it is not hard to understand why thetwo markets are used differently. Futures contracts seldom go to maturity—less than two percent result in delivery—and are widely used for purposes of financial hedging and speculation. The ease of liquidating positions in the futures market makes a futures contract attractive for those purposes.

The high degree of standardization in the futures market means that traders need only discuss the number of contracts and the price, and transactions can be arranged quickly and efficiently. Forward contracts are generally intended for delivery, and many market participants may need more flexibility in setting delivery dates than is provided by the foreign exchange futures market, with its standard quarterly delivery dates and its one-year maximum maturity.

Transactions are typically for much larger amounts in the forward market—millions, sometimes many millions, of dollars—while most standardized futures contracts are each set at about $100,000 or less, though a single market participant can buy or sell multiple contracts, up to a limit imposed by the exchange. Also, forward contracts are not limited to the relatively small number of currencies traded on the futures exchanges.

The foreign currency futures market provides, to some extent, an alternative to the OTC forward market, but it also complements that market. Like the forward market, the currency futures market provides a mechanism whereby users can alter portfolio positions other than through the alternative of the cash or spot market. It can accommodate both short and long positions,and it can be used on a highly leveraged basis for both hedging and speculation. It thus facilitates the transfer of risk—from hedgers to speculators, or from speculators to other speculators.

In addition, the foreign currency futures market contributes to the “information” and the “price discovery” functions of markets— although the contribution may be moderate in the case of foreign exchange, since the estimated total turnover of currency futures markets is far below that of the market in outright forwards.

As in the case of forwards, prices in the foreign currency futures market are related to the spot market by interest rate parity. The theoretical price of a forward contract will be the spot exchange rate plus or minus the net cost of financing (the cost of carry), which is determined by the interest rate differential
between the two currencies. In the case of futures, where there are margin requirements, daily marking to market, and different transactions costs, the price should presumably reflect those differences. In practice, however, the market prices of forwards and futures seem not to diverge very much for relatively short-term contracts.

EXCHANGE-TRADED CURRENCY OPTIONS

Exchange-traded currency options, like exchange-traded futures, utilize standardized contracts—with respect to the amount of the underlying currency, the exercise price, and the expiration date. Transactions are cleared through the clearinghouses of the exchanges on which they are traded, and the clearinghouses guarantee each party against default of the other.

The option buyer—who has no further financial obligation after he has paid the premium—is not required to make margin payments. The option writer—who has all of the financial risk—is required to put up initial
margin and to make additional (maintenance) margin payments if the market price moves adversely to his position.

In the United States, exchange-traded foreign exchange options were introduced in 1982. Options on foreign currencies presently are traded on the Philadelphia Stock Exchange (PHLX) and the Chicago Mercantile Exchange (CME). Options on a U.S. dollar index and on the ECU are traded on Finex, the financial division of the New York Cotton Exchange.

The Securities and Exchange Commission (SEC) has jurisdiction over options on foreign currencies traded on national securities exchanges, while the Commodity Futures Trading Commission (CFTC) regulates options on foreign currency futures and options on foreign currencies traded on exchanges that are not securities exchanges. Abroad, options on foreign exchange are traded in various centers, including Singapore, Amsterdam, Paris, and Brussels.

The PHLX trades options contracts on spot foreign exchange for the Deutsche mark, Japanese yen, British pound, Australian dollar, Canadian dollar, French franc, Swiss franc, and ECU. (As with futures contracts, several of the options contracts will be changed when the euro is introduced.) The amounts of the foreign currencies per contract are set at one-half those in IMM futures contracts (e.g., a PHLX option contract on DEM is set at DEM 62,500 spot, or one-half of the IMM futures contract on DEM, which is DEM 125,000). Similarly, the expiration dates generally correspond to the March, June, September, and December maturity dates on IMM foreign exchange futures. The PHLX trades both American- and European-style options.

The CME trades options on the same eight currencies as the PHLX, but trades options on futures, rather than on spot, or cash.That is to say, at the CME a buyer can purchase a contract that provides the right, but not the obligation, for example, to go long on an exchange-traded foreign exchange futures contract at a strike price stated in terms of a different currency. If an option on foreign currency futures is exercised, any profit can be immediately recognized by closing out the futures position through an offsetting transaction.

All CME options on foreign exchange futures are American style—exercisable on or before the maturity date. These CME options contracts are the same size as IMM futures standardized contracts—each CME option represents the right to go long or short a single IMM foreign exchange futures contract. Figure 6-3 shows the quotes for call and put options on April 27, 1998.

LINKAGES

LINKAGES BETWEEN MAIN FOREIGN EXCHANGE INSTRUMENTS IN BOTH OTC AND
EXCHANGE-TRADED MARKETS

SPOT (settled two days after deal date, or T+2) = Benchmark price of a unit of the base currency expressed in a variable amount of the terms currency.

Pre-Spot: VALUE TOMORROW (settled one day after deal date, or T+1) = Price based on spot rate adjusted for the value for one day of the interest rate differential between the two currencies. (Higher interest rate currency trades at a premium from spot.)

Pre-Spot: CASH (settled on deal date, or T+0) = Price based on spot rate adjusted for the value for two days of the interest rate differential between the two currencies. (Higher interest rate currency trades at a premium from spot.)

OUTRIGHT FORWARD = Price based on spot rate adjusted for the value of the interest rate differential between the two currencies for the number of days of the forward. (Higher interest rate currency trades at a forward discount from spot.)

FX SWAP = One spot transaction plus one outright forward transaction for a given amount of the base currency, going in opposite directions, or else two outright forward transactions for a given amount of the base currency, with different maturity dates, going in opposite directions.

CURRENCY FUTURES = Conceptually, a series of outright forwards, one covering each period from one day’s marking to market and cash settlement to the next.

CURRENCY SWAP = An exchange of principal in two different currencies at the beginning of the contract (sometimes omitted) and a reexchange of same amount at the end; plus an exchange of two streams of interest payments covering each interest payment period, which is conceptually a series of outright forwards, one covering each interest payment period.

CURRENCY OPTION = A one-way bet on the forward rate, at a price (premium) reflecting the market’s forecast of the volatility of that rate. A synthetic forward position can be produced from a combination of options, and a package of options can be replicated by taking apart a forward.