Q. Define a currency futures contract?
A currency futures contract is a standardised contract for the buying or else selling of a specified quantity of currency. It is traded on a futures exchange as well as settlement takes place in three monthly cycles ending in March- June- September and December that is a company can buy or sell September futures December futures and so on. The value of a currency futures contract is the exchange rate for the currencies specified in the contract.
When a currency futures contract is bought or else sold the buyer or seller is required to deposit a sum of money with the exchange called initial margin. If losses are acquired as exchange rates as well as hence the prices of currency futures contracts change the buyer or seller may be called on to deposit additional funds (variation margin) with the exchange. Evenly profits are credited to the margin account on a daily basis as the contract is marked to market. Mainly currency futures contracts are closed out before their settlement dates by undertaking the opposite transaction to the initial futures transaction that is if buying currency futures was the initial transaction it is later closed out by selling currency futures. This method of reversing the position on futures before the settlement date is referred to as offset. If offset is used then physical delivery doesn't occur that is currency will not be physically bought or sold on the settlement date because the position has already been closed out. When a company requires physically buying or selling currency it will have to use the foreign exchange market rather than the futures market. But it must find that any loss on the foreign exchange market is balanced by a gain on the futures market (and vice versa).
Nedwen Co expects to obtain $300000 in 3 months' time and is concerned that sterling may appreciate (strengthen) against the dollar as this would result in a lower sterling receipt. The company must therefore set up a futures position designed to make a gain if sterling rises. The steps are as follow:
- On 1 May buy sterling futures contracts buying any kind of product produces a gain if its price rises whether a physical product or a derivative product. The company requires the hedge to be open until 1 August and therefore must use contracts with a settlement date on or later than this that is September contracts can be used. Enough contracts must be used to cover $300,000 of exposure.
- On August 1st the company will close out its position on futures by selling the same number as September futures contracts. If sterling has increase there will be gain on the contracts (bought low, sold high).
- On August 1st the company should also physically sell the $300000 receipt on the foreign exchange market. If sterling has risen that is become more expensive there will be a loss on this transaction.
- The gain on the futures market must balance (to some degree) the loss on the foreign exchange market. It isn't likely to be a perfect balance however as futures prices rarely move the same amount as prices in the foreign exchange market.