Pricing of Futures Contract, Currency Futures, Hedging In Currency Futures

Pricing Of Futures Contract

The value of a futures contract is derived from the cash value of the underlying asset. While a futures contract may have a very high value, a trader can buy or sell the contract with a much smaller amount, which is known as the initial margin.

The initial margin is essentially a down payment on the value of the futures contract and the obligations associated with the contract. Trading futures contracts is different than trading stocks due to the high degree of leverage involved. This leverage can amplify profits and losses.

Initial Margin

The initial margin is the initial amount of money a trader must place in an account to open a futures position. The amount is established by the exchange and is a percentage of the value of the futures contract.

For example, a crude oil contract futures contract is 1,000 barrels of oil. At $75 per barrel, the notional value of the contract is $75,000. A trader is not required to place this amount into an account. Rather, the initial margin for a crude oil contract could be around $5,000 per contract as determined by the exchange. This is the initial amount the trader must place in the account to open a position.

Maintenance Margin

The maintenance margin amount is less than the initial margin. This is the amount the trader must keep in the account due to changes in the price of the contract.

In the oil example, assume the maintenance margin is $4,000. If a trader buys an oil contract and then the price drops $2, the value of the contract has fallen $2,000. If the balance in the account is less than the maintenance margin, the trader must place additional funds to meet the maintenance margin. If the trader does not meet the margin call, the broker or exchange could unilaterally liquidate the position.

Currency Futures

The global forex market is the largest market in the world with over $4 trillion traded daily, according to Bank for International Settlements (BIS) data. The forex market, however, is not the only way for investors and traders to participate in foreign exchange. While not nearly as large as the forex market, the currency futures market has a respectable daily average closer to $100 billion.

Currency futures – futures contracts where the underlying commodity is a currency exchange rate – provide access to the foreign exchange market in an environment that is similar to other futures contracts.

Currency futures, also called forex futures or foreign exchange futures, are exchange-traded futures contracts to buy or sell a specified amount of a particular currency at a set price and date in the future. Currency futures were introduced at the Chicago Mercantile Exchange (now the CME Group) in 1972 soon after the fixed exchange rate system and gold standard were discarded. Similar to other futures products, they are traded in terms of contract months with standard maturity dates typically falling on the third Wednesday of March, June, September and December.

Hedging In Currency Futures

Currency Hedging is an act of entering into a financial contract in order to protect against anticipated or unexpected changes in currency exchange rates. Currency hedging is used by businesses to eliminate risks they encounter when conducting business internationally.

The concept of Currency hedging is the use of various financial instruments, like Forward Contract and other Derivative contracts, to manage financial risk. It involves the designation of one or more financial instruments (usually a Bank or an Exchange) as a buffer for potential loss.

Suppose a firm receives an export order today with the delivery date being in 3 months time. The contract is worth, say, US$100,000. At the time the contract is placed, the INR is say Rs. 65 per US$. Hence the value of the order, when placed, is Rs. 65,00,000. But suppose that the exchange rate changes significantly between the date when the order is received and the date the order is paid for (which we will assume is one month after the delivery date). The exchange rate of the INR & US$ is at Rs. 62 on payment date. Which means that the firm receives only Rs. 62,00,000 rather than Rs. 65,00,000. This will result in loss of Rs. 3,00,000 for the exporter. To insure against this happening, the firm can, at the time it receives the order, hedge the currency risk.

So any business that has dealing in overseas market is open to such Currency or more popularly known as Forex exposure. There may be other kinds of exposure including commodity risk, Interest rate risk, wage inflation etc. Un-hedged exposure of FX can affect the balance sheet or profitability, which can create cash flow and operational issues. Hedging reduces a firm’s exposure to unwanted risk. This helps in sustaining profits, reducing volatility and ensuring smoother operations.

Different type of Exposure