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Curency Futures

  • Currency Futures

     

     

    September 2009

  • Overview

    Description 

    A futures contract is a legally binding agreement that gives the investor the right to buy or sell an underlying currency at a fixed price on a future date.

    Explanation 

    A Currency Futures contract allows market participants to trade the underlying exchange rate for a period in the future. Participants can buy or sell foreign currency at a set exchange rate on a future date.

    Currency Futures are contracts that allow participants to take a view on the movement of the exchange rate as well as hedge against currency risk.

    The underlying instrument of a Currency Future is the exchange rate between one unit of foreign currency and the South African Rand. Currency Futures have a minimum contract size of 1000 foreign underlying currency (ie. $1000).

  • Trading Positions

    Description 

    When trading in futures contracts an investor can take one of two positions: Buy (Long) or Sell (Short).

    Explanation 

    When you sell (short) you expect the Rand to appreciate. You may need to sell foreign currency after an international trip.

  • Initial Margin

    Description 

    You are required to pay a deposit upfront (initial margin) when trading in Currency Futures, known as a good faith deposit.

    Explanation 

    The initial margin payment is used to eliminate counterparty risk (the risk associated with one of the parties defaulting). The initial margin requirement varies between the different Currency Futures offered.

    Your initial margin payment is held by the exchange and you earn daily interest on this payment. When you close your position, your initial margin plus interest is paid into your margin account.

     

  • Variation Margin

    Description 

    The daily profit / loss payment for each contract, as calculated by the exchange.

    Explanation 

    The Currency Future price is determined from the underlying market spot price to which forward points are added to deliver the final price used in the daily Mark-to-Market process.

    At the end of each trading day contracts are Marked-to-Market l (MTM). The exchange calculates a closing price for each contract.

    The difference calculated from the previous day’s MTM price is either paid to the investors or paid by the investors to the clearinghouse, in cash and Rand denominated.


    Example:
    On day one investor A buys 7 Dollar/Rand currency futures contracts at a trade price of R7.2125. The contract value is $ 7000 (7 contracts x 1000 of the underlying currency contract size).
    On day two the exchange calculates the closing price for this future to be R7.6035. This is the MTM price for investor A’s contract.

    Investor A will make a profit of R2737(R7.6035 – R7.2125) x 1000 x 7

    However, this represents a negative movement for the seller of the contract who will be required to pay R2737 into his variation margin account. This amount will be paid via the respective clearing members and the JSE into the buyer’s variation margin account.

     

  • Expiry of Contracts

    Description 

    The JSE offers four expiration dates for contracts: Two business days prior to the third Wednesday of each expiry month: March, June, September and December respectively.

    Explanation 

    Investors have two options on expiry:

    1. Cash settlement (at expiry cash will change hands)
    2. Contract rolled over to the next expiry date

    You can exit a futures contract before the expiry date; this is called closing your position.
    If an investor has a view on which direction the currency is going to move, the investor needs to contact their broker to transact on their behalf To close out the contract, the investor needs to contact the relevant broker
    and they enter into an equal but opposite transaction . For example, if an investor had bought a currency future contract, the
    investor would close out the trade by selling the contract

    Rolling a position:
    Investors holding a June contract will need to roll their
    position into the September contract. If an investor had bought a June
    contract, the investor would have to sell the June contract and subsequently buy a September contract
    The benefit to the investor is that the same exposure is maintained. The exchange offers discounted trade fees for all positions that are rolled over into the next expiry contract.

  • Using Currency Futures as a hedging tool

    Description 

    Currency Futures can be used to hedge against currency risk such as the Rand weakening against the Dollar

    Explanation 

    Example:
    It is July and you are planning a trip to the USA in September. If the Rand weakens against the Dollar it will be more expensive to purchase your foreign currency for the trip. You can “lock in” the current exchange rate of R7.2125 by purchasing a currency futures contract.

    You calculate that you will need $7000 in September. At the current exchange rate it will cost you R50 488 (R7.2125 x 1000 x 7). You purchase 7 currency futures contracts (value of each contract = $1000). You are only required to pay your initial margin deposit.

    In September the exchange rate is R7.6035. Your cost to purchase $7000 is R53 225 (R2737 more than in July). However, your Currency Futures position made a profit of R2737 (R7.6035 – R7.2125 x 1000 x 7) and this will counteract the additional amount you had to pay in the spot market.

    Your initial margin plus interest is returned to you.

  • Using Currency Futures as a speculation tool

    Description 

    Currency Futures can be used to speculate in a strengthening Rand situation

    Explanation 

    Example:
    You think that the Rand will strengthen against the Dollar and want to profit from such a move. You sell 10 Currency Future contracts at a trading price of R8.2245.

    You are exposed to $10 000 (value of each contract = $1000). The value of your 10 contracts = R82 245 (R8.2245 x 1000 x 10). You are only required to pay your initial margin deposit to gain this exposure.

    A couple of days later the Rand strengthens to R7.8545. You close your position and make a profit of R3 700.
    (R7.8545 – R8.2245) x 1000 x -10
    = R3700

    Your initial margin plus interest is returned to you.

    
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