Basics of Currency Futures
Copyright (c) 2009 Jay Meisler
It seems every time you turn on a television business news program these days the weak dollar is headline news. The discussion is generally about how the weak dollar is impacting other markets, such as stocks, gold, etc. Unlike other markets, the cash forex market is larger than the currency futures market. This means that prices are driven by the cash market and forex futures align with it. The aim of this article is to show how currency futures relate to cash (spot) prices and how one converts cash to futures and vice versa.
How do forex futures trading prices relate to those in the cash forex market?
The most active currency futures trading contracts trade for four fixed dates in the year. They settle on the third Wednesday of March, June, September and December. In contrast to the futures market, the cash forex adjusts its maturity dates daily, trading primarily for monthly maturities of one, two, three, six and twelve months ahead, with the flexibility to quote for any individual date in-between. The interbank market thus trades for spot and forward delivery. The cash or interbank market is a delivery market. That means that all transactions between institutions must be settled for the full face value of each transaction.
In contrast to the cash market, forex futures trading markets allow traders to buy and sell contracts and thus avoid the need for the cash settlement of trades. Such is always available at the settlement of maturing quarterly currency futures contracts allowing professional arbitrageurs to keep the two markets tightly aligned with one another.
Currency Futures are spot prices adjusted by the forwards to arrive at a future delivery price. Professional arbitrageurs job the two markets to keep them in line.
Where then do the forwards come from?
Many mistakenly feel that forwards are the markets prediction of where spot prices will be at some point in time in the future. They are not. They are generated solely by interest rate differentials. For example, suppose a $/yen conversion rate is needed for one year away and the price must be fixed immediately. This can be accomplished by borrowing dollars for a year. Converting immediately into yen and putting the proceeds in a one year time deposit. The yen deposit matures in twelve months and its proceeds at that time are used to meet the future yen commitment. The cost of the hedge is the loss on the interest rate differential. That interest rate differential can be applied to spot forex rates by converting them into point values. These point values are called forward swaps. Global-View provides on a daily basis forward swap values for converting spot currency rates to futures and vice versa as part of its forex resources section.
Example: US$ 12 mo deposit/lending rate 6.25% Yen 12 mo deposit/lending rate 0.50% Interest rate differential = 5.75% $/yen exchange rate 105.00 105.00* -0.0575=-6.038 points
Of course the transaction can be reversed to lock in a dollar value against the yen. In that case, yen would be borrowed and deposited into dollars. On that trade the transaction would earn 5.75%. If ever the forward market gets misaligned with interest rate differentials, traders will quickly bring them into line by use of the deposit market. The market actively trades the forward point values. The IMM maturities (value dates) are now actively quoted in the interbank market, and are often determined by a straight line interpolation between the nearest actively traded value dates.
Quoting conventions in the interbank market and currency futures trading market(IMM):
Due mainly to historical precedent, dollar forex rates are quoted in one of two formats: 1) Dollar value of foreign fx currency unit. (e.g. one Sterling unit (British pound) is worth US$1.6050).
2) Number of per foreign forex currency units per dollar. (e.g. 105.00 yen purchase US$1.
The IMM quotes all currencies using convention #1. This convention allows point values to have a fixed dollar value. Using convention #2, point values would have a fixed foreign currency value. This would create a difficult logistical situation for a dollar-based exchange rates as daily settlement prices would have to be converted to dollars using an arbitrary foreign exchange rate. Convention #1 quotes are simply the reciprocal of #2, and vice-versa.
For example: $/yen 105.00 can be converted from #2 to #1 as follows. 1/105.00=.009524
Global-View posts indicative IMM swaps each trading day and can be found on its website.
It seems every time you turn on a television business news program these days the weak dollar is headline news. The discussion is generally about how the weak dollar is impacting other markets, such as stocks, gold, etc. Unlike other markets, the cash forex market is larger than the currency futures market. This means that prices are driven by the cash market and forex futures align with it. The aim of this article is to show how currency futures relate to cash (spot) prices and how one converts cash to futures and vice versa.
How do forex futures trading prices relate to those in the cash forex market?
The most active currency futures trading contracts trade for four fixed dates in the year. They settle on the third Wednesday of March, June, September and December. In contrast to the futures market, the cash forex adjusts its maturity dates daily, trading primarily for monthly maturities of one, two, three, six and twelve months ahead, with the flexibility to quote for any individual date in-between. The interbank market thus trades for spot and forward delivery. The cash or interbank market is a delivery market. That means that all transactions between institutions must be settled for the full face value of each transaction.
In contrast to the cash market, forex futures trading markets allow traders to buy and sell contracts and thus avoid the need for the cash settlement of trades. Such is always available at the settlement of maturing quarterly currency futures contracts allowing professional arbitrageurs to keep the two markets tightly aligned with one another.
Currency Futures are spot prices adjusted by the forwards to arrive at a future delivery price. Professional arbitrageurs job the two markets to keep them in line.
Where then do the forwards come from?
Many mistakenly feel that forwards are the markets prediction of where spot prices will be at some point in time in the future. They are not. They are generated solely by interest rate differentials. For example, suppose a $/yen conversion rate is needed for one year away and the price must be fixed immediately. This can be accomplished by borrowing dollars for a year. Converting immediately into yen and putting the proceeds in a one year time deposit. The yen deposit matures in twelve months and its proceeds at that time are used to meet the future yen commitment. The cost of the hedge is the loss on the interest rate differential. That interest rate differential can be applied to spot forex rates by converting them into point values. These point values are called forward swaps. Global-View provides on a daily basis forward swap values for converting spot currency rates to futures and vice versa as part of its forex resources section.
Example: US$ 12 mo deposit/lending rate 6.25% Yen 12 mo deposit/lending rate 0.50% Interest rate differential = 5.75% $/yen exchange rate 105.00 105.00* -0.0575=-6.038 points
Of course the transaction can be reversed to lock in a dollar value against the yen. In that case, yen would be borrowed and deposited into dollars. On that trade the transaction would earn 5.75%. If ever the forward market gets misaligned with interest rate differentials, traders will quickly bring them into line by use of the deposit market. The market actively trades the forward point values. The IMM maturities (value dates) are now actively quoted in the interbank market, and are often determined by a straight line interpolation between the nearest actively traded value dates.
Quoting conventions in the interbank market and currency futures trading market(IMM):
Due mainly to historical precedent, dollar forex rates are quoted in one of two formats: 1) Dollar value of foreign fx currency unit. (e.g. one Sterling unit (British pound) is worth US$1.6050).
2) Number of per foreign forex currency units per dollar. (e.g. 105.00 yen purchase US$1.
The IMM quotes all currencies using convention #1. This convention allows point values to have a fixed dollar value. Using convention #2, point values would have a fixed foreign currency value. This would create a difficult logistical situation for a dollar-based exchange rates as daily settlement prices would have to be converted to dollars using an arbitrary foreign exchange rate. Convention #1 quotes are simply the reciprocal of #2, and vice-versa.
For example: $/yen 105.00 can be converted from #2 to #1 as follows. 1/105.00=.009524
Global-View posts indicative IMM swaps each trading day and can be found on its website.
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