Currency
futures markets were developed in response to the shift from fixed to flexible
exchange rates in 1971. They became particularly popular after rates were
allowed to float free in 1973, because of the resulting increased volatility in
exchange rates.
A
currency future is the price of a particular currency for settlement in a
specified future date. A currency future contract is an agreement to buy or
sell, on the future exchange, a standard quantity of foreign currency at a
future date at the agreed price. The counterpart to futures contracts is the
future exchange, which ensures that all contracts will honored. This
effectively eliminates the credit risk to a very large extent.
Currency
futures are traded on futures exchanges and the most popular exchange are the
ones where the contracts are fungible or transferable freely. The Singapore
International Monetary Exchange (SIMEX) and the International Monetary Market,
Chicago (IMM) are the most popular futures exchanges. There are smaller futures
exchanges in London,
Sydney, Tokyo, Frankfurt,
Paris, Brussels, Zurich, Milan, New York
and Philadelphia.
Pricing of Futures Contract
Futures
Price = Spot Price + Cost of Carrying (Interest)
Cost
of carrying is the sum of all costs incurred to carry till the maturity of the
futures contract less any revenue, which may result in this period.
In
India
there is no futures market available for the Indian Corporates to hedge their
currency risks through futures.
The
advantages of Future Contract
o
Low Credit Risk : In case of futures
the credit risk is low as the clearing house is the counter party to every
futures.
o
Gearing : Only small margin money is
required to hedge large amounts.
The
disadvantages of Future Contract
o
Basic Risk : As futures contract are
standardized they do not provide a perfect hedge.
o
Margining Process : The administration
is difficult.
It
is observed that a futures contract is a type of forward contract, but there
are several characteristics that distinguish from forward contracts.
Ø Standardized
Vs. Customized Contract :
Forward
contract is customized while the future is standardized.
Ø Counter
Party Risk :
In
case of futures contract, once the trade is agreed upon the exchange becomes
the counter party. Thus reducing the risk to almost nil. In case of forward
contract, parties take the credit risk to each other.
Ø Liquidity
:
Futures
contract are much more liquid and their price is much more transparent as
compared to forwards.
Ø Squaring
Off:
A
forward contract can be reversed only with the same counter party with whom it
was entered into. A futures contract can be reversed with any member of the
exchange.
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