9.3 Derivatives markets

Box 9.1Exchange rate futures in the Financial Times

The following information was provided in the Financial Timesof 5 April 2006 on the Euro

Futures ($/Euro) contract offered by the Chicago Metal Exchange (CME).

Mercantile Euro futures£125,000 per euro

OpenSettChangeHighLowEst. volOpen int

Jun.1.23161.2357+0.00351.23641.2299106,590159,215

Sep.1.23701.2422+0.00351.24251.23652942,329

The heading tells us the size of each contract (A125,000) and the form of the exchange

rate – ‘per £’ indicates that exchange rates are being quoted in the form A1 $1.2316.

That is, we have the euro quoted indirectly (the dollar is quoted against the euro).

The meaning of each of the columns is:

Open	the price of the contract at the beginning of business on the previous trad-ing day (4 April 2006), i.e. the opening price of the contract that promisedthe delivery of euro at the end of June 2006 was A1 $1.2316.

Sett	the settlement price – the price at which contracts were settled at the closeof the market on 4 April 2006.

Change

the change in the settlement price from the previous day – this is not usually equal to the difference between the rst two columns, and wherevery few contracts have been traded during the day might be signicantly different (as with the September contract above).

High	the highest price reached for the contract on the day.
Low	the lowest price reached for the contract on the day.
Est. vol	the estimated number of contracts entered into during the day.

Open int

open interest – the number of outstanding contracts at the end of the previous trading day.

Note that open interest is much greater for the June contract. This shows the short-

term nature of the market. The settlement date of the September contract was still nearly

ve months into the future and very little interest was being taken in it – only 294

September contracts had been traded on the previous day against the 106,590 June

contracts traded.

Source: Financial Times, 5 April 2006

Investors wishing to cancel out the obligation to deliver or to accept delivery of

the underlying product do so by entering an offsetting (or reversing) contract. That

is, if a market agent has entered a contract to deliver a particular instrument, she

can reverse this by taking out another contract that requires her to take delivery

of the same amount of the same product on the same date. Her obligations under

the two contracts then cancel out. In some cases, such as futures based upon equity

market indices or interest rates on short-term deposits, no delivery is possible and

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Chapter 9 • Exchange rate risk, derivatives markets and speculation

traders meet their obligations by making cash payments based upon the changes in

the value of the index or interest rate in question.

To reduce default risk and hence to make futures more easily tradable, futures

exchanges make use of a clearing house,which covers any default arising from a contract.

Although all futures contracts involve a buyer and a seller, the obligation of each

is to the clearing house, not to each other. That is, after the transaction has been

recorded, the clearing house substitutes itself for the counterparty and becomes the

seller to every buyer and vice versa. Therefore, the only default risk faced by some-

one entering a futures contract stems from any doubts about the creditworthiness of

the clearing house itself.

This is, in turn, reduced in a number of ways. Firstly, all transactions must take

place through members of the exchange who act as brokers for anyone wishing to

invest in the market. The number of members (or seats on the exchange) is limited.

Seats on an exchange are purchased from existing members but new members must

demonstrate their creditworthiness to the exchange. In addition, the members of

the exchange must keep with the clearing house special accounts (margin accounts)

that are adjusted from day to day to ensure that they are always able to settle their

debts to the clearing house. Investors must, in turn, maintain similar accounts with

the members of the exchange. This is known as trading on margin. Futures positions

are thus said to be ‘margined on a marked-to-market basis’. These rules should allow

the clearing house to guarantee the performance of every contract entered into on

the exchange.

Trading on margin:The process of trading in futures markets in which buyers and

sellers initially pay only a small percentage of the value of the underlying assets

(the margin). Adjustments to this amount are then made daily, depending on whether

the value of the underlying assets has risen or fallen.

At the start of the contract period, a member pays into a margin account a small

percentage of the value of the contract (the initial margin). The size of the initial

margin is intended to reect the maximum daily loss likely to arise on the con-

tract and so is related to the volatility of the price movements of that instrument.

Initial margins are generally between 1 and 5 per cent of the value of the contract.

Margin accounts are then adjusted daily to reect gains or losses on a contract over

the day.

Consider a contract such as the sterling future offered by the CME. Assume that

the contract is for the exchange of £62,500 for dollars in three months’ time at an

exchange rate of £1 $1.85 and that this is the current rate of exchange. The con-

tract thus has a commencing value of $115,625 (this is what it would cost at the

current exchange rate to buy the sterling promised for delivery). Each counterparty

pays an initial margin of $5,000 into their margin accounts with the clearing house.

Assume next that during the rst day’s trading, the spot exchange rate of sterling

moves above £1 $1.85. This increases the contract’s value, representing a potential

loss for the seller and a potential gain for the buyer. That is, if the contract had to

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