9.3 Derivatives markets

be settled on that day, the seller of the contract (the person who has promised to

deliver £62,500 at £1 $1.85) would need to pay more than $115,625 to obtain the

necessary sterling. The buyer of the contract, on the other hand, could take delivery

of the sterling at the agreed rate ($1.85) and promptly sell it at the higher price

available in the spot forex market.

Let us be more precise. Assume that, at the end of the day, the settlement com-

mittee of the exchange declares a settlement price for these contracts of £1 $1.86.

This increases the contract’s value to $116,250. Because of the change in the value

of the contract, the clearing house transfers $625 from the seller’s margin account

to that of the buyer. Should the spot exchange rate of sterling rise again the next

day, a similar transfer would occur. If the balance in the seller’s account fell below

a specied level (the maintenance margin), he would be required to make additional

payments into the account (the variation margin) in order to keep the account at

or above an acceptable balance. On the other hand, the buyer could, in this case,

withdraw his daily prots from his margin account. Some exchanges (for example,

Euronext.liffe) set the maintenance margin at the same level as the initial margin.

In our example above, assume that the maintenance margin for buyers and sellers

is indeed the same as the initial margin – in this case, $5,000. On the second day

of trading, the sterling exchange rate rises to £1 $1.88, increasing the value of

the contract to $117,500 and the potential loss of the seller to $1,875. This amount

will have been deducted from the seller’s margin account by the clearing house,

reducing the balance in that account to $3,125. The seller will then have to pay

into the account a minimum additional amount of $1,875 to bring the balance

back up to the $5,000 maintenance margin. In other words, the seller will now

have deposited a total of $6,875 with the clearing house. The balance in the buyer’s

margin account meanwhile will have risen to $6,875, allowing the buyer to with-

draw $1,875. Alternatively, the buyer might at this stage decide to instruct the

exchange to nd someone willing to purchase the contract. The price of the contract

will have risen to reect the potential prot that its terms currently imply. If the

price of the future has risen exactly in line with the change in the spot exchange

rate, the prot from selling the contract would also be $1,875. This amount of prot

on capital of only $5,000 in two days gives a very high per annum rate of prot!

Exercise 9.1

(a)Calculate the per annum rate of prot in the example immediately above. (b)What is left out of this example that would reduce this rate of prot?

(c)	Assume that the buyer has withdrawn his prot from his margin account on the rsttwo days so that, at the beginning of Day 3, both margin accounts stand at $5,000. Then, calculate the variation margin on subsequent days should the spot exchangerate change as follows:

Day 3 $1.87; Day 4 $1.855; Day 5 $1.84.
	Answers at end of chapter

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Chapter 9 • Exchange rate risk, derivatives markets and speculation

Of course, should the exchange rate of sterling fall below $1.85, reducing the value

of the contract below $115,625, the balance in the buyer’s margin account would fall

below $5,000 and he would have to make additional payments to the clearing house.

Failure to make such payments immediately would lead to the closure of the contract

against the defaulting party, who loses any remaining balance in his margin account.

This system of marking accounts to market daily prevents losses from accumulating,

and the holding by the clearing house of margins removes most default risk.

The settlement price set by the settlement committee of the exchange is norm-

ally the closing price for the day (the last price at which the contract has traded).

However, if a contract has not traded for some time prior to the market’s close, the

committee may set a different settlement price in an attempt to reect accurately

the trading conditions at the close of the market. The freedom that the settlement

committee has to x the settlement price also allows it to protect the clearing house

from the remaining default risk that might arise from very large daily swings in the

price of a contract.

It is not very likely, but suppose sterling were to fall dramatically in one day from

£1 $1.85 to £1 $1.75. The value of the above contract would fall to $109,375,

wiping out all of the initial margin deposited with the clearing house by the buyer.

Rather than paying into the exchange an additional $6,250 in what might seem

now to be a losing endeavour, the buyer might be tempted to default. To avoid this,

the exchange might set price limits – maximum movements up and down from

the previous day’s settlement price. In our example, we shall assume a price limit of

5 cents per day. Then, if the exchange rate started the day at £1 $1.85, the limits

for that day would be $1.80 and $1.90. If these limits would otherwise be broken,

the market would close limit-up (£1 $1.90) or limit-down (£1 $1.80). The hope

would be that the temporary closure of the market might lead traders to reassess their

positions. However, the system of price limits has its disadvantages. As long as the

market remains closed, positions cannot be closed out and contracts become illiquid,

destroying one of the major advantages of futures contracts, their tradability. For

this reason, many exchanges do not operate price limits during the delivery month

of a contract.

We have seen above that the relative smallness of the margin requirements is

responsible for another important aspect of futures markets – their high gearing (or

leverage). If all goes well, the effective rate of prot on a futures contract can be

very high. On the other hand, investing in futures markets can be very expensive.

In addition to making margin payments, investors must pay brokers a negotiated

commission for executing orders. Commission (sometimes referred to as the direct

cost of the contract) is charged on both the opening and the closing of a position,

and is normally payable either when the position is closed or when delivery takes

place. More seriously, the small margin requirement and the high potential prot

rate might tempt people to enter contracts beyond their means. Then, if the daily

changes in the value of the contract go against the investor and he is required

constantly to replenish his margin account, he can quickly run into trouble. Futures

contracts, therefore, provide the prospect of high rates of return but involve con-

siderable risks.

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