Module - 2 : Currency and interest rate futures, future contracts, markets and trading process, future prices spot and forward, hedging and speculation with currency futures – interest rate futures – foreign currency options – option pricing models – hedging with currency options – futures options – innovations.

2. Module - 2 :
Currency and interest rate futures, future contracts,
markets and trading process, future prices spot and
forward, hedging and speculation with currency
futures – interest rate futures – foreign currency
options – option pricing models – hedging with
currency options – futures options – innovations.
PART - II

3. CURRENCY & INTEREST RATE FUTURES.
What are 'Currency Futures‘
Currency futures are a transferable futures contract that specifies the
price at which a currency can be bought or sold at a future date.
Currency futures contracts are legally binding and counterparties that are
still holding the contracts on the expiration date must trade the currency
pair at a specified price on the specified delivery date. Currency future
contracts allow investors to hedge against foreign exchange risk.
What is an 'Interest Rate Future‘
An interest rate future is a futures contract with an underlying instrument
that pays interest. An interest rate future is a contract between the buyer
and seller agreeing to the future delivery of any interest-bearing asset.
The interest rate future allows the buyer and seller to lock in the price of
the interest-bearing asset for a future date.

4. Currency futures contracts are marked-to-market daily,
investors can exit their obligation to buy or sell the currency
prior to the contract's delivery date. This is done by closing out
the position. The prices of currency futures are determined
when the contract is signed, just as it is in the forex market,
only and the currency pair is exchanged on the delivery date,
which is usually some time in the distant future. However,
most participants in the futures markets are speculators who
usually close out their positions before the date of settlement,
so most contracts do not tend to last until the date of delivery.
If the spot rate of a currency pair increases, the futures prices
of the currency pair have a high probability of increasing. On
the other hand, if the spot rate of a currency pair decreases, the
futures prices has a high probability of decreasing.

5. Currency Futures Example
For example, assume hypothetical company XYZ, which is based
in the United States, is heavily exposed to foreign exchange risk
and wishes to hedge against its projected receipt of 125 million
euros in September. In August, company XYZ could sell futures
contracts on the euro for delivery in September, which have a
contract specification of 125,000 euros. Therefore, company XYZ
would need to sell 1,000 futures contracts on the euro to hedge its
projected receipt. Consequently, if the euro depreciates against the
U.S. dollar, the company's projected receipt is protected. However,
the company forfeits any benefits that would occur if the euro
appreciates.

6. An interest rate future can be based on underlying instruments such as
Treasury bills in the case of Treasury bill futures traded on the CME or
Treasury bonds in the case of Treasury bond futures traded on the CBT.
Other products such as CDs, Treasury notes and Ginnie Mae are also
available to trade as underlying assets of an interest rate future. The
most popular interest rate futures are the 30-year, 10-year, five-year and
two-year Treasuries, as well as the eurodollar. Interest rate futures are
used for hedging purposes and speculation purposes.
Interest Rate Future Example: Treasury-based interest rate futures
and eurodollar-based interest rate futures trade differently. The face
value of most Treasuries are $100,000, thus the contract size for a
Treasury-based interest rate future is usually $100,000. Each contract
trades in handles of $1,000, but these handles are split into thirty-
seconds, or increments of $31.25 ($1,000/32). If a quote on a contract is
listed as 101'25 (or often listed as 101-25), this would mean the total
price of the contract is the face value, plus one handle, plus 25/32s of
another handle, or:

7. 101'25 price = $100,000 + $1,000 + ($1,000 x 25/32) = $101,781.25.
Eurodollar-based contracts have a contract size of $1 million, a handle
size of $2,500 and increments of $25. These contracts, unlike Treasury-
based contracts, also can trade at half-tick and quarter-tick values. This
means that the minimum price movement of a $1 million contract is only
$6.25, which equals $25 x 25%.
The price of an interest rate futures moves inversely to change in interest
rates. If interest rates go down, the price of the interest rate future goes
up and vice-versa. Assume that a trader speculates that in one year
interest rate may decrease. The trader purchases a 30-year Treasury bond
future for a price of 102'28. One year later, the trader's prediction has
come true. Interest rates are lower, and the interest rate future he holds is
now priced at 104'05. The trader sells, and his profit is:
Purchase price = 102'28 = $102,875.
Sale price = 104'05 = $104,156.25.
Profit = $1,281.25 or 1.25%.

9. THE FUTURES TRADING PROCESS
Futures contracts are traded by a system of open outcry on the trading
floor (also called the trading pit) of a centralized and regulated
exchange. Increasingly, trading with electronic screens is becoming the
preferred mode in many exchanges around the world. All traders
represent exchange members. those who trade for their own account are
called floor traders while those who trade on behalf of others are floor
brokers. Some do both are called dual traders.
The variables to be negotiated in any deal are the price and the number of
contracts. A buyer of futures acquires a long position while the seller
acquires a short position. Two positions will get cleared through
clearing houses of exchange.
When a position is opened, the trader (both the long and the short) must
post an Initial Margin, as prices change, the contract is marked to
market with gains credited to the margin account and losses debited from
the account. These are called Variation Margin.

10. If, as a result of losses, the amount in the margin account falls below a
certain level known as Maintenance Margin, the trader receives a margin
call and must make up the amount to the level of the initial margin in a
specified time.
There are various kinds of orders given to the floor traders and brokers. A
client may ask his or her broker to buy or sell a certain number of contracts
at the best available price (Market Orders) or may specify upper price
limit for buy orders and lower limit for sell orders (Limit Orders). An order
can become a market order, if a specified price limit is touched through it
may not get executed at the limit price or better (Market If Touched or
MIT Orders).
A trader with long position may wish to limit his losses by instructing his
broker to liquidate the position, if the price falls (rises) to below (above) a
specified level below (above) the current market price (stop loss orders).
Stop limit price or better (stop limit orders). Some traders may wish their
orders to be executed during specified intervals of time. Ex: first half an
hour of trading (time of day orders).

11. TYPES OF MARGINS
Exposure Limits: Exchange provides facility in the system enabling the
TCMs to select the commodities in which the TM can trade and also fix
the trading limits for each TM. TCM can also monitor the position of
TMs online.
Initial Margin: The initial margin (IM) is levied on all open positions
(Buy or sell positions) of the members and their clients. The IM
percentage on each commodity varies depending upon its market
volatility. The margin so calculated is reduced from the total margin of
the member available with the exchange and accordingly further
exposure is given on the balance amount. As the IM increases, the
exposure shall decrease.
Special Margins: have primarily been introduced not as a risk
management tool, but to act as a speed-breaker for sharply rising or
falling price. It is applied when price reaches a particular level
above/below the previous day’s closing price.

12. Mark to Market (MTM) Margins: MTM is a mechanism devised by
the exchanges to prevent the possibility of the potential loss
accumulating to the level where the participants might willingly or
unwillingly commit default. All trades done on the exchange during the
day and all open positions for the days are marked to closing price for
the respective delivery/contract and notional gain or loss is worked out.
Such loss/gain is debited / credited to respective member’s account at the
end of each day. The outstanding position of the members is then carried
forward the next day at the closing price.
Delivery Margins: are applicable to the contracting parties (both, buyer
and seller) from the 12th day of the contract maturity month.

13. Standardized Items in a Future Contract:
• Quantity & Quality of the underlying instrument.
• The date and month of delivery, Location of settlement or place
of delivery.
• The Underlying asset or instrument, the type of settlement and
last trading date.
• The currency in which the futures contract is quoted.
• The units of price quotation and minimum price change.
• Other details such as the commodity tick, the minimum
permissible price fluctuation.
Contract Contract size Exchange
Corn 5,000 bushels Chicago Board of Trade (CBT)
Barley 20 metric ton Winnipeg (WPG)
Cotton 50,000 lbs New Cotton Exchange (NCT)
Crude Oil 1,000 barrels New York Mercantile Exchange
S&P Index 500 times Index Chicago Mercantile Exchange (CME)

16. Hedging means reducing or controlling risk. This is done by taking a
position in the futures market that is opposite to the one in the physical
market with the objective of reducing or limiting risks associated with
price changes.
Hedging is a two-step process. A gain or loss in the cash position due to
changes in price levels will be countered by changes in the value of a
futures position. For instance, a wheat farmer can sell wheat futures to
protect the value of his crop prior to harvest. If there is a fall in price,
the loss in the cash market position will be countered by a gain in
futures position.
Hedging is the practice of taking a position in one market to offset and
balance against the risk adopted by assuming a position in a contrary or
opposing market or investment. The word hedge is from Old English
hecg, originally any fence, living or artificial. The use of the word as a
verb in the sense of "dodge, evade" is first recorded in the 1590s; that
of insure oneself against loss, as in a bet, is from the 1670s.

17. HEDGING & SPECULATION WITH CURRENCY FUTURES
Corporations, Banks and others use currency futures for hedging
purpose. In principle, the idea is very simple. If a corporation has an
asset, e.g. a receivable in a currency A which it would like to hedge, it
should take a futures position such that futures generate a positive cash
flow whenever the asset declines in value. In this case since the firm is
long in the underlying asset, it should go short in futures. i.e. it should
sell futures contracts in A. conversely, a firm with a liability in currency
A, e.g. should go long in futures.
Hedging with currency futures involves the following three decisions:-
1. Which contract should be used i.e. choice of “underlying”
2. Choosing the maturity of the contract
3. Choosing the number of contracts.
Hedge Ratio : VF (Value of the Future Position
VC (Value of the Cash Position)

18. Following the correlation analysis, which determines whether the futures
contract is at all suitable for hedging the cash position, the number of
required futures contracts (the hedge ratio) must be determined. The
following factors generally play a role:
A. Size of cash position
B. Futures contract size
C. Price sensitivity of the cash position
D. Price sensitivity of the futures contract
Hedge Ratio = Number of futures used
If one ignores the potential various, strong price fluctuations between
future and cash, the hedge-ratio calculation is simple.

21. How hedging is done
In this type of transaction, the hedger tries to fix the price at a certain level
with the objective of ensuring certainty in the cost of production or revenue
of sale.
The futures market also has substantial participation by speculators who
take positions based on the price movement and bet upon it. Also, there are
arbitrageurs who use this market to pocket profits whenever there are
inefficiencies in the prices. However, they ensure that the prices of spot and
futures remain correlated. Examples of hedging:-
1. Forward exchange contract for currencies
2. Currency future contracts
3. Money Market Operations for currencies
4. Forward Exchange Contract for interest
5. Money Market Operations for interest
6. Future contracts for interest
7. Covered Calls on equities
8. Short Straddles on equities or indexes
9. Bets on elections or sporting events

22. Understanding the meaning of buying/long hedge
A buying hedge is also called a long hedge. Buying hedge means buying
a futures contract to hedge a cash position. Dealers, consumers,
fabricators, etc. who have taken or intend to take an exposure in the
physical market and want to lock- in prices, use the buying hedge
strategy.
Benefits of buying hedge strategy:
1. To replace inventory at a lower prevailing cost.
2. To protect uncovered forward sale of finished products.
The purpose of entering into a buying hedge is to protect the buyer
against price increase of a commodity in the spot market that has already
been sold at a specific price but not purchased as yet. It is very common
among exporters and importers to sell commodities at an agreed-upon
price for forward delivery. If the commodity is not yet in possession, the
forward delivery is considered uncovered.

23. Understanding the meaning of selling/short hedge
A selling hedge is also called a short hedge. Selling hedge means selling
a futures contract to hedge.
Uses of selling hedge strategy.
1. To cover the price of finished products.
2. To protect inventory not covered by forward sales.
3. To cover the prices of estimated production of finished products.
Short hedgers are merchants and processors who acquire inventories of
the commodity in the spot market and who simultaneously sell an
equivalent amount or less in the futures market. The hedgers in this case
are said to be long in their spot transactions and short in the futures
transactions.

24. Understanding the basis
Usually, in the business of buying or selling a commodity, the spot price is different
from the price quoted in the futures market. The futures price is the spot price
adjusted for costs like freight, handling, storage and quality, along with the impact
of supply and demand factors.
The price difference between the spot and futures keeps on changing regularly. This
price difference (spot - futures price) is known as the basis and the risk arising out
of the difference is defined as basis risk. A situation in which the difference
between spot and futures prices reduces (either negative or positive) is defined as
narrowing of the basis.
A narrowing of the basis benefits the short hedger and a widening of the basis
benefits the long hedger in a market characterized by contango - when futures price
is higher than spot price. In a market characterized by backwardation - when
futures quote at a discount to spot price - a narrowing of the basis benefits the long
hedger and a widening of the basis benefits the short hedger.
However, if the difference between spot and futures prices increases (either on
negative or positive side) it is defined as widening of the basis. The impact of this
movement is opposite to that as in the case of narrowing.

25. Natural hedges
Many hedges do not involve exotic financial instruments or derivatives such
as the married put. A natural hedge is an investment that reduces the
undesired risk by matching cash flows (i.e. revenues and expenses). For
example, an exporter to the United States faces a risk of changes in the
value of the U.S. dollar and chooses to open a production facility in that
market to match its expected sales revenue to its cost structure.
Another example is a company that opens a subsidiary in another country
and borrows in the foreign currency to finance its operations, even though
the foreign interest rate may be more expensive than in its home country: by
matching the debt payments to expected revenues in the foreign currency,
the parent company has reduced its foreign currency exposure. Similarly, an
oil producer may expect to receive its revenues in U.S. dollars, but faces
costs in a different currency; it would be applying a natural hedge if it
agreed to, for example, pay bonuses to employees in U.S. dollars. One
common means of hedging against risk is the purchase of insurance to
protect against financial loss due to accidental property damage or loss,
personal injury, or loss of life.

26. Cross Hedge:
An investment strategy that involves taking a position on a commodity
followed by an equal but opposite futures position on a different
commodity with similar price movements. Because the price movements
of the two commodities should be closely correlated, a negative
movement on the present commodity should be offset by a positive
movement on the opposite futures position, and vice versa. Cross
hedging is often used in markets where there is no viable futures market
for the presently-owned commodity.
A cross-currency transaction is one which involves the simultaneous
buying and selling of two or more currencies. An example is the
purchase of Canadian dollars with yen and the simultaneous sale of yen
for U.S. dollars. The term is also used generically for any transaction that
involves more than one currency, such as a currency swap.

27. CATEGORIES OF HEDGEABLE RISK
Commodity risk: the risk that arises from potential movements in the value of
commodity contracts, which include agricultural products, metals, and energy
products
Credit risk: the risk that money owing will not be paid by an obligor. Since credit
risk is the natural business of banks, but an unwanted risk for commercial traders,
an early market developed between banks and traders that involved selling
obligations at a discounted rate.
Currency risk (also known as Foreign Exchange Risk hedging) is used both by
financial investors to deflect the risks they encounter when investing abroad and by
non-financial actors in the global economy for whom multi-currency activities are a
necessary evil rather than a desired state of exposure.
Interest rate risk: the risk that the relative value of an interest-bearing liability,
such as a loan or a bond, will worsen due to an interest rate increase. Interest rate
risks can be hedged using fixed-income instruments or interest rate swaps.
Equity risk: the risk that one's investments will depreciate because of stock market
dynamics causing one to lose money.
Volatility risk: is the threat that an exchange rate movement poses to an investor's
portfolio in a foreign currency.
Volume risk is the risk that a customer demands more or less of a product than
expected.

28. HEDGING & SPECULATION WITH INTEREST RATE
FUTURES – Explanation Done
SPECULATION
The speculators are not genuine investors. They buy securities with a
hope to sell them in future at a profit. They are not interested in
holding the securities for longer period. Hence, their very object of
buying the securities is to sell them and not to retain them. They are
interested only in price differentials.
In reality, there is not a hundred percent speculator or an investor.
Each investor is to a certain extent a speculator. Similarly, every
speculator to a certain extent is an investor. Thus, the difference
between the two is a matter of degree only.

29. KINDS OF SPECULATORS
1. Jobber :- Jobber is a professional speculator who has a complete
information regarding the particular shares he deals. He transacts the
shares of profit. He conducts the securities in his own name. He is the
member of the stock exchange and he deals only with the members.
2. Broker :- Broker is a person who transact business in securities on
behalf of his clients and receives commission for his services. He deals
between the jobbers and members our side the house. He is an
experienced agent of the public.
3. Bull :- He is a speculator who purchases various types of shares. He
purchases to sell them on higher prices in future. He may sell the shares
and securities before coming in possession. If the price falls then he
suffers a loss.

30. 4. Bear :- He is always in a position to dispose of securities which he
does not possess. He makes profit on each transaction. He sells the
various securities for the objective of taking advantages of an expected
fall in prices.
5. Lame Duck :- When bear fails to meet his obligations he struggles to
meet finance like the Lame Duck. This may happen when he has been
concerned. Generally a bear agrees to dispose off certain shares on
specific date. But sometimes he fails to deliver due to non availability of
shares in the market. If the other party refuses to postpone the delivery
them lame duck suffers heavy losses.
6. Stag :- He is also a speculator. He purchases the shares of newly
floated company and shown himself a genuine investor. He is not willing
to become an actual shareholder of the company. He purchases the shares
to sell them above the par value to earn premium. A stag also suffer a
loss.

31. 7. Contango :- Contango means to came over dealing to the settlement.
The broker is paid a reward to carry the settlement, it is also known as
contango. It is paid the buyers, to the brokers. In some cases buyers in
unable make the payment of securities on any particular date. So he
requests the broker to carry on the dealing to the next settlement.
8. Backwardation :- It is an interest which is paid by the sellers of
securities to the buyers who wants to postpone transaction to the next
account.
TYPES OF SPECULATIVE TRANSACTIONS
The various types of transactions, which facilitate speculative dealings,
can be classified into the following:

32. Option Dealings: The term option means a right. Option dealing is an
arrangement of right to buy or sell a certain number of specified
securities at a predetermined price within a prescribed time limit. Option
dealing is a highly risky transaction in securities whose price fluctuates
violently. To avoid the risk of loss, the speculators enter into option
dealings. Ex: Call and Put Options.
Margin Trading: Margin trading is a system of purchasing securities
with funds borrowed from brokers. For margin trading, the client opens
an account with the broker by depositing a certain amount in cash or
securities. He also agrees to maintain the margin at a certain level. The
broker will debit the client’s account with the amount of purchases and
various charges like brokerage, commission etc. and credit the account
with the cash deposited and the sale proceeds. Generally, the price
difference is credited or debited as the case may be.

33. Arbitrage: Arbitrage is a highly specialized and skilled speculative
activity. It is undertaken to make profit out of the differences in prices of
a security in two different markets. The speculator buys the security in
one market where its price is cheaper and sells it in another market where
its price is high. These transactions aim to bring about a leveling of
prices in two markets.
Wash Sales: Wash sales are fictitious transactions. Under this method,
the speculator sells his securities and then repurchases the same through
a broker at a higher price. Actually, no transaction takes place in the
wash sales. By this process, an artificial demand can be created which
mill ultimately, lead to an artificial rise in price. The speculator will then
sell the securities at the increased price and makes the profit.
Carry Over or Budla Transactions: In case of forward delivery
contracts, if both the parties agree, the contract can be settled in the next
settlement date (probably in the next month or fortnight). Such
postponement is called “Carry Over” or “Budla“. This is usually done if
the prices move against the expectations of the speculator.

34. Blank Transfer: It is a method of the transfer without mentioning the
name of the transferee in the transfer deed. Blank transfer, in fact, is a
routine method of transferring the securities from one person to another.
Therefore, it is not a speculative activity. However, it is quite helpful in
making speculation in securities easier.
Cornering: A corner is the condition of the market in which an
individual or a group of individuals holds almost the entire supply of a
particular security. The speculators will enter into purchasing contracts
with the bears in certain securities. Thereafter, by purchasing
substantially the whole of the available securities and getting their actual
delivery, the speculator will make such securities to go out of the market.
Rigging the Market: Rigging means artificially forcing up the market
price of a particular security. The bull speculators generally carry on this
activity. Due to strong bull movement, the price of certain security will
go up and a demand shall be created. When the prices rise, they will sell
the securities and make the profit. Rigging is another unhealthy practice,
which disturbs the free interplay of demand and supply.