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What Does Futures Mean?

A financial contract obligating the buyer to purchase an asset (or the seller to sell an asset),
such as a physical commodity or a financial instrument, at a predetermined future date and
price. Futures contracts detail the quality and quantity of the underlying asset; they are
standardized to facilitate trading on a futures exchange. Some futures contracts may call for
physical delivery of the asset, while others are settled in cash. The futures markets are
characterized by the ability to use very high leverage relative to stock markets.
Futures can be used either to hedge or to speculate on the price movement of the underlying
asset. For example, a producer of corn could use futures to lock in a certain price and reduce
risk (hedge). On the other hand, anybody could speculate on the price movement of corn by
going long or short using futures.

Investopedia explains Futures


The primary difference between options and futures is that options give the holder the right to
buy or sell the underlying asset at expiration, while the holder of a futures contract is
obligated to fulfill the terms of his/her contract.
In real life, the actual delivery rate of the underlying goods specified in futures contracts is
very low. This is a result of the fact that the hedging or speculating benefits of the contracts
can be had largely without actually holding the contract until expiry and delivering the good(s).
For example, if you were long in a futures contract, you could go short in the same type of
contract to offset your position. This serves to exit your position, much like selling a stock in
the equity markets would close a trade.

Futures
An agreement to buy and sell an asset at a certain date at a certain price. For example,
Investor A may make a contract with Farmer B in which A agrees to buy a certain number of
bushels of B's corn at $15 per bushel. This contract must be honored whether the priceof corn
goes to $1 or $100 per bushel. Futures contracts can help reduce volatility in certain markets,
but they contain the risks inherent to all speculative investing. These contracts may be sold
on the secondary market, but the person holding the contract at its end must take delivery of
the underlying asset.

What is the difference between forward and futures


contracts?
Fundamentally, forward and futures contracts have the same function: both types of contracts
allow people to buy or sell a specific type of asset at a specific time at a given price.
However, it is in the specific details that these contracts differ. First of all, futures contracts are
exchange-traded and, therefore, are standardized contracts. Forward contracts, on the other
hand, are private agreements between two parties and are not as rigid in their stated terms
and conditions. Because forward contracts are private agreements, there is always a chance
that a party may default on its side of the agreement. Futures contracts have clearing houses
that guarantee the transactions, which drastically lowers the probability of default to almost
never.
Secondly, the specific details concerning settlement and delivery are quite distinct.
For forward contracts, settlement of the contract occurs at the end of the contract. Futures
contracts are marked-to-market daily, which means that daily changes are settled day by day
until the end of the contract. Furthermore, settlement for futures contracts can occur over a

range of dates. Forward contracts, on the other hand, only possess one settlement date.
Lastly, because futures contracts are quite frequently employed by speculators, who bet
on the direction in which an asset's price will move, they are usually closed out prior to
maturity and delivery usually never happens. On the other hand, forward contracts are mostly
used by hedgers that want to eliminate the volatility of an asset's price, and delivery of the
asset or cash settlement will usually take place.

Distinction between forwards and futures:


The basic nature of a forward and future, in a strict legal sense, is the same, with the
difference that futures are market-driven organised transactions. As they are
exchange-traded, the counterparty in a futures transaction is the exchange. On the
other hand, a forward is mostly an over-the-counter transaction and the counterparty is
the contracting party. To maintain the stability of organised markets, market-based
futures transactions are subject to margin requirements, not applicable to OTC
forwards. Futures market are normally marked to market on a settlement day, which
could even be daily, whereas forward contracts are settled only at the end of the
contract. So the element of credit risk is far higher in case of forward contracts.

1.

Settlement Procedures for the Futures Market

WHY END OF DAY SETTLEMENT ISN'T ALWAYS THE LAST TRADE


Settlement price is the price at which a contract is settled at the end of the trading day.
With stocks this is the last trade of the day. However, with commodities the last trade
does not have to be the settlement price. This is important because margin
determinations are based on the settlement price.
The exchanges have a settlement committee for each commodity which meet
immediately after closing to make sure the last trade fairly represents the value for
that commodity. Usually it does but if not, a new price will be established. Actively
traded contracts have relatively stable pricing and the last trade normaly reflects the
fair value.
Settlement price becomes more difficult for a thinly traded issue which may have last
traded 3 or 4 hours before the close. A complicating issue which could arise might be
a significant news story which came out shortly before the close of trading and which
has a significant impact of the price of that particular commodity. The settlement
committee will now perform an important function. They are going to try to determine

a price for that particular commodity which fairly represents its value in light of the
news story which just broke. They may have a lot of information or very little
information to make this determination. They may be able to look at the spread
between different months or this may be of no use to them. Whatever the case, they
must determine a price which fairly represents the value of that contract(s) given the
new circumstances.

Settlement - physical versus cash-settled futures


Settlement is the act of consummating the contract, and can be done in one of two
ways, as specified per type of futures contract:

Physical delivery - the amount specified of the underlying asset of the


contract is delivered by the seller of the contract to the exchange, and by the
exchange to the buyers of the contract. Physical delivery is common with
commodities and bonds. In practice, it occurs only on a minority of contracts.
Most are cancelled out by purchasing a covering position - that is, buying a
contract to cancel out an earlier sale (covering a short), or selling a contract to
liquidate an earlier purchase (covering a long). The Nymex crude futures
contract uses this method of settlement upon expiration
Cash settlement - a cash payment is made based on the underlying reference
rate, such as a short term interest rate index such as Euribor, or the closing
value of a stock market index. The parties settle by paying/receiving the
loss/gain related to the contract in cash when the contract expires.[5] Cash
settled futures are those that, as a practical matter, could not be settled by
delivery of the referenced item - ie how would one deliver an index? A futures
contract might also opt to settle against an index based on trade in a related
spot market. Ice Brent futures use this method

Currency Futures
What Does Currency Futures Mean?
A transferable futures contract that specifies the price at which a specified currency can be
bought or sold at a future date.

Investopedia explains Currency Futures


Currency future contracts allow investors to hedge against foreign exchange risk. Since these
contracts are marked-to-market daily, investors can--by closing out their position--exit from
their obligation to buy or sell the currency prior to the contract's delivery date.

How to Trade Currency Futures in India


Contributor
By eHow Contributing Writer
Article Rating:
(1 Ratings)

Rupee
The Indian economy has been expanding rapidly over the last twenty years,
and innovations in its capital markets and financial instruments have
accelerated at a similar pace. Now independent traders, large financial
institutions, trading companies, importers, exporters, and commercial hedgers
have a fully functioning system for buying and selling Indian Rupees all over
the world. Learn the steps that can be taken to successfully trade currency
futures in India.

Step by Step Instructions

Things You'll Need:


Brokerage account

Step 1
Understand the Indian currency futures market. The market is primarily
focused on the exchange rate relationship between the US Dollar and
Indian Rupee. Unlike spot foreign exchange, in which one currency is
bought against the sale of the other, Indian currency futures allow
traders to bet on the anticipated direction of one currency without short
selling the other. Indian currency futures are traded domestically on the
National Stock Exchange, in Mumbai, and internationally on Dubai
Gold and Commodities Exchange, based in Dubai.

Step 2
Open a brokerage account . You could either open an Indian futures
brokerage account, with an outfit like JV Capital Services, or open an
account with a US or international broker who offers you access to the
Indian marketplace. Interactive Brokers is one of the few US-based
brokers with an entire division devoted to Indian stock and futures

trading. Richcomm Global Services is another brokerage that offers


access to Indian currency futures. Be aware that if you use an Indian
broker, all of your trading capital will probably have to be denominated
in Rupees, exposing you to exchange rate risk if the Rupee were to
significantly lose value relative to the Dollar.

Step 3
Study and follow the fundamental factors that affect the price of the
Indian Rupee in relation to the US Dollar and other international
currencies. The primary drivers of price change are interest rate
fluctuations, and the factors that have the greatest impact on interest
rates, such as GDP growth, inflation, trade balances, and international
money flows. Keep track of factors that affect both the Rupee in
absolute terms, as well as relative to the US Dollar.

Step 4
Become acquainted with technical analysis, and use it to decide on
when to buy and sell Indian currency futures. Technical analysis is the
use of price charts and indicators to better predict what prices will be
doing in the future. It can help you better determine if the Rupee is
overvalued or undervalued relative to the Dollar, and at what price you
might consider entering a long or short position in the currency futures
market.

Step 5
Implement a comprehensive risk and money management plan. Indian
currency futures, like all futures contracts, are high risk, high reward
instruments, and if you trade without stop losses, there's a very good
chance you'll eventually get caught on the wrong side of a big move
and lose your entire account. When making a trade, always know
exactly how much you're willing to lose ahead of time, as well as at
what price you will be stopped out of the trade.

Definitions
(i) Currency Futures means a standardised foreign exchange derivative contract traded
on a recognized stock exchange to buy or sell one currency against another on a
specified future date, at a price specified on the date of contract, but does not include a
forward contract.
(ii) Currency Futures market means the market in which currency futures are traded.
Permission
(i) Currency futures are permitted in US Dollar - Indian Rupee or any other currency
pairs, as may be approved by the Reserve Bank from time to time.

(ii) Only persons resident in India may purchase or sell currency futures to hedge an
exposure to foreign exchange rate risk or otherwise.
Features of Currency Futures
Standardized currency futures shall have the following features:
a. Only USD-INR contracts are allowed to be traded.
b. The size of each contract shall be USD 1000.
c. The contracts shall be quoted and settled in Indian Rupees.
d. The maturity of the contracts shall not exceed 12 months.
e. The settlement price shall be the Reserve Banks Reference Rate on the last trading
day.
Participants
(i) No person other than 'a person resident in India' as defined in section 2(v) of the
Foreign Exchange Management Act, 1999 (Act 42 of 1999) shall participate in the
currency futures market.
(ii) Notwithstanding sub-paragraph (i), no scheduled bank or such other agency falling
under the regulatory purview of the Reserve Bank under the Reserve Bank of India Act,
1934, the Banking Regulation Act, 1949 or any other Act or instrument having the force of
law shall participate in the currency futures market without the permission from the
respective regulatory Departments of the Reserve Bank. Similarly, for participation by
other regulated entities, concurrence from their respective regulators should be
obtained.
Membership
i. The membership of the currency futures market of a recognised stock exchange shall
be separate from the membership of the equity derivative segment or the cash segment.
Membership for both trading and clearing, in the currency futures market shall be subject
to the guidelines issued by the SEBI.
ii. Banks authorized by the Reserve Bank of India under section 10 of the Foreign
Exchange Management Act, 1999 as AD Category - I bank are permitted to become
trading and clearing members of the currency futures market of the recognized stock
exchanges, on their own account and on behalf of their clients, subject to fulfilling the
following minimum prudential requirements:
a) Minimum net worth of Rs. 500 crores.
b) Minimum CRAR of 10 per cent.
c) Net NPA should not exceed 3 per cent.
d) Made net profit for last 3 years.
The AD Category - I banks which fulfill the prudential requirements should lay down
detailed guidelines with the approval of their Boards for trading and clearing of currency
futures contracts and management of risks.
(iii) AD Category - I banks which do not meet the above minimum prudential
requirements and AD Category - I banks which are Urban Co-operative banks or State
Co-operative banks can participate in the currency futures market only as clients, subject
to approval therefor from the respective regulatory Departments of the Reserve Bank.
Position Limits

i. The position limits for various classes of participants in the currency futures market
shall be subject to the guidelines issued by the SEBI.
ii. The AD Category - I banks, shall operate within prudential limits, such as Net Open
Position (NOP) and Aggregate Gap (AG) limits. The exposure of the banks, on their own
account, in the currency futures market shall form part of their NOP and AG limits.
Risk Management Measures
The trading of currency futures shall be subject to maintaining initial, extreme loss and
calendar spread margins and the Clearing Corporations / Clearing Houses of the
exchanges should ensure maintenance of such margins by the participants on the basis
of the guidelines issued by the SEBI from time to time.
Surveillance and Disclosures
The surveillance and disclosures of transactions in the currency futures market shall be
carried out in accordance with the guidelines issued by the SEBI.
Authorisation to Currency Futures Exchanges / Clearing Corporations
Recognized stock exchanges and their respective Clearing Corporations / Clearing
Houses shall not deal in or otherwise undertake the business relating to currency futures
unless they hold an authorization issued by the Reserve Bank under section 10 (1) of the
Foreign Exchange Management Act, 1999.
Powers of Reserve Bank
The Reserve Bank may from time to time modify the eligibility criteria for the participants,
modify participant-wise position limits, prescribe margins and / or impose specific
margins for identified participants, fix or modify any other prudential limits, or take such
other actions as deemed necessary in public interest, in the interest of financial stability
and orderly development and maintenance of foreign exchange market in India.

Advantages of Futures Contracts


If price moves are favourable, the producer realizes the greatest return with this
marketing alternative.
No premium charge is associated with futures market contracts.
Disadvantages of Future Contracts
Subject to margin calls
Unable to take advantage of favourable price moves
Net price is subject to Basis change

trading volume

Hide links within definitions

Definition
The number of shares, bonds or contracts traded during a given period, for a security or an
entire exchange. also called volume.

Volume
What Does Volume Mean?
The number of shares or contracts traded in a security or an entire market during a given
period of time. It is simply the amount of shares that trade hands from sellers to buyers as a
measure of activity. If a buyer of a stock purchases 100 shares from a seller, then the volume
for that period increases by 100 shares based on that transaction.

Investopedia explains Volume


Volume is an important indicator in technical analysis as it is used to measure the worth of a
market move. If the markets have made strong price move either up or down
the perceived strength of that move depends on the volume for that period. The higher the
volume during that price move the more significant the move.

Trading Futures, Online Futures Trading, Futures


Trade
Futures trading is a form of investment involving speculation of
the price of a commodity in the future. Futures are derivatives bought or sold on a
futures exchange. They are contracts to buy or sell a particular amount of a
commodity at a predetermined price on a specified date in the future. Trading futures
is not for newcomers to investing, since it involves high risk.
The majority of futures trading is speculative and involves cash settlements (also
known as paper investing), rather than for the actual physical delivery of the
commodity. Online futures trading is not as popular as online stock trading, since the
former is substantially more risky.
Till the 1980s, futures trading comprised of only a handful of farm products. The
popularity of the futures market subsequently rose and in the 21st century it involves a
huge variety of commodities, including:

metals - like gold, silver and platinum.


livestock such as pork bellies and cattle.
energy - like crude oil and natural gas.
foodstuffs such as coffee and orange juice.
industrial products - like lumber and cotton.
currencies.
indices - such as the Dow Jones, Nasdaq and S&P 500.

Trading Futures: What does it Involve?


There are two aspects that distinguish futures trading from trading in stocks or bonds.

A futures contract has a specified lot size. So, there could be a futures contract of 100
shares of IBM or 50 shares of Cisco Systems. You could also opt for an index. For instance,
one could opt for purchasing the E-mini S&P 500 futures contract. This gives you exposure to
all the stocks in this index.
You can trade with margin payment. This means that when you purchase a futures
contract, you do not have to pay the entire amount of the contract. You only need to pay a
specified margin amount. For instance, you could purchase a futures contract for
100 shares of IBM worth $102 per share at a 20% margin. This means that
instead of paying $10,200 (100 x $102), you need to pay only $2040 (20% of $10,200). This
offers substantial leverage to the investor.

Benefits of Trading Futures


Among the benefits of trading futures are:

High leverage
High liquidity
Low brokerage fees

Dangers of Trading Futures


The main risk involved in trading futures is that it is a highly speculative market.

Trading futures contracts


To trade futures you open an account with a futures brokerage firm known as a futures commission
merchant (FCM), who will execute and record your trades, and monitor and advise you of your margin
account obligations. You may deal with the FCM directly or go through an introducing broker (IB) or
commodity trading advisor (CTA). As with stocks and bonds, you pay commissions and fees to trade
futures.
You give your broker an order to buy or sell a futures contract, either to open a new position or to offset
and cancel an existing position. Your broker in turn transmits the order to the appropriate exchange
floor or electronic trading system.
You may also invest in futures through a commodity pool, which resembles a mutual fund. Your
investment is pooled with assets from other investors, and the commodity pool operator (CPO) trades
futures contracts using those funds. Or, you may work with a commodity trading adviser (CTA), to whom
you give authority to trade in your account. Both CPOs and CTAs are typically paid based on their
performance.
Trading in action
Traditionally, futures were traded using the open outcry auction method on exchange floors divided into
trading pits. Today, more and more trades are executed electronically, and trading in some commodities
is entirely electronic. On some exchanges, electronic trading systems operate alongside live trading. On
others, open outcry occurs during the day and e-trading on those commodities takes place during the
evening and overnight. Other exchanges are entirely electronic, with no trading floor at all.

Marking to market
Over their term and even throughout a typical trading day, futures
contracts change value. At the end of each trading day, the
exchange's clearinghouse will either credit your account with profits
or require you to add more money to bring your margin account up to
the appropriate level. This process is called daily cash settlement, or
marking to market.
Leverage magnifies
The ability to buy a futures contract with a good faith deposit or initial
margin of 10% or less of the underlying commodity's value appears
to give an investor a lot of buying power. The initial amount required
to open a futures position seems relatively small. For example, you
might buy a gold contract with the following terms:
Quantity 100 troy ounces
Delivery month February
Price in dollars per ounce $350
Minimum tick 10 cents per troy ounce, $10 per contract
For only a $3,500 initial margin, you would control a $35,000
investment in a futures contract for gold. If the price went up $50 to
$400 per ounce, the value of the futures contract would increase by
$5,000 to $40,000.
That increase represents a $1,500 paper gain on the initial margin of
$3,500. On the other hand, if the price dropped $50, the value of the
futures contract would drop $5,000 to $30,000, and you would have
to add $1,500 to your margin account to cover the loss in the
contract's value.
In a volatile market, leveraged investing magnifies the effect of price
changes.

Trading positions
There are two sides to every futures contract an investor who has a long position and an investor
with a short position. And investors in the futures market virtually always take both long and short
positions, as they buy or sell contracts to offset existing positions. So a typical investor will be a long in
some contracts and a short in others.
That's not the case in the stock market. A typical stock market investor takes a long position buying
stock to sell at a higher price at some future date. Selling short is a higher risk strategy that only a
percentage of stock investors employ, hoping to make money on stocks that are losing value. To sell
short, investors borrow shares they don't own and sell them. Then they wait for the price of the stock to
drop so they can buy the shares at the lower price to replace the borrowed shares (plus interest and
commission). The longer the price takes to drop, the higher the interest charges owed to the broker, and
the less profit possible.
In a futures contract, the short may buy an offsetting contract at any time before the expiration of the
contract term. Because the futures contract is a future obligation, nothing is borrowed and interest
penalties do not accrue.

Types of futures orders


When you place an order for a futures contract at the best price offered, the order is a market order.
The price at which it's executed may be several ticks away from what the price was when you placed

the order. So you won't know the price you paid until the order fulfillment is reported back to you.
Contingent orders
To solve the inherent uncertainty of a market order, you may also place restrictions on how an order is to
be filled. The most common contingent order is the limit order. A limit order places a restriction on the
price at which a contract may be bought or sold sell orders will be authorized only at or above the
limit price and buy orders will be authorized only at or below the limit price. Unless otherwise
indicated, a limit order is also a day order, so that if it has not been filled by the end of the trading day, it
expires. Good-til-canceled (GTC) or open orders, on the other hand, do not expire until they are filled
or cancelled.
There is a range of other contingent orders possible. Market-if-touched (MIT) or stop orders trigger
buying or selling if substantial market volatility sends prices in a certain direction. Market-on-close
(MOC) and market-on-open (MOO) orders stipulate buying or selling at the market's open or close.

How futures trading works


Most producers and users of commodities buy and sell them in the cash market, also called the spot
market, because the full cash price is paid on the spot. Cash prices are determined by supply and
demand, which in many cases move in predictable seasonal cycles. Fresh fruits and vegetables are
cheapest in the summer when they're plentiful (and most flavorful). So soup, juice, and jam
manufacturers plan their production season to take advantage of the highest-quality produce at the
lowest prices.
But supply and demand is also affected by unpredictable events. Drought might wipe out a wheat crop,
causing the cash price of wheat to soar. Political turmoil in the Gulf region might threaten the oil supply
and cause the cash price of energy commodities to rise. The futures market is designed to help protect
producers and users from just such price risks. Farmers, loggers, manufacturers, and bakers can buy
futures contracts in the products they produce or use to smooth out the unexpected price fluctuations.
Supply and demand, plus expectations
Futures prices tend to track cash prices closely, but not identically. The difference between the futures
contract price and the cash price of the underlying commodity is the basis. Futures prices are
determined not only by supply and demand, but also by traders' expectations of a host of other factors,
including weather changes, environmental conditions, political situations, and what the market will bear.

TYPES OF FUTURES TRADING CONTRACTS


There are mainly two types of futures trading contracts. They are futures contracts
which are traded for physical delivery, known as commodities and futures contract
which are end with a cash settlement, known as financial instruments. Both types of
futures contracts are traded electronically and directly.
Futures contracts which are traded for physical delivery includes agricultural
commodities like wheat, oats, sugar etc, energy products like crude oil, heating oil,
natural gas etc, or animals. Note that very commodity futures contracts actually end in
delivery. Often these contracts are traded just like shares of a stock market, according
to the changes in price trends. Online futures traders include both speculators and
hedgers.
Futures contracts which are traded for cash settlement involve treasury notes, bonds,

etc. These futures are also known as currency futures and are often traded just like
commodity futures though electronic platforms.

Financial futures are futures contract based on financial instruments such as


Treasury bonds, currencies and CDs. These underlying assets are contracted to be
bought at a specified price on a specified date. Financial futures may also involve
contracts on short term interest rates (STIR).

How are Financial Futures Traded?


Financial futures are highly standardized contracts that are traded in organized futures
exchanges across the world. The mode of trade is open outcry on the floor of these
exchanges. Examples include the International Money Market in Chicago and London
International Financial Futures Exchange (LIFFE) in London.
The contractual agreement stipulates the terms of the agreement such as the number
of units of the financial instrument, the names and details of the parties to the
contract, the futures price and the specified future delivery date. The transfer of profits
or losses accrues on the basis of the difference between the settlement price and the
financial futures price.
For instance, a buyer who purchases a June 3-month Eurodollar contract is
committing to deposit 1 million Eurodollars in June for 3 months. Additionally, the
deposit would be done at an interest rate that is agreed upon at the time of the
contract. The actual procedure, however, depends on the exchange in which the
trading is conducted. The movements of the price are tracked in terms of ticks,
which represent the minimal price fluctuations.
The buyers or sellers of the futures contract are required to deposit an initial amount
called the margins. This is deposited with the clearing house of the futures exchange.
This is a fixed amount which is held with the futures exchange till the position is held.

Benefits of Financial Futures


Financial futures are hedging instruments that can help realize high profits and protect
against risks. Moreover, financial futures offer the following:

High liquidity.
An opportunity to avoid the actual transfer of financial instruments.

Risks of Financial Futures


The risks associated with financial futures are:

High losses are possible if investors overtrade or trade without a plan.


Insider trading can be a problem in futures trading, which can harm the profit prospects
of other traders.

Investors with a high risk appetite tend to like financial futures and their potential for
short term profits.

Commodity futures aim to transfer risks associated with the ownership of a


commodity. The commodity may be anything, from wheat to a foreign currency. At
the time of the futures contract, the actual commodities do not physically change
hands. The contract is legally binding for the transfer of commodities at a future date,
which is specified at the time of entering into the contract. Also, at that moment itself,
the price at which the delivery would take place in the future, is decided.

How are Commodity Futures Traded?


Commodity futures trading are done in an organized futures market. Unlike other
investments such as stocks and bonds, trading in futures does not involve the actual
possession of the commodity. All an investor does is to speculate on the future
direction of the price of that commodity.
A well organized and efficient commodities futures market is acknowledged as
helpful for the price discovery of commodities that are traded in it. Such a market
facilitates the offsetting of transactions without actually impacting the physical goods.
When commodity futures contracts are traded with high leverage, they fall in the high
risk area and get close to speculation. However, such kind of trading can also be done
using low leverage to provide favorable payoffs. This technique would place futures
trading in the low risk spectrum.

Benefits of Commodity Futures

Through commodity futures trading, it is possible for investors to make huge profits
with limited capital. Sometimes it happens even in a short period of time.
Due to its features, the commodity futures market attracts hedgers since they can
minimize their risks. The market also encourages competition among the traders who have
the market information and price judgment.

Commodity Futures: Risks Involved


Often, some investors trade in commodity futures to get rich quickly. Such investors
are prone to losing money as they take big risks which might go against them. Trading
in commodity futures is risky if it is treated as merely a speculative market. It is
advisable for investors to exercise patience while making investing decisions.

What is a Currency Future?


Currency Futures are traded in the same manner as any other form of futures contract.
However, instead of dealing in a tangible product like pork bellies or wheat, the
exchange rate between two given currencies serves as the commodity for the
underlying contract.
There are two ways to settle a currency futures contract you can hold it until
maturity at which point you receive a cash settlement at the rate specified in the
contract, or you can buy and sell currency contracts prior to maturity on an
established exchange. There are several exchanges that specialize in currency futures
including the Chicago Mercantile Exchange (CME), Euronext, and the Tokyo
Financial Exchange to name a few of the larger currency futures trading centers. See
Settlement and Delivery of Currency Futures Contracts for more information how to
settle a currency future contract.

History of Currency Futures


Currency futures were introduced by the Chicago Mercantile Exchange (CME) after
the United States abandoned the Bretton Woods agreement in the early 1970s. Bretton
Woods was implemented after World War II and was intended to help European
countries devastated by years of warfare to rebuild their economies. The central
element of the Bretton Woods agreement was to tie the U.S. dollar to the value of gold
and then force other currencies to maintain their rates within a narrow operating band
of plus or minus one percent, in relation to the value of the U.S. dollar.
In 1971 in an attempt to deal with surging stagflation in the U.S. economy,
President Richard Nixon dropped the gold standard and devalued the U.S. dollar to
1/35th of an ounce of gold. This effectively ended the Bretton Woods restrictions
leading ultimately to a market-based valuation for individual currencies.
Investors soon saw an opportunity to speculate on exchange rate fluctuations, but
currency trading at the time was the exclusive domain of large banks. These
institutions operated in a closed, inter-bank market, forcing outsiders to pay high
service fees in order to conduct currency transactions.
CME traders eager for a market in which they could themselves trade currencies
challenged the banks by launching the International Monetary Market (IMM) in
December of 1971. Initially, the IMM trading facility offered currency futures in
seven different currency pairs, but the IMMs major contribution was that it created a
market for CME traders to deal in standardized contracts where traders could be
assured of high liquidity levels and a matching / clearing service to ensure that trades
were promptly executed. The IMM continues today as a division of the CME.

Pricing Currency Futures Contracts


Contract prices for currency futures are determined by the interest rate for the country
of origin for the currencies listed in the futures contract as well as the spot rates for
each currency. By incorporating the spot rates in the contract price calculation, the
ability to profit solely on arbitrage differences is eliminated as the contract price
moves in tandem with fluctuations in the spot rate of either currency.

Note: Arbitrage occurs when the same currency or commodity is listed on


more than one exchange at the same time. If the price changes on one
exchange but lags behind the other, an opportunity exists to profit on
the difference between the two exchanges this is known as arbitrage
trading.

For example, if the value of the Euro were to rise in the spot currency
market but the increase was not reflected in the futures market, an
arbitrage opportunity would result as the futures price would still be
based on the weaker Euro valuation. Traders could use this information
to buy futures contracts that, in effect, were priced on stale data. By
updating futures prices with changes in the spot market, the ability to
exploit market arbitrage is greatly reduced.

The following formula is used to set the price for a contract for a given currency pair:

F = S (1 + RQ x T) (1 + RB x T)
Where:

F = the price for the currency futures contract


S = the spot rate for the currency pair
RQ = the interest rate of the quote currency
RB = the interest rate of the base currency
T = the tenor or time to maturity (in days)

Because contract prices are determined i.e. derived from the underlying
currencies, currency futures are considered a derivatives product. Currency futures
contracts are similar to forward rate agreements (FRAs) and can also be used for
hedging and speculation purposes. However, unlike FRAs which are agreements
between two parties with terms as agreed to by both parties, currency futures have
standard maturity dates and are offered in fixed amounts only.

MINIMUM PRICE CHANGE


Price changes in currency futures are expressed as pips or somewhat less commonly,
as ticks. A pip short for percentage in point is the smallest unit of measure at
which the currency pair trades. For example, if the current exchange rate for
AUD/USD is quoted at 0.9750 and then moves to 0.9755, this is an increase of five
pips (0.9755 0.9750). In addition, note that this currency pair trades in $100,000
AUD lots, so with a leverage ratio of 1:100, this means that each pip is worth $10
AUD for each AUD / USD currency pair you hold ($100,000 x 0.0001 = $10.00).
Thus, a five-pip change is a $50 AUD swing in the price of one AUD / USD contract.
It is important to note however, that not all currency pairs are expressed to four
decimal places some like the USD / JPY pair for example, list only two decimal
places while others are expressed to three. Some brokers are even offering quote
spreads to five decimal places (known as fractional pips or pipettes). The important
thing to remember however, is that it is the last number whether it be two, four, or
five places after the decimal that represents a single pip for that currency pair.

MARK-TO-MARKET PRICE FIX


A Mark-to-market price fix is a theoretical valuation of all your open positions if they
were settled at the current market prices. At the end of each days trading, your
account will be marked-to-market to ensure that you are still within the margin limits
imposed by the exchange and your broker. See below for more information on margin
and margin-based lending.

MARGIN
There are two types of margin you need to know about prior to trading currency
futures. The first is initial margin this is the money you deposit in your trading
account to establish an account with your broker. If you incur losses and the amount
in your account falls below a certain threshold amount as mandated by the exchange
and your broker, you will then be required to deposit additional money this
threshold is known as maintenance or variation margin. If the balance in your account
falls below the required maintenance margin levels, your broker will notify you
through a margin call that you must bring your maintenance margin back to
compliance levels; failure to do so will result in your broker liquidating your holdings.
Buying on margin or leveraged buying allows you to submit trades for values
considerably more than the amount you have available in your account. To illustrate
the power of leveraged buying, consider a margin ratio of just 20:1 coupled with a
trading account containing $10,000. This means that you could trade amounts up to

$200,000 ($10,000 x 20) thus enabling you to secure greater profits on even small
price movements.
Of course, this can work against you as well. If you have committed all your available
cash to a trade and the value of the trade falls below your maintenance margin level,
you will receive a margin call requiring you to deposit additional margin to your
account.
For example, consider the following scenario where an investor intends to buy a
single USD / CAD currency futures contract:

USD / CAD currency futures contracts are listed in $100,000 CAD lots
One contract is currently valued at $0.9500 CAD per U.S. dollar, or
$95,000 USD
Initial margin required is 10% - therefore, you need at least $9,500
USD margin available in your account (lets assume that you have
exactly this amount available in your account)
Maintenance margin required by your broker is 7.5% - assuming that
you have no other transactions in your account, you need to maintain at
least $7,125 USD in your account in either cash or marked-to-market
value

Based on this information, if the single dollar price moves up to 0.9550 CAD per U.S.
dollar a gain of fifty pips the value of the single contract is now worth $500 more
than you paid. You can calculate this in one of two ways:

1. A single CAD pip is equal to $10 CAD per contract therefore, 50 pips x
$10 = $500, or
2. 0.0050 (fifty pips) x $100,000 CAD = $500 CAD
How about if instead of gaining fifty pips, you lose 300 pips? again, we are
assuming that you have only one order in your account:

1. 300 pips x $10 CAD = ($3,000 CAD) remember this is a loss. You can
also calculate in this manner 2. 0.0300 (300 pips) x $100,000 = ($3,000 CAD)
When your broker performs the mark-to-market evaluation and takes into account this
loss, your available margin will fall from $9,500 to $6,500 CAD. This is obviously

below the $7,125 USD threshold you are required to maintain so this will trigger a
margin call from your broker requesting you to deposit sufficient funds to bring your
account back to compliance.

SETTLEMENT AND DELIVERY OF CURRENCY FUTURES CONTRACTS


Because currency futures are based on the exchange rate between two currencies, no
physical underlying commodity exists. With a wheat futures for example, the contract
holder does have the option to take physical delivery of the wheat, although physical
delivery is quite rare as most commodity futures are settled in cash taking this
concept one step further, currency futures are always settled in cash.
Like most forms of futures trading, there are two types of investors hedgers looking
to protect a future transfer of funds, and speculators looking to profit on fluctuations
in the price of the contract.
Individuals and firms that have either a future payment due or expect to receive a
future payment, may use currency futures to look in a rate if they have concerns that
interest rate changes prior to the payment date could move against them. In other
words, by buying currency futures contracts, hedgers want to make sure that a change
in exchange rates wont cause them to receive less if they expect a future payment, or
cause them to pay more if making a future payment. See Hedging with Currency
Futures for more information.
Speculators on the other hand, are not interested in holding a currency futures contract
until it matures. These investors are looking to profit on fluctuations in the contract
price and may sell and buy several positions a day (so-called day traders). Unlike
hedgers that have a large transfer of funds due in the future, speculators, through the
buying power of margin, move in and out of contract positions continuously and
rarely hold any single contract for an extended period of time.
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What are the risks of trading in Currency Futures?


Trading in Currency futures or forex trading comes with high levels of risk. Even a small adverse
fluctuation in the exchange rate may result in loss of the entire deposit of someone trading in currency.
Only people having an in-depth knowledge of the working of this market or have done a thorough
homework about the risks involved are advised to trade in this market.

Easy to own underlying commodity or stock.


No need for holding/storing the underlying commodity or equity.
Standardized contracts guarantee the quality and quantity of underlying
product.
Reasonable market liquidity available for all major futures types.
Instant execution of market orders.
Availability of both standard and mini contracts helps traders to choose;
especially with modest accounts.
Availability of around the clock electronic trading services.
Futures trading usually includes simple and reasonably low commission fees
and plans.
By using futures contracts, traders can maximize profit or limit risk on trading
other funds, equities or commodities

Advantages and disadvantages


To summarize the aforementioned information, we can conclude that the following
advantages and disadvantages accompany trading in futures contracts.

Advantages

Standardization of contracts' parameters on a developed market leads to high


liquidity.
The leverage effect permits achieving disproportionately greater gains using
a limited amount of invested funds and in the absence of financing costs, as
opposed to classic margin trading.
With futures contracts, it is possible to open short as well as long positions in
the same manner and at the same costs.
If permitted by the respective exchange, there is a choice of several methods
for closing a position.
Daily settlement of gains and losses provides for regular realization of gains,
which the investors may utilize.

Disadvantages

The leverage effect works in both directions and, therefore, makes trading in
futures contracts highly risky.
Daily settlement of gains and losses provides for regular realization of losses,
for which reason an investor must have a sufficient reserve so that his or her
position will not be closed involuntarily.
Futures contracts involve the same risks as may be potentially involved in
other investment instruments, such as market and currency risks.