Mechanics of buying and selling foreign currency future
Foreign Exchange Futures:
Let us assume that in January an importing firm requires Swiss Franc 125,000 in three-month time. It purchases a SF12500 future contract through a broker at the rate of SF1 = $0.6600. the contract’s current value would be ($0.66SF SF125000) U.S, $82500. It would deposit a cash margin of U.S. $2000. The value of the contract would fluctuate daily, based on the movements of the exchange rate as determined in the market.
If the Swiss Franc rises in value relative to the dollar in the international foreign exchange markets, the futures price on the exchange would move in accordance with the movement of the exchange rate. If the price of the Swiss Franc for delivery in March appreciates from $0.6600 to $0.6650/SF, within the daily fluctuation permitted by the rules of the exchange, as a result, the value of the SF 125000 contract will now be $83125 i.e. $625 higher than the initial price of $82,500.
The counter-party who sold the contract to the importer would have to spend $83125 to purchase the Francs to deliver under the contract. Accordingly, he will be required to pay $625 into his margin account. The broker makes payments to the exchange, which, through the clearing-house, will find its ways to the broker who arranged the futures contracts for the American importing firm. Such settlements occur daily, based on price movements as the contract progress to maturity.
Assuming further that the Swiss franc appreciates to $.07500/SF on the international foreign exchange spot market at maturity, the importing firm has two choices:
- It can ask the seller of the contract to deliver SF125000 against payment of U.S.82500, the price contracted for in January
- It can “liquidate” the contract on the last trading day, by obtaining from the broker the deposit $2000 less the fixed rate commission, plus the $11250 the broker has collected from the seller as the value of the contract appreciated.
The importing company then purchases SF125000 from the spot market at the current cost of $93750, which is greater than the price of $82500 prevailing in January by $ by $11,250. This increase in cost matches the amount received from re-sale of the futures contract ($93750-82500= 11,250).
By using a futures contracts, in the way, the importing firm has protected itself from a possible loss arising from an adverse movement in the exchange rate somewhat in the manner of booking a forward purchase contract.
However, two market limitations of the futures contract should be noted. Firstly, the exact amount needed by the importer or exporter cannot be met by a futures contract as it is only available in standardized amounts.
Secondly, the importing firm would not be able to obtain the exact forward maturity in a futures contract. The futures contract has a standardized delivery date.
However, since such futures positions are in nearly all cases liquidated by an offsetting sale or purchase rather than being settled through the exchange delivery procedures, the absence of an exact maturity matching date is not usually a significant handicap.
To sum up, the basic functions performed by the futures market are somewhat similar to those provided by the forward market. The futures market in fact complements the forward market in several important aspects. Particularly, the futures market provides a more standardized, easily liquidated contract designed to meet the needs of the small business units, and speculators as well as large-scale corporations which are willing to bear the degree of exchange rate risk that could be eliminated by the tailor-made contracts of the forward market.