These are the markets that were “derived” from other markets. The first financial future contracts were derived from the foreign exchange market. A financial future contract is a contract to deliver or take delivery of a financial instrument at a future date. In some cases where delivery is difficult, the contract may be settled by cash payment. The main attraction of future in risk management is there leverage or gearing (in UK terminology). Suppose a trader who wants to back his judgement on the outlook for interest rates or currencies; then the essential difference to him between doing this in futures market and doing this in cash market is that in the futures market one can trade on margin. This margin/leverage lets the speculator make large profits compared with the amount of margin committed. This leverage works both ways making it possible to loose more money than originally invested. Because of this, prices are marked to market on a daily basis by the exchanges. Thus if the price moves against the investor his margin account below the prescribed “maintenance level” additional margin must be deposited to bring it back to the initial margin level. It is the margin call system which has generally protected the exchanges and their member firms from losses via the investor’s default.
The traditional forward exchange contract created by banks provide good protection against exchange rate fluctuation risk at minimum cost for many participants in international trade and investment. However, access to the forward market is limited to those customers who have regular relationship with banks and who have bonafide commercial need for forward exchange contracts.
Participants for non-trade purpose or for speculative purpose are excluded from such market. To meet the demand of this latter segment the Chicago Mercantile Exchange (CME) introduced the concept of “future market” by establishing the international monetary market. Trading in future contracts in foreign exchange commenced in May 1972. The IMM was conceived as an extension to the already well-established commodity future market in commodities such as corn, wheat etc., which were bought and sold in specific quantities for delivery at specified futures dates.
Trading on the IMM has expanded rapidly since the exchange rates of major currencies were allowed to float freely in early 1973 after the collapse of the Smithsonian system. The subsequent area of volatile exchange rates contributed to the continued success of the financial futures market. Early players were the European options exchange in Amsterdam and the London international financial futures exchange (LIFFE set up in 1982 which later merged with the stock exchange’s London traded options market in 1991 to form the London derivatives exchange).
Currency futures are standardized contracts that trade like conventional futures on the floor of a future exchange. The financial futures market deals in the futures contract. The futures contract provides for the future delivery of a specified amount of foreign currency at a particular date, time, and at designated price. Fulfillment of the contract depends on whether one is a buyer or seller and is satisfied by accepting or delivering the specified currency on the valve date of the contract. A buy or sell position can also be closed out by entering into an offsetting purchase or sale of an equivalent contract prior to the expiry of trading for the contract.
Users of Future Market
Both “hedgers” and “speculators” participate in the future market. Foreign exchange hedgers consist of banks, multinational corporations and other commercial and financial firms that require protection against adverse exchange rate movements. The hedger obtains his profit from managerial skills in conducting his business activities and not from the incidental fluctuations in exchange rates. The hedger uses the futures market as management tool for fixing the exchange rates that affect his import, export or investment activities. The hedger relies on the foreign currency futures contract as an insurance against adverse fluctuation in exchange rates.
Often, the counter party is a speculator. The speculator plays a vital role in the futures market. He assumes the risk of the hedger. The speculator buys and sells contracts with a view to profiting from exchange rate fluctuations.