T2W Trading Community

2. Practical futures trading

We can now look at some examples of forwards/ futures trading. The basic principles are the same for forwards and futures.

With a futures or forward contract, the rate you pay is related to the spot rate by the net interest differential on the currency pair. For a forward contract, that is the end of the matter, save only for receipt and delivery at the future date. With futures contracts, the exchange will declare an exchange delivery settlement price at expiry.

The future and forward rate will converge towards the spot rate as the contract approaches expiry, as the net cost of carry decreases towards zero over time. If investors want to close out before expiry, they can do so at the prevailing bid or offer price.

2.1 Speculating on a rise

Assume that GBP/USD = 1.5847/52 (spot). If the US base rate is 1.25% p.a. and UK base is 4% p.a.

• You think that the GBP/USD rate will rise over the next 3 months, so you buy 2 futures contracts on the CME International Money Market (IMM) through your UK margin broker. The standard unit of trading for sterling is 62,500 GBP.
• The GBP/USD futures rate with 90 days to delivery should be about 1.5741/46
• The value of your purchase is:

  2 X 62,500 X 1.5746 = 196,825 USD

• You don’t have to pay all of this up front. Your margin will be determined by the IMM minimum plus any supplement charged by your broker.

• As expiry approaches, the spot and futures prices converge. Let us say that the settlement price turns out to be 1.6100. Your gain will be:-

  (1.6100 – 1.5746) X 62,500 X 2 = 4,425 USD

• Had the settlement price been 1.5650, your loss would have been:-

  (1.5746 – 1.5650) X 62,500 X 2 = 1,200 USD

2.2 Insuring against a fall (hedging)

You are the finance director of a British manufacturer that has just negotiated a purchase of raw materials to be delivered and paid for in US dollars 90 days hence. At the time of closing the deal, the GBP/USD spot rate is 1.5847/52. The contract is worth 500,000 USD or 315,517 BP at the bid spot rate.

• You fear that the deal could be unprofitable if sterling falls, so you decide to enter into a forward contract to sell GSB/USD for receipt and delivery 90 days hence.

• The 90-day forward rate for GBP/USD is, say, 1.5741/46. You buy sell 317,642 GBP at the bid rate, i.e.

  317,642 GBP X 1.5741 = 500,000 USD

  

  This represents an “insurance premium” of (317,642 – 315,517) = 2,125 GBP

• Your fears turn out to well founded. Spot GBP/USD falls to 1.5219/24 thirty days later and the forward GBP/USD rate falls to, say, 1.5151/56 at the end of 90 days. Had you not hedged, the consignment of raw materials would have cost the company £328,537 (13,020 GBP more).

• You have saved the company 13,020 – 2,125 = 10,895 GBP. You are tipped for higher things.

• Had GBP/USD spot risen to say 1.6100/06 after 30 days, the cost of the raw materials would have fallen to 310,559 GBP. Had you done nothing, the company would have saved 4,958. Instead, the company has paid 317,642 GBP, a difference of 7,083 GBP.

• You are demoted to internal auditor. That’s insurance, kid.

2.3 Closing out before delivery

GBP/USD spot is trading at 1.5847/52. You feel that the rate will rise over the next 90 days and buy a futures contract for 1.5746 valued at: -

62,500 X 1.5746 = 98,412

After 30 days, spot has risen to 1.6100/06 and the futures rate has risen to 1.6028/34. If I were to close out now I would earn: -

62,500 X 1.6028 = 100,175 USD, a profit of 1,763 USD or 1,095 GBP when converted back at the spot offer rate.

Had GBP/USD spot fallen to 1.5219/24 after 30 days, the futures rate would have been, say 1.5156/62. Had you closed out, you would have lost: -

62,500 X 1.5156 = 94,725 USD, a loss of 3,687 USD or 2,432 GBP when converted back.