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We now look beyond the spot market and examine how private investors can deal in foreign exchange in the futures and options markets and through Contracts for Difference (CFDs).

Derivatives are financial instruments that “derive” their value from underlying assets like shares, market indices, bonds, interest rates and, of course, currencies. They are important instruments for speculation and hedging of risk, and enable investors to dabble in financial commodities without necessarily having to own them.

FORWARDS AND FUTURES

1. Forward v futures

Forwards and futures contracts are both agreements to buy or sell a quantity of a financial or physical commodity (known as the underlying asset) at given price, on a specific future date.

• A forward contract is a private over-the-counter transaction between counterparties known to each other, on terms agreed between themselves.
• A futures contract is a forward contract that is traded on a public exchange like the International Money Market (IMM) division of the Chicago Mercantile Exchange (CME), the New York Board of Trade (NYBOT) and Finex, its Dublin-based division. Private investors transact through brokers who are members of the exchange, but the counterparties will not be known to one another

A futures contract will have standardised features (e.g. units of trading, delivery and settlement dates, minimum price increments etc.). The futures exchange itself acts as a counterparty through the provision of clearance and settlement facilities to safeguard the interests of the parties.

Futures and forward contracts are binding on both parties at expiry, where one party receives and the other delivers. However, investors can buy or sell back their contracts before expiry at the prevailing offer and bid prices respectively.

1.1 Advantages

Forwards and futures have a vital role in the mitigation of currency risk. The main beneficiaries are international corporations who use them to hedge against adverse changes in exchange rates that affect the profitability of projects.

For example, a European manufacturer importing raw materials priced in US dollars would suffer a financial loss if the euro fell against the US dollar. Likewise, a conspicuously-consuming British importer of a luxury European car would be severely out of pocket if sterling were to fall against the euro before payment. Both would benefit from buying their respective US dollars and euros in advance at guaranteed exchange rates.

Private investors might also take a purely speculative interest in currency forwards and futures. Investors would be attracted by the ability to profit in both rising and falling market, by the opportunity to leverage profits through margin trading and the ability to close out contracts before delivery.

1.2 Pricing forwards and futures

Because a forward or futures contract involves the delivery and the settlement of a currency trade in the future, the forward/futures and spot exchange rates will be numerically different, albeit related to one another.

The relationship between the spot and the forward/futures rate is determined by the difference in the rates of interest earned on the respective currencies in the pair (the net “cost of carry”). The “fair” price is the rate that prevents an investor from making a riskless profit by “round tripping” and exploiting the interest rate differential.

Assume that a private investor has 100,000 USD. He has a choice of (a) putting it on deposit at 1.25% p.a. for 3 months or (b) converting it into GBP, investing it at 4% p.a. for 3 months and simultaneously entering into a forward or futures contract for delivery and settlement in 3 months.

If the spot and the forward/futures rates are the same, then our investor could: -

• Borrow USD at 1.5% for 3 months
• Sell USD for GBP at the spot rate
• Enter into a forward/futures contract to buy back USD for GBP at the same rate
• Invest the GBP at 4% p.a. for 3 months
• Buy back the USD with sterling after 3 months and repay the USD loan
• Pocket a riskless profit roughly equal to the interest differential over 3 months.

Generally speaking, the forward and futures exchange rate should trade at a discount to the spot rate for the currency with a positive interest rate differential For example, GBP/USD futures should trade at a discount to GBP/USD spot where sterling base rate is, say, 4% vis-a-vis USD base at 1.25%. Conversely, USD/GBP futures should trade at a premium to USD/GBP spot.

1.3 Risk

Since the currency futures rates are related to spot rates by the cost of carriage, it follows that the risks are comparable.

The same range of stop loss, limit and OCO orders are available for the control of risk in the futures market as in the spot market (Refer to the relevant section of The Spot Market in Part I.)