Currency Futures and Option Markets

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CHAPTER 7: CURRENCY FUTURES AND OPTION MARKETS
7.1 FUTURE CONTRACTS
7.1.1 Definition of future contract–> contracts written requiring a standard quantity of an available currency at a fixed exchange rate and at a set delivery date. A future contract is defined as a contractual agreement to buy or sell an asset at a pre-determined price in the future. The contracts detail the quality and quantity of the underlying asset. Background of currency futures in 1972: Chicago Mercantile Exchange (CME) opens International Monetary Market (IMM) CME began with grain and commodities future contracts more than a hundred years ago. 7.1.2 The International Monetary Market (IMM) provides:

a) An outlet for hedging currency risk with future contracts (* explanation of hedging next page) b) Definition of future contracts (above)
c) Main available futures currencies
* EUR (Euro)- CHF (Swiss Franc)
* GBP (Britain Pound)- BRL (Brazilian Real)
* CAD (Canadian Dollar)- AUD (Australian Dollar)
* JPY(Japanese Yen)- NZD (New Zealand Dollar)
d) Standard contract sizes contract sizes differ for each of the available currencies. For example:
EUR = 125.000
GBP = 62.500
e) Transaction costs : payment of commission to a trader f) Leverage is high the initial margin is required is relatively low, for example, less than 0, 2% of sterling contract value) g) Minimum price movements contracts set to a daily price limit restricting maximum daily price movements. If limit is reached, a margin call may be necessary to maintain a minimum margin. h) Global future exchanges that are competitors to the IMM: * DTB – Deutsche Termin Börse

* LIFFE – London International Financial Futures Exchange * CBOT – Chicago Board of Trade
* SIMEX – Singapore International Monetary Exchange * HKFE – Hong Kong Futures Exchange
* NYMEX – New York Mercantile Exchange
*Hedging making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. An example of a hedge would if you owned a stock, then sold a futures contract stating that you will sell your stick at a set price, therefore avoiding market fluctuations. Investors use this strategy when they are usure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge)

7.1.3 Forward versus Future contracts (basic differences)
A forward contract is a non-standardized contract between two parties to buy or sell an asset at a specific future time at a price agreed up on today. 1. Trading locations
2. Regulations
3. Frequency of delivery
4. Size of contract
5. Delivery dates
6. Settlement date
7. Quotes
8. Transaction costs
9. Margins
10. Credit risk

7.1.4 Advantages and disadvantages of future contracts
ADVANTAGES| DISADVANTAGES|
Smaller contract size| Limited to some currencies|
Easy liquidation| Limited dates of delivery|
Well-organized and stable market| Rigid contract sizes|

7.2 CURRENCY OPTIONS
7.2.1. Definitions of currency options they offer another method to hedge exchange rate risk. It was first offered on Philadelphia Exchange (PHLX) in 1983. It is the fastest growing segment of the hedge markets. Currency options are now traded on the united currency options market (UCOM). “a contract from a writer (the seller) that gives the right but not the obligation to the holder (the buyer) to buy (a call) or sell (a put) a standard amount of an available currency at a fixed exchange rate for a fixed time period” Currency option is a contract that grants the holder the right, but not the obligation to buy or sell currency at a specified exchange rate during a specified period of time. For this right a premium is paid to the broker, which will vary depending on the...
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