What are Currency Futures?
A currency futures contract is a contract that allows market participants to trade the underlying exchange rate for a period of time in the future. Currency futures are agreements between two counterparties where one counterparty buys (longs) the underlying exchange rate and the other sells (shorts) the underlying exchange rate on a specified future date. The underlying instrument of a currency future contract is the rate of exchange between one unit of foreign currency and the South African Rand.
Currency futures are contracts that allow participants to take a view on the movement of the exchange rate as well as hedge against currency risk. Currency futures will be used as a trading, speculating and hedging tool by all interested participants.
Currency Futures Contracts Offered
YieldX offers the following currency futures contracts:
-Dollar/Rand
-Euro/Rand
-Sterling/Rand
-Australian Dollar/Rand
Currency risk
Currency risk or foreign exchange exposure is the exposure to an unfavourable movement in a currency or exchange rate. Investors importing goods from abroad or exporting goods abroad and transacting in foreign currency or the investor's home currency are susceptible to changes in the exchange rate and, as a result, this changes the expected income. Individuals travelling overseas are also subject to exchange rate fluctuations and the weakening of their home currency to the foreign currency in the country that they are visiting. Theoretically, currency risk is the combination of transaction, translation, economic and political exposure.
Transaction exposure refers to cash flow exposure. This is the currency risk a firm has to face when expecting to receive or pay a fixed amount of foreign currency in the future as these cash flows will be revalued in the case of a change in exchange rates. Translation exposure, also known as accounting exposure, is the degree to which exchange rate fluctuations affect a multinational parent company's book value when financial statements of the company's global operations are consolidated and stated in the parent company's home currency.
Economic exposure, also called operating exposure, measures the change in a company's expected operating cash flows as well as the market value of the company due to a change in exchange rates. Economic exposure can affect either the company's profitability or market share by hampering its competitive position in a particular market.
Political exposure refers to changes in an exchange rate value caused by political actions undertaken by a country's government. Examples of political risk include government imposing changes in tax laws and exchange control regulations, both of which will have an effect on the exchange rate of that country's currency compared to other currencies.
Factors that influence exchange rates
An exchange rate between two countries is determined by demand and supply of the relevant two currencies, which is influenced by economic factors including, among many others, the flow of imports and exports, the flow of capital and relative inflation rates. One factor affecting an exchange rate is the merchandise trade balance. By definition, the merchandise trade balance is the net difference between the value of merchandise being exported and imported into a particular country.
For example, consider the exchange rate for USD/ZAR. South Africa (SA) imports products from the U.S. To pay for them, South Africans need US Dollars; therefore, the SA companies trade SA Rand for US Dollars. On the other hand, because Americans desire SA goods, they purchase SA Rands. The net effect is an increase in the supply of US Dollars and SA Rands.
The SA demand for American goods and services contributes to the demand for US Dollars while American purchases of SA goods and services contribute to the demand of SARands. In this case, the net difference between SA purchases of American goods, and American purchases of SA goods, is the merchandise trade balance between the two countries. If the SA demand for American goods is higher than the American demand for SA goods, the demand forUSDollars is higher than the demand of SA Rands. As a result the US Dollar would appreciate against the SARand. The flow of funds between countries to pay for stocks and bonds purchases also contributes to the exchange rate movements. In the near term, these capital flows are greatly influenced by yield or interest differentials. This is known as interest rate parity, which holds that the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.
Over the long run, the spot exchange adjusts to reflect the difference in interest rates between the two countries. All else being equal, the higher the yield on SA securities compared to American securities, the more attractive SA securities are relative to American securities. An increase in SA yields would tend to raise the flow of U.S. Dollars into SA securities as well as decrease the outflow of Rands to American securities.
Combined, this increased flow of funds into SA would lower the value of the U.S. Dollar and increase the value of the Rand, therefore, the SA Rand to U.S. Dollar ("ZARUSD") ratio, as it is represented in the forex market, would increase, hence you would need more Dollars to buy one SARand. The rate of inflation is another factor influencing currency exchange rates. Inflation occurs when the rate of money growth in an economy is higher than the rate of growth in real GDP, hence more money is chasing fewer goods, and this in turn drives up the prices of these goods. Since exchange rates are an expression of one unit of a currency in terms of another, inflation essentially changes the relative value of this relation. For example, if SA is experiencing higher inflation than US then the USD/ZAR ratio increases to represent the increased value of Dollars relative to SA Rand. Or seen in another way, one Rand will now buy less Dollars. This fact is rooted in the concept of a purchasing power parity, which holds that, over the long run, the exchange rate adjusts to reflect the difference in price levels between countries, a given item will thus in theory have the same price in two countries adjusted by the prevailing exchange rate.
Market participants
There are four categories of participants in the currency derivatives market:
-Hedgers
-Arbitrageurs
-Investors
-Speculators
Hedgers use currency futures to protect an existing portfolio (or an anticipated investment) against possible adverse currency movements. Hedgers therefore seek to reduce risk. Hedgers have a real interest in the underlying currency and use futures as a way of preserving their performance.
Arbitrageurs profit from price differentials of similar products in different markets, e.g. price differentials between the spot exchange rate and futures price.
Investors use currency futures to enhance the long-term performance of a portfolio of assets.
Speculators use currency futures in hopes of making a profit on short-term movements in prices. Speculators therefore seek to enhance risk with the aim of making a profit. Speculators have no interest in the underlying currency other than taking a view on the future direction of the currency's price.
A successful and efficient market is made up of a healthy balance of the abovementioned participants.
Expiry months and date
The expiry months specified for foreign currency futures contracts are March, June, September and December. All currency futures contracts expire two business days prior to the third Wednesday of the expiry month or, if that day is not a business day, then the previous business day.
Settlement
The foreign currency futures contracts are cash settled in Rand. In other words, no physical delivery of the underlying currency will ever take place. Contracts are automatically closed out on Expiry
All contracts that have not been closed out or rolled over before expiry will go through the expiration process. All contracts held on expiry will be automatically closed out by the exchange. The investor will receive a final variation margin flow which is calculated using the final or closing currency future price and the previous day's closing price. The exchange charges trading fees for all contracts that expire.
How to roll over a position
All investors who wish to hold their positions beyond the expiry date will be required to roll their positions over into the next expiry date. In other words all investors holding a December contract will need to roll their position into the March contract. Investors will need to close out their positions (as explained) and subsequently enter into the next contract expiry. In other words, if an investor was long a December contract, the investor would have to short the December contract and subsequently enter into a long March contract. The benefit to the investor is that the same exposure is maintained. The exchange offers discounted trade fees for all positions that are rolled over.
Risk of trading Currency Futures
No investment or trading product can offer returns without the investor having to assume some risk. The main risk associated with currency futures trading is attributable to the effect that gearing or leverage has on a position. A geared transaction is simply 'the deposit of a smaller amount of cash, but being exposed to the full value of the transaction'. Investors deposit the 'initial margin amount' but are exposed to the full nominal value of the contracts traded. Gearing can cause significant profits or losses on a currency future position in a short period of time because of the effect of any movement in the underlying currency. The profits and losses on the underlying currency can be up to ten times more than on the future. Assume an investor is long the Dollar/Rand futures contract. This investor thus starts to lose money if the Dollar weakens.
Hedging
Currency futures can be used to hedge against currency risk. Currency hedging refers to the elimination of currency risk by entering into an equal but opposite position which responds to a change in the exchange rate in the opposite manner to the position being hedged. Participants would enter in a long currency futures position in order to protect themselves against depreciation in local currency i.e. ZAR weakening. These investors may have a payment, quoted in a foreign currency, expected in three months time, and are thus exposed to an increase in the exchange rate, i.e. an appreciation of the foreign currency (given the exchange rate is quoted in the home currency per one unit of foreign currency).
Depreciation in local currency escalates the cost of foreign goods in local currency terms, resulting in reduced margins.The long futures position provides the hedge against the weakening local currency such that losses incurred from purchasing foreign currency at unfavourable level in spot is offset by the gains on the futures contract. Short currency future investors enter into currency futures contracts to eliminate local currency appreciation. These investors may have foreign currency receivables expected in three months time and are thus exposed to local currency appreciation (local currency strengthening), i.e. a depreciation of the foreign currency. Local currency appreciation results in less revenue received for the sale of foreign currency. The short futures position provides the hedge against local currency appreciation such that losses incurred from selling foreign currency at spot is offset by the gains on the futures contract.
Speculating
Speculators are directly opposite to hedgers. Where hedgers try to eliminate risk, speculators want to increase risk in the hope that they will make a short term profit. Speculators enter into currency futures contracts in order to take a view on the movement of the underlying exchange rate. Speculators that view the spot exchange rate to increase (local currency depreciation) will go long a currency futures contract.
Speculators that view the spot exchange rate to decrease (local currency appreciation) will go short a currency futures contract.
What are Currency Futures?
A currency futures contract is a contract that allows market participants to trade the underlying exchange rate for a period of time in the future. Currency futures are agreements between two counterparties where one counterparty buys (longs) the underlying exchange rate and the other sells (shorts) the underlying exchange rate on a specified future date. The underlying instrument of a currency future contract is the rate of exchange between one unit of foreign currency and the South African Rand.
Currency futures are contracts that allow participants to take a view on the movement of the exchange rate as well as hedge against currency risk. Currency futures will be used as a trading, speculating and hedging tool by all interested participants.
Currency Futures Contracts Offered
YieldX offers the following currency futures contracts:
-Dollar/Rand
-Euro/Rand
-Sterling/Rand
-Australian Dollar/Rand
Currency risk
Currency risk or foreign exchange exposure is the exposure to an unfavourable movement in a currency or exchange rate. Investors importing goods from abroad or exporting goods abroad and transacting in foreign currency or the investor's home currency are susceptible to changes in the exchange rate and, as a result, this changes the expected income. Individuals travelling overseas are also subject to exchange rate fluctuations and the weakening of their home currency to the foreign currency in the country that they are visiting. Theoretically, currency risk is the combination of transaction, translation, economic and political exposure.
Transaction exposure refers to cash flow exposure. This is the currency risk a firm has to face when expecting to receive or pay a fixed amount of foreign currency in the future as these cash flows will be revalued in the case of a change in exchange rates. Translation exposure, also known as accounting exposure, is the degree to which exchange rate fluctuations affect a multinational parent company's book value when financial statements of the company's global operations are consolidated and stated in the parent company's home currency.
Economic exposure, also called operating exposure, measures the change in a company's expected operating cash flows as well as the market value of the company due to a change in exchange rates. Economic exposure can affect either the company's profitability or market share by hampering its competitive position in a particular market.
Political exposure refers to changes in an exchange rate value caused by political actions undertaken by a country's government. Examples of political risk include government imposing changes in tax laws and exchange control regulations, both of which will have an effect on the exchange rate of that country's currency compared to other currencies.
Factors that influence exchange rates
An exchange rate between two countries is determined by demand and supply of the relevant two currencies, which is influenced by economic factors including, among many others, the flow of imports and exports, the flow of capital and relative inflation rates. One factor affecting an exchange rate is the merchandise trade balance. By definition, the merchandise trade balance is the net difference between the value of merchandise being exported and imported into a particular country.
For example, consider the exchange rate for USD/ZAR. South Africa (SA) imports products from the U.S. To pay for them, South Africans need US Dollars; therefore, the SA companies trade SA Rand for US Dollars. On the other hand, because Americans desire SA goods, they purchase SA Rands. The net effect is an increase in the supply of US Dollars and SA Rands.
The SA demand for American goods and services contributes to the demand for US Dollars while American purchases of SA goods and services contribute to the demand of SARands. In this case, the net difference between SA purchases of American goods, and American purchases of SA goods, is the merchandise trade balance between the two countries. If the SA demand for American goods is higher than the American demand for SA goods, the demand forUSDollars is higher than the demand of SA Rands. As a result the US Dollar would appreciate against the SARand. The flow of funds between countries to pay for stocks and bonds purchases also contributes to the exchange rate movements. In the near term, these capital flows are greatly influenced by yield or interest differentials. This is known as interest rate parity, which holds that the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.
Over the long run, the spot exchange adjusts to reflect the difference in interest rates between the two countries. All else being equal, the higher the yield on SA securities compared to American securities, the more attractive SA securities are relative to American securities. An increase in SA yields would tend to raise the flow of U.S. Dollars into SA securities as well as decrease the outflow of Rands to American securities.
Combined, this increased flow of funds into SA would lower the value of the U.S. Dollar and increase the value of the Rand, therefore, the SA Rand to U.S. Dollar ("ZARUSD") ratio, as it is represented in the forex market, would increase, hence you would need more Dollars to buy one SARand. The rate of inflation is another factor influencing currency exchange rates. Inflation occurs when the rate of money growth in an economy is higher than the rate of growth in real GDP, hence more money is chasing fewer goods, and this in turn drives up the prices of these goods. Since exchange rates are an expression of one unit of a currency in terms of another, inflation essentially changes the relative value of this relation. For example, if SA is experiencing higher inflation than US then the USD/ZAR ratio increases to represent the increased value of Dollars relative to SA Rand. Or seen in another way, one Rand will now buy less Dollars. This fact is rooted in the concept of a purchasing power parity, which holds that, over the long run, the exchange rate adjusts to reflect the difference in price levels between countries, a given item will thus in theory have the same price in two countries adjusted by the prevailing exchange rate.
Market participants
There are four categories of participants in the currency derivatives market:
-Hedgers
-Arbitrageurs
-Investors
-Speculators
Hedgers use currency futures to protect an existing portfolio (or an anticipated investment) against possible adverse currency movements. Hedgers therefore seek to reduce risk. Hedgers have a real interest in the underlying currency and use futures as a way of preserving their performance.
Arbitrageurs profit from price differentials of similar products in different markets, e.g. price differentials between the spot exchange rate and futures price.
Investors use currency futures to enhance the long-term performance of a portfolio of assets.
Speculators use currency futures in hopes of making a profit on short-term movements in prices. Speculators therefore seek to enhance risk with the aim of making a profit. Speculators have no interest in the underlying currency other than taking a view on the future direction of the currency's price.
A successful and efficient market is made up of a healthy balance of the abovementioned participants.
Expiry months and date
The expiry months specified for foreign currency futures contracts are March, June, September and December. All currency futures contracts expire two business days prior to the third Wednesday of the expiry month or, if that day is not a business day, then the previous business day.
Settlement
The foreign currency futures contracts are cash settled in Rand. In other words, no physical delivery of the underlying currency will ever take place. Contracts are automatically closed out on Expiry
All contracts that have not been closed out or rolled over before expiry will go through the expiration process. All contracts held on expiry will be automatically closed out by the exchange. The investor will receive a final variation margin flow which is calculated using the final or closing currency future price and the previous day's closing price. The exchange charges trading fees for all contracts that expire.
How to roll over a position
All investors who wish to hold their positions beyond the expiry date will be required to roll their positions over into the next expiry date. In other words all investors holding a December contract will need to roll their position into the March contract. Investors will need to close out their positions (as explained) and subsequently enter into the next contract expiry. In other words, if an investor was long a December contract, the investor would have to short the December contract and subsequently enter into a long March contract. The benefit to the investor is that the same exposure is maintained. The exchange offers discounted trade fees for all positions that are rolled over.
Risk of trading Currency Futures
No investment or trading product can offer returns without the investor having to assume some risk. The main risk associated with currency futures trading is attributable to the effect that gearing or leverage has on a position. A geared transaction is simply 'the deposit of a smaller amount of cash, but being exposed to the full value of the transaction'. Investors deposit the 'initial margin amount' but are exposed to the full nominal value of the contracts traded. Gearing can cause significant profits or losses on a currency future position in a short period of time because of the effect of any movement in the underlying currency. The profits and losses on the underlying currency can be up to ten times more than on the future. Assume an investor is long the Dollar/Rand futures contract. This investor thus starts to lose money if the Dollar weakens.
Hedging
Currency futures can be used to hedge against currency risk. Currency hedging refers to the elimination of currency risk by entering into an equal but opposite position which responds to a change in the exchange rate in the opposite manner to the position being hedged. Participants would enter in a long currency futures position in order to protect themselves against depreciation in local currency i.e. ZAR weakening. These investors may have a payment, quoted in a foreign currency, expected in three months time, and are thus exposed to an increase in the exchange rate, i.e. an appreciation of the foreign currency (given the exchange rate is quoted in the home currency per one unit of foreign currency).
Depreciation in local currency escalates the cost of foreign goods in local currency terms, resulting in reduced margins.The long futures position provides the hedge against the weakening local currency such that losses incurred from purchasing foreign currency at unfavourable level in spot is offset by the gains on the futures contract. Short currency future investors enter into currency futures contracts to eliminate local currency appreciation. These investors may have foreign currency receivables expected in three months time and are thus exposed to local currency appreciation (local currency strengthening), i.e. a depreciation of the foreign currency. Local currency appreciation results in less revenue received for the sale of foreign currency. The short futures position provides the hedge against local currency appreciation such that losses incurred from selling foreign currency at spot is offset by the gains on the futures contract.
Speculating
Speculators are directly opposite to hedgers. Where hedgers try to eliminate risk, speculators want to increase risk in the hope that they will make a short term profit. Speculators enter into currency futures contracts in order to take a view on the movement of the underlying exchange rate. Speculators that view the spot exchange rate to increase (local currency depreciation) will go long a currency futures contract.
Speculators that view the spot exchange rate to decrease (local currency appreciation) will go short a currency futures contract.