Asides from spot forex, there are cash forwards, swaps, arbitrage, currency futures and currency options. These are all widely circulated throughout the interbank system and various exchanges around the world. Like spot forex, all these instruments allow for physical delivery. Cash forwards and swaps are more typically transacted for the purpose of physical delivery whereas the other three instruments are more speculative in their usage. Physical delivery is usually deferred in the case of arbitrage transactions and currency instruments traded off exchanges with the exception of some limited usage in hedging transactions. We will discuss these various instruments in a little detail to explain the critical differences in form and usage.
- i. Cash forwards
Cash forwards are the oldest known form of currency hedging for price protection. Banks offer a forward rate, a pre-agreed advertised future price at which they will guarantee delivery of a specified quantity of currency. For example, a three-month forward on Japanese Yen may be offered at 138.00 although the spot price may be at 142.00 because of an anticipated appreciation in the Yen in three months time. However, the buyer nevertheless agrees to this higher-priced forward rate because he/she foresees a price rise in the future that could well exceed this pre-agreed rate and considers it a fair mark-up. If the cash market or spot price upon delivery in three months time were to appreciate below 138.00, say to 136.00, the bank would end up taking a slight loss and the buyer would have been correct to take the forward contract.
Conversely, if the Yen were to appreciate to 140.00, the buyer would have lost out slightly against the spot price while the bank gains the difference. The cash forward concept is an agreement fixed in time between two consenting parties known to each other, dealing in private capacity. And it is this concept that preceded the establishment of the futures market. It is the anonymous nature of the futures market, removing the privacy of individuals to interact with each other that forms the great conceptual divide between the cash and futures markets.
- ii. Swaps
Swaps and cash forwards are almost exclusively the domain of the interbank system which specializes in multi-billion dollar transactions. Swaps, unlike cash forwards are third-party facilitated agreements between two consenting parties who agree to contracted amounts of a specified currency for physical delivery, usually through a letter of intent. Two banking parties are assigned, each representing their respective clients, to simultaneously transact the amount, hence the swap, upon the behest of a neutral third party facilitator. It is this third party that arranges the exact timing and location of the transaction to be executed.
Let us use as an example, a transaction between Morgan Guaranty Bank in Chicago representing party A, who agrees to transfer 1.63 million US Dollars for 1 million British Pounds from Midland Bank in England representing party B. The mediator or facilitator submits all the legal documents concerning the specific time, amount, date and location of the transaction between the two parties, A and B, via their representative banks.
On Monday 29th December 1994, 1.63 million US Dollars will be remitted from Morgan Guaranty Bank from account MGYPAYUS$1.63M to account MIDRCVUS$1.63M at Midland Bank. Simultaneously, a swap will take effect where the equivalent amount of $1.0 million British Pounds at the rate of 1.6310 US Dollars per British Pound will be remitted via Midland Bank account MIDPAYGBP1.0M to account MGYRCVGBP1.0M in Morgan Guaranty Bank. The entire transaction takes literally seconds. At the end of the swap, the facilitator of the transaction will notify both parties of the completion of the transaction. In currency transactions such as this, very often neither party is aware of who the buyer or seller of the transaction is, only the respective representative banks. Anonymity is a very common theme in swaps.
- iii. Arbitrage
This is essentially a riskless transaction in which a purchase and sale of a currency is made in quick succession, almost simultaneously, to exploit price discrepancies in different geographic centres from different vendors and buyers. The concept of this transaction lies exploiting minuscule prices differences of the currency. The higher priced offer will be sold and the lower priced bid bought, closing out the transaction completely with no physical delivery requirements, open positions or unfavourable mark-up on the spreads. The riskless nature of this transaction lies in exploiting price discrepancies which are instantly liquidated before any fluctuation in the currency price can occur to create unexpected risk.
The profitability of these transactions lies in the huge dollar volumes transacted per trade and the frequency of such trades that greatly magnify the minute riskless gains from each single transaction. Arbitrage continues until the riskless opportunities are eliminated, for example, when larger than usual spreads in bid and ask prices of currency prices converge upon each other in different geographical locations. At this point, when there is no additional exploitable advantage in price discrepancies, no further attempts are made to effect arbitrage transactions.
For example, it is observed that in Frankfurt, the offer price on Deutschemark is 1.3815 and the bid is 13812, but in Singapore the same currency is showing an offer of 1.3809 but the bid is 1.3805. By simultaneously selling the currency at 1.3809 in Singapore and buying it at 1.3812 in Frankfurt, the arbitrageur earns a minute 3/100 of a pfennig profit per Deutschemark transacted. It is inconsequential to most people, but when 3 million Deutschemarks are transacted in a single setting, this converts to a gross profit of $900. Multiply this by a hundred transactions daily and you have a sizeable guaranteed profit-making operation.
Sometimes such arbitrage transactions combine the sale of a spot contract with the purchase of a forward contract, thereby protecting the arbitrageur against loss by locking in the floating (unrealized) profit. For example, an arbitrageur sells a British Pound spot contract at 1.7000 and simultaneously buys a forward contract at 1.6980. Regardless of the change in the British Pound on the spot market, the cash forward has locked in a permanent profit. Appreciation against the spot contract is offset by appreciation in the forward contract. Likewise, losses from decline of the forward price decline are countered by gains on the spot contract.
Arbitrage is a highly leveraged operation requiring access to quotes from many locations around the world and frequent monitoring of those quotes in search of an opportunity. Yamane Prebon, is one such specialist dealing in arbitrage transactions. The clients whom they trade for require very high minimums to participate, usually in the magnitude of upwards of $1 million. This is because of the incredibly high returns and high capitalization required for the transactions. It is very likely to remain that way in the near future.
- iv. Currency futures
Futures contracts of currency are traded on the International Money Market (IMM) a subdivision of the Chicago Mercantile Exchange (CME), which account for over $14 billion a day in volume. Currency futures are also traded on the Singapore Monetary Exchange (SIMEX), Tokyo International Futures Exchange (TIFE) and the now defunct Manila International Futures Exchange (MIFE) among others. However, the grand total volume of currency futures traded throughout the world's exchanges still pales into insignificance against the spot market's $1.5 trillion daily.
copyright of Singapore International Monetary Exchange
Currency futures are a derivative of the cash market. The specifications of contract size are generally the same as the spot forex market, with very similar margin requirements. However, whereas futures usually reflect 3-7% margins, spot forex can be traded at as little as 1% margin! The futures market was created for those businesses that produce or use cash commodities, but enter the futures market to protect themselves against volatile price fluctuations through hedges. A futures contract is historically, in effect, an insurance policy against price changes. This is not intended to be a course on futures or options trading nor the futures/options market as a whole. However, we will identify a few key differences between the cash and futures markets as this is a commonly asked question by first-time investors and futures traders.
We can identify two types of traders in the futures markets, hedgers and speculators. Hedgers, are users or producers of the cash commodity whose price they are attempting to secure through price protection strategies in the futures market. The producers are businesses like farmers, mining companies, or oil producers. These entities all produce commodities in their raw form, like grain, metals, or petroleum. Businesses that act as users of commodities may be flour millers, goldsmiths, or oil refineries who use the raw cash commodities produced by the previous category of hedgers to produce the finished or refined products.
Both types of hedgers are only concerned with protecting the eventual price of the cash commodity that they will take or make physical delivery on in the future. If they are producers, they will want to protect their physical or anticipated inventory from declining prices by selling equivalent dollar amounts of a designated contract size, of the commodity on the futures exchange. These are known as short hedgers. For example, Ghana, which accounts for almost 40% of world cocoa production, is also a Commonwealth nation engaging in much commerce with England. To protect their payment in British Pounds for cocoa consignments to England, against a decline, they would sell British Pound futures.
Conversely, users are concerned with paying higher than desired prices for future shipments of cash commodity. They seek protection of their price by buying contracts on the futures exchange equivalent in dollar terms to their expected shipments of cash commodity. These hedgers are long hedgers. An example, is Mercedes Benz dealership in Canada, which is required to purchase Deutschemarks for new inventory at year end. As a long-hedger, they would purchase Deutschemark futures to offset any potential increase in value of the currency they will need as payment for new cars from Germany.
copyright of Chicago Mercantile Exchange
The second type of trader are speculators, who never actually uses or intends to use the cash commodities. They trade purely for profit. Whereas, the futures market was begun by and created for the bona fide hedger, speculators today account for the majority of the volume traded on the futures market. They are essentially the market-makers who add to the liquidity and activity. Some estimates put this figure at 55-60% of most individual commodities. For many of the financial markets, this figure is even higher. These speculators take the form of large institutional and commercial traders like Merrill Lynch, Rosenthal, Dean Witter, Refco, etc. Small speculators form only 10-15% of this group. Fundamentally, futures currencies are different from spot for the following reasons.
- (1) Physical delivery requirements - Whereas in the cash (or spot) market, physical delivery is transacted, in futures, this is rarely the case due to the vast majority of speculative traders. The only other point of importance to note is that, in the case of a buyer of currency futures, they have the absolute responsibility for taking physical delivery of the full contract size in the event their position is not settled at expiration of the contract month. The seller, on the other hand, has the absolute responsibility of serving the Notice of Intention to Deliver the physical currency upon unsettled expiration of the contract. Delivery requirements are set by the exchange with designation points, conditions and procedures for delivery.
- (2) Expiration dates - All futures contracts have an expiry date, a date whereupon the contract must be offset, that is, liquidated, settled or closed out. Exchange-traded currency futures are typically traded in quarters (March, June, September and December). Although at this stage, a contract can be rolled over into the following quarter by means of a switch order, prices can change as contract month conditions may vary. This price transition is not contiguous. Spot has an indefinite lifespan and rollover is automatic every two days. The CME has attempted a simulation of spot with the development of the GLOBEX market or night-time currency futures alongside the Rolling Spot Futures using two-day roll-overs much like the interbank system. There are now also Cash Forward Futures with 16 delivery months (January through December of the current year, and March, June, September and December for the following year).
- (3) Anonymity of transaction - Perhaps the most glaring difference in futures, is anonymity of the buyers and sellers, where contracts are traded but there is no direct interaction between the buying and selling parties. All contracts are represented by brokers through an exchange floor where the bid and ask prices determine the executed price for each party. No one buyer or seller will ever know from whom they bought or to whom they sold their contracts. In spot transactions, this is true to an extent, but all parties transact ultimately with the interbank system and participating banks within that system, who generally provide the counterparty to over 95% of all spot forex transactions.
- (4) Carrying cost (or contango) - This is the charge incurred at the start of the futures contract for the accommodation of physical delivery when the contract expires. The charge is variable upon the term period of the contract and is charged for insurance, storage and interest rate. Spot has no formal carrying cost, but at the discretion of the dealer or bank, interest rate credits or debits can be imposed on open positions for the automatic rollover of contracts through night trade using prescribed interest rates such as Prime or LIBOR.
- (5) Liquidity - The ease of opening or closing positions in the spot marketplace is the major difference and also the biggest advantage over its futures counterpart. Liquidity in spot can be upwards of one hundredfold of that on the exchange floors. Since futures trading is restricted only to individual exchanges, the number of participants on any given day or week is in itself restricted. A futures contract can only be traded for any particular month where there are buyers for sellers of contracts and vice-versa. At times, liquidity in the futures market is so low, that a transaction to buy or sell contracts at the market may entail an enormous mark-up against quoted spot prices by 200-500%!
copyright of Tokyo International Financial Futures Exchange
- v. Currency options
Whereas futures are a derivative of the cash or spot market instruments, options are themselves a derivative of the futures instrument. The Philadelphia Stock Exchange, regulated by the Securities Exchange Commission, lists options which are classified as securities. The foreign exchange options traded off the Philadelphia exchange often cost only a few hundred dollars per option but control smaller contract sizes around $40,000. The Stockholm Options Exchange is one of the largest foreign currency options trading centres. However, European currency options can only be exercised upon expiration of the option, while American options can be exercised any time up to expiration, but both types of options can be sold before maturity.
Options permit a buyer, based upon a non-refundable premium that he or she deposits for a specific strike price, to reserve the right but not the obligation to exercise a long (buy) or short (sell) position on a currency future contract before its expiry date. The right to buy is known as a call and the right to sell is known as a put. Buyers of options have limited risk and unlimited profit potential, whereas sellers (also grantors or writers) of options assume unlimited risk for limited profit potential. One can only offset or liquidate a call option by buying or selling it back, and likewise for a put.
Using an example of a March Deutschemark 60.00 cent put, this option contract expires on 13th March 1993. The option has a strike price of 60.00 cents per Deutschemark, meaning it gives you the right to sell Deutschemark for 60.00 cents each. A call at this strike price would have given you the right to buy Deutschemark at 60.00 cents. At a contract size of 62,500 Deutschemarks, the tic or minimum fluctuation (also known as a point) is valued at $6.25 (62,500 divided by 10,000 points). The premium that would be paid for this option by the buyer would be dependent upon the price quoted in tics.
If the price or premium of the option is quoted at say, 0.25 cents or 25 tics or points, the cost of that option is $6.25 x 25 giving $156.25. This would mean that 100 contracts would cost $15,625. This is the maximum loss to the buyer, but the profit potential is virtually unlimited. Should the option contract move in favour of the buyer, when the price of the underlying currency future trades below 60.00 cents, say at 57.50 cents, the buyer can select the right to exercise the underlying contract for a profit of 2.50 cents (or $6.25 x 250). However, if the option moves against the buyer, and the underlying futures price trades through 60.00, say to 60.50 cents, the buyer can simply choose to forego the privilege of exercising the underlying future but instead pass it to the respective seller of the option, losing only the option premium of $156.25 per option.
This brings us to the seller of an option. Sellers of options participate in the options transaction as the opposite side of the transaction which the buyers assume. They receive the premium the buyers pay for the call or put option. A buyer of a 0.25 cent option would pay $156.25 to the seller of the same option. This is the maximum advantage out of the interaction for the seller. However, they run the risk of being dumped with the unfavourable underlying futures contract should the option expire unfavourably against the buyer and hence, take on unlimited liability for the futures contract. In the above example, if the option expires with the underlying futures price trading at 60.50 cents, the seller assumes the exercised position of the 0.50 cent loss foregone by the buyer. If the buyer of the option exercises the futures contract with a profit of 2.50 cents when the option expires below 60.00 cents at 57.50 cents from the above example, the seller will fully realize the gain from the premium.
Currency options are a tremendous hedging tool and can afford the buyer of the option major advantages with minimum risk. However, because currency options are themselves a derivative of a derivative, conceptually, they may be more complicated to understand and more difficult to trade without a good understanding of currency futures themselves. But, they are, in practice, the cheapest form of investment in currencies.
Trading currency options is a complicated affair, with numerous mind-boggling terms and strategies, particularly with regards to spread techniques. Bull call spreads, bear put spreads, diagonal spreads, butterfly spreads, combinations, straddles, strangles and a gamut of other deliciously cruel strategies fill the options market with opportunity for the well-versed trader. Newcomers to the currency markets are well-advised to work with the concepts of cash and futures first before attempting to play on the options board. Permit me the luxury of an analogy.
If you play chess on a physical board against a live opponent, you may consider that you are participating in the spot forex market - you know your opponent. Next, try playing chess against a computer and you may well consider yourself making the transition from spot to futures. Participation has become more abstracted. Have you attempted playing three-dimensional chess, lately? If so, you can consider it a graduation from the futures market to options. Options are lucrative, but you need to study your futures manual very seriously.
The proliferation of currency-based instruments has become mind-boggling in many ways. We have not attempted to deal with Prime Bank Guarantees, Money Market funds, spreads or cross-rates as alternative currency vehicles. In Chapter Three, we will begin to address the definitions, terminology and underlying support system of the spot forex market, which will hopefully open up an understanding of the critical mechanisms of market participation.
What is Spot Forex?
The European or indirect convention quotes the price in terms of foreign currency per unit of US Dollar, that is, the US Dollar is the denominator in this case. For example, Deutschemark at a base price of 1.6000 refers to 1 Deutschemark and 60/ pfennigs per US Dollar. If the price rises to 1.6455, it would indicate that 1 US Dollar can now purchase more Deutschemark and hence, the underlying US Dollar has strengthened and the Deutschemark has weakened. If the price declines from 1.6000 to 1.5890, now 1 US Dollar would be capable of buying or selling 1.5890 Deutschemark, a weakening in the underlying US Dollar and a strengthened Deutschemark.
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