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Learn About Contract Specifications

Understanding Futures Contract Specifications

Every futures contract has an underlying asset, the quantity of the asset, delivery location, and delivery date.

For example, if the underlying asset is light sweet crude oil, the quantity is 1,000 barrels, the delivery location is the Henry Hub in Erath, Louisiana and the delivery date is December 2017.

When a party enters into a futures contract, they are agreeing to exchange an asset, or underlying, at a defined time in the future. This asset can be a physical commodity like crude oil, or a financial product like a foreign currency.

When the asset is a physical commodity, to ensure quality, the exchange stipulates the acceptable grades of the commodity.

For example, WTI Crude Oil contracts at CME Group is for 1,000 barrels of a grade of crude oil known as “light, sweet” which refers to the amount of hydrogen sulfide and carbon dioxide the crude oil contains.

Futures contracts for financial products are understandably more straightforward: the U.S. dollar value of 100,000 Australian dollars is the U.S. dollar value of 100,000 Australian dollars.

Each futures contract specifies is the quantity of the product delivered for a single contract, also known as contract size. For example: 5,000 bushels of corn, 1,000 barrels of crude oil or Treasury bonds with a face value of $100,000 are all contract sizes as defined in the futures contract specification.

The exchange defines the contract size to meet the needs of market participants. For example, participants who wish to take a speculative or hedging position in the S&P 500 futures contract but cannot risk the exposure of that size contract ($250 x the S&P 500) can instead use the E-mini S&P 500 futures contract to gain that exposure ($50 x the S&P 500 Index).

A futures contract also specifies where the asset will be delivered upon execution. Delivery is an important consideration for certain physical commodity markets entailing significant transportation costs. For example, the random-length lumber contract at CME Group specifies that delivery must occur in a specific state and in a certain type of boxcar.

Finally, every futures contract is referred to by its delivery month. Traders refer to the March Corn contract or the December WTI contract since this point in the future is germane to the value and execution of the contract position. Depending on the contract market, delivery can be anywhere from one month to several years in the future. The exchange specifies when delivery will occur within the month and when a given contract initiates and terminates trading. Typically, trading for a contract is halted a few days before the specified delivery date.

If you have questions send us a message or schedule an online review.

Regards,
Peter Knight Advisor

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Fundamentals and Interest Rate Futures

Interest Rate Education Homepage

Fundamentals and Interest Rate Futures

When it comes to trading Interest Rate futures, traders have a variety of products to choose from. Short-term products, like Eurodollar and Fed Fund futures, and extending along the yield curve to longer maturity products like 5-year and 10-year Treasury Notes as well as 30-year Treasury Bonds.

Traders looking to analyze the fundamentals of interest rate futures may review a variety of economic and market information. Some factors that influence pricing of Treasury futures include the level and slope of the yield curve, FOMC interest rate decisions, levels and frequency of U.S. Treasury debt issuance, demand for government bonds, and the overall health of the economy.

Yield Curve

The yield curve is a representation of the yield of securities along the various maturity points of the U.S. Treasury curve. For example, the U.S. Treasury regularly auctions securities with maturities of 2 years, 3 years, 5 years, 7 years, 10 years and 30 years. These are known as “on-the-run” securities and their yields are frequently quoted when referring to U.S. interest rates.

Traders will analyze the level and slope of the yield curve as one point of reference to future interest rates. Sometimes the yield curve will move in a parallel fashion with the yields of short- or long-term securities moving in tandem (parallel move). Sometimes interest rate changes affect one portion of the curve more than the other, causing the curve to steepen or flatten. Analysts will study the yield curve and build models on how they think yields will change for the maturity they are trading.

For example, someone trading the 2-year Treasury Note may see a larger price change in reaction to an FOMC rate increase than someone trading the 30-year Treasury Bond contract. In this case, the yield curve will shift because of greater price on the shorter-dated maturities versus the longer-dated maturities.

Federal Open Market Committee (FOMC) Decisions

FOMC interest rate decisions can have an important effect on the price of interest rate futures. The FOMC influences interest rates by increasing or decreasing the target overnight interest rate (or the effective fed funds rate). The overnight rate is the amount banks are charged to borrow or lend excess funds overnight. This rate is included in factors that influence what banks charge their customers to borrow funds.

If the expectation of an FOMC decision is an increase in the overnight lending rate, then interest rate futures may see a decrease in price. If the expectation is to lower overnight lending rates, then interest rate futures may see an increase in price.

Traders will want to keep an eye on the eight annual interest rate announcements from the FOMC (available on the FOMC website) and observe how the market reacts before and after the rate decisions are released. The rate decisions come with detailed explanations and projections from the FOMC. The wording of these releases is highly scrutinized by analysts and traders, and even small comments may have a large impact on the market.

U.S. Treasury Debt Issuance

As the U.S. Treasury issues debt in the form of notes and bonds, they increase the amount of securities available in the system and increase the amount of the debt owed by the U.S. government. This can put upward pressure on interest rates.

One result of the great financial crisis of 2008 was the U.S. central bank, known as the Federal Reserve, bought large amounts of U.S. Treasuries and other debt instruments. Due to the size of this activity, it had the desired effect of reducing interest rates.

U.S. Treasury interest rates are also impacted by global demand. Nearly 50% of all U.S. Treasury debt is held outside the United States. These non-U.S. participants can have a big impact on the Treasury debt pricing.

Overall Economic Health

Economic indicators that reflect the health of the U.S. economy have a big influence on the price of the U.S. Treasury market.

Economic indicators that influence the slope and level of the yield curve include inflation, growth, employment, and debt as a proportion of GDP.

Overall, the health of the economy is a primary influence on interest rates. When there is rapid growth with inflation, interest rates tend to rise and curve tends to steepen. In periods of slow growth and low inflation, rates tend to fall.

Summary

The U.S. interest rate market is influenced by the health of the U.S. economy and the issuance of U.S. Treasury. Risk managers and traders tasked with analyzing these markets should pay close attention to these factors.

The interaction between the economy and interest rates is complex. Traders looking at interest rate futures have a variety of fundamental inputs that can help them formulate opinions on price.

If you have questions send us a message or schedule an online review.

Regards,
Peter Knight Advisor

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Interest Rate Education Homepage

Introduction to Fed Fund Futures

What are Fed Funds?

Federal Funds, Fed Funds for short, are generally a transaction of an unsecured loan of U.S. dollars to a borrower or purchaser that is a depository institution (DI) from a lender or seller that is a DI, foreign bank, government-sponsored enterprise or other eligible entity. These transactions are usually conducted on an overnight or next day (T + 1) basis.

The Federal Reserve Bank of New York (FRBNY) gathers transactional data on Fed Funds daily from participating banks and broker dealers. Using a volume-weighted average, the FRBNY calculates the Effective Fed Funds Rate (EFFR) and publishes this number on its website.

Fed Funds and Overnight Interest Swap (OIS) rates are highly correlated and therefore, many IRS discounting models will use either Fed funds, OIS or both when building a forward discounting curve. In addition, Fed Fund futures are also used for trading and other funding curve risk management strategies.

Fed Fund Futures – Contract Specifications

Fed Fund futures contracts are based on the EFFR rate as reported by the FRBNY. The contract unit size is $5 million per contract. Contracts are listed monthly, extending 36 months or three years out on yield curve.

Fed Fund futures are traded in IMM index terms, that is, as a price rather than a rate. The price is simply the implied rate subtracted from 100. For example, if the average monthly Fed Funds rate for September is 1.20% the futures price would be 100 – 1.20 = 98.800.

At final settlement, Fed Fund futures are cash-settled, there is no physical delivery involved. The final settlement calculation at expiry is the total of all the daily rates published by the FRBNY divided by the total number of days in that month.

Fed Funds Example

For this example, we will use the September 2017 Fed Funds contract. There are 30 days in the month of September. When we calculate the total of all the reported EFFR rates from FRBNY = 34.600.

You would then divide that by the number of days in the month 34.600 ÷ 30 = 1.153.

Take this number and subtract from 100 you get 100 – 1.153 = 98.847. Therefore, 98.847 was final settlement for the September 2017 Fed Funds futures contract.

Backward Looking Futures Contract

To determine the final value of a Fed Funds futures contract, one must wait until the end of the contract month to determine its price. In other words, this contract is backward looking. Since the Federal Open Market Committee (FOMC) sets the Fed Fund target rate, the months when there is an FOMC meeting can be very important to contract pricing. But since most FOMC meetings occur mid-month, the first Fed Fund futures contract to be fully affected by a rate change would be the next deferred contract month, rather than the contract in which the meeting takes place.

Summary

Understanding the pricing mechanics of a futures contract is essential to understanding its trading behavior. While the contract construction of Fed Funds futures is simple the market forces that go into its pricing like, FOMC meetings, inflation expectations and employment statistics are sometimes complex and uncertain.

If you have questions send us a message or schedule an online review.

Regards,
Peter Knight Advisor

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A Look at FX Exchange For Physical (EFP)

A Look at FX Exchange For Physical (EFP)

An FX Exchange For Physical (EFP), involves simultaneous transactions in the cash and futures markets. EFPs are one type of ex-pit transaction that is allowed to take place outside of the central limit order book under Rule 538.

FX EFP Trade Example

Assume a hedge fund is long a $125 million euro/U.S. dollar (EUR/USD) FX forward in the OTC FX market. He is concerned about counterparty A’s credit risk. One way to mitigate this risk is to utilize futures contracts that are centrally cleared and collateralized.

In this case the OTC FX EUR/USD position can easily be replicated using EUR/USD futures.

To initiate the transaction, the hedge fund contacts his broker to find another counterparty to execute an FX cash versus futures trade (EFP). The hedge fund wants to sell his EUR/USD FX forward position and buy an equivalent position in EUR/USD FX futures using the nearby futures contract. The broker confirms the agreement.

The hedge fund trader writes up his side of the transaction. This consists of two parts, the sell of the cash-side for $125 million EUR/USD FX forwards, and the buy-side of the futures is 1,000 EUR/USD FX contracts.

Why 1 thousand futures contracts?

One euro/U.S. dollar FX futures contract has an equivalent notional value of 125,000 euros.

By dividing the futures contract’s notional value into the existing risk position of 125 million OTC euro/U.S. dollar forward, the result is 1,000 equivalent futures contracts.

The broker writes up the counterparty side of the transaction which is buying $125 million EUR/USD FX OTC forward and selling 1,000 EUR/USD FX futures.

Both parties report their side of the transaction to their respective clearing firms which in turn submit each trade to the clearinghouse. Once the trades are submitted to the clearinghouse, the long futures positions reside in the books of the hedge fund and the short position on the broker’s customer account. The transaction is complete and these new futures positions are just like any other open futures positions. They are subject to margining and can be offset at any time.

The hedge fund now has the euro/U.S. dollar position exposure it wants, and has also mitigated counterparty credit risk by using centrally cleared EUR/USD FX futures.

Immediately Offsetting FX EFP Example

This time assume there is a Commodity Trading Advisor (CTA) who manages money for their customers.

The CTA sees depth and liquidity in the FX OTC market and decides to negotiate a $50 million AUS/USD OTC forward on behalf of his accounts under management.

Immediately thereafter the CTA decides to convert the OTC exposure to futures.

The CTA and the counterparty decide to negotiate and execute an EFP, whereby the quantity of the $50 million AUS/USD OTC forward, originally executed, would cancel out with the $50 million AUS/USD OTC forward of the EFP.

The accounts under management would be left with AUS/USD futures.

In this scenario, because it is an immediately offsetting FX EFP executed by a CTA, the initiating and offsetting cash legs are not required to be passed through to the customer who received the exchange contract as part of the EFP. However, in a circumstance where the futures leg of the transaction fails to clear, the underlying accounts under management must receive the profit or loss of the offsetting cash leg.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Hedging FX Risk

Hedging with FX futures

Given the interconnectedness of today’s global economy, it is hard to imagine a medium-to-large size company that is not exposed to currency risk. Such risk can result from importing parts or components or from exporting finished products to foreign markets.

FX risk is not just for manufacturers, asset managers with large positions in foreign securities not only have exposure to the underlying asset value variability, but also face exposure to the currency in which that asset is priced.

In light of these considerations, risk managers are well aware of currency fluctuation risk to their business. One way to manage currency risk is with a currency overlay program.

The objective of a currency overlay program is to limit losses and maximize gains that arise from currency rate fluctuations. Strategies can be passive, active, or a combination of both.

FX Hedge Example

Consider a Brazilian asset manager who decides to allocate R$40 million into U.S. equities. By investing in U.S. equities, he has two risk exposures:

U.S. equity price risk exposure

U.S. dollar versus Brazilian real currency exposure

Currency Risk Exposure

For this example, we focus exclusively on the currency risk exposure. In order to invest in U.S. equities, the Brazilian asset manager must first convert his cash from Brazilian reais to U.S. dollars.

Starting position R$40,000,000

Brazilian reais to US dollars exchange rate = 4.00

This is 4 Brazilian real for each U.S. dollar

R$40,000,000 ÷ 4 = $10,000,00

The asset manager can now invest the $10 million into U.S. equities.

What is his currency risk?

By converting from Brazilian real to a U.S. dollar, he is now exposed to a weaker U.S. dollar. If the dollar goes down in value versus the Brazilian real, when he converts back to his domestic currency, he will receive fewer reais, reducing the return on his investment.

Creating the Currency Hedge

Brazilian real futures are quoted and traded in American terms. When the terms currency weakens, in this case the U.S. dollar, then the futures price increases. Therefore, to hedge a weaker dollar exposure our manager would be a buyer of the BRL/USD futures (contract symbol 6L).

How many contracts would he buy?

Hedge ratio = “value at risk” ÷ “notional contract value”

Hedge ratio = R$40,000,000 ÷ (BRL/USD contract notional = R$100,000)

Hedge ratio = 40,000,000 ÷ 100,000

Hedge ratio = 400 (6L) contracts

BRL/USD futures contract trade at the inverse price to the spot convention. The spot exchange rate was 4.0000, therefore the futures contract price would be 0.25000.

Spot USD BRL exchange rate = 4.0000

BRL/USD futures contract = 1 ÷ 4.0000 (or 0.25000)

This means our asset manager would buy 400 BRL/USD futures at a price of 0.25000.

Scenario: U.S. Dollar Weakens

New spot exchange rate = 3.5000

BRL/USD Futures price = 1 ÷ 3.5000 (0.28570)

Purchase price for BRL/USD contract = 0.25000

Price movement = 0.28570 – 0.25000 (3570 points)

If we multiply this increase by the 400 contracts we get a profit of $1,428,000.

Converting $1,428,000 amount back into Brazilian reais at the 3.5 exchange rate results in a gain of R$4,998,000 from the hedge.

If you subtract the gains from the hedge position from the loss resulting from the currency rate change results, we end up with a 2,000 reais loss for the asset manager.

Loss from exchange rate change = (R$5,000,000)

Gains from futures contract = R$4,988,000

Total hedge result = (R$2,000)

This small loss is certainly more acceptable than a R$5 million loss if left unhedged.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Understanding the FX Delivery & Settlement Process

Understanding FX Settlement and Delivery

All futures contracts have a specified date on which they expire. Prior to expiration, traders have a number of options to either close out or extend their open positions without holding the trade to expiration.

For those traders who want to take their contract to expiration, there are two ways an FX contract can be settled: cash settlement or physical delivery of the currency. For many FX futures, the last trading day is generally the second business day prior to the third Wednesday of the contract month.

We will look at a how settlement happens using the March British pound futures, which expire on the third Wednesday of the contract month. This contract is physically-delivered.

Example

Assume on the Monday preceding expiration, the expiring March contract is trading at 1.2405, and the next deferred contract, which is June, is trading at 1.2395.

The price difference between these two contracts is known as a calendar spread.

The calendar spread level is important, because it is a factor in determining the final price of the expiring contract.

In this example the calendar spread would be 10 ticks, a difference of 0.0010. British pound futures stop trading at 9:16 a.m. Central Time (CT) on that Monday.

In the final 30 seconds of trading, between 9:15:30 and 9:16:00 a.m., CME Clearing calculates the volume-weighted average price, for the deferred contract. We will assume the VWAP for the deferred June contract is 1.2390.

The calendar spread is then added to the VWAP to arrive at the final settlement price of the expiring contract of 1.2400.

Now that we have calculated the final settlement price for a physically-delivered contract, we will look at how the actual delivery works.

In our example the short would deposit the notional value of 62,500 pounds per contract with an approved agent bank. The long position would have 1.2400 times 62,500, or $77,500, per contract deposited in an acceptable delivery bank.

The two banks agree to these terms per CME Group arrangement and cash versus currency are exchanged over the bank wire. All of this is completed by 10:00 a.m. CT on the settlement day, which is the third Wednesday of the contract month, two business days after last trading day.

For cash-settled FX futures, the process is much simpler. The final settlement price is determined by the clearinghouse. Any profit or loss is calculated by taking the difference between the final settlement price and the previous day’s mark-to-market

Summary

Like any other futures contract, a trader with an open position they may decide to offset or roll forward their position to avoid expiration and delivery. However, if they decide to go to expiration, they should understand the final settlement procedures for the specific contract they are trading.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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The Importance of FX Futures Pricing and Basis

Understanding FX Basis

The difference between the futures price and spot price of a currency pair is referred to as the basis.

Basis can be either positive or negative. It will depend on the current relationship between the short-term interest rates of the base and terms currencies being considered.

The base currency is the first currency in a currency pair quotation, and the terms currency is the second half of the quotation.

FX Futures Pricing

The price of an FX futures product is based on the currency pair’s spot rate and a short-term interest differential. The pricing formula is similar to how FX forwards are priced in the OTC market. In the following equation, R is the short-term interest rate of a currency and d is the number of days from trade settlement until expiration.

If the short-term interest rate of the terms currency rate is lower than the short-term interest rate of the base currency, futures should trade at a discount to the spot price of the currency pair. The basis (that is, futures minus spot) would be quoted as a negative number.

This negative number is the result of what is known as positive carry. It is referred to as positive because an investment in the base currency’s short-term interest rate generates more income than the income generated by the terms currency’s short-term interest rate.

Example

Consider Mexican peso/U.S. dollar futures, quoted in American terms as MXN/USD. The Mexican peso resides in the base currency position. Assume it has a short-term interest rate of roughly 4.25% for a term settlement to expiration of 82 days.

The USD resides in the terms position and has an equivalent-dated short-term interest rate of 0.70%.

Notice that the USD rate is lower than the Mexican rate. This implies positive carry, so the futures price should be lower than the spot. Using the inputs provided, along with a spot equivalent rate of 0.05158, results in an implied futures price of 0.05116 versus a quoted mid-market price of 0.05115. Futures are quoted at -43 points under spot due to positive carry.

Shorter time

Going one step further, we will change the time value to expiration from 82 days to 30 days. How does this effect the multiplier?

Using the same calculation, the new multiplier is 0.99705 which is higher than our multiplier at 82 days. This means the futures price, while still lower, will be closer to spot. This is because of the erosion of the time value of money, or time decay.

As a futures contract approaches expiration, the time value of money runs out and futures price converges toward spot.

The 30-day implied futures price comes to 0.05143 versus a spot of 0.05158. When we subtract the futures price from the spot we get a -15 points.

The basis has narrowed from -43 to -15. At expiration, futures and spot will converge to the same level.

Summary

For FX futures, basis is the difference between the futures price and spot price of a currency pairing.

There is a cost of carry consideration for FX futures products. This is a determining factor in whether the futures price trades at a discount or a premium to spot.

If the terms rate is greater than the base rate, futures should trade at a premium to the spot price of the currency. However, when the terms rate is less than the base rate, futures should trade at a discount to spot.

The basis, or difference in futures price versus spot, can be either positive or negative. What is important to remember, is that regardless of whether the basis is positive or negative, the futures price will converge to spot as it approaches expiration. In other words, as time runs out on the futures contract, the interest rate differential has less effect on the futures price and that futures price converges to the spot value.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Understanding FX Quote Conventions

Identifying Currencies

Ever wonder what it means when you see currency quotations like these?

EUR/USD

Currencies are quoted in relation to another currency. For example, when we refer to the exchange rate of the euro (the currency of the European Union) to the U.S. dollar we quote the relationship, or exchange rate, as EUR/USD.

The first currency in the quotation – in this case the euro – is represented by its three-letter symbol, EUR. This is known as the named or base currency.

The second currency – in this case the U.S. dollar, shown by its three-letter symbol, USD – is known as the terms or quote currency.

Currency Pairs

When trading FX, the trading action is applied to the base, or first, currency in the currency pair. So, if you purchase the EUR/USD at 1.1250, you would receive one unit of the euro (EUR) in exchange for a payment of 1.1250 U.S. dollars (USD).

American and European Terms

Currency pairs versus U.S. dollars tend to be quoted in one of two ways; in either American or European terms.

European terms do not limit or refer to just Europe-based currencies, but to any currency other than the USD. European terms mean the U.S. dollar sits in the base currency location and the other currency occupies the terms position.

For example, the Swiss franc trades in the spot market in European terms. It is quoted in USD/CHF convention. CHF is the three-letter symbol for the Swiss franc.

American terms are currency pairs where the quote convention places the USD in the terms location.

For example, the British pound trades in American terms in the futures market and is shown as GBP/USD. GBP is the three-letter symbol for the British pound.

It’s important for traders to understand that the quote convention for futures may be different than the spot for the currency pairs they wish to trade.

Trading Codes

On futures execution platforms, all currency futures will be listed using a trading code that includes the instrument, month and year.

For example, when trading euro FX futures on CME Globex, the contract code for March 2017 would be 6EH7; 6E is the product code, H is the month code and 7 is the year.

Summary

Traders looking to express an opinion in the FX futures market need to be aware of the quoting convention and the trading code symbols for each currency pair offered by the exchange.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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