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Understanding Margin

Securities margin is the money you borrow as a partial down payment, up to 50% of the purchase price, to buy and own a stock, bond, or ETF. This practice is often referred to as buying on margin.

Futures margin is the amount of money that you must deposit and keep on hand with your broker when you open a futures position. It is not a down payment and you do not own the underlying commodity.

Futures margin generally represents a smaller percentage of the notional value of the contract, typically 3-12% per futures contract as opposed to up to 50% of the face value of securities purchased on margin.

Margins Move with the Markets

When markets are changing rapidly and daily price moves become more volatile, market conditions and the clearinghouses’ margin methodology may result in higher margin requirements to account for increased risk.

When market conditions and the margin methodology warrant, margin requirements may be reduced.

Types of Futures Margin

Initial margin is the amount of funds required by CME Clearing to initiate a futures position. While CME Clearing sets the margin amount, your broker may be required to collect additional funds for deposit.

Maintenance margin is the minimum amount that must be maintained at any given time in your account.

If the funds in your account drop below the maintenance margin level, a few things can happen:

You may receive a margin call where you will be required to add more funds immediately to bring the account back up to the initial margin level.

If you do not or can not meet the margin call, you may be able to reduce your position in accordance with the amount of funds remaining in your account.

Your position may be liquidated automatically once it drops below the maintenance margin level.

Summary

Futures margin is the amount of money that you must deposit and keep on hand with your broker when you open a futures position. It is not a down payment, and you do not own the underlying commodity.

The term margin is used across multiple financial markets. However, there is difference between securities margins and futures margins. Understanding these differences is essential, prior to trading futures contracts.

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)

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 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 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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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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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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