Futures

Forex exchange markets

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Forex exchange markets

Nakul PANJABI

In this article, Nakul PANJABI (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2024) explains how the foreign exchange markets work.

Forex Market

Forex trading can be simply defined as exchange of a unit of one currency for a certain unit of another currency. It is the act of buying one currency while simultaneously selling another.

Foreign exchange markets (or Forex) are markets where currencies of different countries are traded. Forex market is a decentralised market in which all trades take place online in an over the counter (OTC) format. By trading volume, the forex market is the largest financial market in the world with a daily turnover of 6.6 trillion dollars in 2019. At present, it is worth 2,409 quadrillion dollars. Major currencies traded are USD, EUR, GBP, JPY, and CHF.

Players

The main players in the market are Central Banks, Commercial banks, Brokers, Traders, Exporters and Importers, Immigrants, Investors and Tourists.

Central banks

Central banks are the most important players in the Forex Markets. They have the monopoly in the supply of currencies and therefore, tremendous influence on the prices. Central Banks’ policies tend to protect aggressive fluctuations in the Forex Markets against the domestic currency.

Commercial banks

The second most important players of the Forex market are the Commercial Banks. By quoting, on a daily basis, the foreign exchange rates for buying and selling they “Make the Market”. They also function as Clearing Houses for the Market.

Brokers

Another important group is that of Brokers. Brokers do not participate in the market but acts as a link between Sellers and Buyers for a commission.

Types of Transactions in Forex Markets

Some of the transactions possible in the Forex Markets are as follows:

Spot transaction

As spot transaction uses the spot rate and the goods (currencies) are exchanges over a two-day period.

Forward transaction

A forward transaction is a future transaction where the currencies are exchanged after 90 days of the deal a fixed exchange rate on a defined date. The exchange rate used is called the Forward rate.

Future transaction

Futures are standardized Forward contracts. They are traded on Exchanges and are settled daily. The parties enter a contract with the exchange rather than with each other.

Swap transaction

The Swap transactions involve a simultaneous Borrowing and Lending of two different currencies between two investors. One investor borrows the currency and lends another currency to the second investor. The obligation to repay the currencies is used as collateral, and the amount is repaid at forward rate.

Option transaction

The Forex Option gives an investor the right, but not the obligation to exchange currencies at an agreed rate and on a pre-defined date.

Peculiarities of Forex Markets

Trading of Forex is not much different from trading of any other asset such as stocks or bonds. However, it might not be as intuitive as trading of stocks or bonds because of its peculiarities. Some peculiarities of the Forex market are as follows:

Going long and short simultaneously

Since the goods traded in the market are currencies themselves, a trade in the Forex market can be considered both long and short position. Buying dollars for euros can be profitable in cases of both dollar appreciation and euro depreciation.

High liquidity and 24-hour market

As mentioned above, the Forex market has the largest daily trading volume. This large volume of trading implies the highly liquid feature of Forex Assets. Moreover, Forex market is open 24 hours 5 days a week for retail traders. This is due to the fact that Forex is exchanged electronically over the world and anyone with an internet connection can exchange currencies in any Forex market of the world. In fact for Central banks and related organisations can trade over the weekends as well. This can cause a change in the price of currencies when the market opens to retail traders again after a gap of 2 days. This risk is known as Gapping risk.

High leverage and high volatility

Extremely high leverage is a common feature of Forex trades. Using high leverage can result in multiple fold returns in favourable conditions. However, because of high trading volume, Forex is very volatile and can go in either upward or downward spiral in a very short time. Since every position in the Forex market is a short and long position, the exposure from one currency to another is very high.

Hedging

Hedging is one of the main reasons for a lot of companies and corporates to enter into a Forex Market. Forex hedging is a strategy to reduce or eliminate risk arising from negative movement in the Exchange rate of a particular currency. If a French wine seller is about to receive 1 million USD for his wine sales then he can enter into a Forex futures contract to receive 900,000 EUR for that 1 million USD. If, at the date of payment, the rate of 1 million USD is 800,000 EUR the French wine seller will still get 900,000 EUR because he hedged his forex risk. However, in doing so, he also gave up any gain on any positive movement in the EUR-USD exchange rate.

Related posts on the SimTrade blog

   ▶ Jayati WALIA Currency overlay

   ▶ Louis DETALLE What are the different financial products traded in financial markets?

   ▶ Akshit GUPTA Futures Contract

   ▶ Akshit GUPTA Forward Contracts

   ▶ Akshit GUPTA Currency swaps

   ▶ Luis RAMIREZ Understanding Options and Options Trading Strategies

Useful resources

Academic resources

Solnik B. (1996) International Investments Addison-Wesley.

Business resources

DailyFX / IG The History of Forex

DailyFX / IG Benefits of forex trading

DailyFX / IG Foreign Exchange Market: Nature, Structure, Types of Transactions

About the author

The article was written in December 2022 by Nakul PANJABI (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2024).

Initial and maintenance margins in futures contracts

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Initial and maintenance margins in futures contracts

Akshit Gupta

This article written by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) explains the mechanisms of initial and maintenance margin used in futures contracts.

Introduction

In financial markets, margin requirements are present in leveraged positions in derivative products. They refer to a percentage of assets that an investor must pay for with his or her own cash or assets (collateral) as a means of protection against the risk exposure to its potential default for the other counterpart.

Margin requirements serve as a guarantee that the investor providing the margins will fulfil its trade obligations. Many exchanges across the world provide leverage facilities to investors for trading in different derivative assets. For example, an investor can use leverage facilities for trading in futures contracts across different asset classes like equities, bonds, currencies, interest rates, etc.

Margin requirements can be categorized as initial and maintenance margin requirements.

Initial margin

Initial margin (or IM) refers to the initial deposit required when an investor opens a position in a derivative product and amounts to a percentage of the nominal contract value. The amount for initial margin requirement is calculated in accordance with approved margin models that are based on the market’s regulatory rules. The determination of the initial margin requirement is essentially based on the volatility of the underlying asset of the derivative product being covered. The more volatile the underlying asset, the higher the initial margin requirement.

You can download below the file to learn about the different Euronext Clearing margin requirements used in derivatives trading.

Maintenance margin

When an investor holds an underlying asset on margin, she is required to maintain a minimum margin amount of that asset position in her portfolio to keep her position open and this is known as the maintenance margin. Maintenance margin requirements aim to protect against excess losses and ensures the broker has enough capital to cover any losses the investor may incur. Maintenance margin is generally calculated on a daily mark-to-market basis between the period starting from the trading date to the contract expiration date.

In case the investor is unable to fulfil the maintenance margin requirements, she receives a margin call initiated from the broker to deposit further amount in order to keep her position open. If she fails to provide adequate maintenance margins, the broker has the power to close her positions.

Mechanism of initial and maintenance margins

Now, we will see how initial and maintenance margins work in the financial markets using S&P 500 mini futures contract. Since the investor has bought the futures contract, he/she is required by its broker to post an initial margin at the time the trade is initiated. For instance, this initial margin is set to 40% of the nominal value of the contract. This money is essentially the collateral on the purchase to protect the seller of the contract in the future against the default of the buyer (the investor).

Followed by this, a maintenance margin is required at any point of time after the trade is initiated. The maintenance margin call is triggered when the value of the initial margin falls below the 30% threshold (i.e. 70% of the initial margin). The buyer has to ensure that any time the position falls below this maintenance margin requirements, he will get a margin call and has to increase funds into the margin account.

Example with initial margin

Here is an example of a typical case of buying a futures contract and its margin mechanism:

The characteristics of the contract and market data include:

Margin call on futures

Margin call on long futures

The final value of the investor’s brokerage account is equal to $253,000. At the end of the contract, the investor can get back its initial margin of $158,000 leaving $95,000 on its account. The gain is equal to $10,000 which is the amount left on the account ($95,000) minus the sum of the margin calls ($85,000).

Here is an example of a typical case of selling a futures contract and its margin mechanism using the same characteristics and market data:

Margin call on short futures

The final value of the investor’s brokerage account is equal to $178,000. At the end of the contract, the investor can get back its initial margin of $158,000 leaving $20,000 on its account. The loss is equal to $10,000 which is the amount left on the account ($20,000) minus the sum of the margin calls ($30,000).

You can download below the Excel file for the computation of the Intial and Maintenance Margins for the futures contracts.

Download the Excel file to compute the initial margins for futures

Related posts in the SimTrade blog

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   ▶ Akshit GUPTA Analysis of the Trading places movie

Useful resources

Maintenance margin

Initial Margin

Financial Industry Regulatory Authority (FINRA)

Prof. Longin’s website Margin Call mechanism for a futures contract (in French).

About the author

Article written in August 2022 by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

Forward Contracts

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Forward Contracts

Akshit Gupta

This article written by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) introduces Forward contracts.

Introduction

Forward contracts form an essential part of the derivatives world and can be a useful tool in hedging against price fluctuations. A forward contract (or simply a ‘forward’) is an agreement between two parties to buy or sell an underlying asset at a specified price on a given future date (or the expiration date). The party that will buy the underlying is said to be taking a long position while the party that will sell the asset takes a short position.

The underlying assets for forwards can range from commodities and currencies to various stocks.

Forwards are customized contracts i.e., they can be tailored according to the underlying asset, the quantity and the expiry date of the contract. Forwards are traded over-the-counter (OTC) unlike futures which are traded on centralized exchanges. The contracts are settled on the expiration date with the buyer paying the delivery price (the price agreed upon in the forward contract for the transaction by the parties involved) and the seller delivering the agreed upon quantity of underlying assets in the contract. Unlike option contracts, the parties in forwards are obligated to buy or sell the underlying asset upon the maturity date depending on the position they hold. Generally, there is no upfront cost or premium to be paid when a party enters a forward contract as the payoff is symmetric between the buyer and the seller.

Terminology used for forward contracts

A forward contract includes the following terms:

Underlying asset

A forward contract is a type of a derivative contract. It includes an underlying asset which can be an equity, index, commodity or a foreign currency.

Spot price

A spot price is the market price of the asset when the contract is entered into.

Forward price

A forward price is the agreed upon forward price of the underlying asset when the contract matures.

Maturity date

The maturity date is the date on which the counterparties settle the terms of the contract and the contract essentially expires.

Forward Price vs Spot Price

Forward and spot prices are two essential jargons in the forward market. While the strict definitions of both terms differ in different markets, the basic reference is the same: the spot price (or rate according to the underlying) is the current price of any financial instrument being traded immediately or ‘on the spot’ while the forward price is the price of the instrument at some time in the future, essentially the settlement price if it is traded at a predetermined date in the future. For example, in currency markets, the spot rate would refer to the immediate exchange rate for any currency pair while the forward rate would refer to a future exchange rate agreed upon in forward contracts.

Payoff of a forward contract

The payoff of a forward contract depends on the forward price (F0) and the spot price (ST) at the time of maturity.

Pay-off for a long position

Long Position

Pay-off for a short position

Short Position

With the following notations:
N: Quantity of the underlying assets
ST = Price of the underlying asset at time T
F0 = Forward price at time 0

For example, an investor can enter a forward contract to buy an Apple stock at a forward price of $110 with a maturity date in one month.

If at the maturity date, the spot price of Apple stock is $120, the investor with a long position will gain $10 from the forward contract by buying Apple stock for $110 with a market price of $120. The investor with a short position will lose $10 from the forward contract by selling the apple stock at $110 while the market price of $120.

Figure 1. Payoff for a long position in a forward contract
long forward

Payoff for a short position in a forward contract
Short forward

Use of forward contracts

Forward contracts can be used as a means of hedging or speculation.

Hedging

Traders can be certain of the price at which they will buy or sell the asset. This locked price can prove to be significant especially in industries that frequently experience volatility in prices. Forwards are very commonly used to hedge against exchange rates risk with most banks employing both spot and forward foreign exchange-traders. In a forward currency contract, the buyer hopes the currency to appreciate, while the seller expects the currency to depreciate in the future.

Speculation

Forward contracts can also be used for speculative purposes though it is less common than as forwards are created by two parties and not available for trading on centralized exchanges. If a speculator believes that the future spot price of an asset will be greater than the forward price today, she/he may enter into a long forward position and thus if the viewpoint is correct and the future spot price is greater than the agreed-upon contract price, she/he will gain profits.

Risks Involved

Liquidity Risk

A forward contract cannot be cancelled without the agreement of both counterparties nor can it be transferred to a third party. Thus, the forward contract is neither very liquid nor very marketable.

Counterparty risk

Since forward contracts are not traded on exchanges, they involve high counterparty risk. In these contracts, either of the counterparties can fail to meet their obligation resulting in a default.

Regulatory risk

A forward contract is traded over the counter due to which they are not regulated by any authority. This leads to high regulatory risk since it is entered with mutual consent between two or more counterparties.

Related posts in the SimTrade blog

   ▶ Akshit GUPTA Futures contract

Useful Resources

Hull J.C. (2015) Options, Futures, and Other Derivatives, Ninth Edition, Chapter 1 – Introduction, 23-43.

Hull J.C. (2015) Options, Futures, and Other Derivatives, Ninth Edition, Chapter 5 – Determination of forward and futures prices, 126-152.

About the author

Article written in June 2021 by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

Analysis of The Rogue Trader movie

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Analysis of The Rogue Trader movie

Akshit Gupta

This article written by Akshit Gupta (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) analyzes The Rogue Trader movie and explains the related financial concepts.

Rogue Trader (1999) is a British drama film depicting the life of Nick Leeson, a former derivate broker based out in Singapore. The story is inspired by real-life events that shook the global financial system and led to the collapse of the world’s second-oldest merchant bank named Barings Bank based out in England. The movie is based on a book by Nick Leeson named Rogue Trader: How I brought down Barings Bank and shook the financial world and is one of the greatest examples of why a trader shouldn’t try to fight the market.

Summary of the movie

The Rogue Trader movie

The movie starts by introducing Nick Leeson, a person who starts his career by working for Barings Bank in Indonesia and is later promoted to work as a derivatives trader at the trading seat of the bank at Singapore International Monetary Exchange (SIMEX), Singapore. He was made to look after the trades as well as the back office work of and entering and settling those trades by the end of the day. His job is to trade futures contracts based on Nikkei 225, a stock index at Japan Stock Exchange, on behalf of Baring’s clients, and generate profits by arbitraging the small price difference between SIMEX and Japan Stock Exchange. He hires a team of people to be the floor traders for him and imparts them requisite training for executing the orders. Everything seemed fine until, owing to a trader’s error, Nick accrues a small loss. To cover the losses made by the trader, Nick starts trading futures under a newly formed account numbered 88888, an unauthorized account, which is prohibited under the bank laws. Soon, his trades start falling apart and he starts incurring losses amounting to millions of pounds. To conceal the facts from his seniors, Nick lands up a big client and makes enough commission on his trades to make up for the losses. But since he wanted to play big, instead of making profits by arbitraging his positions, Nick starts to hold on to his positions in expectations of higher future prices.

However, his unhedged positions start pouring in heavy losses when a major earthquake hits Japan in 1995 and the stock market starts dwindling. Still determined to cover his losses, Nick starts buying Nikkei futures in large quantities and tries to move the market in his favor. To meet the margin calls, Nick asks the head office in London to wire him more money to enter bigger deals.  But as the market keeps on falling, the losses start amounting to hundreds of millions of pounds. The management of the bank remains oblivious of the losses that are accumulating in the account number 88888, which is an account operated under a client’s name. Barings back had a poor compliance system and regular audits weren’t carried out in a proper manner giving rise to losses amounting to 800 million pounds, almost double the amount of capital Barings had.

As the market keeps going against him, Nick realizes that his game is coming to an end. Nick and his wife plan to leave Singapore to save him from judicial actions. But eventually, Nick is caught at Frankfurt airport and deported to Singapore where he is sentenced to 6 years’ imprisonment.

Relevance to the SimTrade course

The lessons learnt from the movie Rogue Trader are correlated to courses taught in the SimTrade course. The importance of market news has correctly been reflected in the movie by the amount Nick had to pay, trying to fight the trend. The strategy used by Nick to cover his losses known as Martingale’s strategy, or doubling the bets, is a very common mistake traders make in order to cover their past losses, but most of the time it results in even higher losses. A trader should never try to fight the market since it is rightly said that markets are always right, even when they are wrong.

The courses taught on SimTrade teach traders to cover their positions by using different types of orders to protect them from any unexpected market movements. If a stop loss/stop limit strategy would have been entered in by Nick, the losses could have been cut down. A proper investment plan with adequate use of margins and a stop-loss strategy should be put in place by every trader before entering trades. Also, a good trader should never let emotions, such as fear or greed, dictate her judgment.

Most famous quotes from the movie

“I just have to keep buying futures to support the market. If it sticks at 18,000 my options are still in the money. I could get the position back. I may even out ahead.” – Nick Leeson

“Listen to me now. You don’t fight the market!” – Another trader

“The way the market’s going, your losses could be catastrophic.” – Another trader

Trailer of the movie

Related Posts

   ▶ Marie POFF Film analysis: Rogue Trader

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   ▶ Alexandre VERLET Understanding financial derivatives: futures

   ▶ Akshit GUPTA Futures Contract

About the author

Article written in October 2020 by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).