Major Differences between Futures and Forward contracts:

1) Futures Usually have Lower Transactions Costs (a small commission only to the broker, perhaps a small bid-ask spread when you buy if from a floor trader.
     In contrast, Forward Contracts can have substantial Dealer Spreads)

2) Futures traders have fewer Currencies Available: The Chicago Mercantile Exchange (CME) trades mainly Yen, DM, Pound, Can$, SFr, and $A.   Recently added the Mexican Peso and Brazilian Real.   French Francs and Russian Rubles trade but are usually listed under Other Futures.   The forward Market can arrange for forward contracts in most convertible currencies, (where there is an open exchange market - not just a Black Market).

(Note:  A generic name for nonconvertible currencies issued by some third world nations is "Googoos";  these are the "roach motels" of world currencies.  You can (often have to) buy 'em, but you can't sell 'em back.   These currencies are always absurdly overvalued.  The Chinese Yuan is "semiconvertible"  whatever that means.)

3) Standardized Size Contracts: DM 125,000, Y12.5 million, etc.  Forward Markets are usually larger and tailored to the clients' exact currency needs and  delivery dates.   A useful analogy is that futures are mass market, off the rack, while forward contracts are "custom made".

4) Limited Delivery Dates. (Once each Quarter - Last Trade is 3rd Wednesday of the Month).  Forward Markets are anytime.

SOME MECHANICS:

Our Exporter is owed one million D-Marks. Offset this LONG position by going SHORT (selling) eight DM Futures Contracts at the June Settlement Price of $.5426. The face value of this Short Hedge is thus $542,600. The Broker requires a Margin deposit (Performance Bond) of perhaps 5-10% of this face value.

This margin is different from using margin in the stock market:  With stocks, you are buying today with borrowed funds _ here the margin is simply a down payment.  You thus pay interest (to the broker)on the borrowed funds.  With futures, you have not bought or sold anything, you have only contracted to buy or sell in the sometime future.  Thus you are not borrowing, there is no downpayment and no interest payment.  The margin in this case is more like a security deposit against your reneging on your contract.  (By the way, you can't simply "walk away" from a contract and give up your deposit if things go badly.  You are responsible for the performance of the contract no matter what! (And you would soon find out why most futures trading is done in Chicago)

Marking to Market: If the DM future falls the following day to $.5411, this short position will gain $1,500. At the End of Trading, at "Settlement", the account will be credited the $1,500.   Any losses will be deducted from the Account.
 If the DM rises dramatically (that is, losses mount), the Broker may call for more "Margin".

Our Hedger could end up strapped for cash.

Although more Costly, Forward Contracts are generally less trouble for the Hedger/Trader.

1) "Tailored" to Customers' needs; Currency, time of delivery, amount.

2) Bank usually performs the actual delivery.   Usually associated with the spot transfer the bank would be making at the delivery time anyway.  In Contrast, Futures Contracts are usually settled through an OFFSETTING TRADE. The Exporter would BUY Eight DM Contracts near the time the German Customer pays off the Trade Credit.

Options vs. "Everything Else":   Someone wishing to reduce currency exposure by "locking in" a currency rate has three major choices:

The case of the exporter who is owed Euros:

1)  Forward Hedge:  you essentially deal with with your exposure by arranging ahead of time, the sale of the incoming currency.   The bank (after you assign over the payment) basically pays you (for the Euros) in dollars at the previously contracted forward rate.  The dollars go into your account. All very simple.

2) Spot Hedge:  You borrow just enough Euros from a bank so that the amount of the loan plus accrued interest equals your expected Euro receipts.  You immediately convert the Euros into dollars and use them for whatever purpose. When the customer finally pays what you are owed, you use these Euros to pay off the bank loan.   Again pretty simple.

3) Futures Hedge:  While you can use the futures contract to sell the Euros you expect to receive , most of the time it will play out like this:  Since you are owed Euros, you are long the asset: So you create an "anti-Euro" on the futures market by selling enough contracts to match your long exposure.  Since the spot Euro and the future Euro will move up and down together, (linked through IRP), the spot Euro and your short position will move in opposite directions.    If the Euros that the customer owes you falls before you can convert them into dollars, the short futures position should rise in value so that the "spot loss" and the "futures contract gain" cancel out.  When you finally get the Euros from your customer and convert them into dollars at the new "low" exchange rate.  Simultaneously you "buy back" the futures you sold, pocketing the gains - which should offset the decline of the Euro the spot market.

In all three cases, you are basically aggreeing to accept the current exchange rate (note, the forward rate is essentially the current exchange rate adjusted for interest rate differences). However, wouldn't you be really ticked if the Euro shot up in value just after you hedged your exposure?    A put option might be your answer if you think that Euro would be likely to move up, but you still want the downside protect.  In another scenario: what if the amount you are owed is "conditional", that is, whether or not you get the Euros depends on whether the European customer decides to accept your bid to sell him a good or service. Since you are not really sure whether  you even have a long exposure to the Euro until you get a firm "yes" from the client you use a put option to hedge. (See the Options table site for a fuller explanation.)

The Put Option gives you the right to sell your "incoming Euros" at market or at some minimum price set by the put contract. (This minimum price is usually called the striking price, strike price, or the exercise price - confused?) There are three basic types of currency put options:

1) The currency futures option: the most popular and the one we cover in detail on this web site. These trade on the Chicago Mercantile Exchange and give the owner the right to sell a futures contract worth of currency at a specified price, on or by the third Wednesday of the month.

2) The currency (spot) options: these trade on the Philadelphia Exchange and are no where as popular as the futures options. Gives the buyer the right to sell currency at the strike price on or by the expiration date. Contracts are typically half the size of the futures options. Some "European-style" options offered - where the option can only be exercised on the expiration date ("American-style" options can be exercised on or before - usually this distinction makes little practical difference).

3) Forward contract options: like the above, only through the forward market, and the money-center banks. You tend to actually exercise these options (assuming they are worth exercising at expiration) just like you would a regular forward contract. Like, forward contracts, these are tailored to the client's needs and cover many currencies. (You are not responsible for these on the exam)

All three accomplish the same thing: they allow you to profit if the currency you are long appreciates in value, but limits your loss if the currency declines.
 
 

Who takes the other side of the trade? This is never a bad question to ask yourself when you buy or sell financial assets. First, realize that you never really trade with a particular individual in the sense that you face default risk. Contract performance (futures and options) is guaranteed through the Exchange Clearinghouse, so in a sense every trade is with the Clearinghouse. The Clearinghouse is owned by the exchange and usually has lots of reserves.

Second, with futures contracts, you may be trading with another hedger or an arbitrageur. These folks are presumably not buying or selling out of some conviction that the currency is about to move. In contrast, the speculator, who trades from some conviction about the future spot price, may know more than you may.

Currency Puts and Calls: Some Basics

Puts give the owner the right to sell currency at a specified price, on or by a specified date. Calls give the buyer owner the right to buy currency at a specified price, on or by a specified date. The best way to understand options is to realize that they are very much like your car insurance.

The put, in this analogy, is a little easier to explain than the call. A put provides the opportunity to sell your asset (currency) at some floor price - even if (like the Brazilian Real) if it has plummeted in value. If your car has "plummeted" in value due to an accident or theft (so it is written off or "totaled"), you will receive a check for the fair value of the vehicle less the deductible you selected when you took out the policy. In essence, you were able to sell your valueless car to the policy writer at some pre-agreed floor price.

There are no less than three things that affect the cost of your auto insurance and the cost of a put option:

1) The length of time the policy is in force: so a 12-month policy costs more than a 6-month policy. Similarly a two-month put or call costs more than a one-month option.

2) The level of the deductible: when you select a high deductible (say $1,000) you are doing a bit of "self insuring" and the amount of the check that you could get from the insurance company would be lower than with a $500 deductible. When you select a low strike price on a put (a high strike price on a call) you are in essence selecting a high deductible as you get lower price for your for your currency from the put writer than otherwise.

3) The risk to the policy writer: just as drivers with bad records or red sports cars usually pay high insurance premiums, people who are trying to protect themselves from volatile currencies (like the Peso and the Real) will pay high option premiums (regardless of whether it is a put or a call).

Other factors: relative interest rates can play in currency option premiums, not so much in currency futures options (Don't worry about this on an exam).

Who takes the other side of the trade? (who is selling puts and calls?)

With options, your are essentially buying insurance and paying a premium for it. People  who are writing (selling) the options (usually large currency dealers) do so primarily to earn the premium income. Obviously, they hope that the option never has to "pay off" or at least they hope to make an overall profit. Put writers may think that the currency is unlikely to decline very much, but again, they probably don't have a strong feeling about it and are only in the game for the premium income.

Put (call) writers can lose a lot of money if the currency falls (rises) sharply. In contrast, there is no real potential for a large gain (the reverse is true for the option buyer).

Next see the web site "how to read a currency futures option table."