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Finance textbooks and markets tend to utilize four figures after the decimal point (X.XXXX).

Setting the Stage

On June 28, 2020, the exchange rate for US Dollars to Chinese Yuan is 1.0000USD = 7.0700RMB.

A Chinese student (Zhang) plans to begin a study abroad program at the University of America on August 31, 2020. At that time, he must pay tuition of $100,000 US Dollars

This requires exchanging his Yuan (RMB) for the Dollar (USD) before August 31.

Spot Rate Exchange — (Exchange Now)

The Spot Rate is the exchange rate applied to “immediate” transactions (it may take a few days to process, but is more or less completed now). If Zhang were to go to an airport and exchange his money at this precise moment, he’d face the Spot Rate.

Using the Spot Rate, Zhang would pay 707,000RMB at a rate of 1.0000USD = 7.0700RMB

Volatile Rates

Unfortunately, Zhang will not have 707,000RMB available for exchange until August 15th when he is paid for his summer job. 😓

If exchange rates were consistent, Zhang would simply send the tuition in August after he gets paid. No problem.

Unfortunately, exchange rates are volatile — they change minute by minute, day after day. There is no guarantee the exchange rate will not change unfavorably in the coming months. When discussing the exchange rate anticipated for the future (e.g. 30days, 60 days, 90 days from now), it is called the Forward Rate.

Exchange Rates fluctuate minute by minute, day by day.

The RMB per USD exchange rate between June 27 to June 28 (shown above) ranged from 7.0720 (high) to 7.0590 (low).

If the money exchanged is miniscule, such changes are insignificant. But when the funds are more substantial, even minor fluctuations can become notable.

Two key rates discussed in Futures: Spot Rate (present rate) and Forward Rate (future expected rate).

Depreciation v. Appreciation

Whether a currency exchange rate has changed positively or negatively for Zhang is a matter of Depreciation and Appreciation. A more in-depth assessment can be found in a previous article “Appreciation, Depreciation, and Calculating the Rate of Change.” Still, a very brief introduction is necessary for the discussion of futures as laid out hereafter.

Spot Rate: 1.0000USD = 7.0700RMB

Depreciation occurs where a currency loses value and can purchase less foreign currency on the market. Zhang takes 10RMB to the bank on two separate days. On the first day, he is given $1.50 and on the second day he is given $1.47. In this case, the Chinese RMB has depreciated or decreased in value because he purchases fewer US Dollars on the second day.

If Zhang’s forward rate in August is $1.00 = 7.08RMB, the RMB would have depreciated.

Appreciation occurs where a currency gains value and can purchase more foreign currency. Zhang takes 10RMB to the bank on two separate days. On the first day, he is given $1.50 and on the second day is given $1.54. In this case, the Chinese RMB has appreciated or increased in value.

If the Chinese yuan depreciates and the new exchange rate on August 15, 2020 was 1.0000USD = 7.0800RMB:

If the Chinese yuan appreciates and the new exchange rate on August 15, 2020 was 1.0000USD = 7.0300RMB:

RMB appreciation is clearly preferred by Zhang; however forward rates are volatile and cannot be forced.

Zhang’s Decision

Zhang now faces two choices:

1. Assume the forward exchange rate will not change or that the RMB will appreciate (USD depreciate). ➡ Wait. Exchange the money on August 15th at the Forward Rate.
2. Assume the RMB will depreciate (USD appreciate). ➡ Minimize loss as much as possible.

Currency Futures are beneficial in the second scenario — where the forward rate is expected to be unfavorable.

“Currency Futures“ are a financial contract where a buyer and seller agree to exchange money at a future date using a predetermined rate; thus minimizing risks from potentially volatile and costly forward rates.

Adjusting Our Example

We will assume that Zhang does expect the RMB to depreciate and falls under the second scenario. He anticipates that the forward rate on August 15, 2020 will be 1.0000USD = 7.0800RMB. In other words, he will have to pay 708,000RMB to cover tuition — 1,000RMB more than under the spot rate.

A Brief Summary:

Person A (Buyer) enters into a contract with Person B (Seller). The agreement states that Person A will pay Currency X on a specific date in the future in exchange for Currency Y at a specific exchange rate that is more favorable to Person A than the expected forward rate.

Example:

Sarah enters into a futures contract with Jared. Sarah promises to buy €100,500 at the spot rate of $2.0000 = €1.000 on July 30. The forward rate is $2.1500 = €1.0000 on July 30. Has Sarah earned or lost money under this contract?

(Notice the domestic currency (USD) has depreciated – unfavorable; so the futures contract is likely to be good for her).

Since the USD depreciated, Sarah saved $15,075 by exercising the futures contract compared to waiting and using the forward rate.

Long or Short Position

A bit of vocabulary:

• A Long Position means one is expecting to purchase the currency (Buyer)
• A Short Position means one is expecting to sell the currency (Seller)

Some students get confused here as there is always a buyer and seller of both currencies (Zhang here seems to be buying USD and selling RMB, so isn’t he both long and short?).

Zhang is taking a long position in US Dollars and a short position in RMB.

Currency Futures (Step-By-Step)

*Futures contracts tend to be large ($100,000+) so one would not purchase futures for something as small as a year’s tuition, but we’ll maintain the example for simplicity.

Identify the Clearinghouse

Zhang researches his options very carefully and identifies a reliable Clearinghouse. Clearinghouses are third-party companies brokering futures contracts (usually online). They offer a marketplace matching buyers and sellers together and helping them complete the exchange safely and anonymously. Clearinghouses are something of a futures e-bay or taobao.

Generally, clearinghouses profit via a commission — some fee for each transaction.

Zhang has a long position in USD (buyer) and needs to be matched by the clearinghouse with a seller taking a short position.

Setting Up The Margin Accounts

Zhang must first set up his accounts with the Clearinghouse site. He establishes a payment account known as his margin* account. Think of the Margin Account as something like a paypal or wechat account for futures transactions. You can deposit money and the clearinghouse will withdraw funds when settling the accounts.

*Modern traders and texts may replace the term “margin” with “performance bond” – same idea, just new vocabulary (e.g. margin account = performance bond account).

Contract Varieties

Once his margin account is established, Zhang confirms his intent to purchase a futures contract of $100,000 at the June 28 spot rate (1.0000USD = 7.0700RMB) for a total of 707,000RMB to be paid on August 15, 2020.

A couple of notes:

1. The date when the contract will expire (end) is the maturity date (August 15 in our example).
2. To complete a futures contract by making the exchange is known as exercising the contract. Zhang will exercise his contract (make the exchange) on the maturity date of August 15.
3. Clearinghouses use specific pre-determined “delivery months” (e.g. January, March, July, October), so the August 15th date may not be an option.
4. Futures contracts are offered in specific amounts (e.g. $100,000 . . . $500,000 . . . $125,000. . . ). If Zhang wanted to purchase a different quantity (e.g. $200,000), he may need to purchase multiple contracts. The quantity of money in the contract (e.g. $100,000) is the contract size.

The Initial Margin

The clearinghouse will examine the size of Zhang’s contract and ask him to demonstrate that he can pay in August. He must place a deposit in his margin account based on a percentage (%) of the contract. This is known as the initial margin, and a futures position is opened once the initial margin is paid.

An initial margin is money deposited into the margin accounts in order to open the futures position. It is leverage showing the owner is good for the money and will be used to complete the daily settlements (discussed later in this article)

The initial margin required may vary and note both long and short positions have initial margins.

Let’s say the clearinghouse demands a 5% initial margin from Zhang.

Once Zhang deposits the 35,350RMB initial margin, he has opened a long position in the futures contract and the contract begins. His Margin Account Balance is 35,350RMB.

Daily Settlements (The Value of a Contract)

The Clearinghouse will settle the accounts daily. Daily Settlements can be a difficult concept and are explained herein as clearly as possible.

Futures contracts include a risk that the seller(buyer) may default should the forward rate prove more favorable than the futures contracted rate.

Example:

Spot (Futures) Rate: 7.0700RMB = 1.0000USD
Forward Rate: 7.08000RMB = 1.0000USD

Without the futures contract, the seller would make 708,000RMB in exchange for his USD. With the futures contract, the seller only gets 707,000RMB. The seller now has a loss and an incentive to default. Zhang is in trouble — his university will still demand payment but Zhang has lost his contract. He will have to pay 708,000RMB to someone else and loses 1,000RMB (the very thing he tried to avoid).

To minimize this risk of default, Clearinghouses use daily settlements.

How It Works:

At the end of each market day, the Clearinghouse identifies a closing settlement price for the contract. This price has a formula (not discussed here) based on the present market value for the money.

Day	Opening Price (RMB per USD)	Closing Price (RMB per USD)	Change (D-o-D)
June 29	7.0700	7.0710	+0.0010

• Opening Price (beginning of day): 7.0700
• Closing Price (end of day): 7.0710
• Change = +0.0010

Based on that closing price, they publish the value of each futures contract for the day. This process is called mark-to-market. For example, based on the opening and closing prices above, the mark-to-market value of the contract changed from 707,000RMB to 707,100RMB.

If the futures contract is exercised, Zhang has saved 100RMB (profited) as of today.😊 However the seller has lost 100RMB. 😓

To minimize the risk for Zhang and to keep the other party from abandoning the contract, at the end of the day 100RMB will be removed from the seller’s margin account and deposited into Zhang’s margin account.

The result:

• Seller defaults, sells at forward rate of 7.0710.
  • Receives 707,100RMB from new buyer
  • Pays 100RMB to Zhang through daily settlement
  • Result = 707,000RMB (same as under the contract).
• Buyer suffers from defaults, buys at forward rate of 7.0710
  • Receives 100RMB from seller through daily settlement
  • Pays 707,100RMB to new seller
  • Result = 707,000RMB (same as under the contract).

The opposite is also true. If the forward rate is favorable for Zhang (e.g. 7.03000), the Clearinghouse will remove money from him and give it to the seller.

Day	Opening Price (RMB per USD)	Settlement Price (RMB per USD)	Change (D-o-D)
June 29	7.0700	7.0710	+0.0010
June 30	7.0710	7.0718	+0.0008
July 1	7.0718	7.0712	-0.0006

Based on these daily settlement figures:

• June 29 (+)
  • Seller (Short Position) lost money from the margin account.
  • Buyer (Long Position) received money in the margin account.
• June 30 (+)
  • Seller (Short Position) lost money from the margin account.
  • Buyer (Long Position) received money in the margin account.
• July 1 (-)
  • Seller (Short Position) received money in the margin account.
  • Buyer (Long Position) lost money from the margin account.

Date	Buyer’s Margin	Seller’s Margin
June 29	(0.0010)×$100,000 ×1 + 100RMB	(-0.0010)×$100,000 ×1 -100RMB
June 30	(0.0008)×$100,000 ×1 +80RMB	(-0.0008)×$100,000 ×1 -80RMB
July 1	(-0.0006)×$100,000 ×1 -60RMB	(0.0006)×$100,000 ×1 +60RMB
TOTAL	+120RMB Profit	-120RMB Loss

Remember that Zhang had to input 5% of the money into his account as an initial margin (35,350RMB). After July 1, his account will be totaled at 35,470RMB.

*Note: Real Markets may note the opening and closing settlement values in “ticks” reflecting the change for an entire contract rather than per dollar. Each “tick” will have a corresponding value (e.g. on a contract sized at 125,000Euro if there is a change of 0.0001 Ticks = $12.50 change in the margin account). Calculating the change in margin accounts is: (Tick opening – Tick settlement) * Multiplier * # of Contracts.

Why Daily?

Losses can increase infinitely over time. To minimize the potential loss, clearinghouses clear smaller losses daily to limit accumulation.

Day	Opening Price (RMB per USD)	Settlement Price (RMB per USD)	Change (D-o-D)
June 29	7.0700	7.0710	0.0010
August 15	18.0500	17.9500	-0.1000

Notice that between July 29th and August 15th, the mark-to-market value changes from 707,000RMB to 1,795,000RMB. 😨 The seller may not that kind of money in his account. So the clearinghouse settles daily in smaller increments, giving the seller notice to fill up his margin account.

On the maturity date, Zhang will pay 708,000RMB and will be offset the difference of 1,000RMB through his margin account.

Maintenance Margin

Because margin account levels are rising and falling daily, they have to be maintained.

In addition to the initial margin, the clearinghouse will issue a maintenance margin requirement.

The Maintenance Margin is the minimum for the margin account. Should money fall below the maintenance margin, the owner must re-fill the account to the initial margin level.

Assume the Clearinghouse tells Zhang the maintenance margin is 90% of his initial margin. Recall that he originally deposited 5% (35,350RMB) into his margin account.

This means Zhang is required to maintain an account balance of at least 31,815RMB in his account throughout the daily settlements until August 15. If his account falls below that minimum limit, the clearinghouse will issue a margin call. Zhang is then required to refill his account to the initial margin (35,350RMB).

The margin call can be significant where the individual losses are higher than expected or where substantial contracts are involved as realized in the 2001 and 2008 financial crises.

Voiding Futures Contracts

There are two ways for Zhang to “cancel” his future contract if he ultimately decides he no longer wants to complete the exchange.

The first is by off-setting his long position by opening a short position. In this case, on August 15, Zhang would both buy and sell the $100,000 simultaneously. The clearinghouse will realize the off-set and clear his accounts on the maturity date.

The second is by selling his contract before the maturity date. In this case, he could close his position in the contract say on August 1. Any profits or losses will be adjusted for accordingly with the clearinghouse and a new buyer will be able to take up a long position in the contract.

Spot Rate	The exchange rate used in transactions processed more or less ‘immediately‘
Forward Rate	The exchange rate anticipated at some point in the future (e.g. 30 days from now).
Depreciation	When a currency loses value and purchases less foreign currency on the market
Appreciation	When a currency gains value and purchases more foreign currency on the market.
Volatile	Often changing
Currency Futures Contract	A financial contract wherein a buyer and seller agree to exchange money at a future date using a predetermined rate.
Long Position	(Buyer) — the party is expecting to purchase the currency.
Short Position	(Seller) — the party is expecting to sell the currency.
Clearinghouse	3rd party broker that manages futures contracts, offering the marketplace and tools needed to complete the exchange
Margin Account	A payment account wherein money is deposited to open a futures position and money is then deposited/withdrawn in daily settlements
Performance Bond Account	*See Margin Account.
Maturity Date	The date when the contract will expire. Often in one of a series of pre-determined months used by the clearinghouse
Exercise the Contract	To complete the exchange of money and settle the contract.
Contract Size	The quantity of money included in one futures contract.
Initial Margin	The money deposited into the margin account to open the futures position and used for daily settlements.
Daily Settlement	Where the clearinghouse marks-to-market each contract and clears any profits / losses the parties may find under the new market price.
Default	To fail to cancel or complete the contract.
Settlement Price	The price whereby the present market value of a contract is determined.
Open Interest	The number of futures contract that are currently “open” in the market at the end of the day.
Mark-to-Market	The establishment of the present market value of a futures contract based on the settlement price.
Maintenance Margin	The minimum limit for the margin account. Should the account fall below this margin, the owner must refill the account to the initial margin levels
Margin Call	The demand from the clearinghouse that the margin accounts be re-filled in the event that levels fall below the maintenance margin.

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