Currency Futures, Daily Profits and Balances, and Margin Call

Sofian is a small investor. All his life, he invested in stocks and bonds. Nowadays, he is looking into different alternatives like futures and options. He doesn't know much about these investment tools so he has decided to get some help from his friend Thomas. They are having lunch at a place close to Thomas's firm.

"Thomas, thanks for coming. As I mentioned on the phone, I am thinking about investing infutures and options. I don't know much, so I need your help."

"No problem Sofian. I know a little bit about these. What do you want to learn? Do you want to learn how to trade?" Thomas asks.

"Thomas, they told me that, when you invest in futures, sometimes your broker will contact you if you lose too much money. Is that correct?"

"Yes, everyday your balance changes depending on whether that asset goes up or down. Let's say, you took a long position in oil futures and oil went up. Your balance at the end of the day will go up. But, if oil goes down, your balance goes down. And if one day, your balance goes below a certain level which they call the "maintenance margin", your broker will contact you and you will either put more money in or close your position and take out your money" Thomas explains.

Sofian asks, "What happens if I take a short position in oil futures?"

"If you take a short position and oil goes down, it is good, your balance will go up. But, if oil goes up when you have a short position, then your balance will go down. Again, if your balance drops below the maintenance margin, you will receive a margin call, meaning that your broker will contact you. The same thing happens: you will either put more money in or close your position and take out your money" Thomas responds.

The differences between futures contracts and forward contracts are:

i) Futures contracts are:

Standardized in terms of contract size and delivery date

For example:

62,500/contract with maturity date of 3/31/2018; or

Y12.5 million/contract with maturity date of 6/30/2017

Forward contracts are tailor-made by the two parties with the help of a large bank.

ii) Most of the time, no delivery (no exchange of $ and for example when the maturity date comes).

With forward contracts, delivery occurs ($ and will be exchanged when the date comes).

iii) Futures contracts are "marked-to-market" meaning that the investor's account balance goes up or down each day, depending on the value of the versus the $.

If the investor wants to close his/her position, he/she will take out the balance on that day.

Almost all the time, investors close their position before the maturity date, therefore no actual exchange of currencies occur on the maturity date.

Forward contracts are not "marked-to-market". The two parties just wait until the maturity date to exchange the two currencies in the pre-specified amounts (i.e. the forward rate).

Forward contracts are not like an investment account where you buy or sell futures, stocks, bonds, etc. Forward contracts are just agreements between the two parties to exchange currencies in the future.

iv) In futures markets (these are exchanges like Chicago Mercantile Exchange, which is similar to an exchange like NYSE for stocks), there is a clearinghouse (a separate entity) that deals with the problems.

If one party cannot make the payment, for example, the clearinghouse will make the payment and then will go after the party that could not pay.

With forward contracts, no clearinghouse (no exchange building also).

Investors can take a long or a short position. Investopedia.com explains the long position as follows: "A long (or long position) is the buying of a security such as a stock, commodity or currency with the expectation the asset will rise in value." A short position, on the other hand, is taken when the investor expects the asset (or currency) to go down.

To take a long or a short position in a futures contract, you need to open an account in a brokerage firm. You will need to deposit an initial amount to start (called initial margin or initial performance bond). Also, your balance cannot fall below "maintenance margin", if it does, you will receive a "margin call". Your broker will contact you and you will either deposit additional money or you will close your position and take out the remaining balance.

With futures, we have daily resettlement of gains and losses rather than one big settlement at maturity.

Every trading day:

If the price goes down, the long pays the short

If the price goes up, the short pays the long

After the daily resettlement, each party has a new contract at the new price with one-day shorter maturity.

Three days ago, Sofian entered into a futures contract to sell 125,000 at $1.40 per . Over the past three days the contract has settled at $1.32, $1.28, and $1.26. He started with $3,000.

Required:

a) Calculate how much has Sofian made or lost in $ every day (day 1, 2, 3)? What is his balance at the end of each day?

(6 marks)

b) Estimate what is his total profit or loss in $ for the 3-day period.

(6 marks)

c) If Sofian start with $3,000 and if your maintenance margin is $1,000, would he receive a margin call during this period? Explain.

(3 marks)

d) Let's assume that, at the end of the third day, you withdraw $15,000. Let's also assume that, the next day (at the end of the fourth day), the exchange rate is $1.30/. Will Sofian receive a margin call? Calculate.

(6 marks)

e) If Sofian closes his account after that, determine what will be his total profit/loss?

(6 marks)

f) Currency futures can be used for speculation or hedging? Or both? If so, how? Explain.

(3 marks)