world of economics
- An individual, firm, or bank can also purchase or sell foreign exchange futures and options. Trading in foreign exchange futures was initiated in 1972 by the International Monetary Market (IMM) of the Chicago Mercantile Exchange (CME). A foreign exchange future is a forward contract for standardized currency amounts and selected calendar dates traded on an organized market (exchange).
- The currencies traded on the IMM are the Japanese yen, the Canadian dollar, the British pound, the Swiss franc, the Australian dollar, the Mexican peso, and the euro. International Monetary Market trading is done as contracts of standard size. For example, the IMM Japanese yen contract is for ¥12.5 million, the Canadian dollar contract is for C$100,000, the pound contract is for £62,500, and the euro contract is for ¤125,000. Only four dates per year are available: the third Wednesday in March, June, September, and December.
- The IMM imposes a daily limit on exchange rate fluctuations. Buyers and sellers pay a brokerage commission and are required to post a security deposit or margin (about 4 percent of the value of the contract). A market similar to the IMM is the NYSE Euronext Liffe and the Frankfurt-based Eurex.
- The futures market differs from a forward market in that in the futures market only a few currencies are traded; trades occur in standardized contracts only, for a few specific delivery dates, and are subject to daily limits on exchange rate fluctuations; and trading takes place only in a few geographical locations, such as Chicago, New York, London, Frankfurt, and Singapore.
- Futures contracts are usually for smaller amounts than forward contracts and thus are more useful to small firms than to large ones but are somewhat more expensive. Futures contracts can also be sold at any time up until maturity on an organized futures market, while forward contracts cannot. While the market for currency futures is small compared with the forward market, it has grown very rapidly, especially in recent years. (The value of currency futures outstanding was about $475 billion in April 2010). The two markets are also connected by arbitrage when prices differ. Since 1982, individuals, firms, and banks have also been able to buy foreign exchange options (in Japanese yen, Canadian dollars, British pounds, Swiss francs, and euros) on the Philadelphia Stock Exchange, the Chicago Mercantile Exchange (since 1984), or from a bank.
- A foreign exchange option is a contract giving the purchaser the right, but not the obligation, to buy (a call option) or to sell (a put option) a standard amount of a traded currency on a stated date (the European option) or at any time before a stated date (the American option) and at a stated price (the strike or exercise price). Foreign exchange options are in standard sizes equal to those of futures IMM contracts. The buyer of the option has the choice to purchase or forego the purchase if it turns out to be unprofitable. The seller of the option, however, must fulfill the contract if the buyer so desires. The buyer pays the seller a premium (the option price) ranging from 1 to 5 percent of the contract’s value for this privilege when he or she enters the contract. About $207 billion of currency options were outstanding in April 2010.
- Spot and In contrast, neither forward contracts nor futures are options. Although forward contracts can be reversed (e.g., a party can sell a currency forward to neutralize a previous purchase) and futures contracts can be sold back to the futures exchange, both must be exercised (i.e., both contracts must be honored by both parties on the delivery date). Thus, options are less flexible than forward contracts, but in some cases they may be more useful.
- For example, an American firm making a bid to take over an EMU firm may be required to promise to pay a specified amount in Euros. Since the American firm does not know if its bid will be successful, it will purchase an option to buy the Euros that it would need and will exercise the option if the bid is successful.