. . Chapter 20Foreign Currency Futures and OptionsQUESTIONS1. How does a futures contract differ from a forward contract?Answer: Foreign currency futures contracts, or futures contracts for short, allow individuals and firms to buy and sell specific amounts of foreign currency at an agreed-upon price determined on a given future day. Although this sounds very similar to forward contracts, there are a number of important differences between forward contracts and futures contracts.The first major difference between foreign currency futures contracts and forward contracts is that futures contracts are traded on an exchange, whereas forward contracts are made by banks and their clients. Orders for futures contracts must be placed during the exchanges trading hours, and pricing occurs in the “pit” by floor traders or on an electronic trading platform where demand is matched to supply. In contrast to forward contracts, where dealers quote bid and ask prices at which they are willing either to buy or sell a foreign currency, for each party that buys a futures contract, there is a party that sells the contract at the same price. The price of a futures contract with specific terms changes continuously, as orders are matched on the floor or by computer.A second major difference is that futures exchanges standardize the amounts of currencies that one contract represents. Thus, futures contracts cannot be tailored to a corporations specific needs as can forward contracts. But the standardized amounts are relatively small compared to a typical forward contract, and if larger positions are desired, one merely purchases more contracts. Standardization with small contract sizes makes the contracts easy to trade, which contributes to market liquidity. A third major difference involves maturity dates. In the forward market, a client can request any future maturity date, and active daily trading occurs in contracts with maturities of 30, 60, 90, 180, or 360 days. The standardization of contracts by the futures exchanges means that only a few maturity dates are traded. For example, IMM contracts mature on the third Wednesday of March, June, September, and December. These dates are fixed, and hence the time to maturity shrinks as trading moves from 1 day to the next, until trading begins in a new maturity. Typically, only three or four contracts are actively traded at any given time because longer-term contracts lose liquidity. The final major difference between forward contracts and futures contracts concerns credit risk. This issue is perhaps the chief reason for the existence of futures markets. In the forward market, the two parties to a forward contract must directly assess the credit risk of their counterparty. Banks are willing to trade with large corporations, hedge funds, and institutional investors, but they typically dont trade forward contracts with individual investors or small firms with bad credit risk. The futures market is very different. In the futures markets, a retail client buys a futures contract from a futures brokerage firm, which in the United States is typically registered with the Commodity Futures Trading Commission (CFTC) as a futures commission merchant (FCM). Legally, FCMs serve as the principals for the trades of their retail customers. Consequently, FCMs must meet minimum capital requirements set by the exchanges and fiduciary requirements set by the CFTC. In addition, if an FCM wants to trade on the IMM, it must become a clearing member of the CME. In years past, clearing memberships used to be tradable, and the prices at which they traded were indications of how profitable futures trading on the exchange was expected to be. In 2000, the CME became a for-profit stock corporation, and its shares now trade on the NYSE. To obtain trading rights, an FCM must buy a certain amount of B-shares of CME stock and meet all CME membership requirements.When a trade takes place on the exchange, the clearinghouse of the exchange, which is an agency or a separate corporation of a futures exchange, acts as a buyer to every clearing member seller and a seller to every clearing member buyer. The clearinghouse imposes margin requirements and conducts the daily settlement process known as marking to market that mitigates credit concerns. These margin requirements are then passed on to the individual customers by the futures brokers.2. What effects does “marking to market” have on futures contracts?Answer: The process of marking to market implies that futures contracts have daily cash flows associated with them. One can be either long (having bought the contract) or short (having sold the contract) in the futures market at a particular price. Since both sides are treated symmetrically, lets assume you are long. You must post funds in a margin account, and if on subsequent days, the futures price moves in your favor, that is, the foreign currenc