WHAT IS A FUTURES CONTRACT?

A futures contract is a standardized and regulated agreement between a buy and seller for the exchange of a specific amount of currency at a specific price and date. It is really however a bet on whether the price will go up or down. If the futures price goes up you make money if it goes down you lose money. Therefore it is a binding agreement to pay up your bet on a daily basis.

THE DAILY SETTLEMENT

A daily settlement occurs between the buyer and seller since the futures contract expires at the end of each day. Due to the expiration of contracts at the end of each day, there is only a day-long risk. However, the futures contract has a fixed date, amount, and delivery time in the future.

THE CLEARING HOUSE

The clearinghouse in charge of all buying and selling will require a deposit called the margin. The clearinghouse is also responsible for the settlement and the shifting of money to accounts.

Futures clearinghouses have AAA credit ratings. This removes credit risk.

Buyers and sellers of futures contracts can leave the market at any time with a reverse transaction. When a buyer or seller leaves, a new counter party is assigned to the trade. This removed market risk.

CONTRACT MATURITY

It is important that the contract maturity and the maturity of the exposure match in order for the futures contract to be entirely useful. Therefore it is better to continue each day until price expiration. New prices are set for each contract at the end of each trading day. Daily settlements will effect daily cash inflows and outflows.

CORPORATIONS AND DERIVATIVES

Futures contracts are normally used by corporations operating in the millions to billions of dollars in currency exchanges. The multinational corporation uses derivatives to protect against exchange rate fluctuations. This way a corporation will not lose money in a respective currency.

It is up to the financial analysts of a corporation to decide which derivatives to use. They can use either of the following four derivatives:

1) Futures
2) Forward
3) Money market
4) Currency Options

CORPORATIONS AND EXCHANGE RATE MOVEMENT

Multinational corporations closely monitor exchange rate movements when the cash flows are denominated by foreign currencies.

Exchange rate fluctuations are dependent on demand and supply. Demand and supply are influenced by:

inflation rates
interest rates
income levels
government

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