Forex Investment and Currency Trading

You as an investor must consider that financial futures have a symmetrical risk profile. This means that both the buyer and the seller face an equal distribution of potential profits or losses, and that these are essentially unlimited for both the buyer and seller.

Market price risk

The risk of changes in market prices and rates ahs the following effect: The buyer (seller) incurs a loss if the price of the futures contract falls (rises). The buyer (seller) makes a profit if the price of the futures contract rises (falls).

The price performance of a futures contract depends in particular on changes in the spot price of the underlying asset, the cost of carry, and other influencing factors (e.g. market liquidity).

Basis risk

Basis risk is a form of market price risk which results from the relationships between futures prices and changes in market parameters. The latter may influence the price of a futures contract, reducing the value of an existing futures position even though the credit quality of the counterparty obligated to perform under the contract has not changed.

A description of basis risk requires an understanding of the factors influencing the price of a futures contract. The price of a futures contract is determined by:

• Changes in the spot price,
• the cost of carry, and
• other influencing factors (F).

Basis is the difference between the futures price and the spot price. It is comprised of the cost of carry and other influencing factors.

Basis = actual futures price – spot price = cost of carry + F

Basis may be positive or negative, and it generally converges to zero towards the end of the term of a contract, as the spot price and the futures price are identical on the maturity date. Basis may change over the course of time and is thus subject to interim fluctuations. The exact value of the basis on a given date in the future cannot be predicted with any certainty. The reasons for this are the changing cost of carry over the course of time and differing expectations on the spot and futures markets.

Basis risk affects offsetting (hedged) positions on the spot and futures market which are closed out during the term of the contract. From the hedger’s perspective, there is the (basis) risk of the price of the futures contract not moving fully in lock step with the price of the underlying asset. Because of this basis risk, a hedge that is to be closed out prior to expiry can therefore never be calculated with absolute certainty. Hedging transactions can thus always result in some unforeseeable loss or gain.

Risk of leverage

In order to engage in a futures transaction, you initially require a very minimal level of funds. The initial amount of capital which is invested is limited to the initial margin which must be deposited. However, futures transactions generally involve a leverage effect, such that the change in value of a futures position can be a multiple of this initial capital investment. Even minimal changes in the price of the underlying asset may thus lead to substantial profits, but also to the consequence of large losses. The potential for losses is practically unlimited.

The following example should make the leverage effect more clear. The profits and losses which you as the holder of a futures position incur depending on changes in the futures price are relative to the nominal value of the contract. As the purchaser of a contract with a nominal value in the amount of US$ 100,000, then if the initial margin is 1% of the nominal value, you only have to deposit US$ 1,000 at the time you execute the transaction. However, if the price subsequently changes by 5%, you will have to put up an additional US$ 5,000 (=5% of US$ 100,000) of variation margin.

Correlation risk

Because of the standardization of futures contracts, you cannot assume that a perfect 100% hedge of an underlying transaction will always be possible. This risk of a mismatch between an underlying position and a futures contract arises particularly when:

• the amount of the position to be hedged does not match the standard futures contract size or a multiple thereof (whole contract problem),
• the expiry dates of the futures position and the position to be hedged do not match (maturity mismatch), or
• no futures contract is offered which exactly matches the underlying asset and/or currency to be hedged (availability problem).

Delivery risk

As the buyer of a futures contract, you should be aware that, unless you have already closed out your position prior to final settlement, you must make funds in the amount of the agreed purchase price available on the expiry date in order to pay for the delivered underlying asset. This requires substantial funds which generally far exceed the amount of the margin already provided.

As the seller of a futures contract, you must be aware that, unless you have closed out your position by the final day of contract trading, you must deliver the underlying asset or instrument on which the contract is based. If you do not possess the underling asset, you must buy it at the current market price which may be substantially above the originally agreed futures price. You therefore bear a risk of loss which is theoretically unlimited. The loss incurred may exceed the amount of the margin you have provided many times over.