248 CHAPTER 6. THE MARKET FOR CURRENCY FUTURES
Many of the European futures contracts are in effectcollateralized forward con-
tracts, where the investor puts up more collateral (securities, or interest-bearing
deposits) if the price evolution is unfavorable, rather than making a true payment.
As was explained in Chapter 6, a collateralized forward contract is not subject to
interest risk.
Let us now see how a eurocurrency futures contract works. A useful first analogy
is to think of such a contract as similar to a futures contract on aCD, where the
expiration day,T 1 , of the futures contract precedes the maturity date,T 2 , of theCD
by, typically, three months. (The three-month money-market rate is widely viewed
as the representative short-term rate,) Thus, such a futures contract serves to lock
in a three-month interest rate at timeT 1.
Example 6.15
Suppose that in January you agree to buy, in mid-March, aCDthat expires in mid-
June. The maturity value of theCDis 100, and the price you agree to pay is 99.
This means that the return you will realize on theCDduring the last three months
of its life is (100 – 99)/99 = 1.0101 percent, or 4.0404 percent simple interest on a
yearly basis. Thus, this forward contract is analogous to signing anFRAat 4.0404
percentp.a.for three months, starting mid-March.
In the example, we described the futures contract as if it were a forward contract.
If there is marking to market, the interest risk stemming from the uncertain marking-
to-market cash flows will affect the pricing. Another complication with futures is
that the quoted price is often different from the effective price, as we discuss below.
Still, it helps to have the above example in mind to keep from getting lost in the
institutional details. We first derive how forward prices on T-bills orCDs are set,
and how they are linked to the forward interest rate. We then discuss the practical
problems with such a system of quotation, and explain how this has led to a modern
futures quote, an animal that differs substantially from the forward price on a T-bill
orCD.
6.6.1 The Forward Price on aCD.
The forward price on aCDis just the face value (1, most often quoted as 100 percent)
discounted at the forward rate of return, rt,Tf 1 ,T 2. To understand this property,
consider a forward contract that expires atT 1 and whose underlying asset is a euro-
CDmaturing atT 2 (>T 1 ). Since the euro-CDhas no coupons, its current spot price
is:
Vt=1
1 +rt,T 2, (6.18)
where, as always in this textbook,rt,T 2 denotes an effective return, not ap.a.interest
rate. TheCD’s forward price at t, for delivery atT 1 , is this spot value grossed up
with the effective interest between t andT 1 (line 1, below), and the combination of