DERIVATIVE TRADING

SUBMITTED TODr. Sarwar Uddin Ahmed Course Instructor Options, Futures & Other Derivatives (FIN 545) MBA Program

BRITISH POUND TRADING IN CHICAGO MERCANTILE EXCHANGE (CME)

SUBMITTED BYMD. Zahid Islam ID:1025025 Nowshin Chowdhury ID: 1025036

Sanzida Rashid
ID: 0815047 Shamima Yasmin ID: 1110863
DATE OF SUBMISSION- APRIL 06, 2013 INDEPENDENT UNIVERSITY BANGLADESH

Executive Summary
Derivative trading has become very popular these days on many exchanges throughout the world. Derivative exchanges have existed for a long time. Chicago Board of Trade (CBOT, www.cbot.com), the largest derivative exchange in the world, was established in 1848 to bring farmers and merchants together. A rival futures exchange, the Chicago Mercantile Exchange (CME, www.cme.com) was established in 1919. The purpose of this project is to integrate the risk management approach through experiencing a real life trading on the Chicago Mercantile Exchange (CME, www.cme.com) along with the difficulties and limitations of the techniques applied. In compliance with the purpose we have chosen GBP/USD (a product from foreign exchange market of CME group). The GBP/USD cross rate exchange is one of the major currency pairs that make up 85% of all of the currency cross rate trades. To buy the GBP/USD one would be speculating on the British Pound/Sterling strengthening vs. the US Dollar. To sell the GBP/USD one would be speculating on the British Pound/Sterling weakening vs. the US Dollar. There are many factors affecting the GBP/USD cross rate- Money supply, inflation, interest rates, Gross Domestic Product, Balance of Trade numbers, political turmoil and commodity prices if the country relies heavily on a commodity (oil, metals, and agriculture) for its GDP. After selecting GBP/USD for trading we had to make analysis regarding the factors affecting the exchange rate for taking decision on position (Short/Long) to be taken for the GBP/USD Future Contract. After analyzing different factors on present economic situation we found that it would be justified to take Long position for the contract. We have maintained a margin table taking the settlement price at the end of each trading day. The calculation had started from 15 March, 2013 till 4th April, 2013 and the margin account was adjusted to reflect the investment gain or loss at the end of each trading day. From the margin table we found that as the price of GBP shows a general uptrend movement, going long would yield a $987.5 profit on the trade. On the other hand, if one goes short, due to the general uptrend movement of price, one will miss to reap the benefit of the upward trend of the price and will incur loss. Quite logically, the chart shows a net profit of $987.5 at the end of the period considered. However, the trend has not been a clear upward trend. The price also went down on day 1, 3, 7, 8 and 9. As such, the trader cannot be sure as to which direction the price would move the next day. Here, the trader needs to have a sound knowledge of the fundamentals the demand and supply of the currencies. If the research shows that the value of dollar is likely to fall steadily, going long would be a better option. But if the research shows that this trend is only transitory, and the dollar price would increase in near future, going short would be appropriate.

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Introduction
Foreign Exchange products are very popular in derivative markets as they are highly volatile. Forward & Future contracts on foreign exchange are very popular. Most large Banks employ both spot and forward foreign exchange traders. Spot traders are trading a foreign currency for almost immediate delivery. Forward/Future traders are trading for delivery at a future time.

Forward/Future contracts can be used to hedge foreign currency risk. Foreign Currency trading and trading on margin carries a high level of risk and can result in loss of part or all of an investors investment. Due to the level of risk and market volatility, Foreign Currency trading may not be suitable for all investors and investors should not invest money they cannot afford to lose. Before deciding to invest in the foreign currency exchange market investors should carefully consider their investment objectives, level of experience, and risk appetite. They should be aware of all the risks associated with foreign currency exchange trading.

Investment Description
As part of the projects requirement we had to select a future product from Chicago Mercantile Exchanges website portal www.cmegroup.com/company/cbot.html, therefore we came to a decision to trade GBP/USD (a product from foreign exchange market of CME group). We have decided to take Long Position on trading GBP/USD Future Contract. At the time when we select the derivative for future trade, the future price of GBP/USD was $1.5072 for three month contract (settling month Jun, 2013), and settling price of that day was $1.5081. The initial margin required for GBP/USD is $1320 and maintenance margin is $1200 and each contract size is 62500/per contract.

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Contract specification
GBP/USD FUTURES
Product Asset Class Product Symbol Contract Size Contract Month Listings Venue Trading Hours British Pound FX BP

62,500 British pounds Six months in the March quarterly cycle (Mar, Jun, Sep, Dec)

CME Globex; Electronic Markets: 6B OPEN OUTCRY (RTH) Globex (ETH) CME ClearPort 7:20 a.m. 2:00 p.m.

Sundays: 5:00 p.m.-4:00 p.m. Central Time (CT) next day. MondayFriday: 5:00 p.m.-4:00 p.m. CT next day, except on Friday closes at 4: p.m. and reopens Sunday at 5:00 pm Sunday Friday 6:00 p.m. 5:15 p.m. (5:00 p.m. 4:15 p.m. Chicago Time/CT) with a 45-minute break each day beginning at 5:15 p.m. (4:15 p.m. CT)

Price Quotation Minimum Fluctuation Initial Margin Maintenance Margin Future Price

U.S. Dollars per pound 0.0001 per British Pound increments ($6.25/contract)

$1320 $1200

$1.5072 (settling month Jun, 2013)

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Justifications for Taking Long Position in GBP/USD Forward Contract

BACKGROUND
The pound fell to its lowest level against the dollar since June 2010 as weak industrial production data heightened concerns that the U.K. economy is sinking into another recession. British central bank was likely to inject more money into the economy, which would see the currency deflate further. The pound has weakened 6.7 percent this year, the second- worst performer after the yen among 10 developed-market currencies tracked by Bloomberg Correlation-Weighted Indexes.

RECENT ANALYSIS
But during recent days GBP has strengthened itself against both the EUR and USD over the past couple of days; there are a number of variables we have to consider. The first is of course the on-going debate in Cyprus which involves The exposure of Cypriot banks to the Greek Debt Crisis. The downgrading of the Cypriot economy to junk status by international rating agencies. The consequential inability to refund its state expenses from the international markets. And The reluctance of the government to restructure the troubled Cypriot financial sector. For this reason, a bank levy charge on all foreign and domestic imports has been met with the expected uproar. This has caused the EUR to weaken and the knock on effect was the Pound rising against the single currency. It was the lack of investor confidence that caused the EUR to loose value, rather than any real confidence in GBP. The second thing to consider is that due to the fact the USD strengthened so quickly against GBP and by so much, some sort of rearrangement was always to be expected. Another view can be taken as the US economy has started to pick up, investors risk appetite has started to return and this has led to a move away from the safe haven USD

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and into riskier assets. Further spikes dependent on how economic data is viewed over the coming weeks. The pound took advantage of positive British data late last two week. Retail Sales jumped 2.1%, its sharpest rise since March 2010. As well, Public Sector Net Borrowing posted a much smaller deficit than expected. Thus, these information leads to a rise in British Pound. The following mentioned reasons work behind the uptrend in British Pound against US Dollar. 1. Nationwide HPI: Analysts are interested in House Price indexes as higher house prices signify more activity in the housing market. The index recorded a modest gain of 0.2% in the February release. The market was in a hope for another strong showing in the March release. 2. Current Account: Current Account is a key indicator, as a stronger reading indicates that foreigners are purchasing more British goods and services with pounds. In February there was a sharp reduction in the Current Account Deficit, which fell to 12.8 billion pounds. This beat the estimate of 14.1 billion pounds. The March forecast calls for a modest drop in the deficit, at 12.4 billion pounds. 3. Final GDP: Analysts are always interested in GDP releases, which measure the change in value of goods and services of the UK economy. Final GDP, which is released each quarter, jumped 0.9% in Quarter 4, its sharpest increase since 2010. 4. Consumer Confidence: Consumer Confidence has been stuck deep in negative territory, signifying that the British consumer is very pessimistic about the economys prospects. Thus Consumer Inflation Index (CPI) has been steady as a rock. 5. PPI Input: The Producer Price Input is a key release and a potential market-mover. The index climbed a robust 1.3% in February, beating the forecast of 0.9%. The markets were expecting another strong release for March, with the estimate standing at 1.6%. 6. RPI: The Retail Price Index includes housing costs, in contrast to CPI. The February reading came in at 3.3%, and the estimate is identical for the upcoming release. 7. BOE Credit Conditions Survey: This indicator is released on a quarterly basis. The survey polls bank and other lenders for their views of short-term credit conditions in the UK. If the indicator points to rising debt levels, this in turn is indicative that lenders are comfortable providing loans and consumers are borrowing and spending more. Public Sector Net Borrowing posted a rare surplus in February. , but nonetheless fell short of the estimate. The markets are expecting a deficit with an estimate at 8.4 billion pounds. 8. CBI Industrial Order Expectations: This important manufacturing indicator has been mired deep in negative territory. The indicator improved last month, but posted a weak reading of -14 points. The estimate for the March release is -16 points.
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9. Index of Services: This third-tier indicator measures the change in Gross Value Added (GVA) of the government and private service sectors. The index dropped sharply from the February reading, posting a decline of 0.1%. The markets are expecting another weak release in March, with an estimate of -0.2%. Furthermore, after analyzing all the factors we found that pound managed to push itself against other currencies due to a growth in UK Service sector. On a year-on-year basis, U.K. service output was up 0.8 percent. Helping services in January was activity in the transport, storage and communications sector as well as in business services and finance. GBP has outperformed other European currencies due to its safe haven status.

Arbitrage Opportunity
Forex arbitrage is a risk-free trading strategy that allows retail forex traders to make a profit with no open currency exposure. The strategy involves acting fast on opportunities presented by pricing inefficiencies, while they exist. This type of arbitrage trading involves the buying and selling of different currency pairs to exploit any inefficiency of pricing. The arbitrage opportunity occurs when there is difference between the prices offered by different currency sellers or there is difference between the spot prices on different dates. Each currency contract is a quote for that currency directly against the U.S. dollar, a net short amount of contracts means that more speculators are betting that currency to fall against the dollar and a net long position expect that currency to raise versus the dollar. There lies an arbitrage opportunity in trading the future contract of GBP/USD, as the British pound rate is rising against USD. Thus in future if the price keeps the uptrend the product can be purchased at a lower rate under long position. And thus Pound can be sold to the market at high rates resulting in a gain from the price fluctuation of spot price on different dates.

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Margin Table & Investment Performance

Day Future Price ($) Daily Gain/Loss ($) Cumulative Gain/loss ($) Margin Account Balance ($) Daily Interest on Gain ($) Daily Interest Paid on Initial Margin ($) Total Margin Account Balance ($) Margin Call

A 1.5072
15-Mar-13 18-Mar-13 19-Mar-13 20-Mar-13 21-Mar-13 22-Mar-13 25-Mar-13 26-Mar-13 27-Mar-13 28-Mar-13 1-Apr-13 2-Apr-13 3-Apr-13 4-Apr-13 1.5081 1.5118 1.5094 1.5108 1.5175 1.5222 1.5175 1.5151 1.5122 1.5165 1.5224 1.5101 1.5137 1.5230

D $1,320

E= (C*0.10/360)

F= (1320*0.16/360)

G= (D+E)-F $1,320 $1,200

56.25 231.25 -150 87.5 418.75 293.75 -293.75 -150 -181.25 268.75 368.75 -768.75 225 581.25

56.25 287.5 137.5 225 643.75 937.5 643.75 493.75 312.5 581.25 950 181.25 406.25 987.5

1376.25 1607.5 1457.5 1545 1963.75 2257.5 1963.75 1813.75 1632.5 1901.25 2270 1501.25 1726.25 2307.5

0.01562 0.07986 0.03819 0.06250 0.17882 0.26042 0.17882 0.13715 0.08681 0.16146 0.26389 0.05035 0.11285 0.27431

0.58667 0.58667 0.58667 0.58667 0.58667 0.58667 0.58667 0.58667 0.58667 0.58667 0.58667 0.58667 0.58667 0.58667

1375.68 1606.99 1456.95 1544.48 1963.34 2257.17 1963.34 1813.30 1632.00 1900.82 2269.68 1500.71 1725.78 2307.19

Total

1.90104

8.21333

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Performance Evaluation:
We entered on the Future contract of GBP/USD on 15th March, 2013 with a strike rate of $1.5081 against each Great Britain Pound (GBP) with $1320 initial margin for a contract size of 62500, and we have to maintain minimum maintenance margin of $1200. On the following working day (18th March), the strike price for the contract hits to $1.5118 against each GBP, which is slight increase of price than the previous day ($1.5118 - $1.5081 = $0.0038). By this price increase, our total margin increased by ($1376.25 - $1320) $56.25. Here the return from investment is 10%, so our daily interest gain from our investment for 18th March, 2013 was ($56.25 * 10%/360) $0.01562. Again, here our cost of financing is 16%, so our interest payment for margin on 18th March was ($1376.25 * 16%/360) $0.61167. Therefore, our total margin balance remain after 1st day of trading (Margin account balance + Gaining return form investment daily interest paid on financing) is $1375.65 At the end day of our trading, our final margin account balance remained with $1900.57. This means, we have gained ($1900.57 - $1320) $580.57 by taking long position of a future contract after meeting all standard interest payment criteria. The following chart shows the Future price trend in trading GBP/USD Future contract from the Margin Table-

Future Price
1.525 1.52 1.515 1.51 1.505 1.5 1.495 Future Price

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Conclusion
Foreign Exchange market is highly volatile and trading with foreign exchanges is exposed to a high degree of risk. Though the Sterling market was in down trend since last year; Pound has been benefited since last two weeks from the on-going unrest in Cyprus. Thus, through taking the Long position we can be benefitted in near future, as the price may rise if the unrest and investors lack of confidence on EURO market continue. We can gain from trading the GBP/USD future contract through taking short position while the price is high but we can buy British Pound at a lower rate. However, risk may lies with this decision of trading. If we look historically it is very rare rates stay below 1.50 for very long and it would be wise to anticipate GBP/USD levels to fluctuate between 1.5050-1.5350 over the coming weeks, based on the current market conditions. The UK economic outlook at present remains fragile and unable to maintain, in its own right, a strong Pound.

Bibliography
1. 2. 3. 4. 5. 6. 7. 8. https://www.cmegroup.com/trading/fx/g10/british-pound_quotes_settlements_futures.html https://www.forexcrunch.com/wp-content https://www.countingpips.com/fx/wp-content http://www.poundsterlingforecast.com/2013/03/26/cypriot-debt-crisis-leaves-the-marketsguessing-once-again-matthew-vassallo/ http://www.poundsterlingforecast.com/2013/03/21/will-the-pounds-recent-spike-continuematthew-vassallo/

http://online.wsj.com/article/SB10001424127887323826704578355470409605776.html http://www.bbc.co.uk/news/business-21496997 http://www.economy-news.co.uk/fx/2941-pound-sterling-rate-pushes-higher-453543

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