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# New kids on the block: Currency Futures, Islamic Banking and Spot-to-Futures Arbitrage

Posted by TheEconomist, 17 September 2007 · 81756 views

As I promised to my readers, I am returning with an article about the "new" currency futures contracts introduced by the non-NFA regulated brokers. Together with arbitrageable commodities, currency futures prove to be some of the most valuable contracts to be found in a broker's datafeed.

1. Basics of Currency Futures
======================

Currency futures are the standardized, transferrable version of currency forwards. Currency forward contracts lock in the price at which an entity can buy or sell a currency on a future date. But how is a currency futures priced?

A spot forex rate is the rate at which two currency amounts are equal : for example, 10000 USD are (at a moment, "spot") equal to 1.230.000 JPY at 123 JPY/USD rate. Since the time value of a currency is given by the interest, the currency futures rate which equalizes them incorporates the differential rate.

Suppose we have two currencies, A and B, both equal now, as A/B = 1 spot rate.

A interest in 20%, while B interest is 5%

so there is a rate which equalizes 1.20 with 1.05 , and that rate is 0.875 , as 1.20 x 0.875 = 1.05

Hence the futures formula:

In our case, the spot rate didn't had any effect, since it was 1.

We must know 2 elements:

1. The interest rates
2. Futures expiry dates

1. The interest rates

That's an easy one. A reliable source for this can be found here on FXStreet .

2. Futures expiry dates

This can be done in a few ways:
a. Download WHC's MetaTrader. Then point to Market Watch, right click, (Show All if they are not already) , Show All, then Properties, then expand the Currencies top folder.
b. Directly from CME website (see below)

Of course, when you use the formula you must calculate the time to expiry as precise as possible , because it influences the interests put inside the formula.
For example, if we have 90 days to expiry, that 1+C2 Interest Rate % from the formula transforms in 1 + (0.5/100) / 365 x 90 = 1.001232876

Almost forgot: depending on the strategy you'll decide to use, it may be useful to check when the next meetings of the central banks officials will take place and also what's the expectation about the interest rates.

2. Spot-to-Futures Arbitrage
=====================

Since the futures are linked to the spot by the interest to expiry, and futures at expiry equalizes the spot (this equalization is a feature of all futures contracts that have a spot counterpart) there are two possible spot-to-futures arbitrages:

a. exploiting the difference between spot and futures (often called basis) and cashing it in while paying interest on spot position (the "Covered Interest Arbitrage" in finance books) ; or, depending on the broker's feed , the reverse : paying the basis and getting interest on spot position (which is ockward and not likely to happen for real, but never say never)
b. exploiting missalignments of the converted futures to the spot (or of the real futures to the calculated futures , which is the same thing) using interest rates.

However, type b. arbitrage is not as seldom as that picture lets to be understood. You don't have to be a genius to see that a misprice happens not only when futures is on the wrong side, but also when futures is not where it should be: We could also discount (let's call it like that the conversion of futures to spot, even if some futures are discounted, e.g. USDJPY) the futures and see how far is from the real spot. We should also have a neat time conversion on hand to have a continuous time, not a jumpy one (e.g. not the time that decreases by one day when a day passes, but a time in real number format). The discounted futures is calculated using the reversed upper formula (get the spot from the equation to find it out).

Discounted futures to spot basis fluctuation

The overlay indicator : DiscountedFutures
The window indicator : DiscountedBasis

As you can see, with 5-6 pips in magnitude of arbitrage windows, you could cover the 4 pip costs of arbitrage (2 pips on EURUSD, 2 pips 6E equivalent commission in pips). But is MetaTrader fast enough? However, with a pretty superior account trading at 1 pip spread it might work smoothly... With a regular case of EURUSD - 6E you could, for example, when DiscountedBasis has a higher value, sell the futures and buy the spot, and close when it reaches a lower than regular value...

The picture below depicts the basis and swaps consuming reciprocally (in the normal swap rate regime), while the new, swap-free accounts based on brokers arrangements with islamic banks provide new, outstanding arbitrage opportunities:

Parameters : Account equity about 450 USD; Account leverage about 200 ; Margin usage = 90% ;

from Futures.mq4 script

This example was run on WHC (although WHC doesn't offer swap free accounts).

How are the calculations done?

Below is a picture with the implementation made by Beaverhea Financial. Although it's an untrustable broker, the implementation is useful for calculus and demo.

The real currency futures implementations on CME

The ones that can be found with brokers are:

CME Euro FX
CME Australian Dollar
CME British Pound
CME Japanese Yen
CME Swiss Franc

WHC comes also with these two, but they don't seem to work properly:
CME EC/JY Cross Rate
CME EC/SF Cross Rate

Now the arbitrage is pretty simple to understand if it's about EURUSD and 6E. Provided that EURUSD's lotsize is 100K and 6E's lotsize is 125K, the ratio : EURUSD traded lots / 6E traded lots = 5/4, as 5 x 100K = 4 x 125K to equalize pip movements.

But what if it's a reversed futures, such as USDJPY to 6J ?

This is a calculus example, using the Impeccable Hedge algorithm that powers FPI, Intercross Arbitrage and Swap Arbitrage

We consider:

USD - 5.25%
JPY - 0.25%

USDJPY right before old futures expiry: 123.00
6J right before old futures expiry = 100/123.00 = 0.8130

New futures, in the first moments, with expiry in 3 months:

Actually tested the formula on june 15 data and it was accurate on a range of 6 pips
(of course I used 92 days period instead of dividing to 4)

Prepairing the hedge : USDJPY spot > transformed USDJPY futures : Sell USDJPY, Sell 6J

Sold 100000 (1 lot) USDJPY @ 123
Sold 100000 USD
Bought 12300000 JPY

Sold 12300000 (0.98 lots) JPYUSD (6J) @ 0.8232 (/100)
Sold 12300000 JPY
Bought = 101253.6 USD

That 1253.6 must be the embedded interest in the futures.

Supposing now USDJPY=127 on expiry ; 6J is right reversed = 0.7874

Sell 100000 USDJPY @ 123 -> (1 pip = 10*100/127 = 7.87 USD) : -400 pips x 7.87 = -3148 USD
Sell 1230000 6J @ 0.8232 -> (1 pip = 12.3 USD) : 358 pips x 12.3 = 4403.40 USD

Result = 1255.40

Supposing now USDJPY=119 on expiry ; 6J is right reversed = 0.8403

Sell 100000 USDJPY @ 123 -> (1 pip = 10*100/119 = 8.40 USD) : 400 pips x 8.40 = 3360 USD
Sell 1230000 6J @ 0.8232 -> (1 pip = 12.3 USD) : -171 pips x 12.3 = -2103.30 USD

Result = 1256.70

As you see, arbitrage holds no matter the direction. And if the regime is swap free, pocket all of it... about 200K USD in traded volume, this would be tradable with a 500 USD account at about 450 leverage! This means more than double!

Of course it is advisable to review articles on central banks monetary policies especially if their meetings happen close to the beginning of futures. Create scenarios about what might happen if interest differential enlarges. Calculate the damage done to the equity, add 20-30 pips or more of market "missalignments" and see at what leverage it is sustainable (also include here the issues about not trading microlots - see the Intercross Arbitrage article). If you're heavy leveraged and faint hearted, better close positions before central bank meetings, and , most important, don't EVER forget to close positions before expiry or your account will likely be blown up due to violent futures shift on expiry change (or hopefully you'll just lose the profit!) . You could even test broker's vigilance by reversing positions with a day before expiry in order to make the entire profit on the expiry shift moment... Whatever, the method is a great progress from leaving the forex madness for a slow paced and profitable trading with controllable risks!

========================

Be very careful about how you set up DiscountedFutures and DiscountedBasis, especially with the interest rates and the expiries!
Look close at the SwapFree parameter when running Futures.mq4 script!
And be extremely careful when running on real accounts! Measure ten times and cut once! The script supposes all margin requirements are the same, however with some brokers margins for futures are bigger. Experiment first on demo.

#### Attached Files

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Hi Bog.

Very good article and good sourcecode. I'm going to have a deeper look in it, as currently I'm working on the same thing, as you know.

Keep in touch, Andi.
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Are you planning an trading EA for the so called "Type B" Arb? Would be nice to see, if its possible to catch such ppportunities.

Andi
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Are you planning an trading EA for the so called "Type B" Arb? Would be nice to see, if its possible to catch such ppportunities.

Andi

Matt did a similar thing but with correlations (picked a common point and displayed movements of spot and futures from that one).
He made cash.... now they put him on manual execution.
I'd think about an EA if I'd have a pip spread. I'd be confortable with that.

I see there is this lure... that passive trading gives the impression money are not really used, while active trading gets the full consideration.
However, I'd consider a combinated strategy, with a long hedge to generate interest, both trades being hedged by another pair of hedges (when basis gets big), in order to get the b. type arbitrages (of course this pair of trades is closed when arbitrage window closes).

Bogdan
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I repaired and placed back for download the DiscountedBasis and DiscountedFutures indicators, because 6C wasn't treated as a reversed futures of USDCAD (also modified expiries and interest rates). However USDCHF - 6S is not displaying right and I don't have a clue where the mistake is.
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I would really like someone to explain me why there is a difference between the discounted futures and the spot... I don't see why it exists, why the discounted futures isn't 90% of the time 2-3 pips around the spot...
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Bog,
I do not understand well your question.
Are you asking why futures have a discount or premium of spot?
juan
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Bog,
I do not understand well your question.
Are you asking why futures have a discount or premium of spot?
juan

No, I am asking why the discounted futures already is distant from the spot...(as if it's not completely discounted).

P.S.
If you have trouble running futures.mq4 , slide the MarginUsage to 85.
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I'm with you Bog. Cannot understand, why there is a gap between the calculated future from real spot and the real spot.
Just checked some brokers - everywhere the same...

Andi.
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Give me an example and I will see...
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Hi Juan.

Sample from yesterday:

EURUSD spot is BID 1.3862
Interest EUR=4.0%
Interest USD=5.25%
6E Future expires 17.12.2007 = 90 days

6E Future BID = EURUSD spot BID x (1+(USD Interest/100)/365 x days)) / (1+(EUR Interest/100)/365 x days))

6E = 1.3862 x (1+(5.25/100)/365 x 90)) / (1+(4/100)/365 x 90)) = 1.3904

The REAL 6E Future at that time was 1.3893 -> about 10 pips differ to our calculation. And this gap holds on...

Andi
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Guys, Fed has lowered fed rates from 5.25% to 4.75% yesterday.

So 1.3862*(1+(4.75/100)/365*90)/(1+(4/100)/365*90) = 1.3887

very near to the 1.3893, only 5 pips difference

But remember that Central bank rates are a proxy of the real cost of building a synthetic future. I will post a comment on this later today.
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Hi guys, one way to create a synthetic currency Future is using swaps. You can also do it with put and calls. Let´s stick to swaps...

If you look at this link
http://www.saxobank....lt.aspx?id=1572
You will get the interests rates for EUR and USD. The swap charge or credit are based on the LIBOR/LIBID interest rates of the two traded currencies with an added a markup of +/- 0.25%.
So if we adjust the rates given

EUR LIBID:3.8%+0.25%
USD LIBOR:5.2%-0.25%

We recalculate

1.3862*(1+(4.95/100)/365*90)/(1+(4.05/100)/365*90)= 1.3892

So there is one pip difference... 1.3892 vs 1.3893

Enjoy
Juan
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Hi guys, one way to create a synthetic currency Future is using swaps. You can also do it with put and calls. Let´s stick to swaps...

If you look at this link
http://www.saxobank....lt.aspx?id=1572
You will get the interests rates for EUR and USD. The swap charge or credit are based on the LIBOR/LIBID interest rates of the two traded currencies with an added a markup of +/- 0.25%.
So if we adjust the rates given

EUR LIBID:3.8%+0.25%
USD LIBOR:5.2%-0.25%

We recalculate

1.3862*(1+(4.95/100)/365*90)/(1+(4.05/100)/365*90)= 1.3892

So there is one pip difference... 1.3892 vs 1.3893

Enjoy
Juan

Very smart So we could just modify the parameters area of the indicators.
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Hi Juan.

You got it. I also thought about a "flat fee" beeing charge from the broker, near the global interest rate.
We now can rearrange the calculations and use brokers swap.

Andi.
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Mr. H
Hi Everyone,

Has anybody noticed any broker providing NZD/USD Futures and Spot on the same account?
Is it allowed to hedge Forex Spot with Forex Futures with non interest brokers?

Best wishes.
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Hi Everyone,

Has anybody noticed any broker providing NZD/USD Futures and Spot on the same account?
Is it allowed to hedge Forex Spot with Forex Futures with non interest brokers?

Best wishes.

Hi there Mr. H,

I didn't see a broker that offers NZD/USD, at least for the MT brokers area that I know.
Now I won't put the problem as "if it would be allowed to hedge". You have the spot, you have the futures, you can trade both simultaneously, why not?
I'm putting the problem like this : "Is it allowed to keep trades for a long period of time ?"
This is a thing to ask your broker before starting up this strategy.

Regards,
Bogdan
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Mr. H
Bog,

Windsor Brokers Ltd. told me a non interest forex spot position is allowed for 10
days then they charge a daily fixed fee until the position is closed.
I don't know this fixed daily charge yet.

Regarding placing 2 or 3 orders together on MetaTrader, do you use a script or EA or do it manually one after the other?

Thanks,

Mr. H
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Bog,

Windsor Brokers Ltd. told me a non interest forex spot position is allowed for 10
days then they charge a daily fixed fee until the position is closed.
I don't know this fixed daily charge yet.

Regarding placing 2 or 3 orders together on MetaTrader, do you use a script or EA or do it manually one after the other?

Thanks,

Mr. H

Well, it could work, or it may not be enough. I see that sometimes it takes a lot of time to push forward, then jumps instantly, so the growth is not necesarilly day-by-day. You can use my futures.mq4 to place the trades (supposing the symbols are the same), or you could learn the calculations and place them yourself. If you do by futures.mq4, test how it works first on a demo. However, it would be interesting to find out how much that fixed fee is. Because, if it's fixed, may be a way around it.

Regards,
Bogdan
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Mr. H

Well, it could work, or it may not be enough. I see that sometimes it takes a lot of time to push forward, then jumps instantly, so the growth is not necesarilly day-by-day. You can use my futures.mq4 to place the trades (supposing the symbols are the same), or you could learn the calculations and place them yourself. If you do by futures.mq4, test how it works first on a demo. However, it would be interesting to find out how much that fixed fee is. Because, if it's fixed, may be a way around it.

Regards,
Bogdan

Bogdan,

Yes, I noticed that the growth is not consistent day-by-day but by the Futures expiry, profit can be realized.
I have not looked at Futures.MQ4 yet but my idea is for example:
Do the Calculation manually then
Set up the following in a script / EA:
Sell X lots of USD/CHF Spot at Market BID and
Sell Y Lots of CHF/USD Futures at Market BID
Once all orders filled then
Close all open positions at a specific exit date and time.

Sorry Bogdan, I don't know what you mean by
"However, it would be interesting to find out how much that fixed fee is. Because, if it's fixed, may be a way around it."

Regards,

Mr. H
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Well, it could work, or it may not be enough. I see that sometimes it takes a lot of time to push forward, then jumps instantly, so the growth is not necesarilly day-by-day. You can use my futures.mq4 to place the trades (supposing the symbols are the same), or you could learn the calculations and place them yourself. If you do by futures.mq4, test how it works first on a demo. However, it would be interesting to find out how much that fixed fee is. Because, if it's fixed, may be a way around it.

Regards,
Bogdan

Bogdan,

Yes, I noticed that the growth is not consistent day-by-day but by the Futures expiry, profit can be realized.
I have not looked at Futures.MQ4 yet but my idea is for example:
Do the Calculation manually then
Set up the following in a script / EA:
Sell X lots of USD/CHF Spot at Market BID and
Sell Y Lots of CHF/USD Futures at Market BID
Once all orders filled then
Close all open positions at a specific exit date and time.

Sorry Bogdan, I don't know what you mean by
"However, it would be interesting to find out how much that fixed fee is. Because, if it's fixed, may be a way around it."

Regards,

Mr. H

You're right. If you want to trade using similar risk parameters like me, consider a margin usage of 50%. Suppose your broker allows max leverage of 200,
X = ( Account equity * 200 * 50% )/100.000
Z units of bought CHF = X*100.000*(USD/CHF bid);
Y=Z/125.000

As for the closing moment, that one should be on december 13. The day before the one you can see in WHC's MetaTrader (don't know, perhaps you have it on Windsor Brokers Metatrader too).

Now let's settle out that daily fee problem.
If the daily fee is fixed, it means that the cost of maintaining the position is for the entire period to expiry, no matter which forex/futures pair you use, be it the best or the least profitable, and also, no matter how the interests rate change until that time. Now, what "flat" exactly means, is something I can just suppose. Say this would behappening to me:
My strategy should make, in average , $16 a day, as you see, I sold 1.6 lots of USDJPY, and, at that time, there were aproximately 70 pips left to go (after cutting a few pips as error and a few pips for the commission and spread) for about 70 days left to expiry. So, one pip a day. Suppose I'd have to pay$5 a day, fixed fee. I should stand up to it pretty easily. Even if I'd trade double, and make $32 a day, it would be no difference, the "fixed" thing would still be$5 a day. I've traded the best thing I had available. Supposed I would have chosen to trade EURUSD/6E, with, let's roll the dice, 40 pips to win / 92 days to expiry. At the same 1.6 lots EURUSD, it would have meant 40/92 x $16 =$6.88 a day. Dangerously closed to the $5 daily costs. Almost nothing, but the profit would help me get a bit farther from these costs for the next cycle. Now, what if those$5 a day would be "per lot" ?. For my trading, it would mean $5 * 1.6 =$8. This would have wiped out the EURUSD/6E strategy and would have eaten 50% of the USDJPY/6J strategy output. Even more, the $8 cost would double in the next trading cyle, so it would be at a rate of 50% of the average profit, whereas by being absolutely flat, the$5 cost would become insignifiant over time. You have to find out all the terms linked to the flat fee if you want to use this trategy.

Regards,
Bogdan
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### My Infocard

Bogdan Caramalac
[email protected]

Studies:
The Financial & Accounting Management Faculty within the "Spiru Haret" University, Bucharest, 2002 (BS degree issued by The Faculty of Finance, Insurance, Banking and Stock Exchanges within the Academy of Economic Studies, Bucharest)

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