Question

A foreign exchange trader working for a bank enters into a long forward contract to buy one million pounds sterling at an exchange rate of 1.6000 in three months. At the same time, another trader on the next desk takes a long position in 16 three-month futures contracts on sterling. The futures price is 1.6000 and each contract is on 62,500 pounds. Within minutes of the trades being executed the forward and the futures prices both increase to 1.6040. Both traders immediately claim a profit of $4,000. The bank’s systems show that the futures trader has made a $4,000 profit, but the forward trader has made a profit of only $3,900. The forward trader immediately picks up the phone to complain to the systems department. Explain what is going on here. Why are the profits different?

Answer 1

Given Information

1. Trader 1 - Forward Contract (1,000,000 Pounds of Sterling) Exchange Rate: 1.6 (3 months)
2. Trader 2 - Futures Contract (16 * 62,500 pounds = 1,000,000 Pounds of Sterling) Exchange Rate: 1.6 (3 months)
3. Profit realized by Future Traders = 4,000 Pounds
4. Profit realized by Forward Traders = 3,900 Pounds
5. Difference in profit realized by forward trader and future trader = 4,000-3,900= 100 Pounds

Reason for Difference of Profit Realisation of 100 Pounds

Profit realized by forward trader and future trader are different because,

• The profit realized by the futures trader is due to the daily settlement of the futures contract and hence the futures trader immediately realises the profit of 4,000 pounds by entering a short contract with a rate of 1.6040.i.e (1.6040-1.6000) * 1,000,000=4000 Pounds
• The forward trader cannot realise the same profit because, if he decides to close his position by entering a short position, the position will only be closed after 3 months since forward contracts do not have daily settlement.
• He can only then realise the profit of at the end of the contract which may be smaller profit than the futures trader has made.