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Financial Futures: Equity Indexes, Interest Rates, Foreign Currency Exchange

Updated: Sep 21

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(1) Equity Index Futures

Market Indices are portfolios of securities (stocks or bonds) representing a segment of the final market, are widely used as a benchmark and also to develop investable instruments such as Index Funds and Exchange Traded Funds (ETF). As an alternative to investing in these index tracking funds, equity indexes can also be traded in futures market.

For these equity index futures contracts, macro-economic data as well as data for specific stocks held within the index will need to be reviewed to make buying and selling decisions. Each particular index futures market will have unique factors that will affect price. These are cash-settled contract based upon the value of a stock market index, have a broad spectrum of uses including risk hedging for stocks investment.

Economic factors such as GDP, inflation, interest rates and employment rates will influence the domestic economy, and thus impact individual stocks by affecting financials of the company. This results in price increase or decrease in an equity index. Available economic data can be analysed to create trading strategies based on expected behaviours. For e.g. if there are high unemployment rates, consumer confidence will drop, people are less willing to spend money on certain discretionary items, so companies in these sectors may see decreases in revenue and profits, leading to long term stock price dip. If stock prices of sufficient companies in the index move, the index will correspondingly move because each stock contributes to the index based on the size of its market capitalization. So if stock prices of large cap companies move, they will affect the index more than small cap companies.

As equity index futures are based on stock price of the underlying companies, the trader can estimate how a company’s current stock price will be affected in the future outlook. If there is belief that there will be growth in the economy for the next few years, this assumption will be incorporated to the analysis, i.e. If overall stocks are in a growth cycle and earnings are increasing across the market, then index should increase. Equity prices move up and down based on the financial health of a company, and current price is based on the estimated future earnings of the company. Strong companies will grow earnings over time, resulting in stock price rise. Conversely, if the company expects lower future earnings, their stock price should drop.

However, reactions of the futures contracts over time might be different from this theory since futures markets are complex and sometimes move in a different direction from predicted. Some macroeconomic factors might have more than one effect on the equity indexes, so the immediate reaction might be different than the reaction that occur over long term. For e.g., if GDP increases too quickly, inflation may rise as measured by the Consumer Price Index, and the Central Bank (Federal Reserve) may increase interest rates to try and cool down the economy. This interest rates boost may lead to longer term price reduction in equity index futures. So some factors that influence equity index futures in the short-term might have an opposite effect in the long-term. The trader will need to adjust projections to his/her investment timeframe and make assumptions based on intended length of time he/she plans to hold the trade. If the trade is short-term, the trader might come up with very different assumptions than if the trader is planning to hold for longer term.

Due to incorporation of different variables, the globalized and interconnected modern economy provides intricacy to equity indices futures price analysis.

(2) Interest Rate Futures

These interest rate futures contract has an interest-bearing instrument as an underlying asset and are typically employed to hedge against the risk of interest rates rising or falling in an adverse direction. There are a variety of short-term products: e.g. Eurodollar and fed fund futures, and longer maturity products: e.g. 5-year, 10-year Treasury Notes and 30-year Treasury Bonds. Traders looking to analyse interest rate futures may review a variety of economic and market information. Factors that influence pricing of Treasury futures include Federal Open Market Committee (FOMC) interest rate decisions, level and slope of the yield curve, U.S. Treasury debt issuance, demand for government bonds, and overall health of domestic economy.

FOMC interest rate decisions have important effects on price of interest rate futures. The US Central Bank (Federal Reserve or Fed) controls monetary policy. Within the Fed, the Board of Governors is responsible for discount rate (Fed discounted overnight lending rate) and bank reserve requirements, and the Federal Open Market Committee (FOMC) is responsible for open market operations (buying and selling of US treasuries). The FOMC influences interest rates by adjusting the benchmark overnight interest rate (the effective Fed Funds rate) which is what banks are charged to borrow or lend excess funds overnight between each other. This rate influences the prime interest rate or what banks charge their customers to borrow funds. If the market expects FOMC decision to increase the fed funds rate, interest rate futures may experience price decrease, but if it expects to lower it, interest rate futures prices may increase. Traders would monitor the eight annual FOMC interest rate announcements and observe how market reactions before and after the announcement releases. These announcements are highly scrutinized by analysts as these FOMC comments may have a large impact on the market.

The yield curve represents the yield of securities along the various maturity points of the U.S. Treasury curve. U.S. Treasury regularly auctions securities with maturities of 2 years, 3 years, 5 years, 7 years, 10 years and 30 years. When referring to U.S. interest rates, the yields of these “on the run” securities are frequently quoted. Traders can analyse the level and slope of the yield curve to forecast future interest rates. The yield curve can either move in tandem with short- or long-term securities yields (parallel move), or interest rate changes can affect one part of the curve more than other causing the curve to steepen or flatten. Analysts build models on future projected change in yields for the maturity they are trading. For e.g. traders for shorter term 2-year treasury note may see larger price changes in reaction to FOMC rate increase than traders for 30-year treasury bond contract. The yield curve shifts because of higher price on shorter-dated maturities versus longer-dated maturities.

The level and frequency of U.S. Treasury debt issuance in the form of notes and bonds increases supply of securities available in market, increases debt owed by the U.S. government, and can put upward pressure on interest rates. One result financial crisis of 2008 and 2020 was how U.S. central bank (Federal Reserve) bought large amounts of U.S. Treasuries and other debt instruments, fulfilling the desired effect of reducing interest rates. In addition, global demand for U.S. Treasuries affects interest rates as nearly 50% of all U.S. Treasury debt is held outside the US.

Economic indicators that reflect health of the U.S. domestic economy, including inflation, growth, employment, and debt as proportion of GDP, have a big influence on the price of the U.S. Treasury market. During periods of economic growth with high inflation, interest rates would rise and yield curves steepen. In times of slow growth and low inflation, interest rates would fall.

Sophisticated interactions between the economy and interest rates are reviewed so traders of interest rate futures have variety of factors to assist in formulating opinions on price.

(3) Foreign Exchange (FX) Futures

Market participants can transact futures contracts representing the relationship between two currencies, also known as the foreign exchange (Forex or FX) market. FX futures contracts are regulated and traded on the open market, a major difference compared to the cash Forex market where each dealer sets their own prices with no common exchange.

FX contracts are priced based on how much it takes for one country’s currency to buy one unit of another country’s currency. FX Contracts, like Euro/U.S. Dollars (EUR/USD) futures, allow you to trade based on the exchange rate between the Euro and U.S. dollar. Majority of futures contracts are based on a foreign currency in terms of USD; but the Euro/USD futures contract is priced based on how many USD it takes to buy one Euro. Cross rate futures can also be traded, allowing relationship between two foreign currencies to be traded, such as Euro/British Pound futures (EUR/GBP), where both the base and foreign currency are not in USD. Certain factors need to be studied to determine where the price movement of currencies that are traded.

As exchange rates are direct comparisons of two currencies, relative differences of economic factors will be evaluated. The analyst researches factors that differentiate the economies of the two countries and attempts to determine future performance of each economy, making assumptions on exchange rates movements between the two countries. The absolute value of each country’s economy will also impact the exchange rate, but in smaller scale. For e.g. comparing two currencies where there is higher than 20% inflation, the economic conditions will be different than if comparing two currencies where the countries have lower than 2% inflation. Inflation rate comparisons between two countries will tend to have a larger effect than the absolute inflation level.

Since FX futures are priced as a ratio, there are combinations that can influence price, for e.g. for EUR/USD FX futures contract: USD is base currency and EUR is quote (or terms) currency:

· Base currency can strengthen or weaken, decreasing or increasing price of currency futures contract respectively.

If U.S. dollar strengthens against Euro, price of EUR/USD futures contract will decrease

· Quote (terms) currency can either strengthen or weaken, increasing or decreasing price of currency futures contract respectively.

If Euro strengthens against USD, price of the EUR/USD futures contract will increase

Economic factors that can affect the price of currency futures include interest rates, inflation and foreign trade negotiations:

Interest rates impact the demand for currencies. If there are high interest rates in a specific country, demand for their bond securities will be higher since investors prefer to invest in instruments offering higher relative returns compared to alternatives. Demand for the currency increases as foreign buyers will exchange funds in home currency for the specific foreign currency before they can invest in these bonds, and this demand will lead to an increase in relative value of that country’s currency.

Inflation rates decrease the buying power of a country’s currency and are evaluated for relative strength of each country. A country with higher inflation will have a weaker currency, so the price of the foreign exchange futures will increase.

For e.g., if inflation rate in USA is higher than inflation rate in UK, the USD will decrease in price relative to the British pound. Traders interested in the GBP/USD futures contract will experience price increase, as it will take more USD to buy one British pound.

Trade between different countries influence the relative values of a country’s currency. Countries that export more will have their currency more in demand, increasing the relative value of their currency. For e.g. if USA exports more goods than it imports (trade surplus), demand for USD will be high and its value will increase. If the U.S. exports more goods in relation to the EU (i.e. EU runs a trade deficit with US), the USD might increase in value and EUR/USD futures contract could decrease in price.

Interactions between these economic factors can be complex and traders can create models to show relationships between the economy and foreign exchange futures.

You are welcome to checkout our webpage EVERYDAY TRADING WON at www.everydaytradingwon.com and www.facebook.com/everydaytradingWON/. We provide education in stock investment, and trading in options and futures.

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