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Currency Derivatives of Future Markets

Currency futures markets are commonly used as a means of capitalizing on shifts in currency values, because the value of a futures contract tends to move in line with the change in the corresponding currency value. Recently, many currencies appreciated against the dollar. Most speculators anticipated that these currencies would continue to strengthen and took large buy positions in currency futures. However, the Fed intervened in the foreign exchange market by immediately selling foreign currencies in exchange for dollars, causing an abrupt decline in the values of foreign currencies (as the dollar strengthened). Participants that had purchased currency futures contractsincurred large losses. One floor broker responded to the effects of the Fed's intervention by immediately selling 300 futures contracts on British pounds (with a value of about $30 million). Such actions caused even more panic on the futures market.

a) Explain why the central bank's intervention caused such panic for currency futures traders with buy positions.

b) Explain why the floor broker's willingness to sell 300 pound futures contracts at the going market rate aroused such
concern. What might this action signal to other brokers?

c) Explain why speculators with short (sell) positions could benefit as a result of the central bank's intervention.

d) Some traders with buy positions may have responded immediately to the central bank's intervention by selling futures
contracts. Why would some speculators with buy positions leave their positionsunchanged or even increase their positions
by purchasing more futures contracts in response to the central bank's intervention?

Solution Preview

a) Futures prices on pounds rose in tandem with the value of the pound. However, when central banks intervened to support
the dollar, the values of the pound declined, and so did values of futures contracts on pounds. So traders with long (buy)
positions in these contracts experienced losses because the contract values declined.

b) Normally, this order ...

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