USDX Futures
Futures on the U.S. Dollar Index (USDX) can provide a trading opportunity for participants with a view on the direction of interest rate movements between the United States and countries overseas, with little foreign exchange risk.
For example, in the fall of 1992, interest rates in the United States were well below those of most other major countries and many market participants were expecting interest rate differentials to narrow, primarily as the Bundesbank eased monetary policy in response to weakening domestic growth. Three-month German Euro-deposit rates had already declined by more than 100 basis points from their level in early September, and interest rates in many other European countries had also edged lower, apart from a brief upward spike during the crisis of the Exchange Rate Mechanism (ERM) in mid-September- In particular, the suspension of Italy and the United Kingdom from the ERM was thought to give these countries more freedom to adopt an expansionary monetary policy to stimulate their depressed economies.
Even though USDX futures are a foreign currency contract, simultaneously buying a contract of one expiration month while selling another of a different expiration month creates a straddle spread whose value depends almost solely on interest rate differentials between the United States and an average of the ten countries whose currencies compose the USDX.
The relationship between prices of USDX futures having different expirations is largely determined by interest rate differentials in a manner consistent with the theory of Interest Rate Parity. For instance, if interest rates in the United States are lower than those abroad, deferred futures will trade at a premium to nearby futures (and nearby futures will correspondingly trade at a premium to the spot USDX). As interest rate differentials narrow, the spread will narrow as the decline in the deferred futures will outpace the decline in the nearby futures. The spread will invert if interest rates in the United States rise above interest rates overseas.
USDX futures prices also incorporate a volatility premium which is a consequence of the pricing mechanism of the futures contract. Straddle spreads also capture the difference between volatility premiums of the two futures contracts of the spread. Since these volatility premiums tend to move together, though, their impact on the straddle spread is usually small, though may at times be significant over very short time horizons.
Example:
On October 14 1992, the December 1992 futures settled at 85-20 and the March 1 993 futures, at 86.48. A Dec-Mar straddle would be priced at 1.28 USDX points premium March, or $1,000xl.28 = $1,280. In midSeptember, when interest rates in many European countries rose sharply as a consequence of the turmoil in foreign exchange markets, the DecMar straddle had risen in value to around 1.55 USDX points. Over the subsequent month, European interest rates eased back, and the straddle spread correspondingly followed.
Traders who expected interest rate differentials between the United States and the USDX's component currencies to narrow further could have sold the spread (at 1.28 USDX points) by selling March futures and buying December futures. Approximate theoretical changes of this position for various changes in interest rate differentials are listed in Table 1. For instance, a reduction of 150 basis points in the differential might have reduced the straddle to .96 USDX points premium March, a gain of $320 per spread. However, if interest rates overseas had risen so that differentials with the United States increased, this position would have suffered losses. In this case, the proper trade would have been to buy the spread by buying the March futures and selling the December futures.
Table IWhile a USDX straddle moves in response to changing interest rates, its exposure to currency movements is very limited. Since a USDX futures straddle consists of both buying and selling simultaneously, foreign currency gains arising from one contract are more or less offset by losses on the other contract.Value of Short Dec-Mar USDX Straddle for Various Interest Rate Scenarios
Change in Int. Approximate Changein
Differential Straddle Value Straddle Value
(basis points) (USDX points) (U.S.$)
(200) 0.85 $ 430
(150) 0.96 $ 320
(100) 1.07 $ 210
(50) 1.17 $ 110
0 1.28 $ 0
50 1.38 ($ 100)
100 1.49 ($ 210)
Because straddle spreads entail less risk than an outright USDX position, FINEX margin requirements are reduced, so percentage returns on a capital basis can be quite significant. Please consult the Exchange for further details.