Textbook Problem

Risk of Currency Futures 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 have 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 contracts incurred large losses. One prominent trader 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 in the futures market.

1. Explain why the central bank’s intervention caused such panic among currency futures traders with buy positions.
2. Explain why the prominent trader’s willingness to sell 300 pound futures contracts at the going market rate aroused such concern. What might this action signal to other traders?
3. Explain why speculators with short (sell) positions could benefit as a result of the central bank’s intervention.
4. 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 positions unchanged or even increase their positions by purchasing more futures contracts in response to the central bank’s intervention?