What are Currency Futures?
The term “currency futures” (CF) refers to the exchange traded future contracts that are used to purchase or sell a definite amount of a particular currency at a predetermined rate for a scheduled transaction on a future date. These derivative contracts are legally binding and hence on the expiry of the contracts, the counterparties must deliver the specified currency amount at the predetermined rate on the delivery date.CF is also popularly known as foreign exchange futures or simply forex futures.
Explanation of Currency Futures
By the year 1972, the gold standard and the fixed exchange rate system lost their popularity in the business world and it is when the Chicago Mercantile Exchange (the CME Group) introduced the CF. Typically, currency futures are used by investors and traders for hedging trade and currency risks or for speculating price movements in different currencies.
How Does Currency Futures Work?
CF are standardized derivative contracts that are traded on centralized exchanges and are either settled in cash or have to be delivered physically on the expiration date. The cash-settled contracts are settled every day on a mark-to-market (MTM) basis such that the differences arising due to daily price changes are settled in cash. In futures contracts where the transactions are settled through physical delivery, the currencies are exchanged as per the specifications mentioned in the contract.
Examples of Currency Futures
Now, let us look at some of the examples of CF.
Let us take an example to explain how CF is used for speculation. Let us assume that David purchased 10 future Euro contracts (€100,000 per contract) at 0.93$/€. On the expiration day, the settlement price went up to 0.96 $/€. Determine the profit earned by David through this transaction.
- Given, Opening price = 0.93 $/€
- Expiring price = 0.96 $/€
- Contract size = €100,000
- No. of contracts = 10
The price increased from 0.93 $/€ to 0.96 $/€ indicating profit. Now, the profit earned by David can be calculated as,
Profit is calculated as
Profit = (Expiring Price – Opening Price) * Contract Size * No. of Contracts
- Profit = (0.96 $/€ – 0.93 $/€) * €100,000 * 10
- Profit = $30,000
Therefore, David earned a profit of $30,000 from the above transaction.
Let us take the example of XYZ Inc., a US-based company, which is expected to receive €5,000,000 on 30th September. The company decided to hedge its position by buying CF at an exchange rate of 1.1 $/€ which will expire on 30th September. Determine the company’s payoff if the spot rate on expiration goes up to 1.12 $/€.
- Given, Futures price = 1.10 $/€
- Spot price = 1.12 $/€
- Size of position = €5,000,000
Now, the payoff on the expiration date can be calculated as,
Payoff = (Spot Price –futures Price) * Size of Position
- Payoff = (1.12$/€ – 1.10 $/€) * €5,000,000
- Payoff = $100,000
Therefore, in this case, the payoff will be $100,000.
Types of Currency Futures
There are various types of CF available in the market and the most popular one is the €/$ (Euro/US dollar)currency futures. Besides, there are also E-Micro Forex Futures that are traded at one-tenth the size of the usual currency futures and emerging market currency pairs, such as RUB/USD (Russian Ruble/US dollar) futures, PLN/USD (Polish zloty/US dollar) futures, etc.
Why Trade in Currency Futures?
Although there can be several motivations for trading in CF, investors and traders usually purchase or sell CF in order to protect themselves against foreign currency exchange risks. Basically, the traders hedge their position using these derivative contracts. However, some traders use it for speculative purposes or exploiting arbitrage opportunities.
Currency Futures Exchanges
The CF trade on exchanges that offer centralized pricing and clearing in a standardized way. The market price of any particular currency futures contract remains the same irrespective of the brokers employed. The CME Group is one of the largest regulated exchanges for currency futures and it offers 49 currency futures contracts amounting to daily liquidity of more than $100 billion. There are also several smaller exchanges available across the globe, which include NYSE Euronext, Brazilian Mercantile, Tokyo Financial Exchange, and Futures Exchange.
Uses of Currency Futures
The CF contracts are usually used for the following purposes:
- It is used by businesses to hedge their positions (receipt or payment in foreign currency) against future volatility in the currency exchange rate.
- It is used by some traders for speculative purposes when they expect one currency to appreciate against another. They intend to gain from the changing currency exchange rate.
- Given that its initial margin is a small fraction of the actual size of the contract, the traders use it as financial leverage and gain more exposure to the currency exchange rates.
Some of the major advantages of CF are as follows:
- The margin requirement upfront is largely fixed in nature in most cases.
- Mostly the CF are traded over exchanges in a highly regulated market.
- The clearinghouses eliminate counterparty risk to a large extent.
- The parties participating in CF transactions can enter and exit positions very easily as the currency futures market is very liquid.
- The presence of a strong regulatory body ensures that there are no hidden costs.
Disadvantages of Currency Futures
Some of the major disadvantages of currency futures are as follows:
- Lower margin requirements result in single parties creating multiple future contracts. However, this risk is somewhat mitigated due to a vigilant regulatory body.
- Dealing in CF can be very confusing for beginners.
So, it can be seen that currency futures allow investors and traders to hedge their positions or earn profits through speculation. The CF market is more or less similar to any other futures market as it provides participants the opportunity to enter the foreign exchange market in a more regulated and transparent way.
This is a guide to Currency Futures. Here we also discuss the introduction and how does currency futures work? along with advantages and disadvantages. You may also have a look at the following articles to learn more –