Currency Futures
When one currency is exchanged for another at a fixed price on the purchase date, it is known as a currency futures (FX Futures), sometimes known as a foreign exchange future.
What are Currency Futures?
A currency future (FX Futures), often referred to as a foreign exchange future, is a futures contract in which one currency is exchanged for another at a fixed price on the purchase date; see Foreign exchange derivative. The US dollar is usually one of the currencies.
At the New York International Commercial Exchange, currency futures were initially developed in 1970. The contracts, however, did not "take off" since the Bretton Woods system remained in place.
President Richard Nixon gave up the fixed exchange rate system and the gold standard on August 15, 1971. When they thought there would be big changes in the currency market in the early 1970s.
Several commodity dealers at the Chicago Mercantile Exchange were unable to gain access to the interbank exchange markets. On May 16, 1972, the CME started the International Monetary Market and traded seven currency futures.
Although they claim to have developed the idea separately from the International Commercial Exchange, the CME today acknowledges the International Commercial Exchange as having invented the currency contract.
The IMM is now a subsidiary of CME. CME Group FX activity averaged 754,000 contracts per day in the fourth quarter of 2009, representing an average daily notional value of about $100 billion. The majority of these are currently traded electronically.
Intercontinental Exchange and Euronext. Life is two futures exchanges dealing in currency futures.
The traditional maturity dates for currency futures sold on the CME are the IMM dates: the 3rd Wednesday in March, June, September, and December. The first Friday following the first Wednesday of the given month is when traditional option maturity dates occur.
Serial months have recently been introduced. EUR/USD terms, for example, are currently 20 consecutive quarters plus three serial contract months.
FX Futures are distinct from non-standardized currency forwards, which trade over-the-counter (OTC).
Key Takeaways
- Currency futures are standardized contracts traded on exchanges, allowing exchange rates at a fixed price on future dates. They aid hedging against currency risk and speculation on price movements.
- These contracts entail standardized sizes, expiration dates, and margin requirements, offering cash or physical settlement. They differ from non-standardized OTC currency forwards.
- Investors use currency futures to hedge future cash flows in foreign currency, securing present exchange rates. Speculators capitalize on price fluctuations, aiming for profits from changing exchange rates.
- Futures reduce counterparty risk due to centralized trading, utilizing margins and daily mark-to-market clearance. They offer leverage, allowing larger exposures with lower initial margins.
- Currency futures help businesses and individuals secure future currency rates, offering protection against market volatility. They're versatile tools for risk management and capitalizing on exchange rate movements.
Understanding Currency Futures
Currency Futures are standardized contracts traded on organized exchanges. Futures contracts can be settled in cash or physically delivered. For cash-settled futures, daily mark-to-market clearance is employed.
Cash is used to settle discrepancies until expiration as the daily price changes. Currency exchange for the amount specified by the contract size is required for futures settled by physical delivery at the expiration date.
Foreign exchange futures contracts comprise various components listed below:
- The underlying asset: the selected currency exchange rate.
- Expiration Date: The last time a cash-settled futures contract is settled. This is the date the currencies are exchanged for physically delivered futures.
- Size: The sizes of contracts are standardized. A euro currency contract, for example, is standardized at 125,000 euros.
- Margin Requirement: A futures contract must have a minimum starting margin to enter into.
Also, a maintenance margin will be set up. If the original margin drops below it, a margin call will occur, requiring the trader or investor to deposit funds to raise the initial margin above the maintenance margin.
Comparing foreign currency futures to currency forwards, foreign currency futures have significantly lower counterparty risk because they are traded on centralized exchanges, through clearinghouses, and with margins. A normal initial margin of 4% and a maintenance margin of 2% are typical.
Note
The spot rate is the quoted rate at which a currency can now be purchased or sold in exchange for another currency.
A "pair" refers to the two currencies involved. When an investor or hedger performs a deal at the current spot rate, the exchange of currencies occurs at the time of the trade or immediately afterward.
FX Futures typically shift in response to changes in spot rates because forward currency prices depend on those rates. If a currency pair's spot rate rises, the currency pair's futures prices are also likely to rise. The futures prices, on the other hand, are likely to fall if the spot rate of a currency pair declines.
Yet, this is not always the case. For example, the spot rate may fluctuate at times, while futures contracts with expiration dates in the future may not. This is because the spot rate move may be seen as transient or short-term and has little impact on long-term prices.
The use of FX Futures allows for the long-term locking of exchange rates. This can be used to hedge against swings in foreign currency, especially valuable in international trade and among multinational organizations.
On the other hand, The operations of currency forwards and futures are fairly similar. The main distinction is that exchanges allow for the trading of futures contracts, which have standardized terms. Conversely, forwards have adjustable terms and are traded over the counter (OTC).
What are Currency Futures used for?
Futures dealers can cancel their commitment to purchase or sell the currency before the contract's delivery date. This is accomplished by closing out the position.
Investors use these futures contracts to hedge against currency risk. For example, suppose an investor expects to receive a cash flow in a foreign currency on a future date.
The investor can lock in the present exchange rate by engaging in an equivalent FX Futures position that matures on the cash flow date.
Mike, for example, is a US-based investor who will get £1,000,000 on January 1. The current implied exchange rate by the futures is $1.2 /£. So he can lock in this currency rate by selling £1,000,000 worth of December 1 futures contracts.
That way, he is guaranteed an exchange rate of $1.2 /£ independent of future exchange rate variations.
Note
Most futures market participants are speculators who close their bets before expiration. They need to deliver the physical money. Rather, they profit or lose money based on price changes in futures contracts.
Currency futures can also be used to speculate and profit from rising or decreasing exchange rates by taking a risk.
Jennifer, for example, purchases ten October CME Euro FX Futures contracts for €2500,000 (each future is worth €250,000) at $1.3120 /€. The futures contract closes the day at $1.3185/€.
The price has changed by $0.0065/€. Because each deal is worth more than €250,000 and she has ten contracts, her profit is US$16,250. This is paid to her immediately, as with any future.
Each $0.0001 /€ (the minimum Commodity tick size) movement generally results in a profit or loss of US$25 per contract.
Most futures market participants are speculators who close their bets before the futures expiry date. As a result, they fail to deliver the physical money. Rather, they profit or lose money based on price changes in futures contracts.
Currency Futures Importance
Foreign exchange futures, like other futures, can be used for speculative or hedging purposes. FX futures are bought by someone who knows they will need foreign currency in the future but does not want to buy it right now.
This will act as a hedge against any future currency volatility. They will be guaranteed the exchange rate of the FX futures contract when it expires, and they need to acquire the currency.
Likewise, if a party expects to receive a cash flow in a foreign currency, they may use futures to protect their position.
Currency futures are also commonly used by speculators. Suppose a trader feels one currency will rise in value against another. He or she may decide to purchase FX futures contracts to profit from fluctuating exchange rates.
These contracts can be advantageous to speculators because the initial margin kept is often a fraction of the contract size. This allows them to successfully leverage their position and enhance their exposure to the exchange rate.
FX Futures can also be used to check interest rate parity. If interest rate parity does not hold, a trader may earn purely on borrowed funds and futures contracts using an arbitrage approach.
Currency forwards are widely utilized by investors looking to hedge a position due to the ability to change these over-the-counter contracts. In addition, FX Futures are popular among traders due to their high liquidity and ability to leverage positions.
Fx futures contracts can be settled in two ways. Before the last trading day, buyers and sellers almost always adopt a different position to balance their initial positions.
When an opposite position closes the transaction before the last day of trading, the profit/loss is credited to or debited from the investor's account.
Contracts are normally retained until the maturity date. At this point, depending on the contract and the exchange, they are either physically delivered or settled in cash.
Note
Most currency futures are physically delivered four times a year, on the third Wednesday of March, June, September, and December.
Currency Futures Example
Here we will discuss two possible scenarios regarding FX Futures.
Example 1: Consider ABC Inc., a US-based corporation, is anticipated to receive €6,000,000 on December 30th. The corporation hedged its position by purchasing CF at 1.3 $/€ until December 30th. Calculate the company's payout if the expiration spot rate rises to 1.32 $/€.
Solution:
Considering that the futures price is 1.30 $/€,
The current spot price is 1.32$/€.
Position size = €6,000,000
The payout on the expiration date can now be calculated as follows:
Payoff = (Spot Price - Futures Price) * Position Size
Payoff = (1.32$/€ minus 1.30$/€) * €6,000,000
Payment = $120,000
As a result, the payment in this situation will be $120,000.
Example 2: An importer has ordered electronic components from abroad and must pay USD 30,000 within two months. The current exchange and two-month forward rates are 6,69 to 1 USD.
If the spot currency rate stays unchanged after two months, the importer must pay $200,700 to acquire USD for the import contract. On the other hand, if the exchange rate climbs to 7:1 USD, the importer must pay 210,000 USD after two months.
Note
If the exchange rate falls to 6.5:1 USD, the importer must pay 195000.
Importer wishes to resist unpredictable currency markets and secure future payment regarding importers' face currency risk, which they can alleviate by having a long position in the futures market.
After two months, importers can lock in the currency rate at 6.69 per USD by establishing a long position in 30000 future contracts. Whatever the currency rate is after two months, the importer will be certain to receive the 30000 USD by paying a net amount of 200,700.
A future contract gain, and vice versa, offset a loss in the spot market. An importer can protect itself from currency risk by having a long position in the futures market. The importer grows impervious to currency fluctuations.
Everything You Need To Master Financial Statement Modeling
To Help You Thrive in the Most Prestigious Jobs on Wall Street.
or Want to Sign up with your social account?