Currency Futures
Futures contracts based on exchange rates
What are Currency Futures Contracts?
Currency futures contracts also referred to as foreign exchange futures or FX futures for short, are a type of futures contract to exchange a currency for another at a fixed exchange rate on a specific date in the future.
Since the value of the contract is based on the underlying currency exchange rate, currency futures are considered a financial derivative. These futures are very similar to currency forwards however futures contracts are standardized and traded on centralized exchanges rather than customized.
Summary
- Currency futures contracts are a type of futures contract to exchange a currency for another at a fixed exchange rate on a specific date in the future.
- The contracts are standardized and are traded on centralized exchanges.
- Currency futures can be used for hedging or speculative purposes.
- Due to the high liquidity and ability to leverage the position, speculators will often use currency futures over currency forwards.
How Do Currency Futures Work?
Currency futures are standardized contracts that trade on centralized exchanges. The futures are either cash-settled or physically delivered. Cash-settled futures are settled daily on a mark-to-market basis.
As the daily price changes, the differences are settled in cash until the expiration date. For futures settled by physical delivery, at the expiration date, the currencies must be exchanged for the amount indicated by the size of the contract.
Foreign exchange futures contracts comprise several components outlined below:
- Underlying Asset – This is the specified currency exchange rate
- Expiration Date – For cash-settled futures, this is the last time it is settled. For physically delivered futures this is the date the currencies are exchanged
- Size – Contracts sizes are standardized. For example, a euro currency contract is standardized to 125,000 euros
- Margin Requirement – To enter into a futures contract, an initial margin is required. A maintenance margin will also be established and if the initial margin falls below this point, a margin call will happen, meaning the trader or investor must deposit money to bring it above the maintenance margin
Since currency futures are traded on centralized exchanges and through clearinghouses, and margins are put into place, this vastly reduces counterparty risk compared to currency forwards. A typical initial margin can be around 4% and a maintenance margin around 2%.
What are Currency Futures used for?
Like other futures, foreign exchange futures can be used for hedging or speculative purposes. A party who knows they will need a foreign currency at a future point, however, does not want to purchase the foreign currency at this point in time may buy FX futures. This will act as a hedged position against any volatility in the exchange rate. At the expiration date when they need to buy the currency, they will be guaranteed the FX futures contract’s exchange rate.
Similarly, if a party knows that they will receive a cash flow in the future in a foreign currency, they can use futures to hedge this position. For example, if a company in the US is doing business with a country in Germany, and they are selling a large item payable in euros in a year, the US company may purchase currency futures to protect against negative swings in the exchange rate.
Currency futures are also often used by speculators. If a trader expects a currency to appreciate against another, they can buy FX futures contracts to try to gain from the shifting exchange rate. These contracts can also be useful for speculators because the initial margin that is held will generally be a fraction of the size of the contract. This allows them to essentially lever up their position and have more exposure to the exchange rate.
Currency futures can also be used as a check for interest rate parity. If interest rate parity does not hold, a trader may be able to employ an arbitrage strategy to profit purely from borrowed funds and the use of futures contracts.
Investors looking to hedge a position often use currency forwards due to the ability to customize these over-the-counter contracts. Speculators often use currency futures due to the high liquidity and ability to leverage their position.
Currency Futures – Worked Example
Let us now look at an example that involves currency futures. Say you purchase 8 future Euro contracts (€125,000 per contract) at 0.89 US$/€. At the end of the day, the settlement price has moved to 0.91 US$/€. How much have you lost or profited?
The price has increased meaning you have profited. The calculation to determine how much you have profited is as follows:
(0.91 US$/€ – 0.89 US$/€) x €125,000 x 8 = 20,000 US$
Additional Resources
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