Currency Futures

What are Currency Futures Contracts?

Currency futures contracts also referred to as foreign exchangeForeign ExchangeForeign exchange (Forex or FX) is the conversion of one currency into another at a specific rate known as the foreign exchange rate. The conversion rates for almost all currencies are constantly floating as they are driven by the market forces of supply and demand. futures or FX futures for short, are a type of futures contractFutures ContractA futures contract is an agreement to buy or sell an underlying asset at a later date for a predetermined price. It’s also known as a derivative because future contracts derive their value from an underlying asset. Investors may purchase the right to buy or sell the underlying asset at a later date for a predetermined price. 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 derivativeDerivativesDerivatives are financial contracts whose value is linked to the value of an underlying asset. They are complex financial instruments that are used for various purposes, including hedging and getting access to additional assets or markets.. These futures are very similar to currency forwards however futures contracts are standardized and traded on centralized exchanges rather than customized.

How do Currency Futures work?

Currency futures are standardized contracts that trade on centralized exchanges. These 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 have several components outlined below:

• Underlying AssetAsset ClassAn asset class is a group of similar investment vehicles. Different classes, or types, of investment assets – such as fixed-income investments - are grouped together based on having a similar financial structure. They are typically traded in the same financial markets and subject to the same rules and regulations. – 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 marginMaintenance MarginMaintenance margin is the total amount of capital that must remain in an investment account in order to hold an investment or trading position and avoid a 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 clearing houses, and margins are put into place, this vastly reduces counterparty risk RiskIn finance, risk is the probability that actual results will differ from expected results. In the Capital Asset Pricing Model (CAPM), risk is defined as the volatility of returns. The concept of “risk and return” is that riskier assets should have higher expected returns to compensate investors for the higher volatility and increased 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 hedgingHedgingHedging is a financial strategy that should be understood and used by investors because of the advantages it offers. As an investment, it protects an individual’s finances from being exposed to a risky situation that may lead to loss of value. or speculativeSpeculationSpeculation is the buying of an asset or financial instrument with the hope that the price of the asset or financial instrument will increase in the future. 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 volatilityVolatilityVolatility is a measure of the rate of fluctuations in the price of a security over time. It indicates the level of risk associated with the price changes of a security. Investors and traders calculate the volatility of a security to assess past variations in the prices in the exchange rateForeign ExchangeForeign exchange (Forex or FX) is the conversion of one currency into another at a specific rate known as the foreign exchange rate. The conversion rates for almost all currencies are constantly floating as they are driven by the market forces of supply and demand.. 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 speculatorsSpeculatorA speculator is an individual or firm that, as the name suggests, speculates – or guesses – that the price of securities will go up or down and trades the securities based on their speculation. Speculators are also people who create fortunes and start, fund, or help to grow businesses.. 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 leverLeverageIn finance, leverage is a strategy that companies use to increase assets, cash flows, and returns, though it can also magnify losses. There are two main types of leverage: financial and operating. To increase financial leverage, a firm may borrow capital through issuing fixed-income securities or by borrowing money directly from a lender. Operating leverage can up their position and have more exposure to the exchange rate.

Currency futures can also be used as a check for interest rate parityInterest Rate Parity (IRP)The interest rate parity (IRP) is a theory regarding the relationship between the spot exchange rate and the expected spot rate or forward exchange rate of two currencies, based on interest rates. The theory holds that the forward exchange rate should be equal to the spot currency exchange rate times the interest rate of the home country, divided by the interest rate of the foreign country.. If interest rate parity does not hold, a trader may be able to employ an arbitrageArbitrageArbitrage is the strategy of taking advantage of price differences in different markets for the same asset. For it to take place, there must be a situation of at least two equivalent assets with differing prices. In essence, arbitrage is a situation that a trader can profit from 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

Thank you for reading CFI’s article on currency futures. If you would like to learn about related concepts, check out CFI’s other resources:

• DerivativesDerivativesDerivatives are financial contracts whose value is linked to the value of an underlying asset. They are complex financial instruments that are used for various purposes, including hedging and getting access to additional assets or markets.
• Futures ContractFutures ContractA futures contract is an agreement to buy or sell an underlying asset at a later date for a predetermined price. It’s also known as a derivative because future contracts derive their value from an underlying asset. Investors may purchase the right to buy or sell the underlying asset at a later date for a predetermined price.
• Currency SwapCurrency Swap ContractA currency swap contract (also known as a cross-currency swap contract) is a derivative contract between two parties that involves the exchange of interest payments, as well as the exchange of principal amounts in certain cases, that are denominated in different currencies.
• Interest Rate ParityInterest Rate Parity (IRP)The interest rate parity (IRP) is a theory regarding the relationship between the spot exchange rate and the expected spot rate or forward exchange rate of two currencies, based on interest rates. The theory holds that the forward exchange rate should be equal to the spot currency exchange rate times the interest rate of the home country, divided by the interest rate of the foreign country.