What are 'Currency Futures'
Currency futures are a transferable futures contract that specifies the price at which a currency can be bought or sold at a future date. Currency futures contracts are legally binding and counterparties that are still holding the contracts on the expiration date must trade the currency pair at a specified price on the specified delivery date. Currency future contracts allow investors to hedge against foreign exchange risk.
BREAKING DOWN 'Currency Futures'Because currency futures contracts are marked-to-market daily, investors can exit their obligation to buy or sell the currency prior to the contract's delivery date. This is done by closing out the position. The prices of currency futures are determined when the contract is signed, just as it is in the forex market, only and the currency pair is exchanged on the delivery date, which is usually some time in the distant future. However, most participants in the futures markets are speculators who usually close out their positions before the date of settlement, so most contracts do not tend to last until the date of delivery.
Difference Between Spot Rate and Futures Rate
The currency spot rate is the current quoted exchange rate that a currency pair could be bought or sold. If an investor or hedger conducts a trade at the currency spot rate, the exchange of the currency pair may take place at the point at which the trade took place or shortly after the trade. Since currency forward rates are based on the current currency spot rate, currency futures could be substantially affected if currency spot rates change.
If the spot rate of a currency pair increases, the futures prices of the currency pair have a high probability of increasing. On the other hand, if the spot rate of a currency pair decreases, the futures prices has a high probability of decreasing.
Currency Futures Example
For example, assume hypothetical company XYZ, which is based in the United States, is heavily exposed to foreign exchange risk and wishes to hedge against its projected receipt of 125 million euros in September. In August, company XYZ could sell futures contracts on the euro for delivery in September, which have a contract specification of 125,000 euros. Therefore, company XYZ would need to sell 1,000 futures contracts on the euro to hedge its projected receipt. Consequently, if the euro depreciates against the U.S. dollar, the company's projected receipt is protected. However, the company forfeits any benefits that would occur if the euro appreciates.