Forex – The Global Giant
The global forex market is the largest market in the world with over US$5 trillion traded daily, according to Bank for International Settlements (BIS) data. The forex market, however, is not the only way for investors and traders to participate in foreign exchange. While not nearly as large as the forex market, the currency futures market has a respectable daily average closer to $100 billion.
Currency futures—futures contracts where the underlying commodity is a currency exchange rate—provide access to the foreign exchange market in an environment that is similar to other futures contracts. Figure 1 (below) shows a price chart of one of the many currency futures contracts.
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What Are Currency Futures?
Currency futures, also called forex futures or foreign exchange futures, are exchange-traded futures contracts to buy or sell a specified amount of a particular currency at a set price and date in the future. Currency futures were introduced at the Chicago Mercantile Exchange (now the CME Group) in 1972 soon after the fixed exchange rate system and the gold standard were discarded. Similar to other futures products, they are traded in terms of contract months with standard maturity dates typically falling on the third Wednesday of March, June, September, and December.
A wide variety of currency futures contracts are available. Aside from the popular contracts such as the EUR/USD (euro/U.S. dollar currency futures contract), there are also E-Micro Forex Futures contracts that trade at 1/10th the size of regular currency futures contracts, as well as emerging market currency pairs such as the PLN/USD (Polish zloty/U.S. dollar futures contract) and the RUB/USD (Russian Ruble/U.S. dollar futures contract).
Different contracts trade with varying degrees of liquidity; for instance, the daily volume for the EUR/USD contract might be 400,000 contracts versus 33 contracts for an emerging market like the BRL/USD (Brazilian real/U.S. dollar).
Currency Futures Exchanges
Unlike forex, wherein contracts are traded via currency brokers, currency futures are traded on exchanges that provide regulation in terms of centralized pricing and clearing. The market price for a currency futures contract will be relatively the same regardless of which broker is used. The CME Group offers 49 currency futures contracts with over $100 billion in daily liquidity, making it the largest regulated currency futures marketplace in the world. Smaller exchanges are present worldwide, including NYSE Euronext, the Tokyo Financial Exchange (TFX) and the Brazilian Mercantile and Futures Exchange (BM&F).
Traders and investors are drawn to markets with high liquidity since these markets provide a better opportunity for profiting. The emerging markets typically have very low volume and liquidity, and they will need to gain traction before becoming competitive with the other established contracts. The G10 contracts, the E-mini and the E-Micro contracts are the most heavily traded and have the greatest liquidity. Figure 2 (below) shows some of the most popular currency futures contracts and their specifications.
Futures contracts, including currency futures, must list specifications including the size of the contract, the minimum price increment, and the corresponding tick value. These specifications help traders determine position sizing and account requirements, as well as the potential profit or loss for different price movements in the contract, as indicated in Figure 2.
The Euro/U.S. dollar contract, for example, shows a minimum price increment of .0001, and a corresponding tick value of $12.50. This indicates that each time there is a .0001 movement in price, the value of the contract will change by $12.50 with the value dependent on the direction of the price change. For instance, if a long trade is entered at 1.3958 and moves to 1.3959, that .0001 price move would be worth $12.50 to the trader (assuming one contract). If that same long trade moves to 1.3968, the price move would be worth $125.00 ($12.50 X 10 ticks or pips).
There are two primary methods of settling a currency futures contract. In the vast majority of instances, buyers and sellers will offset their original positions before the last day of trading (a day that varies depending on the contract) by taking an opposite position. When an opposite position closes the trade prior to the last day of trading, a profit or loss is credited to or debited from the trader's account.
Less frequently, contracts are held until the maturity date, at which time the contract is cash-settled or physically delivered, depending on the specific contract and exchange. Most currency futures are subject to a physical delivery process four times a year on the third Wednesday during the months of March, June, September, and December. Only a small percentage of currency futures contracts are settled in the physical delivery of foreign exchange between a buyer and seller. When a currency futures contract is held to expiration and is physically settled, the appropriate exchange and the participant each have duties to complete the delivery.
The CME, for example, is responsible for establishing banking facilities in the United States and in each country represented by its currency futures contracts. These agent banks, as they are called, act on behalf of the CME and maintain a U.S. dollar account and a foreign currency account to accommodate any physical deliveries. In addition, futures contracts do not exist directly between clients (for example, a buyer and a seller). Instead, each participant has a contract with a clearinghouse, greatly reducing the risk for buyers and sellers that a counterparty would fail to meet the terms of the contract.
Buyers (participants holding long positions) make arrangements with a bank to pay dollars into the International Monetary Market (IMM) delivery account, a division of the CME. The IMM is also the account from which sellers (participants holding short positions) are paid. The transfer of foreign currency occurs similarly in other countries. Essentially, a participant's delivering bank transfers the currency to the IMM delivery account, which then transfers the currency to the appropriate account.
Futures brokers, including those that offer currency futures, must follow regulations enforced by governing agencies including the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA), as well as rules set forth by the exchanges. For example, the CME Group, the largest futures exchange in the world, ensures that self-regulatory duties are fulfilled through its Market Regulation Department, including market integrity protection by maintaining fair, efficient, competitive and transparent markets. Currency futures markets have a great deal more oversight that the spot forex markets, which are at times criticized for things like non-centralized pricing and forex brokers trading against their clients.
Currency futures are exchange-traded futures. Traders typically have accounts with brokers that direct orders to the various exchanges to buy and sell currency futures contracts. A margin account is generally used in the trading of currency futures; otherwise, a great deal of cash would be required to place a trade. With a margin account, traders borrow money from the broker in order to place trades, usually a multiplier of the actual cash value of the account.
Buying power refers to the amount of money in the margin account that is available for trading. Different brokers have varying requirements for margin accounts. In general, currency futures accounts allow a rather conservative degree of margin (leverage) when compared to forex accounts that can offer as much as 400:1 leverage. The liberal margin rates of many forex accounts provide traders the opportunity to make impressive gains, but more often suffer catastrophic losses.
Currency Futures vs. Forex
Both currency futures and forex are based on foreign exchange rates; however, there are many differences between the two:
- The forex spot market is the largest market in the world. Currency futures trade at a fraction of the volume, with many currency futures contracts trading under high volume and good liquidity.
- Currency futures are exchange-traded and are regulated like other futures markets. Forex has less regulation and trading is conducted over the counter through forex dealers (there is no central marketplace for forex).
- Currency futures can be traded using modest leverage; forex offers the ability to trade with a great deal of leverage, leading to large wins and, of course, large losses.
- The tax treatment for profits and losses incurred from currency futures trading and forex trading may differ, depending on the particular situation.
- Commissions and fees differ: currency futures typically involve a commission (paid to the broker) and other various exchange fees. Though forex traders don't pay these commissions and fees, they are subject to exchange rate spreads through which the forex dealer profits.
The Bottom Line
Investors and traders interested in participating in the foreign exchange market have options. Forex and currency futures offer traders unique vehicles with which to hedge or speculate. The currency futures market is similar to other futures markets and provides participants a means of entering the foreign exchange market with greater regulation and transparency.