What Are Currency Futures?
Currency futures are a exchange-traded futures contract that specify the price in one currency at which another 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 deliver the currency amount at the specified price on the specified delivery date. Currency futures can be used to hedge other trades or currency risks, or to speculate on price movements in currencies.
Currency futures may be contrasted with non-standardized currency forwards, which trade OTC.
- Currency futures are futures contracts for currencies that specify the price of exchanging one currency for another at a future date.
- The rate for currency futures contracts is derived from spot rates of the currency pair.
- Currency futures are used to hedge the risk of receiving payments in a foreign currency.
Basics of Currency Futures
The first currency futures contract was created at the Chicago Mercantile Exchange in 1972 and it is the largest market for currency futures in the world today. Currency futures contracts are marked-to-market daily. This means traders are responsible for having enough capital in their account to cover margins and losses which result after taking the position. Futures traders 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. Except for contracts that involve the Mexican Peso and South African Rand, currency futures contracts are physically delivered four times in a year on the third Wednesday of March, June, September, and December.
The price of currency futures are determined when the trade is initiated.
For example, buying a Euro FX future on the US exchange at 1.20 means the buyer is agreeing to buy euros at $1.20 US. If they let the contract expire, they are responsible for buying 125,000 euros at $1.20 USD. Each Euro FX future on the Chicago Mercantile Exchange (CME) is 125,000 euros, which is why the buyer would need to buy this much. On the flip side, the seller of the contract would need to deliver the euros and would receive US dollars.
Most participants in the futures markets are speculators who close out their positions before futures expiry date. They do not end up delivering the physical currency. Rather, they make or lose money based on the price change in the futures contracts themselves.
The daily loss or gain on a futures contract is reflected in the trading account. It is the difference between the entry price and the current futures price, multiplied by the contract unit, which in the example above is 125,000. If the contract drops to 1.19 or rises to 1.21, for example, that would represent a gain or loss of $1,250 on one contract, depending on which side of the trade the investor is on.
Difference Between Spot Rate and Futures Rate
The currency spot rate is the current quoted rate that a currency, in exchange for another currency, can be bought or sold at. The two currencies involved are called a "pair." If an investor or hedger conducts a trade at the currency spot rate, the exchange of currencies takes place at the point at which the trade took place or shortly after the trade. Since currency forward rates are based on the currency spot rate, currency futures tend to change as the spot rates changes.
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 have a high probability of decreasing. This isn't always the case, though. Sometimes the spot rate may move, but futures that expire at distant dates may not. This is because the spot rate move may be viewed as temporary or short-term, and thus is unlikely to affect long-term prices.
Currency Futures 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. Prior to September, the company could sell futures contracts on the euros they will be receiving. Euro FX futures have a contract unit of 125,000 euros. They sell euro futures because they are a US company, and don't need the euros. Therefore, since they know they will receive euros, they can sell them now and lock in a rate at which those euros can be exchanged for US dollars.
Company XYZ sells 1,000 futures contracts on the euro to hedge its projected receipt. Consequently, if the euro depreciates against the US dollar, the company's projected receipt is protected. They locked in their rate, so they get to sell their euros at the rate they locked in. However, the company forfeits any benefits that would occur if the euro appreciates. They are still forced to sell their euros at the price of the futures contract, which means giving up the gain (relative to the price in August) they would have had if they had not sold the contracts.