Currency Futures

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21 Aug, 2024

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Currency futures can typically be referred to as a contract where two parties agree to exchange a specified quantity of a specific currency at a pre-agreed price on a specified date. They are traded in an over-exchange and do not necessarily entail the delivery of the underlying currency; instead, they might be settled or reversed before the maturity date.

The price for the currency during currency futures trading is determined by the spot rates of the currency pair. This option is used majorly to hedge the risk of receiving foreign currency as payments. Traders can exit their contract or obligation before the delivery date. They can do so by closing out on their position on the currency pair.

What is Currency Futures?

. A currency futures contract is an agreement to exchange a set amount of one currency for another at an agreed-upon date, usually settled through an exchange platform. No physical delivery is necessary.
Currency futures contracts come in different sizes based on traded currency. The most traded currencies are USD, GBP, CAD, EUR, CHF, and JPY. Contract sizes include full-sized, mini, and micro. Each size is around ten times smaller than the standard.
Currency futures trading occurs in international exchanges. Chicago Mercantile Exchange reports most of these transactions. Clearing houses and sales offer protection against potential losses.

Currency Futures Explained

Currency futures are contracts for currencies that show the price for exchanging a specific currency for another currency at a future date. The underlying asset, currency’s future market value is speculated and traded up to earn premiums or hedge risks of receiving payments in foreign currency.

The fluctuations of the market can mean that organizations doing business with their clients overseas have a high risk of compromising on their profit margins due to the rise or fall of the other currency. Therefore, these traders rely on the currency futures market to hedge the risk of potential losses.

Currency futures, sometimes termed financial exchange derivatives, are traded at several global exchanges. The highest volume of such trades has been reported at the Chicago Mercantile Exchange. Involving exchanges and clearing houses protects the parties from any probable losses.

The marking to market is also performed every day, never letting parties go out of sight. Currency futures are also said to have very symmetric payoffs, making them a haven for speculators who mostly use these to make bets on the movement of one currency concerning another.

A currency futures contract can be of several types based on the type of currency traded and the contract size. The most commonly traded currencies are Euro, US, Canadian, Pound, Franc, and Yen. Depending upon size, they can be standard or full-sized, mini or half-sized, and micro (about a tenth of the standard).

Contract

Let us understand the specific of a contract for currency futures trading. These specifications help both parties involved to clearly agree upon the rules and can be referred back in case of discrepancies.

Two Parties to the Contract - One is the buyer, who is said to hold a long position and agrees to buy a particular quantity of a currency at an agreed future date; another is the seller holding a short position with an underlying obligation to sell the same.
Size of the Contract - Specifies the quantity of currency.
Limits on the Position Held - To prevent speculators from manipulating the market, they are only allowed to hold a maximum number of contracts.
Spot Price and Futures Price - Spot price is the current price, while futures price is today's price for future delivery. The difference between the two is referred to as ‘basis.’

The Requirement of Margins:

Initial margin- the amount required to enter into a futures contract
Maintenance margin- Minimum amount required to maintain one’s position
Variation margin- When the margin maintained falls below the minimum required, the difference is referred to as the variation margin.
The margin call is made to restore the margin account balance to the maintenance margin.
Settlement can happen through physical delivery, cash settlement, private settlement informing the exchange later, or by taking reverse positions.
Marking to Market- Gains and losses are calculated on each trading day, and margins are maintained.

Formula

The two major formulae that are used in the currency futures market are the pricing formula and the payoff calculation formula. Let us understand both of them in detail as it would act as a basis for all other related factors of the concept.

Where,

S= Spot rate; (r-rf)= interest rate differential between domestic and foreign currency; T= time

Examples

Let us understand currency futures trading with the help of a couple of examples. These examples will give us a practical understanding and application of the formulae as well.

Example #1

Compute the price of an 8-month futures contract on euros. The risk-free rate in Europe is 12%, while the same in the US is 4%. The current exchange rate being $0.80/€,

Futures price = $0.80e^(0.04-0.12)^8/12

= $0.66/euro

Example #2

An investor thinks the euro will strengthen against dollars over the next five months and chooses to take a position with a value of € 500,000 by purchasing four futures contracts at 0.78 $/€ with an initial margin of $20,000. The current spot rate in the market is 0.75 $/€. Considering four different scenarios, profit calculation will be as follows:

Purchasing euros - The spot rate after five months is 0.80 $/€.
Purchasing euros - The spot rate after five months is 0.73 $/€.
Purchasing Futures - The spot rate after five months is 0.80 $/€.
Purchasing Futures- The spot rate after five months is 0.73 $/€.

Payoff Calculation Table

Currency Futures (Payoff Calculation Formula)

Day Trading

A category of traders in the currency futures market, also known as Day traders, close out all currency futures positions before the day ends. Profit calculation is depicted below:

Where a tick can be explained as the smallest change in the price, which might have a different value in different contracts.

E.g., a day trader buys 100 CHF (Swiss Franc) futures contracts at $1.0345 per contract and sells them at $1.0375 per contract. Each tick in the contract is valued at $10.

Advantages

Let us understand the advantages of investing in the currency futures market to gain premiums or hedge risks through the points below.

Fixed upfront cost (Margin)- Margin requirements may temporarily vary in some cases but remain more or less unchanged most of the time.
Highly regulated market- They are mostly traded over exchanges.
No counterparty risk- The presence of a clearinghouse eliminates counterparty risk. Clearinghouse acts as the counterparty to every party and maintains that all obligations should be met.
Liquid market- The currency futures market is very liquid, allowing parties to enter and exit positions as and when required.
Due to strong regulations, hidden costs are absent.

Disadvantages

Despite the advantages mentioned above, there are a few factors that disappoint traders and other participants in the market. Let us understand the disadvantages of currency futures trading through the discussion below.

Lower entry costs can lead to the creation of multiple future contracts by the same party, which is somewhat mitigated by the presence of a regulatory body.
They can be a bit complicated for beginners to comprehend.
Parties cannot take advantage of a favorable increase in prices.
Currency futures contracts cannot be customized to adjust for contract sizes other than the standard ones.
Speculations not based on detailed analysis may result in potentially huge losses.

Frequently Asked Questions (FAQs)

How can corporations use currency futures?

The use of currency futures allows for the long-term locking of exchange rates. To protect against foreign exchange rate swings, this can be employed. Multinational firms and international commerce both benefit significantly from this.

How to buy currency futures?

Traders often have accounts with intermediaries who book the orders to buy and sell currency futures contracts on various markets. Currency futures trading often uses a margin account; otherwise, substantial cash would be needed to execute a trade.

What are foreign currency futures options?

Currency futures are contracts that allow exchanging one currency for another at a pre-determined price on a future date. The contract rate is based on the current spot rates for the currency pair. Currency futures are commonly used to manage the risk of receiving payments in a foreign currency.