Forex futures contracts
The foreign exchange (forex) rates for currencies are always changing depending on several factors, so a business trader may wish to ensure that currency is available at a specified rate in the future. Currency futures contracts are a type of forex futures contract for exchanging a particular currency to another at an exchange rate fixed on a specified future date. These future contracts are also called forex futures contracts or abbreviated as FX futures. Since the future contract value depends on the exchange rate for the currencies, futures contracts are considered financial derivatives.
Currency forwards are similar to forex futures in many ways. However, unlike the forwards, who are customized, the contracts for futures are standardized. These futures contracts are also traded on centralized exchanges. These currency futures may be used for speculative purposes or hedging. Since speculators holding the futures can leverage their position, and the futures contracts are extremely liquid, the speculators will prefer to use currency futures instead of currency forwards. Typically one of the currencies in the futures contract is the US dollar.
Understanding currency futures
The forex futures or currency futures are standardized contracts for specified amounts, which can be purchased or sold at the exchanges. These futures are either physically delivered or cash-settled. For future physical delivery, the currencies of the amount indicated in the contract must be exchanged at the expiry date. The cash settlement of the futures is done daily based on market prices. Since the currencies change daily, the difference is settled by paying cash until the contract’s expiration date. The contract can be closed at any date. Forex-futures contracts have multiple components.
Foreign currency futures contract components
Underlying asset – this is the exchange rate that has been specified for the currencies.
Expiration date – for futures that are physically delivered, it is the date when the currencies are to be exchanged. In the case of cash-settled futures, it is the last date when it will be settled.
Size – the size of a futures contract is standardized. For example, the currency contract for euros is typically standardized at 125,000 euros.
Margin requirement – A margin is initially required to enter a futures contract called the initial margin. A maintenance margin is also usually specified. If the initial margin reduces below the maintenance margin, a margin call will take place. The trader or investor should deposit money to ensure that the margin is above the maintenance margin specified. Margins can be implemented since currency futures can be traded through clearinghouses and centralized exchanges. These margins reduce the counterparty risk when compared to currency forwards. Typically the initial margin and maintenance margin are four and two percent, respectively.
Margin required for currency futures NSE
The required margin for currency futures can be calculated from 0.3% to 1.5% as the gross open position’s value. For example, USDINR is 1% of the gross open position’s value, EURINR is 0.3% of the value of the gross open position, or GBPINR is 0.5% of the value of the gross open position.
How are currency futures used?
Forex futures may be used for speculation or hedging like other futures. The FX futures may be purchased by a business that knows that it will require foreign currency in the future yet does not wish to purchase the foreign currency immediately. This purchase will help the business in hedging against the volatility, if any, in the currency exchange rate. On the expiration date, when the business has to purchase the currency, it will be guaranteed the exchange rate specified in the contract for the FX futures. Similarly, if the business knows that they will receive a large amount in foreign currency for payment, they may use futures for hedging.
Example – How can currency futures be used to hedge the risk?
For example, the trader sells futures contracts on the euro (EURUSD projection down) to hedge its projected receipt. If the euro depreciates against the US dollar, the company’s projected receipt is protected.
Speculators also use currency futures to make a profit. If the speculators expect the exchange rate for a particular currency to increase, he may purchase a contract for FX futures, hoping for a profit. The speculators can afford these contracts since the initial margin is usually tiny compared to the contract size. The speculators can leverage their position to increase their exposure to changes in the exchange rate.
The currency futures can also be used while comparing interest rates in different countries. If there is no parity in the interest rates, the trader may implement arbitrage, using borrowed funds and a futures contract to profit. Investors interested in hedging will prefer to use currency forwards since they can be easily customized compared to the standardized futures contracts. In contrast, currency futures are preferred by speculators since they allow leverage and have high liquidity.