Forex futures contracts
The foreign exchange (forex) rates for currencies constantly change depending on several factors, so a business trader may wish to ensure that currency is available at a specified rate. Currency futures contracts are a type of forex futures contract for exchanging a particular currency for another at an exchange rate fixed on a specified future date. These futures are also called forex futures contracts ab, 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, which 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 highly 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 expires. The contract can be closed at any date. Forex-futures contracts have multiple components.
- Definition: Currency futures are standardized contracts to buy or sell a specific currency at a predetermined price on a future date.
- Trading Venue: These contracts are traded on regulated exchanges like the Chicago Mercantile Exchange (CME).
- Participants:
- Hedgers: Businesses and investors use currency futures to protect against adverse currency movements.
- Speculators: Traders who seek to profit from currency fluctuations without intending to take delivery of the actual currency.
- Contract Specifications:
- Contract Size: The amount of the underlying currency the futures contract covers.
- Delivery Date: The date on which the contract expires.
- Tick Size: The minimum price movement of the futures contract.
- Margin Requirements:
- Initial Margin: A deposit is required to enter a futures position.
- Maintenance Margin: The minimum account balance is used to keep a future position open.
- Leverage: Futures contracts allow traders to control prominent positions with relatively small capital, amplifying potential gains and losses.
- Mark-to-Market: Futures positions are marked to market daily, meaning gains and losses are calculated based on the daily closing prices.
- Settlement:
- Physical Delivery: The actual exchange of currencies (rare in currency futures).
- Cash Settlement: The difference between the contract and spot prices at expiration is settled in cash (standard practice).
- Example Scenario:
- Hedging: A US-based company expecting a payment in Euros in three months might sell Euro futures to lock in the exchange rate.
- Speculation: A trader believes the Euro will strengthen against the Dollar and buys Euro futures to profit from the anticipated price increase.
- Pricing:
- Influenced by the spot exchange rate, interest rate differentials between the two currencies, and the time to expiration.
- Liquidity and Volatility: Currency futures are highly liquid, with significant trading volumes, but can be volatile due to geopolitical events, economic data releases, and central bank policies.
- Risk Management: Traders use stop-loss orders, position sizing, and other strategies to manage risk associated with currency futures.
- Regulation and Oversight: Exchanges and regulatory bodies, such as the Commodity Futures Trading Commission (CFTC) in the US, ensure transparency and reduce the risk of default.
Foreign currency futures contract components
Underlying asset – this is the exchange rate specified for the currencies.
Expiration date – for physically delivered futures, it is 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. A margin call will occur if the initial margin reduces below the maintenance margin. The trader or investor should deposit money to ensure the margin is above the specified maintenance margin. 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 and maintenance margins 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 it will require foreign currency in the future but does not wish to purchase it immediately. This purchase will help the business hedge against any volatility 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 receives a significant amount in foreign currency for payment, it uses 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. The company’s projected receipt is protected if the Euro depreciates against the US dollar.
Speculators also use currency futures to make a profit. If the speculators expect the exchange rate for a particular currency to increase, they may purchase a contract for FX futures, hoping for a profit. The speculators can afford these contracts since the initial margin is usually smaller than the contract size. The speculators can leverage their position to increase their exposure to changes in the exchange rate.
Currency futures can also be used to compare 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 prefer to use currency forwards since they can be easily customized compared to standardized futures contracts. In contrast, speculators prefer currency futures since they allow leverage and have high liquidity.
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