Currency futures
With $4.0 trillion traded daily, currency future (FX future or foreign exchange future) markets represent the largest asset class in the world. Forex futures are used for currency price trend speculation as well as hedging against foreign currency risks by international companies. Currency futures is a contract in the futures markets for exchange of currencies at a specific exchange rate. 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.
Trading in currency futures on stock exchanges is in order to provide a liquid, transparent and vibrant market for foreign exchange rate risk management. The primary purpose of exchange-traded currency derivatives is to provide a mechanism for price risk management and consequently provide price curve of expected future prices to enable the industry to protect its foreign currency exposure. The need for such instruments increases with increase of foreign exchange volatility
Currency Futures defined
An agreement to make or take delivery of a standard quantity of a specific foreign currency at a specified future date and at a price agreed on an Exchange.
Currency futures contract
A currency futures contract is a standardized version of a forward contract that is traded on a regulated exchange. It is an agreement to buy or sell a specified quantity of an underlying currency on a specified date in future at a specified rate (e.g., USD 1 = INR 46.00).
Need of currency futures
Currency futures are needed if your business is influenced by fluctuations in currency exchange rates. If you are in India and are importing something, you have done the costing of your imports on the basis of a certain exchange rate between the Indian Rupee and the relevant foreign currency. By the time you actually import, the value of the Indian Rupee may have gone down and you may lose out on your income in terms of Indian Rupees by paying higher. On the contrary, if you are exporting something and the value of the Indian Rupee has gone up, you earn less in terms of Rupees than you had anticipated. Currency futures help you hedge against these exchange rate risks.
More on Forex futures
A currency futures contract, like any other financial futures contract, is a legally binding agreement between two parties to take or make delivery on a specified date (or dates) in the future of a given quantity of a currency at an agreed price. This price is established in a regulated market place on the date the contract is entered into.
Currency futures are traded on a centralised and regulated exchange and are highly standardised with regard to trading in specific months for specific amounts of currencies. The transactor is required to lodge an initial margin in cash with the broker for the duration of the contract, and has to maintain margin requirements in line with market movements as profits and losses on currency futures contracts are settled daily. Currency futures are delivered through a clearing house, which guarantees the fulfilment of contracts entered into by members.
FX futures contract
As the price of a currency futures contract is established irrespective of the financial status of the individual transactor, it may at times be cheaper than a forward contract obtained from a bank, particularly if only small amounts are involved. Even though an FX forward contract is more flexible in so far as date of delivery and amount are concerned, an FX futures contract may be closed at any time by an opposite transaction.
An FX futures contract is rarely undertaken with the intention of delivery actually taking place. The easiness to “undo” an FX futures contract together with its standardized nature makes it particularly attractive to speculators.
Forex Futures Hedging Example:
Assuming a US company is buying a shipment of cars from Germany for 1,000,000 Euro to be delivered and settled in 3 months time. Assuming the exchange rate of EUR/USD is $1.4 upon signing of contract and the cost of the shipment in USD is $1,400,000. The US company wants to make sure it pays no more than USD $1,400,000 when it comes time to pay in 3 months time. The US company goes long EUR futures for 80 contracts of $125,000 per contract at $1.40. Assuming EUR rises to $1.45 in 3 months time.
- Amount payable in USD = $1,4500,000
- Loss in USD = $1,4500,000 – $1,400,000 = $500,000
- Profit on EUR futures = $1.45 – $1.40 = $0.05 x 125,000 = $6,250 x 80 = $500,000
In this simplified example of forex futures hedging, the profit on the EUR futures completely offset the loss on the amount of USD payable for 1 million Euros, thereby saving the US company $500,000 in foreign exchange loss on the purchase.
Difference between Futures & Forwards?
Forward – A forward contract is an agreement between two parties to buy or sell an asset at a specified point of time in the future.
Futures – An agreement to buy or sell a standard quantity of a specific asset at a specified future date and at a price agreed on an Exchange.
Difference between Futures & Forwards
- Future contracts are Exchange Traded
- Standardized
- Counter‐party risk is absent (Settlement of trades on organized exchanges is guaranteed)
- Marked‐to‐Market everyday
Margin Requirement
- Initial margin
- Calendar Spread
- Extreme Loss Margin
- Marked to Market
Initial Margin
- Cash / Collateral deposited against short term price movement.
- Initial margin for each contract is set by the Exchange. Exchange has the right to vary initial margins at its discretion, either for the whole market or for individual members.
Calendar Spread
- When a CF position at one maturity is hedged by an offsetting position at a different maturity, Rs. 250/‐Calendar Spread Margin per Calendar Spread contract is charged.
Extreme Loss Margin
- Extreme Loss Margin is computed at 1% on the MTM value of the gross open position.
Marked To Market
- Default risk is reduced by marking to market.
- MTM value would be calculated on the basis of the last half an hour weighted average traded price of the futures contract.
- MTM value is used for calculation of Profit / loss on open positions.
- T+1 settlement (pay in / out) with exchange through Trading Member.
Hedging
Hedge means “to minimize loss or risk”. It means taking a position in the futures market that is opposite to a position in the physical market with a view to reduce or limit risk associated with unpredictable changes in the exchange rate.
Participants of a currency futures market
Hedgers: A high-liquidity platform for hedging against the effects of unfavourable fluctuations in the foreign exchange markets is available on exchange.
Investors: All those interested in taking a view on appreciation (or depreciation) of exchange rate in the long and short term can participate
Arbitrageurs: Arbitrageurs get the opportunity of trading in currency futures by simultaneous purchase and sale in two different markets, taking advantage of price differential between the markets.
Currency Trading
While trade is international, currencies are national. As international transactions are settled in global currencies, usually they are brought/sold for one another and this constitutes ‘currency trading’.
Factors that affect the exchange rate of a Currency
A country’s currency exchange rate is typically affected by the supply and demand for the country’s currency in the international foreign exchange market. The demand and supply dynamics is principally influenced by factors like interest rates, inflation, trade balance and economic & political scenarios in the country. The level of confidence in the economy of a particular country also influences the currency of that country.
- Demand and supply of a currency
A rise in export earnings of a country increases foreign exchange supply. A rise in imports increases demand. These are the objective reasons, but there are many subjective reasons too. Some of the subjective reasons are: directional viewpoints of market participants, expectations of national economic performance, confidence in a country’s economy and so on.
- Risks involved in currency futures market
Risks in currency futures pertain to movements in the currency exchange rate. There is no rule of thumb to determine whether a currency rate will rise or fall or remain unchanged. A judgement on this will depend on the knowledge and understanding of the variables that affect currency rates.
- Global exchanges that provide trading in currency futures
Internationally, exchanges such as Chicago Mercantile Exchange (CME), Johannesburg Stock Exchange, Euronext.liffe, BM&FBOVESPA and Tokyo Financial Exchange provide trading in currency futures.