What is the Function of Currency Futures?
You might have come across the term currency futures but may not know what it entails. If you are a forex trader enthusiast, you may need to learn the basics of currency futures to hedge yourself from exchange rate risks.
Simply put, currency futures are contracts between two parties agreeing to buy or sell a particular currency for another at a specified price at a future date. Currency futures are also referred to as forex futures or foreign exchange futures.
This article will answer the question: what are currency futures? You will learn how currency futures work and about popular currency futures.
Let's get started.
What Is Currency Futures’ Function?
The primary function of currency futures is to hedge investors against the movement of the currency exchange rate. It is mainly used by investors, speculators, importers, exporters, and travellers. Below are some uses of currency futures:
- Investors will use currency futures to hedge themselves against currency exchange rate risks.
So, suppose an investor expects to receive cash flow in a foreign currency at a given future date. In that case, the investor can lock in the current exchange rate by entering into a currency future contract that expires at the date of receiving cash flow. So, the investor will hedge themselves from a lower exchange rate.
- Also, investors use currency futures contracts to protect costs on products and services purchased in a foreign country or to protect profit margins on products and services sold abroad by locking in exchange rates over a specified time.
- Speculators use currency futures to profit in the short-term movement of prices. So, a speculator will trade a currency future in pursuit of making a profit due to exchange rate movement. Here, the speculator takes a risk.
- Exporters and importers use a currency futures contract to hedge their foreign currency payments from exchange rate fluctuations.
How Does Currency Futures Work?
A currency futures contract specifies a specific price at which a given currency will be sold or bought at a future date. It is legally binding, and the parties involved must deliver the currency amount specified on the specified delivery date, that is, before the expiration date.
So, one party agrees to buy the futures at a specific exchange rate, and the other agrees to sell the currency before the expiry date. Furthermore, a currency future involves trading two currencies.
To understand how currency futures work, you need to understand the following terminology:
The spot rate is the current quoted rate that a currency can be bought or sold in exchange for another currency. The two currencies quoted against each other are known as a currency pair. So, if you trade using a spot rate, you use the exchange rate at that particular time. As the spot rate changes, currency futures will also likely change.
If the expiry date of your currency future is distant, the future prices of the currency pair may not be affected by the changes in the spot rate. The spot rate is short-term and primarily affects the prices of almost expiring currencies.
A clearinghouse (designated intermediary between a buyer and seller in a financial market) foresees currency futures contracts. So, a clearinghouse requires a given deposit from the parties involved, referred to as margin.
In the currency futures, the margin refers to the initial minimum amount deposited to meet the requirement of the clearinghouse.
Since there is no borrowing involved in currency futures, the margin deposited will act as a form of good faith to ensure participants fulfill their obligations.
Contract Specification and Tick Value
Any currency futures contract depicts unique characteristics that make them different from the other contracts. Currency futures must list specifications like the size of the contract, the minimum price increment, and the corresponding tick value. The tick value is the minimum price movement of a trading instrument in a market.
Investors and traders use the above specification to determine the position sizing (number of units invested in particular security) and the account requirements.
For example, you can engage in a currency futures contract between the Canadian and US. The specifications for the CAD/USD pair/contracts involve:
- Physical deliveries on the settlement day.
- Standardized size of CA$100,000.
- The trade goes for twenty months based on the March quarterly cycle (i.e., March, June, September, and December).
However, the minimum price fluctuation is of utmost interest to traders, also known as the tick. A tick is unique to each contract, and the trader must understand its properties. It’s the smallest change in the price of securities, either upward or downward. Note that all future contracts have unique tick values that vary by type of security.
Mostly, the currency futures are settled at the expiry date or earlier. Different currency futures contracts have varying expiration dates based on the contract specifications. So, most buyers and sellers will offset their original positions before the last day of trading.
Sometimes, contracts are held until the maturity date, when the contract is cash-settled or physically delivered, depending on the specific contract and exchange. Some currency futures get delivered four times annually, especially in March, June, September, and December.
However, since currency futures contracts are marked to market daily, investors can exit their obligation to buy or sell the currency before the contract's delivery date.
Popular Currency Futures
Popular currency futures include:
- Euro to US Dollar
- Canadian Dollar to US Dollar
- British Pound to US Dollar
- Australian Dollar to US Dollar
- Swiss Franc to US Dollar
- Euro to British Pound
- Euro to Swiss Franc
Currency futures or FX futures are contracts between two parties to exchange one currency for another at a fixed exchange rate on a specified future date. So, you can use it to hedge yourself from exchange rate risks using a lock-in technique.
By locking in the exchange rates at which you’ll buy a currency, you forfeit the opportunity of profiting from a favourable exchange rate movement. Also, unfavourable exchange rate movements may take away a chance for the party to make profits.
So, as an investor, trader, or speculator, you can use currency futures to hedge from exchange rate risks or make profits. However, if the currency's exchange rate goes against your trade, you lose as a speculator and investor.