Currency futures contracts are the future agreement at which the trader buys or sells a specific quantity of currency at a pre-determined rate on a specified delivery date. These contracts are legally binding in nature and the asset used in the contract is a currency exchange rate. They are also known as foreign exchange futures.
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The currency futures market includes several types of currency. Some of the most common currency traded are the US Dollars (USD), Euro (EUR), British Pound (GBP), Australian Dollar (AUD), Swiss Franc (CHF), and Japanese Yen (YEN). Before trading in a currency futures market, one must have a basic understanding of the background, types, how they work, features, and how they are traded in an exchange.
The Chicago Mercantile Exchange (CME) was the first one to establish the currency futures contract in the year 1972. CME is now the largest currency futures market in the world. The currency future consists of two different currencies exchange rates. For example, Canadian dollar to US dollars (CAD/USD) in this the Canadian dollars is the controlling currency i.e., 1 CAD = 0.79 USD (the rate keeps on changing) this signifies that in exchange for 1 Canadian dollar a trader will receive a price of 0.79 USD.
How does Currency Future Contract work?
Currency futures contracts are standardized in nature and are settled in cash daily on a mark-to-market basis. In case of physical delivery, they are settled at the expiration date. Following are some of the important constituents that are used to outline a currency future contract.
- Buyer/Seller: A future contract must consist of a buyer willing to buy the underlying asset at a given rate and on the agreed future date and the seller willing to hold a short position with the obligation to sell the same.
- Lot size: It demonstrates the quantity of currency. Also, there is a limit imposed to prevent speculators from manipulating the forex market. In simple words, the exchange allows a trader to hold a specific number of contracts.
- Spot & Future price: Spot price is the current price of the asset and Future price is the price a trader would pay in the future to buy the underlying asset.
- Margin Requirement: To enter into a futures contract a trader must keep a specific margin amount known as the initial margin. Later a maintenance margin will be set depending on the traded amount. If the trader incurs losses and the initial margin falls below the maintenance margin point then the trader will receive a margin call. In simple words, the trader will have brought the margin amount back to the initial margin. This activity is known as variation margin.
Some features of currency futures contract:
- Currency futures contracts are standardized in nature and are traded on a centralized exchange.
- The clearinghouse acts as a counterparty and eliminates the counterparty’s credit risk. It also sees to it that all the other obligations are fulfilled.
- The currency futures contract is highly liquid in nature and the settlement takes place in cash on a daily mark-to-market basis till the expiration date. In case of physical delivery of the currency future contract, the settlement is made on the expiration date.
- The parties must keep a required margin amount with the exchange before trading in a currency future contract. Also known as initial margin. The maintenance and variation margin is adjusted depending on the future losses of the counterparty.
- Last but not least currency futures contracts can be used for speculative purposes or for hedging.
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Investor B purchased 10 futures Japanese yen contracts (¥ 10,000.00 per contract) at 103.50 US$/¥. At the end of the day, the settlement price moved up to 103.84 US$/¥. How much did the investor gain or lose?
(103.84 US$/¥ – 103.50 US$/¥) * ¥ 10,000.00 * 10 = $ 34,000
Currency Futures are popular tools and are traded on a centralized exchange. Due to their highly liquid nature and low credit or default risk investors prefer currency futures over currency forwards. An investor can gain substantial profit if the right trading method is used for anticipating future prices.
Author – Divyashri Kadam
About The Author – Divyashri is a Bachelor’s Degree Holder in Accounting and Finance. Also, a Certified Financial Modeling and Valuation Analyst (FMVA). She is enthusiastic to learn more about financial markets, financial analysis, and anything relating to stocks.