Key Takeaways
- Currency futures are contracts that lock in the price for exchanging currencies at a future date.
- These contracts are standardized and traded on exchanges like the CME, with standardized delivery dates, making them different from OTC currency forwards.
- Most futures market participants are speculators who aim to profit from price fluctuations rather than take delivery of the currency.
- Currency futures can help hedge against foreign exchange risks and are especially useful for multinational firms and international trade.
- The prices of currency futures are determined at trade initiation and are influenced by the spot rate, but futures prices may not always reflect short-term spot rate changes.
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Currency futures are exchange-traded contracts with standardized terms. They set the price in one currency at which a second currency may be bought or sold at a future date. Currency futures contracts are traded on global derivatives exchanges.
Most participants in futures contracts are speculators who hope to profit from the movements in prices. However, currency futures are also used to hedge against foreign exchange risk.
What Are Currency Futures?
Currency futures are an exchange-traded futures contract that specify the price in one currency at which another currency can be bought or sold at a future date.
Currency futures contracts are binding, requiring holders to deliver the currency at the agreed price on the expiration date. They can be used to hedge other trades or currency risks, or to speculate on price movements in currencies.
Unlike currency futures, currency forwards are non-standardized and traded over the counter (OTC). They can be useful for both businesses and investors.
How Currency Futures Work in Financial Markets
The first currency futures contract was created at the Chicago Mercantile Exchange (CME) in 1972, and it is the largest market for currency futures in the world today. Currency futures are marked-to-market, requiring traders to maintain capital to cover margins and potential losses.
Futures traders can exit their obligation to buy or sell the currency prior to the contract’s delivery date. This is done by closing out the position. Except for contracts that involve the Mexican peso and South African rand, currency futures contracts are physically delivered four times a year on the third Wednesday of March, June, September, and December.
For example, buying a Euro FX future on the U.S. exchange at 1.20 means the buyer is agreeing to buy euros at $1.20 USD. If they let the contract expire, they are responsible for buying 125,000 euros at $1.20 USD. Each Euro FX future on the Chicago Mercantile Exchange is 125,000 euros, which is why the buyer would need to buy this much. On the flip side, the seller of the contract would need to deliver the euros and would receive U.S. dollars.
Most participants in the futures markets are speculators who close positions before expiry, profiting or losing from price changes instead of delivering the currency.
The daily loss or gain on a futures contract is reflected in the trading account. It is the difference between the entry price and the current futures price, multiplied by the contract unit, which in the example above is 125,000. If the contract drops to 1.19 or rises to 1.21, for example, that would represent a gain or loss of $1,250 on one contract, depending on which side of the trade the investor is on.
Fast Fact
The prices of currency futures are determined when the trade is initiated.
Comparing Spot Rate vs. Futures Rate
The currency spot rate is the current quoted rate that a currency, in exchange for another currency, can be bought or sold at. The two currencies involved are called a “pair.” If an investor or hedger conducts a trade at the currency spot rate, the exchange of currencies takes place at the point at which the trade took place or shortly after the trade. Since currency forward rates are based on the currency spot rate, currency futures tend to change as the spot rates change.
When a currency pair’s spot rate rises, its futures prices likely increase, and they likely decrease when the spot rate falls. This isn’t always the case, though. Sometimes the spot rate may move, but futures that expire at distant dates may not. This is because the spot rate move may be viewed as temporary or short-term, and thus is unlikely to affect long-term prices.
Practical Example of Currency Futures
Assume hypothetical company XYZ, which is based in the United States, is heavily exposed to foreign exchange risk and wishes to hedge against its projected receipt of 125 million euros in September. Prior to September, the company could sell futures contracts on the euros they will be receiving. Euro FX futures have a contract unit of 125,000 euros. They sell euro futures because they are a U.S. company, and don’t need the euros. Therefore, since they know they will receive euros, they can sell them now and lock in a rate at which those euros can be exchanged for U.S. dollars.
Company XYZ sells 1,000 futures contracts on the euro to hedge its projected receipt. Consequently, if the euro depreciates against the U.S. dollar, the company’s projected receipt is protected. They locked in their rate, so they get to sell their euros at the rate they locked in. However, if the euro gains value, the company loses potential profits since they must sell at the pre-set futures price.
Where Are Currency Futures Traded?
How Do Currency Futures and Forwards Differ?
Currency futures and forwards are very similar in how they work. The difference is that futures contracts have standardized terms and are traded on exchanges. Forwards instead have customizable terms and are traded over the counter (OTC).
Why Do People Use Currency Futures?
Currency futures are used to lock in an exchange rate over some period of time. This can be used to hedge foreign currency fluctuations, which is especially useful in international trade and among multinational corporations.
The Bottom Line
Currency futures are exchange-traded futures contracts that specify the price in one currency at which another currency can be bought or sold at a future date. The rate for currency futures contracts is derived from spot rates of the currency pair. They can be used to hedge foreign exchange risks in international trade and among multinational corporations. Butures can be exited before the delivery date by closing out the position, mitigating the need for physical delivery of the currency.
Most traders are speculators who profit or lose based on futures price fluctuations rather than currency delivery.
