Currency futures contracts, also known as foreign exchange futures, or FX futures, are the kind of contracts where trades are made to exchange a currency for another at a fixed exchange rate. But the fun part is, the transactions are made on a future date.
Since the value of the contract is concerned with the underlying exchange currency rate, currency futures are considered a financial derivative.
How do forex futures work?
The kind of contract is standardized contracts that trade on centralized exchanges. If the daily price changes, the differences are settled in cash until the last date. For the kind of contracts that are decided by physical delivery, when the later date arrives, it must exchange the currencies based on the size of the contract.
Forex futures consist of several components, including underlying asset, expiration date, size, and margin requirement. Each of these components is crucial in ensuring the futures process runs smoothly.
Since currency futures are traded on centralized exchanges, and margins are put into place, this vastly reduces counterparty risk compared to currency forwards. A typical initial margin can be around 4% and a maintenance margin around 2%.
What are Currency Futures used for?
They can use forex futures for hedging and speculative purposes like other futures. For example, suppose a party knows that they will need foreign currency sometime in the future but does not want to purchase it.
In that case, they may buy FX futures, which may be referred to as hedging because this will act as a hedged position against possible volatility in the exchange rates.
In the same way, if a party knows that they will receive cash flow in the future in a foreign currency, the traders can use futures to hedge this position. Neat, isn’t it?
Currency exchanges are also often used by speculators. If a trader expects a currency to appreciate against another, they can buy FX futures contracts to gain from the shifting exchange rate.
We can also use currency futures as a check for interest rate parity. If there is a case in which an interest rate parity does not hold, a trader may employ an arbitrage strategy. It is done to profit purely from borrowed funds and the use of futures contracts.
As the capital market is becoming more competitive and constrained, it is more common to see market participants exploring the value of cleared and listed FX futures and options both as a hedging tool and a means of market exploration.
There are several things that one must remember when working in the trade. First, it is risky and unpredictable. So, it is essential to know what risks are worth taking and what is not. It is still better to keep an eye on what is happening and what to do next instead of finding yourself in a situation where it is difficult to get out.