Currency Futures Definition Example How This Contract Works

Currency Futures Definition

Types of Currency Futures

A currency futures contract can be of several types based on the type of currency traded and the contract size. The most commonly traded currencies are Euro, US, Canadian, Pound, Franc, and Yen. Depending upon size, they can be standard or full-sized, mini or half-sized, and micro (about a tenth of the standard).

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Currency Futures (wallstreetmojo.com)

Specifics of a Currency Futures Contract

Two Parties to the Contract – One is the buyer, who is said to hold a long position and agrees to buy a particular quantity of a currency at an agreed future date; another is the seller holding a short positionShort PositionA short position is a practice where the investors sell stocks that they don’t own at the time of selling; the investors do so by borrowing the shares from some other investors to promise that the former will return the stocks to the latter on a later date.read more with an underlying obligation to sell the same.Size of the Contract – Specifies the quantity of currency.Limits on the Position Held – To prevent speculatorsSpeculatorsA speculator is an individual or financial institution that places short-term bets on securities based on speculations. For example, rather than focusing on the long-term growth prospects of a particular company, they would take calculated risks on a stock with the potential of yielding a higher return.read more from manipulating the market, they are only allowed to hold a maximum number of contracts.Spot Price and Futures Price – Spot priceSpot PriceA spot price is the current market price of a commodity, financial product, or derivative product, and it is the price at which an investor or trader can buy or sell an asset or security for immediate delivery.read more is the current price, while futures price is today’s price for future delivery. The difference between the two is referred to as ‘basis.’

The Requirement of Margins:

Initial margin- the amount required to enter into a futures contractMaintenance margin- Minimum amount required to maintain one’s positionVariation margin- When the margin maintained falls below the minimum required, the difference is referred to as the variation margin.The margin call is made to restore the margin account balance to the maintenance margin.Settlement can happen through physical delivery, cash settlementCash SettlementCash settlement is a settlement option frequently used in trading futures and options contracts, where the underlying assets are not physically delivered at the expiration date. At the same time, only the difference is paid by either of the parties, depending on the market rate.read more, private settlement informing the exchange later, or by taking reverse positions.Marking to Market- Gains and losses are calculated on each trading day, and margins are maintained.

Pricing Formula

Where,

S= Spot rateSpot RateSpot Rate’ is the cash rate at which an immediate transaction and/or settlement takes place between the buyer and seller parties. This rate can be considered for any and all types of products prevalent in the market ranging from consumer products to real estate to capital markets. It gives the immediate value of the product being transacted.read more; (r-rf)= interest rate differential between domestic and foreign currency; T= time

Example:

Compute the price of an 8-month futures contract on euros. The risk-free rateRisk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more in Europe is 12%, while the same in the US is 4%. The current exchange rate being $0.80/€,

Futures price = $0.80e(0.04-0.12)8/12

= $0.66/euro

Payoff Calculation Formula

An investor thinks the euro will strengthen against dollars over the next five months and chooses to take a position with a value of € 500,000 by purchasing four futures contracts at 0.78 $/€ with an initial marginInitial MarginInitial margin refers to the equity to be contributed by the investor trading on margin to the margin account, and it is expressed as a percentage of the total purchase price. read more of $20,000. The current spot rate in the market is 0.75 $/€. Considering four different scenarios, profit calculation will be as follows:

Purchasing euros – The spot rate after five months is 0.80 $/€.Purchasing euros – The spot rate after five months is 0.73 $/€.Purchasing Futures – The spot rate after five months is 0.80 $/€.Purchasing Futures- The spot rate after five months is 0.73 $/€.

Payoff Calculation Table

Day Trading

A category of traders, also known as Day tradersDay TradersThe day trader is an individual who trades in the financial markets daily to earn profits by exploiting the inefficiencies present in the market. The three types of traders are - individual traders, financial institution traders, scalpers and momentum traders.read more, closes out all currency futures positions before the day ends. Profit calculation is depicted below:

Where a tick can be explained as the smallest change in the price, which might have a different value in different contracts.

E.g., a day trader buys 100 CHF (Swiss Franc) futures contracts at $1.0345 per contract and sells them at $1.0375 per contract. Each tick in the contract is valued at $10.

Advantages

Fixed upfront cost (Margin)- Margin requirements may temporarily vary in some cases but remain more or less unchanged most of the time.Highly regulated market- They are mostly traded over exchanges.No counterparty risk- The presence of a clearinghouse eliminates counterparty riskCounterparty RiskCounterparty risk refers to the risk of potential expected losses for one counterparty as a result of another counterparty defaulting on or before the maturity of the derivative contract.read more. Clearinghouse acts as the counterparty to every party and maintains that all obligations should be met.Liquid market- The currency futures market is very liquid, allowing parties to enter and exit positions as and when required.Due to strong regulations, hidden costs are absent.

Disadvantages

Lower entry costs can lead to the creation of multiple future contracts by the same party, which is somewhat mitigated by the presence of a regulatory body.They can be a bit complicated for beginners to comprehend.Parties cannot take advantage of a favorable increase in prices.

Limitations

Currency futures contracts cannot be customized to adjust for contract sizes other than the standard ones.Speculations not based on detailed analysis may result in potentially huge losses.

Conclusion

Currency futures, sometimes termed financial exchange derivatives, are traded at several global exchanges. The highest volume of such trades has been reported at the Chicago Mercantile Exchange. Involving exchanges and clearing housesClearing HousesA clearinghouse is a mediator between two firms (which may or may not know each other) that are engaged in a financial transaction (wherein one party is a buyer & another party is the seller in the said transaction), taking the exact opposite positions for each firm and ensures that there is no risk of default in the transaction.read more protects the parties from any probable losses.

The marking to marketMarking To MarketMarking to market (MTM) is the concept of recording the accounts, i.e., the assets and liabilities at their fair value or at the current market price, which varies with time rather than historical cost. It helps to represent the company’s actual financial condition.read more is also performed every day, never letting parties go out of sight. Currency futures are also said to have very symmetric payoffs, making them a haven for speculators who mostly use these to make bets on the movement of one currency concerning another.