Currency Futures Definition
Currency futures can typically be referred to as a contract where two parties agree to exchange a specified quantity of a specific currency at a pre-agreed price on a specified date. They are traded is an over exchange and do not necessarily entail the delivery of the underlying currency, instead, they might be settled or reversed prior to the maturity date.
Types of Currency Futures
Based on the type of currency traded and the contract size, a currency futures contract can be of several types. The most commonly traded currencies are Euro, US Dollar, Canadian Dollar, 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).
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 being 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. with an underlying obligation to sell the same.
- Size of the Contract – Specifies the quantity of currency.
- Limits on the Position Held – To prevent speculators from manipulating the market, they are only allowed to hold a particular 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. is the current price, while futures price is the price today 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 contract
- Maintenance margin- Minimum amount required to maintain one’s position
- Variation 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., 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.
S= Spot rate; (r-rf)= interest rate differential between domestic and foreign currency; T= time
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. 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
Payoff Calculation Formula
An investor is of the opinion that 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 margin 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- Spot rate after five months is 0.73 $/€.
Payoff Calculation Table
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., 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.
For e.g., a day trader buys 100 CHF (Swiss Franc) futures contracts at $1.0345 per contract and sells it at $1.0375 per contract. Each tick in the contract is valued at $10.
- 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 risk. Clearinghouse acts as the counterparty to every party and maintains that all obligations should be met.
- Liquid market- 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.
- Lower entry costs can lead to the creation of multiple future contracts by the same party, which is, however, 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.
- Currency futures contracts cannot be customized to adjust for contract sizes other than the standard ones.
- Speculations that are not based on detailed analysis may result in potentially huge losses.
Currency futures, also sometimes termed as financial exchange derivatives, are traded at a number of exchanges throughout the world. The highest volume of such trades has been reported at the Chicago Mercantile Exchange. The involvement of exchanges and clearing houses protects the parties from any probable losses.
The process of 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. is also performed every day that never lets parties go out of sight. Currency futures are also said to have very symmetric payoffs, making them a safe haven for speculators who mostly use these to make bets on the movement of one currency with respect to another.
This has been a guide to what is Currency Futures and its Definition. Here we discuss the specifics of a Currency futures contract along with Types, Advantages, and Disadvantages. You can learn more about Accounting from the following articles –