Currency Futures

Currency futures, also called FX futures, are contracts traded on an exchange in which two parties agree to exchange a fixed amount of one currency for another at a set exchange rate on a specified future date. Each contract is a futures contract whose underlying asset is a currency pair. The exchange fixes the contract size, the delivery dates and the minimum price movement, so that every contract in a given series is identical.

Currency futures were introduced in 1972 on the International Monetary Market, a division of the Chicago Mercantile Exchange, shortly after the system of fixed exchange rates broke down. They were the first financial futures. They are used by companies and investors to hedge currency exposure and by traders to speculate on exchange rates, and they form a small but transparent part of the wider foreign exchange market.

A contract specifies the currency amount and how the price is quoted. On CME, for example, the euro contract covers 125,000 euros and is quoted in US dollars per euro. The main contracts expire quarterly, in March, June, September and December, and smaller versions exist for traders who need less exposure.

Trading runs through a central counterparty, which stands between buyer and seller and guarantees performance. Each side posts initial margin when the position is opened. Positions are revalued every day through mark-to-market, and gains and losses are paid in cash as variation margin. Some contracts end with physical delivery of the currencies. Others, especially those on currencies that are not freely convertible, are settled in cash. Most positions are closed or rolled to a later month before expiry.

The futures price is tied to the spot rate by the interest rates of the two currencies, a relationship known as covered interest parity:

• $F$ is the futures price, in units of domestic currency per unit of foreign currency.
• $S$ is the spot rate, quoted the same way.
• $r_d$ is the interest rate of the domestic (quote) currency.
• $r_f$ is the interest rate of the foreign (base) currency.
• $T$ is the time to delivery in years.

Suppose the euro trades at 1.1000 dollars, the dollar interest rate is 5 percent, the euro rate is 3 percent and the contract matures in three months, so $T = 0.25$. The futures price is 1.1000 × (1.0125 ÷ 1.0075) = 1.1000 × 1.00496 = 1.1055. The currency with the lower interest rate trades at a premium for future delivery. If the futures price strayed far from this level, a trader could borrow one currency, lend the other and lock in a profit through arbitrage.

Gains and losses follow from the contract size. A trader who buys one euro contract at 1.1055 and sells it at 1.1105 gains 0.0050 dollars per euro, or 0.0050 × 125,000 = $625. The calculation is covered in more detail under futures profit and loss.

The closest alternative is the FX forward contract, a private agreement between a customer and a bank.

• Standardization. Futures have fixed sizes and dates. A forward can be written for any amount and any date, which suits a company with a specific payment to cover.
• Credit risk. Futures are cleared and margined daily, so counterparty risk is small. A forward carries the credit risk of the other party unless collateral is agreed.
• Cash flow. Daily margin calls on futures create cash movements during the life of the hedge. A forward usually involves no payment until maturity.
• Access and transparency. Futures prices and volumes are public, and anyone with a futures account can trade. Forward pricing depends on the bank relationship.

The forward and swap markets are far larger than the futures market in currencies, but futures prices track them closely because of arbitrage between the two.

An exporter expecting foreign currency in three months can sell futures to fix the rate, a form of FX hedging. Because sizes and dates are fixed, the hedge rarely matches the exposure exactly, leaving some residual risk. Asset managers use futures to adjust the currency exposure of international portfolios. Speculators, including systematic trend-following funds, use them to take positions with leverage, since the margin is a small fraction of the contract value.

In countries with capital controls, exchange-traded currency futures give domestic participants a regulated way to manage currency risk. Exchanges in India, Brazil and other emerging markets list cash-settled contracts on the local currency against the dollar.

Leverage magnifies losses as well as gains, and a position can lose more than the margin posted. A sharp move can trigger a margin call that forces a trader to add funds or close out at a loss, even when the underlying hedge is sound. Liquidity is concentrated in the nearest contract months and the major currencies. In the United States, currency futures are regulated by the Commodity Futures Trading Commission, and exchanges publish position data that is widely followed as a gauge of trader positioning.

• CME Group
• Commodity Futures Trading Commission