Currency Futures means a standardized foreign exchange derivative contract traded on a recognized stock exchange to buy or sell one currency against another on a specified future date, at a price specified on the date of the contract but does not include a forward contract.
In other words, it is an agreement between two parties to exchange one currency for another, with the actual exchange taking place at a specified date in the future but with the exchange rate being fixed at the time the agreement is entered into.
However, there are a number of significant differences between forwards and futures.
These relate to contractual features, the way the markets are organized, profiles of gains and losses, kinds of participants in the markets, and the way in which they use the two instruments.
Features of Currency Futures
The features of currency futures are as follows:
1. Organised Exchanges: Unlike forward contracts, which are traded in the OTC market, futures are traded on organized exchanges, either with a designated physical location where trading takes place, i.e., the trading pit or via computer screens.
This provides a ready, liquid market in which futures can be bought and sold at any time during trading hours as in a stock market.
2. Standardisation: In the case of a forward currency contract, the amount of the currency to be delivered and the expiry date are negotiated between the buyer and the seller and can be tailor-made to suit the requirements of either party.
In a futures contract, both these are standardized by an exchange on which the contract is traded.
For each contract, the exchange specifies a set of delivery months and specific delivery days within those months.
The exchange also specifies the minimum size of the price movement (this is known as a tick) and, in some cases, may also impose a ceiling on the maximum price change within a day.
3. Clearinghouse: On the trading floor, a futures contract is agreed upon between two parties, A and B.
When it is recorded by the exchange, the contract between A and B is immediately replaced by two contracts, one between A and the clearinghouse and another between B and the clearinghouse.
This process is called novation. Thus the clearinghouse interposes itself in every deal, being a buyer to every seller and seller to every buyer.
Further, the clearinghouse guarantees performance. This eliminates the need for A and B to investigate each other’s creditworthiness and ensure the financial integrity of the market.
The exchange enforces delivery for contracts held till maturity.
4. Margins: Only members of the exchange can trade in futures contracts on the exchange.
The other participants, i.e., non-members use the member’s services as brokers to trade on their behalf (of course, an exchange member firm can also trade on its own account).
A subset of exchange members is the clearing member, i.e., members of the clearinghouse when the clearinghouse is a subsidiary of the exchange.
A non-clearinghouse member must clear all transactions through a clearing member for a fee.
Thus, every transaction is between an exchange member and the exchange clearinghouse.
5. Marking to Market: This essentially means that, at the end of a trading session, all outstanding contracts are re-priced at the settlement price of that session.
Margin accounts of those who made losses are debited, and of those who gained are credited.
At this stage, there is an important difference that marking to market creates between forwards and futures.
In a forward contract, gains or losses arise only on maturity. There are no intermediate cash flows.
In a futures contract, even though the overall gain/loss is the same, the time profile of its accrual is different.
The total gain or loss over the entire period is broken up into a daily series of gains and losses that clearly has different present value.
6. Actual Delivery: In most, if not all forward contracts, the exchange of currencies actually takes place.
Forward contracts are usually entered into to acquire or dispose of a currency at a future date but at a price known today.
In contrast, in most futures markets, actual delivery takes place in less than one percent of the contracts traded.
Futures are used as a hedging device against price risk and as a way of betting on price movements rather than as a means of physical acquisition of the underlying currency.
Most of the contracts are extinguished before maturity by entering into a matching contract in the opposite direction.
7. Payoff Profile: If one holds a long position in forwards or futures and the underlying currency value goes up (or down), again (or loss) will be realized.
Thus, the pay-off is symmetrical. It has unlimited profit as well as unlimited loss potential.
If one wants unlimited profit potential and at the same time limited downside, then options provide that alternative.
Uses of Currency Futures by Firms
Corporations that have open positions in foreign currencies can consider purchasing or selling futures contracts to offset their positions.
1. Purchasing Futures to Hedge Payables: The purchase of futures contracts locks in the price at which a firm can purchase a currency.
For example, Teton Co. orders Canadian goods and, upon delivery, will need to spend $500,000 to the Canadian exporter.
Thus, Teton purchases Canadian dollar futures contracts today, thereby locking in die price to be paid for Canadian dollars at the future settlement date by holding futures contracts.
Teton does not have to worry about changes in the spot rate of the Canadian dollar over time.
2. Selling Futures to Hedge Receivables: The sale of futures contracts locks Hn the price at which a firm can sell a currency.
For example, Karla Co. sells futures contracts when it plans to receive a currency from exporting that it will not need (it accepts a foreign currency when the importer prefers that type of payment).
By selling a futures contract, Karla Co. locks in the price at which it will be able to sell this currency as of the settlement date.
Such an action can be appropriate if Karla expects the foreign currency to depreciate against Karla’s home currency.