Currency Futures Market

Currency Futures Market

Currency futures contracts are contracts specifying a standard volume of a particular currency to be exchanged on a specific settlement date. They are commonly used by MNCs to hedge their foreign currency positions. In addition, they are traded by speculators who hope to capitalize on their expectations of exchange rate movements. A buyer of a currency futures contract locks in the exchange rate to be paid for a foreign currency at a future point in time. Alternatively, a seller of a currency futures contract locks in the exchange rate at which a foreign currency can be exchanged for the home currency. In the United States, currency futures contracts are purchased to lock in the amount of dollars needed to obtain a specified amount of a particular foreign currency; they are sold lock in the amount of dollars to be received from selling a specified amount of a particular foreign currency.

Credit Risk of Currency Futures Contracts

Each currency futures contract represents an agreement between a client and the exchange clearinghouse, even though the exchange has not taken a position. For example, assume you call a broker to request the purchase of a British pound futures contract with a March settlement date. Meanwhile, another person unrelated to you calls a broker to request the sale of a similar futures contract. Neither party needs to worry about the credit risk of the counterparty. The exchange clearinghouse assures that you will receive whatever is owed to you as a result of your currency future position.

To minimize its risk in such a guarantee, the CME impose margin requirements to cover fluctuations in the value of a contract, meaning that the participants must make a deposit with their respective brokerage firms when they take a position. The initial margin requirement is typically between $1,000 and $2,000 per currency futures contract. However, if the value of the futures contract declines over time, the buyer may be asked to add to the initial margin. Margin requirements are not always required for forward contracts due to the more personal nature of the agreement; the bank knows the firm it is dealing with and may trust is to fulfill its obligation.

Speculation with Currency Futures

Currency futures contracts are sometimes purchased by speculators who are simply attempting to capitalize on their expectation of a currency’s future movement. Currency futures are often sold by speculators who expect that the spot rate of a currency will be less than the rate at which they would be obliged to sell it. Of course, expectations are often incorrect. It is because of different expectations that some speculators decide to purchase futures contracts while other speculators decide to sell the same contracts at a given point in time.

Currency Futures Market Efficiency

If the currency futures market is efficient, the futures price for a currency at any given point in time should reflect all available information. That is, it should represent an unbiased estimate of the respective currency’s spot rate on the settlement date. Thus, the continual use of a particular strategy to take positions in currency futures contracts should not lead to abnormal profits. Some positions will likely result in gains while others will result in losses, but over time, the gains and losses should offset. Research has found that in some years, the futures price has consistently exceeded the corresponding price as of the settlement date, while in other years, the futures price has consistently been below the corresponding price as of the settlement date. This suggests that the currency futures market may be inefficient. However, the patterns are not necessarily observable until after they occur, which means that it may be difficult to consistently generate abnormal profits from speculating in currency futures.

Trading Platforms for Currency Futures

There are electronic trading platforms that facilitate the trading of currency futures. These platforms serve as a broker, as they execute the trades desired. The platform typically sets quotes for currency futures based on an ask price at which one can buy a specified currency for a specified settlement date, and a bid price at which one can sell a specified currency. Users of the platforms incur a free in the form of a difference between the bids and ask prices.