Currency futures were first introduced on the New York International Commercial Exchange in 1970, but they had little practical use due to the situation with the fixed exchange rates regulated by the Bretton Woods system. However, as soon as the Bretton Woods system ended in 1972, the Chicago Mercantile Exchange (CME) began offering institutional investors the opportunity to trade currency futures.
Over the past few decades, the popularity of currency futures has increased significantly. Currently, the Chicago Mercantile Exchange (CME) currency futures market has an average daily trading volume of over $100 billion, making it the second largest foreign exchange market after the interbank spot forex market.
The main currency futures contracts offered by the Chicago Mercantile Exchange (https://www.cmegroup.com/trading/fx/):
While there are many different types of commodity futures, currency futures contracts are usually only quoted against US dollars. For example, the Chicago Mercantile Exchange (CME) offers approximately 49 currency futures contracts along with numerous other E-mini futures contracts that are smaller than full size contracts.
One thing that novice traders often get confused about is forward and futures contracts. Therefore, it is worth mentioning that a foreign exchange forward contract is an over-the-counter private transaction between counterparties. In contrast, a futures contract is traded only through a public exchange.
If you are familiar with how commodity futures contracts work, understanding foreign currency futures contracts should be relatively simple. Like commodity futures, currency futures and options also allow the buyer of the contract to complete a transaction in the future based on the current agreed price.
If you are new to trading, you may want to further expand your basic knowledge of futures contracts before delving into forex futures trading. We will discuss some of the details that you should be aware of in relation to the currency futures market so that you can consider adding currency futures to your investment portfolio.
What are currency futures?
A currency futures contract or foreign exchange futures contract is a derivative financial instrument where the buyer agrees to buy one currency in exchange for another currency in the future at the current agreed price by both the buyer and the seller at the time the contract is created.
When you trade forex, you are also exchanging one currency for another at an agreed price. However, an important difference between forex trading and currency futures trading is that with a futures contract, you agree to trade one currency in exchange for another currency based on an already agreed rate.
Commodity futures contracts may involve the physical delivery of a commodity. Many manufacturers and sellers use the futures market to lock in the price of a product before it is produced. The currency futures market is often used by buyers and sellers to mitigate the risks of price fluctuations through hedging or attempting to profit through speculation.
As a result, currency futures contracts almost never result in the physical delivery of the currency. Instead, currency speculators often use currency futures contracts to profit from exchange rate fluctuations. Obviously, just like with spot currency in forex, if your prediction of price movement is wrong and the market moves against your position, you can incur losses from trading currency futures.
E-Mini and E-Micro currency contracts
Please note that if you are new to currency trading, it is best to start trading E-mini and E-Micro contracts, as the lower margin requirements will help you trade a variety of instruments with lower risk factors.
As a rule, the liquidity of currency futures is much lower compared to the spot forex market. Also, the volume of standard currency futures is much higher than that of micro contracts.
The Relationship Between Interest Rates and Futures Contract Rates
Before you start trading currency futures, you need to understand the relationship between forex spot rates and futures rates. It is important to know that the difference in interest rates associated with the currency pair in question often plays an important role in pricing for a futures currency contract.
In the currency futures industry, this relationship between interest rate differentials is known as "carryover cost".
As you may already know, central banks that issue currencies offer overnight rates. Your forex broker usually uses swaps for this.
Let's assume that the Bank of England offers 4% per annum in interest on the pound, and the Federal Reserve - 1.25% per annum. If you are a US Forex trader, you can borrow $100,000 at 1.25%, then convert it to pounds and invest it for three months at 4% per annum. At the same time, you can enter into a currency futures contract to receive the same amount of US dollars within three months.
By opening a spot Forex trade and a currency futures contract at the same time, you can receive an income of (4-1.25) 2.75% per year, which for three months will turn out to be risk-free at 0.688%. This assumes that the price of the currency remains unchanged at the end of the 3-month period.
Therefore, the currency futures rate can always be higher or lower compared to the spot forex rate, depending on the positive or negative interest rate differential of the currency pair in question. Typically, the currency futures rate trades at a discount to the spot forex rate for a currency pair with a positive interest rate differential and vice versa.
Using currency futures for hedging
You can use currency futures for two things:
- You can hedge your exposure to the future Forex spot price by buying currency futures or selling currency futures.
- You can assume that the future Forex spot price will be different from the quoted foreign exchange futures prices and try to capitalize on the price difference.
While large corporations involved in international business buy currency futures contracts for the physical delivery of currency, they also insure themselves against any future exchange rate fluctuations.
Suppose the Japanese car manufacturer Toyota received an order to supply 100 vehicles to an importer in Kuwait for $3,000,000. Here, the delivery date is set three months from the date of the contract, and payment will be received after the vehicles are physically shipped to Kuwait. If the USD/JPY rate at the date of signing the contract is 120 yen to the US dollar, then Toyota will receive an income of 360,000,000 yen in three months.
Toyota executives can now begin car production in Japan the next day and hope the USD/JPY spot rate remains at 120 in three months. However, if the USD/JPY spot rate drops to 110, their yen gain is only 330,000,000. This means a loss of 30,000,000 yen, or $250,000 at a USD/JPY spot rate of 120.
A $250,000 or 8.33% reduction in revenue could significantly reduce the net income of the transaction. Therefore, to mitigate the risk of the USD/JPY spot rate fluctuating within three months, Toyota executives can turn to the forex market and hedge the Yen currency futures contract for 3,000,000 (360,000,000 yen) against the US dollar, maturity which is three months.
In this currency futures example, I tried to demonstrate the practical side of how large companies can use currency futures contracts. However, the vast majority of Forex traders will not use currency futures in the same way.
Rather than expect an actual payment in the future, futures traders may want to hedge their current positions in the spot forex market. Assume that you have purchased one lot of EUR/USD from your broker in the spot Forex market at a rate of 1.1000. You expect that in a few months the euro / dollar will rise to 1.2. If this happens, then you can liquidate your position to make a profit of 0.1 or 1000 pips.
However, after several weeks, the unemployment rate in the United States unexpectedly dropped, causing the EUR/USD price to drop from your previous speculations, and you now have a small loss.
At this point, you can either liquidate your EUR/USD position for a small loss, or sell the same amount of EUR/USD futures as your EUR/USD position, due in a few months. Thus, if the EUR/USD spot rate continues to decline, you will still have the opportunity to exit the position with a small loss in the future, not now.
On the other hand, if the EUR/USD price continues to rise as you originally expected, you can simply buy an additional EUR futures contract to cover the first futures contract.
With these three trades, you can hedge your exposure when the market moves against your position.
Using currency futures for speculation
Most forex traders know that the real nature of the business they are involved in is financial speculation. As a spot Forex trader, you are trying to predict how the price of a currency pair will move and trying to buy or sell according to your predictions.
When you place a trade, you risk your capital. If your guesses turn out to be correct, you will be rewarded with profits, and if your prediction turns out to be wrong, you will lose some of your capital. In short, you take on risks in order to generate potential profits.
In the same way, you also buy or sell currency futures to speculate. Here you also have the chance to make a profit if you are right, or lose money if you are wrong.
Conclusion
Most professional and institutional forex traders keep a close eye on the futures contracts of the respective currency pairs they trade in order to understand the overall trend in the market. After all, ceteris paribus, the Forex spot rate is likely to move in the direction of the futures rate in the coming months.
Since the market often behaves irrationally, you can try to find a divergence between the general trend of the futures price and short-term counter movements and develop a comprehensive arbitrage trading system to speculate and profit from irrational market behavior.
Regardless of how you choose to use currency futures, it's important that you have a basic understanding of how they work and how the major players use them. As forex traders, we must clearly understand how interest rates and other important market factors contribute to the relationship between the spot forex rate and the rate of currency futures.