Currency futures are contracts tied to the currencies of specific countries. These contracts are selected based on the significance of the currency in global commercial and financial markets.
Currencies of relatively stable countries are often considered hard or convertible, meaning their exchange value is determined by the market. However, the relative value of these currencies is in constant flux, exposing currency-related transactions to exchange rate risk.
Currency futures overview
Foreign currencies and assets linked to them are traded across various markets, including cash, forward, futures, options, and futures options markets.
Major international banks, foreign currency dealers, and national governments through their central banks are principal players in foreign currency markets.
In cash markets, foreign currencies are traded with the immediate exchange of one currency for another.
When a US citizen visiting Toronto exchanges US dollars for Canadian dollars, a cash market transaction occures.
A U.S. company needing to pay for imported goods in the exporter’s currency can purchase the required foreign currency in the cash market. Active forward markets in foreign currencies allow banks to offer clients forward contracts, protecting against exchange rate risk—the risk associated with the price at which one currency can be converted into another. Banks and foreign currency dealers trade billions in cash and forward markets to limit exposure to and to speculate on the exchange rate movements.
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Foreign currency futures or (FX) trade on the IMM division of the CME Group. Options on currency futures are traded on the International Monetary Market (IOM) of the CME. When an option on a currency futures contract is exercised, the option holder, the writer, or both receive positions in the underlying foreign currency futures contract.
Hedging with foreign currency futures
Exchange rate risk can be hedged using currency futures or options on currency futures. Foreign currency risk arises when one holds assets denominated in a foreign currency or has unmatched revenues or expenses in a foreign currency.
Short hedges
Holders of assets denominated in a foreign currency face the risk of a decline in the asset’s value if the foreign currency depreciates against their own. Short hedges can be used to protect against a decrease in the foreign currency’s exchange value relative to their domestic currency, such as the U.S. dollar. Exporters who accept payment in a foreign currency also encounter exchange rate risk. However, this situation is relatively rare in international trade, as exporters usually prefer to be paid in their own domestic currency.
An English wool mill normally demands payment in British pounds rather than US dollars.
Occasionally, an exporter may choose to accept payment in a foreign currency. A short hedge protects the exporter receiving payment in a foreign currency against a decline in that currency’s value relative to his own country’s currency.
Anyone who will be negatively affected by a decline in the value of a particular foreign currency or a rise in the value of the U.S. dollar relative to that foreign currency needs to use foreign currency futures as a short hedge.
Short hedge examples
- American exporters who intend to sell products or services abroad and will be paid in a foreign currency.
- A foreign importer who plans to buy products or services in the United States and must pay for the transactions in US dollars.
- Multinational banks that deal in foreign currencies.
As with any short hedge, if an investor plans to sell a particular foreign currency in the future, they should take a corresponding short position in the futures market today to mirror their future cash market transaction.
Long hedges
Long hedges protect against rising foreign currency values or declining domestic currency values. When foreign currency values increase, those making payments in a foreign currency they don’t hold face higher costs. Most importers use long hedges in foreign currencies. For example, if a U.S. clothing manufacturer agrees to pay an English wool mill in British pounds, the manufacturer must pay a fixed amount of pounds at a future date.
If the foreign currency appreciates relative to the domestic currency and the position is not hedged, purchasing the foreign currency will cost more than anticipated, potentially leading to lower profits or losses when selling the imported goods.
However, if the transaction is hedged with a long (buy) position in futures for the currency in which payment is due, any higher costs incurred in the spot market will be offset by gains on the long futures position.
Delivery on foreign currency futures occurs by depositing the appropriate amount of the foreign currency in any designated depository in the currency’s home country.
Anyone who will be negatively affected by an increase in the value of a particular foreign currency or a decline in the value of the U.S. dollar needs to use foreign currency futures as a long hedge.
Long hedge examples:
- American importers who plan to purchase products or services from a foreign country and who must pay for the transaction in the currency of the foreign country.
- Foreign exporters who plan to sell products or services in the United States and will be paid in US dollars.
- Multinational banks that use foreign currencies in their daily business.
In a long hedge, if an investor needs to buy a specific foreign currency in the future, they should take a long position in the futures market now to mirror the future cash market transaction. This strategy locks in the cost of the foreign currency and protects against adverse movements in exchange rates.
In conclusion
Hedging Summary
- Futures contracts are purchased in a long hedge.
- A long hedge protects against rising prices.
- If the prices increase, the profit on futures offsets the higher cash market price.
- If the prices decrease, the loss on futures is offset by a lower cash market price to buy the commodity.
- The long hedger is short the basis.
- The long hedger wants the basis to weaken.
- The long hedge is a substitute purchase.
Businesses involved in exporting or importing goods use currency futures to manage exchange rate risk. Importers who need to pay for goods in foreign currency buy futures to hedge against an increase in the foreign currency’s value. Conversely, exporters who will receive payment in a foreign currency sell futures to protect against a decrease in the foreign currency’s exchange rate.
What Are Currency Futures? Explained by Inna Rosputnia
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