Currency futures are contracts based on the currencies of selected countries. Contracts are chosen on the basis of the importance of a particular currency in international commercial or financial trading.
Typically, currencies of relatively stable countries are hard, or convertible, in that their exchange value is set by the market. However, the relative value of different currencies constantly changes, subjecting currency-related transactions to exchange rate risk.
Currency futures overview
Foreign currencies and assets related to foreign currencies trade in many 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.
Cash markets in foreign currencies involve 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 US company that must pay for imported goods in the exporter’s currency can buy the necessary foreign currency in the cash market. Active forward markets in foreign currencies enable banks to offer clients forward contracts to protect against exchange rate risk, which is the price at which one country’s currency can be converted into another’s. 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 trade on the IOM of the CME. Exercise of an option on a currency futures results in the option holder or the writer or both receiving positions in the foreign currency futures contract underlying the option.
Hedging with foreign currency futures
Exchange rate risk is hedged by using either currency futures or options on currency futures. Foreign currency risk occurs when one holds assets dominated in a foreign currency or has unmatched revenues or expenditures in a foreign currency.
Holders of assets denominated in a foreign currency risk a change in the asset’s value if the other country’s currency value declines against their own. Short hedges protect against a fall of a foreign currency’s exchange value relative to their domestic currency, in this case, the US dollar. Exporters accepting payment in a currency other than their domestic currency also face currency exchange risk. This is relatively unusual in international trade because exporters typically demand payment in their domestic currency.
An English wool mill normally demands payment in British pounds rather than US dollars.
Occasionally, however, an exporter will accept payment in 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.
Who needs to use foreign currency futures as a short hedge? The answer is: anyone who will be harmed if the value of a particular foreign currency falls or if the value of the US dollar rises in relationship to that specific foreign currency.
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 must sell a particular foreign currency in the future, the investor should do in the futures market today what he will do in the cash market in the future.
Long hedges protect against increasing foreign currency values or declining domestic currency values. Rising foreign currency value increases costs to those making payments in a currency they do not hold. Most importers are long hedgers in foreign currencies. Once an importer, such as US clothing manufacturer, agrees to pay an exporter, such as an English wool mill, in an agreed-upon foreign currency (British pounds), the importer must pay a fixed amount of the foreign currency at a specified future date.
If the foreign currency rises relative to the domestic currency and the position is not hedged, the purchase of foreign currency will cost more than expected. This results in lower profits or possible losses when the imported goods are sold.
If the transaction is hedged with a long (buy) position in futures on the currency in which payment is to be made, the higher costs of the currency purchased in the spot market are offset by profits 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.
Who needs to use foreign currency futures as a long hedge? The answer is: anyone who will be harmed if the value of a particular foreign currency rises or if the value of the US dollar declines.
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.
So, as with any long hedge, if an investor must buy a specific foreign currency in the future, the investor will do in the futures market now what he will do in the cash market in the future: establish a long hedge.
- 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 that export or import goods use currency futures to protect themselves against exchange rate risk. Importers that will pay for goods in foreign currency buy futures to hedge against a rising foreign currency value. Exporters that will be paid in a foreign currency sell futures to hedge against a decline in the exchange rate of the foreign currency.
What Are Currency Futures? Explained by Inna Rosputnia
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