Forex futures are financial derivatives built on currency. The contract specifies when one party must either buy or sell a certain amount of a specific currency and how big the payment will be in another specific currency.
- 1 General inforation about derivatives
- 2 Spot forex vs. Futures
- 3 Forex Futures vs. Forex Forwards
- 4 What is a tick?
- 5 Using forex futures for hedging
- 6 Using forex futures for speculation
- 7 Derivatives and collateral (margin)
General inforation about derivatives
Within the world of finance, derivatives are various instruments whose value is tied to the value of an underlying asset or product. Derivatives can for instance be used to speculate on the price movements of stocks, currency pairs or commodities.
Examples of well known derivatives are options, futures, forwards, warrants, and swaps.
A derivative instrument always has two contract parties and is tied to an event or condition at a specific time or time period in the future.
There being two contract parties does not automatically mean that both parties are bound to the contract in the same way. A well known example of the opposite is the stock options contract, where only one of the two parties is obliged to carry out the transaction.
Spot forex vs. Futures
If you are used to speculating on forex spot prices, there are some things to keep in mind before you start risking your money on forex futures. Here are few examples of things to consider:
- Price With forex spot trading, the spot price – right here, right now – is the relevant price. The valuation of forex futures is instead based on assumptions about where the currency exchange rate will be at a certain time or time period in the future.
- Time horizon With forex spot trading, the currency exchange takes place right now or very soon, in accordance with the terms of the deal. With forex futures, the currency exchange will not happen until the pre-specified time or time period in the future, and it can be quite far away from now.
- Size Even a very small-scale hobby dealer can easily get access to forex spot speculation with an online broker, and can also turn around pretty sizeable volumes with the help of leverage. Speculation utilizing forex futures contracts will typically require a lot of capital up front and it is also common for the contracts to be for huge amounts of currency, e.g. to suit institutional traders.
Futures and forwards are both derivative instruments and both can have forex as the underlying asset.
- Forex forwards are created for suit specific parties and are tailor made. The exact terms and conditions can therefore vary widely between the different forwards. They are traded over-the-counter (OTC). Settling only takes place once: when the contract expires. More trust is involved, since you need to trust the counterparty´s ability to honour the contract.
- Forex futures are created for exchange-trading and are therefore highly standardized. Settling takes place each trading day, until the contract has expired. Since they are exchange traded, they are under the supervision of the exchange and liable to a strict third-party framework of rules. In general. counter-party risk is considered to be much lower for futures than forwards. In the United States, future trading takes place under the auspices of the Commodity Futures Trading Commission (CFTC).
What is a tick?
As mentioned above, forex futures contracts are highly standardized and will always include certain information, such as size, date of expiry and settlement info. Another piece of information that will be in there and which is really important is tick size. Tick size will tell you about how small the smallest possible price change is.
Example: This is a forex futures contract for CAD/USD. The tick size is $0.0001 for each CAD. The contract is for 100,000 CAD. Therefore, the smallest price change is $10.
Using forex futures for hedging
Forex futures are used for both speculation and hedging. Investors using forex futures for hedging are typically trying to reduce their exposure to currency exchange risk.
Using forex futures for hedging is very common among institutional investors. In theory, it works on smaller scales as well, but in practical reality it is uncommon for small-scale traders to use forex futures to hedge against currency exchange risk.
Reducing currency exchange risk by using forex futures – an example:
A company based in the United States has been carrying out work in Europe and will be paid a lump sum 5 months from now. The payment will be €1 million.
Currently, the EUR/USD exchange rate is 1.1200. This means that €1 million is worth $1,120,000 (one million and one hundred and twenty thousand dollars).
A lot of things can happen to the exchange rate in five months and the company is worried that when they finally get their €1 million it will be worth less than today. If the EUR/USD exchange rate would go from 1.1200 to 1.1000 that €1million would be worth $20,000 less than today.
To mitigate this risk, the company decides to use forex futures. They sell 8 forex futures á €125,000 each, which will give the company a profit if the USD lose in value against the EUR. This profit would compensate them when exchanging their €1 million for USD.
Using forex futures for speculation
In the example above, a company was using forex futures to reduce their exposure to currency risk. It is, however, also possible to use forex futures for pure speculation. A trader can buy and sell forex futures based on their predictions of currency exchange movements.
Since forex futures are standardized and exchange-traded, it is much more common to use them for speculation compared to forex forwards. The high liquidity and regulatory framework is another plus for speculators.
Using fx mini-futures for speculation
The standardized contracts for exchange-traded forex futures are for large volumes of currency and therefore out of reach for small-scale traders. Therefore, some retail online brokers have begun offering so-called mini-contracts for forex futures. This product is not the same as the heavily standardized exchange-traded futures.
Mini-contracts for forex futures are marketed under various names, including E-minis and E-micros.
Derivatives and collateral (margin)
A broker offering derivative trading will typically require a type of security from the trader and this security is known as margin.
Really large actors on the forex market usually enter into collateral agreement directly with each other, since they act in systems where contracts are netted against each other and only the difference is paid.
For small-scale traders, this is not a feasible solution, so they accept the margin requirements stipulated by the broker. Typically, you will start by depositing the initial margin which makes it possible for you to enter into a derivative contract. If the market value of the contract drops below a certain point, the broker will demand that you deposit a variation margin. When the broker makes this demand, it is called a margin call. If the price continues to drop, several new margin calls can occur.
In transactions where a Central Counterparty Clearing House (CCP House) act as the middle-man to reduce counter-party risk, the CCP House will be the entity demanding margin from the contract parties.
Exchanges where derivatives are traded will typically have information about their rules and margin requirements posted on their web site. So, if you for example want to know more about the margins at the famous Chicago Mercantile Exchange (CME), you can visit their site. CME is the largest exchange in the world for forex future trading, so their rules and decisions tend to have a huge impact. Other examples of important exchanges for forex futures are the Intercontinental Exchange (ICE) and Eurex.