Forex futures are futures markets where the underlying commodity is a foreign currency. Foreign currency futures are essentially the same as all other futures markets (index and commodity futures markets), and are traded in exactly the same way. Forex futures markets trade futures contracts that reflect the exchange rates of two currencies. For example, the most popular currency futures market is the EUR futures market, which is based upon the Euro to US Dollar exchange rate.
Hedging with Forex Futures
Tenders make use of the market for forex futures/foreign currency futures in order to hedge their foreign exchange risk. For instance suppose a US importer importing goods from India for 1 million Rupees and he needs this amount for making payment to the exporter. He will purchase Rupee at a future settlement date. By holding a futures contact, the importer does not have to worry about any change in the spot rate of the Rupee over time. On the other hand, if the US exported exports goods to an Indian firm and has to receive Rupee for the exports, the exporter would sell a Rupee futures contract. This way the exporter will be locking in the price of the export to be received in terms of Rupee. It will protect itself form the loss that may occur in case of depreciation of the Rupee over time.
Speculation with Forex Futures
Speculators make use of the foreign currency futures for reaping profits. When they expect that the spot rate of a particular currency will move up beyond those mentioned in the currency futures contract, they buy currency futures denominated in ‚¬ that particular currency. At maturity, if their expectations come true, the difference in the sport rate and the rate mentioned in the futures contract will be the profit to be reaped by them. Suppose, the futures rate is US & 1.75/ ‚¬ and the spot rate on maturity is expected to be US$ 1.76 ‚¬. If the speculator purchases £ 62,500at the rate of US1.75 (under the futures contract) and the expectation comes true and so sells that Euro at the rate of US $1.76 in the spot market, the profit will be US $ (1.76-1.75)* 62,500 = US $625. In other words, the speculators buy currency futures in a currency when the future rate of that currency is expected to be greater than the currency futures rate. On the other hand, if the sport rate of a particular currency is expected to depreciate below the rate mentioned in the currency. For example, if the value of the Euro is expected to drop to US $ 1.74 on the maturity date, the speculator will strike a currency futures deal to sell Euros. On the maturity date, it will sell ‚¬ 62,500 at US $ 1.75 and with the sale proceeds to be obtained in US dollars, it will buy Euros at the spot rate. This way, it will make profits equal to US $ (1.75-1.74)* 62,500 or US $ 625. It may be noted here that these transactions involve cost that is to be deducted from the gain. The transaction cost is very nominal for the locals, but is significant for the speculators.
- Intra-currency Spread: Speculators can buy or sell futures of the same currency for two delivery dates if the rates for those two dates differ. This is known as intra-currency spread. Suppose, sport rate is US$ 1.795/ ‚¬: the June-delivery rate is US$ 1.79/ ‚¬ and the September —delivery rate is US $ 1.775/ ‚¬. If the speculator expects that the Euro will depreciate more rapidly than exhibited by the futures rates, he will buy two futures in Euros for the above two dates. Prior to maturity, he will reverse the two contracts respectively, say, at US $ 1.78 and US $ 1.76. Now in the original contract, the price difference in the two different maturity contracts is US $ 1.79-1.775 = 0.015 while in the reverse contracts, the difference amounts to US $ 0.02. Since the difference in the price of the reverse contracts is greater than the difference in the price of the original contracts, the speculator makes profit amounting to US $ (0.020-0.015)* 62,500 = 312.5.
- Inter-currency Spread: Besides the intra-currency spread, inter-currency spread is also used by the speculators. Such spread occurs when the deal involves purchase and sale of future contracts with the same delivery date but with two different underlying currencies. Suppose the speculator expects an appreciation of US dollar relative to the Euro. He will buy US dollar futures and sell Euro futures. Before maturity, he will reverse the two contracts. If the price difference of the two reverse contracts is less than the price difference of the original contracts, the speculator will make a profit.