Foreign currency futures are a type of financial derivative that allows investors and traders to buy or sell a specific amount of one currency for another at a predetermined exchange rate and date in the future. Unlike currency forwards, which are customized contracts that trade over-the-counter (OTC), foreign currency futures are standardized contracts that trade on centralized exchanges, such as the Chicago Mercantile Exchange (CME) or the National Stock Exchange of India (NSE).
Foreign currency futures can be used for various purposes, such as hedging, speculation, or arbitrage. Hedging involves using foreign currency futures to reduce the risk of adverse exchange rate movements on an existing or anticipated position in the spot market. For example, an importer who needs to pay for goods in euros in three months can buy euro futures contracts to lock in the exchange rate and avoid paying more if the euro appreciates against their home currency.
Speculation involves using foreign currency futures to profit from expected changes in exchange rates. For example, a trader who expects the euro to depreciate against the US dollar can sell euro futures contracts and buy them back later at a lower price, earning a profit from the difference. Speculators can also use leverage to amplify their returns, as they only need to deposit a small percentage of the contract value as margin.
Arbitrage involves using foreign currency futures to exploit price discrepancies between different markets or instruments. For example, an arbitrageur can buy a currency in the spot market and sell it in the futures market if the futures price is higher than the spot price, or vice versa. Arbitrage opportunities are usually short-lived and require fast execution and low transaction costs.
Foreign currency futures have several advantages over other types of currency derivatives, such as liquidity, transparency, standardization, and lower counterparty risk. Liquidity refers to the ease of buying and selling contracts without affecting their prices significantly. Transparency refers to the availability of market information, such as prices, volumes, and open interest. Standardization refers to the uniformity of contract specifications, such as size, expiration date, and settlement method. Lower counterparty risk refers to the reduced possibility of default by either party, as futures contracts are cleared and guaranteed by a central clearinghouse.
However, foreign currency futures also have some disadvantages, such as inflexibility, basis risk, and margin requirements. Inflexibility refers to the inability to customize contract terms to suit specific needs or preferences. Basis risk refers to the risk that the futures price may not move in line with the spot price, resulting in a loss or lower gain than expected. Margin requirements refer to the obligation to maintain sufficient funds in the trading account to cover potential losses or margin calls.