Currency Futures

What is a Currency Future?

Currency Futures are traded in the same manner as any other form of futures contract. However, instead of dealing in a tangible product like pork bellies of wheat, the exchange rate between two given currencies serves as the commodity for the underlying contract.

There are two ways to settle a currency futures contract – you can hold it until maturity at which point you receive a cash settlement at the rate specified in the contract, or you can buy and sell currency contracts prior to maturity on an established exchange. There are several exchanges that specialize in currency futures including the Chicago Mercantile Exchange (CME), Euronext, and the Tokyo Financial Exchange to name a few of the larger currency futures trading centers. See Settlement and Delivery of Currency Futures Contracts for more information how to settle a currency future contract.

History of Currency Futures

Currency futures were introduced by the Chicago Mercantile Exchange (CME) after the United States abandoned the Bretton Woods agreement in the early 1970s. Bretton Woods was implemented after World War II and was intended to help European countries devastated by years of warfare to rebuild their economies. The central element of the Bretton Woods agreement was to tie the U.S. dollar to the value of gold and then force other currencies to maintain their rates within a narrow operating band of plus or minus one percent, in relation to the value of the U.S. dollar.

In 1971 – in an attempt to deal with surging stagflation in the U.S. economy, President Richard Nixon dropped the gold standard and devalued the U.S. dollar to 1/35th of an ounce of gold. This effectively ended the Bretton Woods restrictions leading ultimately to a market-based valuation for individual currencies.

Investors soon saw an opportunity to speculate on exchange rate fluctuations, but currency trading at the time was the exclusive domain of large banks. These institutions operated in a closed, inter-bank market, forcing outsiders to pay high service fees in order to conduct currency transactions.

CME traders – eager for a market in which they could themselves trade currencies – challenged the banks by launching the International Monetary Market (IMM) in December of 1971. Initially, the IMM trading facility offered currency futures in seven different currency pairs, but the IMM’s major contribution was that it created a market for CME traders to deal in standardized contracts where traders could be assured of high liquidity levels and a matching / clearing service to ensure that trades were promptly executed. The IMM continues today as a division of the CME.

Pricing Currency Futures Contracts

Contract prices for currency futures are determined by the interest rate for the country of origin for the currencies listed in the futures contract as well as the spot rates for each currency. By incorporating the spot rates in the contract price calculation, the ability to profit solely on arbitrage differences is eliminated as the contract price moves in tandem with fluctuations in the spot rate of either currency.

The following formula is used to set the price for a contract for a given currency pair:

F = S (1 + RQ x T) ÷ (1 + RB x T)

Where:

• F = the price for the currency futures contract
• S = the spot rate for the currency pair
• RQ = the interest rate of the quote currency
• RB = the interest rate of the base currency
• T = the tenor or time to maturity (in days)

Because contract prices are determined – i.e. derived – from the underlying currencies, currency futures are considered a derivatives product. Currency futures contracts are similar to forward rate agreements (FRAs) and can also be used for hedging and speculation purposes. However, unlike FRAs which are agreements between two parties with terms as agreed to by both parties, currency futures have standard maturity dates and are offered in fixed amounts only.

Minimum Price Change

Price changes in currency futures are expressed as pips or somewhat less commonly, as ticks. A pip – short for percentage in point – is the smallest unit of measure at which the currency pair trades. For example, if the current exchange rate for AUD/USD is quoted at 0.9750 and then moves to 0.9755, this is an increase of five pips (0.9755 – 0.9750). In addition, note that this currency pair trades in $100,000 AUD lots, so with a leverage ratio of 1:100, this means that each pip is worth $10 AUD for each AUD / USD currency pair you hold ($100,000 x 0.0001 = $10.00). Thus, a five-pip change is a $50 AUD swing in the price of one AUD / USD contract.

It is important to note however, that not all currency pairs are expressed to four decimal places – some like the USD / JPY pair for example, list only two decimal places while others are expressed to three. Some brokers are even offering quote spreads to five decimal places (known as fractional pips or pipettes). The important thing to remember however, is that it is the last number – whether it be two, four, or five places after the decimal – that represents a single pip for that currency pair.

Mark-to-Market Price Fix

A Mark-to-market price fix is a theoretical valuation of all your open positions if they were settled at the current market prices. At the end of each day’s trading, your account will be marked-to-market to ensure that you are still within the margin limits imposed by the exchange and your broker. See below for more information on margin and margin-based lending.

Margin

There are two types of margin you need to know about prior to trading currency futures. The first is initial margin – this is the money you deposit in your trading account to establish an account with your broker. If you incur losses and the amount in your account falls below a certain threshold amount as mandated by the exchange and your broker, you will then be required to deposit additional money – this threshold is known as maintenance or variation margin. If the balance in your account falls below the required maintenance margin levels, your broker will notify you through a margin call that you must bring your maintenance margin back to compliance levels; failure to do so will result in your broker liquidating your holdings.

Buying on margin – or leveraged buying – allows you to submit trades for values considerably more than the amount you have available in your account. To illustrate the power of leveraged buying, consider a margin ratio of just 20:1 coupled with a trading account containing $10,000. This means that you could trade amounts up to $200,000 ($10,000 x 20) thus enabling you to secure greater profits on even small price movements.

Of course, this can work against you as well. If you have committed all your available cash to a trade and the value of the trade falls below your maintenance margin level, you will receive a margin call requiring you to deposit additional margin to your account.

For example, consider the following scenario where an investor intends to buy a single USD / CAD currency futures contract:

• USD / CAD currency futures contracts are listed in $100,000 CAD lots
• One contract is currently valued at $0.9500 CAD per U.S. dollar, or $95,000 USD
• Initial margin required is 10% - therefore, you need at least $9,500 USD margin available in your account (let’s assume that you have exactly this amount available in your account)
• Maintenance margin required by your broker is 7.5% - assuming that you have no other transactions in your account, you need to maintain at least $7,125 USD in your account in either cash or marked-to-market value

Based on this information, if the single dollar price moves up to 0.9550 CAD per U.S. dollar – a gain of fifty pips – the value of the single contract is now worth $500 more than you paid. You can calculate this in one of two ways:

1. A single CAD pip is equal to $10 CAD per contract – therefore, 50 pips x $10 = $500, or

2. 0.0050 (fifty pips) x $100,000 CAD = $500 CAD

How about if instead of gaining fifty pips, you lose 300 pips? – again, we are assuming that you have only one order in your account:

1. 300 pips x $10 CAD = ($3,000 CAD) – remember this is a loss. You can also calculate in this manner -

2. 0.0300 (300 pips) x $100,000 = ($3,000 CAD)

When your broker performs the mark-to-market evaluation and takes into account this loss, your available margin will fall from $9,500 to $6,500 CAD. This is obviously below the $7,125 USD threshold you are required to maintain so this will trigger a margin call from your broker requesting you to deposit sufficient funds to bring your account back to compliance.

Settlement and Delivery of Currency Futures Contracts

Because currency futures are based on the exchange rate between two currencies, no physical underlying commodity exists. With a wheat futures for example, the contract holder does have the option to take physical delivery of the wheat, although physical delivery is quite rare as most commodity futures are settled in cash – taking this concept one step further, currency futures are always settled in cash.

Like most forms of futures trading, there are two types of investors – hedgers looking to protect a future transfer of funds, and speculators looking to profit on fluctuations in the price of the contract.

Individuals and firms that have either a future payment due or expect to receive a future payment, may use currency futures to look in a rate if they have concerns that interest rate changes prior to the payment date could move against them. In other words, by buying currency futures contracts, hedgers want to make sure that a change in exchange rates won’t cause them to receive less if they expect a future payment, or cause them to pay more if making a future payment. See Hedging with Currency Futures for more information.

Speculators on the other hand, are not interested in holding a currency futures contract until it matures. These investors are looking to profit on fluctuations in the contract price and may sell and buy several positions a day (so-called day traders). Unlike hedgers that have a large transfer of funds due in the future, speculators, through the buying power of margin, move in and out of contract positions continuously and rarely hold any single contract for an extended period of time.