Businesses that trade in foreign currencies are at risk from adverse movements in the exchange rate. This risk is known as currency risk. Where a business loses money as a result of an adverse move in exchange rates this is known as currency loss.
There are many ways that businesses can protect themselves against currency loss and one way that it can be done is through the use of currency futures. Currency futures are contractual agreements made between two parties. They are ordinary futures contracts (which are commonly used in the world of finance) made for exchanging currencies.
What is a Futures Contract?
A futures contract is an agreement made between two parties to buy or sell something at a set price at a specified time in the future. The key thing is that the price of what is being sold does not change between the time the contract is agreed and payment takes place.
Normally, futures contracts are used to trade commodities and financial instruments and are bought and sold on an exchange, which is a marketplace connecting buyers and sellers. They are sold in standardised formats with contracts coming with standardised dates for settlement and standardised amounts to be traded. The standardisation of the formats is regulated by the exchanges on which they are sold.
What are Currency Futures?
Futures used in currency exchange are known as currency futures, FX futures or foreign exchange futures. Currency futures contracts are the same as ordinary futures contracts, but what is exchanged is specifically two currencies. One party will agree to buy a certain amount of another currency at a set price at a specified time in the future.
US dollars to euro futures are a popular futures contract and are a good example.
CME Group EUR/USD Futures
Euro to US dollar futures contracts are sold by the CME Group on the Chicago Mercantile Exchange. These are sold at standardised amounts of 125,000 EUR with quarterly settlement dates for March, June, September, and December. The rates which are available vary over time.
With a CME EUR/USD future, a buyer could agree in January to buy 125,000 EUR in March for something like 143,000 USD. This is an exchange rate of around 0.87 USD/EUR. When March comes, they can then exchange currencies at this rate. What the currency futures contract does is lock the exchange rate for a future date.
Where Do FX Futures Come From?
FX futures are a relatively recent addition to the futures market, have been available since the early 1970s. While they were introduced in 1970 by the New York International Commercial Exchange, the first successful futures contracts actually came from the Chicago Mercantile Exchange in 1972. This was after President Nixon abandoned both the gold standard and fixed exchange rates.
The Chicago Mercantile Exchange did not have access to the interbank exchange markets but wanted to speculate on the currency markets. To get around this, they launched the International Monetary Market and as part of this, they began trading in seven types of currency futures.
Nowadays there are a number of futures exchange markets and they are located all over the world. The US, for example, has twenty-two notable exchanges which offer futures contracts. In the UK there are three.
How Futures are Used in FX Hedging
Currency futures are used in FX hedging to lock the exchange rate for a future date. This removes currency risk for companies that trade in foreign currencies.
The simplest way to demonstrate is with an example.
If a company imports materials from overseas, they may wish to use futures contracts to remove currency risk associated with the purchase of materials. When purchasing materials, whether this is for an isolated purchase or for recurrent purchases, there may be a time delay between the time that they commit to purchasing the materials and they actually pay for them.
The risk for this company is that if exchange rates change adversely in the intervening period, the cost of the purchase will end the uprising. The resultant loss is known as currency loss.
To avoid this happening the company can use futures contracts to set the exchange rate for a future date or dates. They simply take out futures contracts to purchase an amount of foreign currency at a convenient date. Note that as futures contracts are sold in standardised amounts, it is never possible to exchange exactly the right amount.
When the date comes to make payment for materials, they can exchange currencies at the rate set in the futures contract and make the payment. Changes to the exchange rate will not need to be taken into consideration because the exchange rate is locked by the futures contract.
Futures contracts can also be used by importers. Instead of agreeing to buy foreign currency at a set price, they agree to buy their own domestic currency with the future proceeds of a sale made in a foreign currency.
Futures Can also be Used for Speculation
It is worth noting that as well as being used for hedging against currency risk, futures contracts are also used for speculation. By locking in a certain exchange rate, the owner of a futures contract can profit if exchange rates go in the right direction.
Futures vs Forwards
Futures contracts and forward trades are two similar things that sometimes get confused. With a forward trade, there is essentially the same agreement made between two parties. However, the difference is that the agreements are not standardised and are, instead, bespoke agreements made between two parties.
With a forward trade, the two parties are committed to exchanging a set amount of one currency for another at a set rate on or before a specified date. It’s just that the details of the agreement are negotiated individually for each contract that is agreed to.
Rather than being provided on an exchange, forward trades are offered by currency brokers, banks, or online platforms which provide a similar service to that of a currency broker.
Which is Better?
The bespoke nature of forward trades makes them far more useful to many businesses. With a forward trade, a company that trades in foreign currencies can decide the amount that it would like to exchange and by when it would like to do so. On top of this, they can also compare different rates which are on offer.
With futures contracts, there are only standardised contracts available.
With a forward trade, a company can hedge the full value of a transaction it is expecting in a foreign currency, for the date it would like to do so and at a rate that it finds acceptable. What futures contracts provide in terms of FX hedging is highly valuable, however, the same hedging benefits come from forward trades far more conveniently.
Other Ways of Hedging Against FX Risk
As well as futures contracts and forward trades, there are various other ways of hedging against currency risk. One commonly used example is an option trade.
With a forward trade, once an exchange of currencies has been agreed to there is a commitment made by both parties to complete it. This is where option trades come in. With an option trade, there is no commitment to completing the exchange of currencies.
This gives the party which has taken out the option trade two choices when confronting currency risk. When the time comes to exchange currency, they will have the security of being able to exchange currencies at a pre-agreed rate set in the option trade. But they don’t necessarily have to.
In the event that exchange rates have turned out to make the rate in the option trade favourable to the spot rate (the current market rate), the option trade will save them from losing money. If exchange rates move favourably, on the other hand, they can disregard the option trade and exchange currencies at the spot rate. They will benefit from doing so.
What is Available on Bound?
Bound provides forward and option trades for UK-based businesses which are exposed to currency risk. Businesses that import or export from the UK can go on the Bound platform to book forward and option trades in order to protect themselves from fluctuations in the exchange rate. Simple spot trades (exchanges of currency done at the current market rate) are also available on Bound.
The Bound platform is easy to use and highly convenient to businesses that need to hedge themselves against currency risk. Increasingly, businesses are turning to online platforms as they offer a safe and regulated, fast, and technologically advanced way to exchange currencies and handle international business transactions.