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A currency future, also FX future or foreign exchange future, is a
futures contract to exchange one currency for another at a specified
date in the future at a price (exchange rate) that is fixed on the
purchase date.
Currency futures were first created at the Chicago Mercantile Exchange
(CME) in 1972, less than one year after the system of fixed exchange
rates was abandoned along with the gold standard. Some commodity traders
at the CME did not have access to the inter-bank exchange markets in the
early 1970s, when they believed that significant changes were about to
take place in the currency market. They established the International
Monetary Market (IMM) and launched trading in seven currency futures on
May 16, 1972. Today, the IMM is a division of the CME. Other futures’
exchanges that trade currency futures are Euronext.liffe and the Tokyo
Financial Exchange.
Globally, the currency futures market remains small, though a rapidly
growing market, in relation to the size of the OTC spot as well as
forward market. According to the preliminary results of the Triennial
Central Bank Survey of Foreign Exchange and Derivatives Market Activity
in 2007, the average daily turnover in exchange-traded currency
contracts stood at US$72 billion in 2007. However, it is still small in
relation to US$3,998 billion total foreign exchange turnover, which
includes US$1,305 billion daily spot turnover in 2007. The exchange
traded currency contracts comprise futures as well as options and
options on futures.
Currency risks could be hedged mainly through forwards, futures, swaps
and options. Each of these instruments has its role in managing the
currency risk. The main advantage of currency futures over its closest
substitute product, viz., forwards, which are traded over-the-counter
(OTC) lies in price transparency, elimination of counterparty credit
risk and greater reach in terms of easy accessibility to all. Currency
futures are expected to bring about better price discovery and also
possibly lower transaction costs.
The pricing of a currency futures contract is completely determined by
the prevailing spot rate and interest rates. Otherwise, investors would
be able to arbitrage the difference between the futures and spot prices.
The futures price is given by:
Where,
- F = futures price
- S = spot price
- rT = interest rate of the term currency
- rB = interest rate of the base currency
- T = tenor (calculated according to the appropriate day count
convention)
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