Question

Use real or hypothetical examples as a way to illustrate your explanation:

- Currency Futures: speculation vs. hedging; gains, losses, costs

Answer 1

A Currency Future is known as an FX future or foreign exchange future. It is a type of futures contract to exchange a currency for another at a fixed exchange rate on a specific date in the future. Since the value of the contract is based on the underlying currency exchange rate, currency futures are considered a financial derivative. These futures are very similar to currency forwards however futures contracts are standardized and traded on centralized exchanges rather than customized.
Currency futures are one of the instruments used to hedge against currency risk.
For example, the euro and the dollar (EUR/USD) is a pair of currencies that have an exchange rate. The controlling currency is the first currency listed in the pair—in this case, it is the euro price that futures traders are concerned with. Traders buy a contract worth a set amount, and the value of the contract goes up or down with the value of the euro.
Currency futures only trade in one contract size, so traders must trade in multiples of that. As an example, buying a Euro FX contract means the trader is effectively holding $125,000 worth of euros.

Futures based upon currencies are similar to the actual currency markets called Forex, but there are some significant differences. For example, currency futures are traded via exchanges, such as the CME (Chicago Mercantile Exchange); currency markets are traded via currency brokers and are therefore not as regulated as currency futures.

Many of the most popular futures markets that are based upon currencies are offered by the CME (Chicago Mercantile Exchange), including the following :

• EUR—The Euro to US Dollar currency future
• GBP—The British Pound to US Dollar currency future
• CHF—The Swiss Franc to US Dollar currency future
• AUD—The Australian Dollar to US Dollar currency future
• CAD—The Canadian Dollar to US Dollar currency future
• RP—The Euro to British Pound currency future
• RF—The Euro to Swiss Franc currency future

Currency futures contracts are marked-to-market daily. This means traders are responsible for having enough capital in their account to cover margins and losses which result after taking the position. Futures traders can exit their obligation to buy or sell the currency prior to the contract's delivery date. This is done by closing out the position.
For example, buying a Euro FX future on the US exchange at 1.20 means the buyer is agreeing to buy euros at $1.20 US. If they let the contract expire, they are responsible for buying 125,000 euros at $1.20 USD. Each Euro FX future on the Chicago Mercantile Exchange (CME) is 125,000 euros, which is why the buyer would need to buy this much. On the other side, the seller of the contract would need to deliver the euros and would receive US dollars.

Currency Futures can be used for hedging or speculative purposes.
A party who knows they will need a foreign currency at a future point, however, does not want to purchase the foreign currency at this point in time may buy FX futures. This will act as a hedged position against any volatility in the exchange rate. At the expiration date when they need to buy the currency, they will be guaranteed the FX futures contract’s exchange rate.

Similarly, if a co. knows that they will receive a cash flow in the future in a foreign currency, they can use futures to hedge this position.
For example, if a company in the US is doing business with a co. in Germany, and they are selling a large item payable in euros in a year, the US company may purchase currency futures to protect against negative swings in the exchange rate.

Currency futures are also often used by speculators. If a trader expects a currency to appreciate against another, they can buy FX futures contracts to try to gain from the shifting exchange rate. These contracts can also be useful for speculators because the initial margin that is held will generally be a fraction of the size of the contract. This allows them to essentially lever up their position and have more exposure to the exchange rate.

Investors looking to hedge a position often use currency forwards due to the ability to customize these Over the Counter contracts.
Speculators often use currency futures due to the high liquidity and ability to leverage their position. They close out their positions before futures expiry date. They do'nt end up delivering the physical currency. Rather, they make or lose money based on the price change in the futures contracts themselves.

Let's take a hypothetical example that involves currency futures. Say a speculator purchases 8 future Euro contracts (€125,000 per contract) at 0.89 US$/€. At the end of the day, the settlement price has moved to 0.91 US$/€. How much have the speculator lost or profited?

The price has increased meaning the speculator has profited. The calculation is as follows:-

(0.91 US$/€ – 0.89 US$/€) x €125,000 x 8 = 20,000 US$

Settlement, Delivery, and Profits

Currency futures are based on the exchange rate of a currency pair and are settled in cash in the underlying currency. For example, the EUR futures market is based upon the euro to dollar exchange rate and has the euro as its underlying currency.
Settlement and delivery occurs when a EUR/USD futures contract expires—the holder receives delivery of $125,000 worth of euros in cash to their brokerage account.

Let's assume a hypothetical company XYZ, based in the United States & is heavily exposed to foreign exchange risk. It wishes to hedge against its export receipt of 125 million euros in September. Prior to September, the company could sell futures contracts on the euros they will be receiving.We know, Euro FX futures have a contract unit of 125,000 euros. They sell euro futures because they are a US company, and don't need the euros. Hence, since they know they will receive euros, they can sell them now and lock in a rate at which those euros can be exchanged for US dollars.
Company XYZ sells 1,000 futures contracts on the euro to hedge its projected receipt. Consequently, if the euro depreciates against the US dollar, the company's projected receipt is protected. They locked in their rate, so they get to sell their euros at the rate they locked in. However, the company loses any benefits that would occur if the euro appreciates. They are still forced to sell their euros at the price of the futures contract, which means giving up the gain (relative to the price in August) they would have had if they had not sold the contracts.