Using Futures to Navigate the Volatile Forex Market
What if you could see the future? All your business decisions would be easy and successful. Unfortunately, seeing into the future is reserved for science fiction. However, there is a financial tool that can help you navigate the world of currency fluctuation and improve the future predictability of your business. It’s called futures.
What Are Futures?
Futures are a type of contract where buyers and sellers agree to deliver an asset at a specified future date for a specified price. The two parties involved in this contract are the long (buyer) and the short (seller). On the contract’s maturity date, the short (seller) is obligated to deliver the asset, and the long (buyer) is bound by the contract to accept delivery.
Most currency futures contracts are physically deliverable, meaning the seller must deliver the amount of currency obligated in the contract to the buyer. We don’t do this with cash anymore, but with wire or ACH. That said, most contracts are liquidated just before expiration to avoid the obligation of coordinating delivery. In other words, they are cash-settled.
Futures are a type of contract where buyers and sellers agree to deliver an asset at a specified future date for a specified price.
Parts of a Futures Contract
- Underlying asset (currencies)
- Specified maturity date
- Long (buyer)
- Short (seller)
How Hedging with Forex Futures Works
Currency futures contracts are designed to track the underlying currency’s movement against the dollar. Longs produce profits when the market rises, and shorts are profitable when the market drops. You can use currency futures to protect against either upside or downside currency moves.
For example, assume a US-based company’s London subsidiary has 5 million British pounds that the company plans to convert to dollars in several months. Their concern is that the pound may drop in the interim, meaning they will bring home fewer dollars. To hedge the risk, they will sell short British pound futures. If the pound falls, the profit made on the short position will offset the loss on the pounds they own.
Forex futures contracts are available for all the “major” currencies, including the euro (EUR), British pound (GBP), Australian dollar (AUD), Japanese yen (JPY), Canadian dollar (CAD), and Mexican peso (MXN).
Advantages of Futures
- Exchange-traded: The exchange is the counterparty to all trades, virtually eliminating concerns about counterparty risk.
- Competitive pricing: Futures are heavily traded and competitively arbitraged against the forex market, meaning they are usually easy to get a competitive price.
- Low cost: Commissions and exchange fees are extremely low.
- Highly liquid: You can terminate a futures position well before the contract expires, allowing you to modify your trading strategy if market conditions change.
- Easy accessibility: Except for a brief daily closing period (one hour), futures trade around the clock during the business week.
What Is the Cost of Futures?
The primary “cost” associated with futures is the cost of capital for margin. Margin is the money deposited with the exchange to ensure sufficient funds to pay for any losses accrued in trading. The margin for futures generally represents a small percentage of the contract’s notional value, typically 3-12%.
The margin is not a fee, as you get the margin deposit back when you close the position. Margin amounts are determined by the exchange and are subject to change based on market conditions.
Commissions and exchange fees are also associated with futures costs. So you have a thorough understanding, we break these down in-depth in Derivative Costs: Spread and Commission.
The Futures Is Yours
Futures are a powerful tool to mitigate the risk of the highly volatile forex market. Volatility has increased and is likely to remain elevated for the foreseeable future, so now is an excellent time to start preparing to meet your forex challenges.
Check out forwards, options, and swaps to learn about more tools that can help you implement a risk-hedging strategy.
- Futures are a type of contract where buyers and sellers agree to deliver an asset at a specified future date for a specified price.
- Futures are traded on exchanges, making them easy to access, relatively cheap, and a safe way to hedge.
- The costs involved with futures are margin, commission, and exchange fees.
Want to take the stress out of managing your forex risk? Let Pangea Prime help you mitigate your risk without the time, expense, and headache.
AI Hedging for the Future. Empowering organizations to intelligently manage their Foreign Currency Exchange Risk with AI and Automation at scale in the cloud.