Traders sometimes use forwards to take advantage of the difference between interest rates in different countries. If the European Central Bank’s (ECB) interest rate is five percent and the U.S.’s is three percent, a trader might convert his or her dollars into euros to gain the higher return offered by the ECB. At the same time, however, the trader could also buy dollars forward for delivery some time in the future, thus locking in the favorable exchange. When the trader delivers the contract, he has more dollars left over.
Of course, it’s not that easy to make money. The difference in interest rates is factored into most forward contracts by the market. Thus, a forward price may be cheaper or more expensive than the current spot price, depending on interest rates. Continuing with the preceding example, a forward contract for euros would be more expensive because of the superior rate of return available in Europe. This higher price is called a premium. A cheaper price is called a discount.
The value of a forward, therefore, is not calculated by the market’s anticipation of how much one currency is worth compared to another, but rather the difference in the interest rates of both countries.
A currency future, like a forward, is an agreement between a buyer and a seller to trade a currency at a certain price on a specified date in the future. The primary difference between a forward and a future is that a future is traded on a regulated exchange, but a forward is not.
Futures are not new to the markets. They were developed centuries ago to protect businesses from fluctuations in prices by transferring the risk to speculators. Hedgers can be businesses that want to protect themselves from price gyrations in materials they rely on.
For example, a baker might need to buy grain every year at a certain price. He might buy a grain future, thus protecting himself if a storm wipes out most of the crop and makes the price of grain skyrocket.
Speculators are on the other side of the hedge. They hope to make money if the price of the underlying commodity fluctuates in their favor. Using the same example of the baker, let’s say the weather is exceptionally good, the grain crop is huge, and the price falls because there’s so much grain on the market. The baker has already agreed to buy the grain at a higher price, so the speculator makes money on the difference between the two prices.
The baker would rather have the security of knowing that he has access to grain at a certain price instead of waiting to see what the market delivers, good or bad. Speculators, on the other hand, absorb that risk and get a chance to make money. In this sense, speculators play a critically important role in the economy. They provide a kind of insurance to the markets that protects corporations and individuals and encourages stability and innovation.
It makes sense that futures were first offered for currencies in 1972, when currencies were allowed to float against the U.S. dollar. (For a full discussion of those events, see Chapter 3, “The History of Forex (and Why You Should Care).) Transnational corporations were suddenly exposed to swings in currency values that could wreak havoc on their carefully planned business operations and balance sheets.
Futures contracts are typically traded over an exchange (exchange-traded contracts). To buy a future, an individual or corporation posts a small amount of cash as a margin or a bond. The price of futures fluctuates depending on market conditions.
If events cause the market to believe that a currency will rise in value over the next year, a contract that locks in a lower price will be worth more. The difference between the future price and the market price is settled at the end of each business day. This difference is added to (or subtracted from) the margin. Losses on the margin must be replenished, or the market participant’s position is closed.
Currency futures were first offered on the Chicago Mercantile Exchange (CME) in 1972. (Before then, the CME specialized in offering futures for commodities such as grain, pork, and orange juice.) Today, a full range of futures is available at the CME 24 hours a day via the GlobeEx trading platform.
Read More: Forwards and Futures
