Currency Futures Market Vs Currency Forward Market

Currency futures and currency forwards are two tools used to manage currency risk and speculate on exchange rate movements. While currency futures are standardised contracts traded on exchanges with guaranteed clearing, currency forwards are customisable agreements conducted over-the-counter (OTC) between two parties. Each has distinct features, such as the absence of counterparty risk in futures versus the flexibility of forwards to tailor contract terms. Understanding these differences is essential for businesses, traders, and investors looking to navigate the complexities of foreign exchange markets effectively.

Key Highlights

• Currency forward and currency futures markets differ in terms of their trading mechanisms. While currency futures are exchange-traded, currency forwards are OTC contracts.
  
• Clearing of currency futures mitigates counterparty risk, but some counterparties remain in currency forward trade.
  
• Currency futures are traded in smaller denominations than currency forwards.
  
• Forward exchange contracts require an uncovered currency position in the underlying, while traders can speculate on these positions through futures contracts.
  
• As far as trading is concerned, currency futures are cash-settled, while currency forwards involve the physical delivery of currency.
  

What are Futures and Forwards?

The most frequently traded derivatives are futures and forwards. A futures contract is a structured financial contract that is traded on stock exchanges. SEBI regulates these contracts under equities and commodities, and the RBI regulates them under currency futures.

Currency Futures: Currency futures are exchange-traded contracts that set the price at which a currency can be purchased or sold in another currency at a future date. Participants in the futures market include banks, mutual funds, etc. These contracts make predictions regarding currency price swings. They aid in hedging foreign exchange risks such as exchange rate swings.

Four different currency pairs are available in India for use in currency futures contracts. These include the Indian currency and the US Dollar, the Indian currency and the British Pound, the Indian currency and the Euro, and the Indian currency and the Japanese Yen.

Forward Contracts: The opposite end of the spectrum is represented by forward contracts, which are similar to future contracts but are traded over the counter. Forward Contracts are not structured like the Future Market. Buyers and sellers are allowed to alter the contract's terms and settlement procedure without consulting a third party.

There is always a chance that one of the parties won't uphold their end of the deal because these contracts are between private parties. The term for this is counterparty risk. The party to the Forward Contract consents to enter a performance bond, which is typically given by a third party, in order to reduce the risk. Even if one party doesn't uphold their end of the bargain, a bond like this ensures complete payment. The exchange rate for buying or selling a currency in the future is fixed by currency forwards. They are Over-the-counter (OTC) traded forward contracts. Exporters and importers choose currency forward contracts, a sort of currency forward, since they assist in protecting them against changes in the exchange value of the currency.

Currency forward contracts are available from banks in two different forms: optional delivery contracts, which are paid at any time within a 12-month period, and Fixed day delivery contracts, which are settled on a certain future day.

Key Features of Currency Futures

Currency futures are derivative contracts that allow investors to hedge or speculate on exchange rate movements between two currencies. Some key features of currency futures are below.

Standardisation - Currency futures have standardised contract specifications set by the exchanges on which they trade. This includes standard contract size, delivery months, tick size and trading hours. For example, one USD/INR futures contract on NSE equals $1000.

Leverage - Like other futures contracts, currency futures allow traders to gain exposure to large currency values without having to pay the full underlying amount. Margin requirements are in the range of 4-10% of contract value.

Daily settlement - All open positions in currency futures are marked to market daily, with profits credited and losses debited from the trader’s account. This avoids build-up of credit risk.

Physical settlement - Most currency futures are physically settled, requiring actual delivery of the currencies on expiry. However, some contracts like USD/INR are cash settled in Indian rupees.

Hedging - Currency futures help importers, exporters, and institutional investors hedge their foreign exchange risk cost effectively. Futures are an alternative to forward contracts.

Read More: Hedge Benefits in Currency Derivatives

Speculation - Traders use currency futures to bet on exchange rate movements and profit from the price difference between contract price and settlement price. Intraday trading is possible.

Correlation with spot FX - Currency futures generally mirror movements in underlying exchange rates. Arbitrage ensures futures pricing is aligned with spot and forward rates after adjusting for cost of carry.

Accessibility - Currency futures are exchange traded and centrally cleared, providing easy participant access, price transparency and counterparty guarantees. They are more accessible than OTC forward contracts.

Key Features of Currency Forwards

Currency forwards are customised over-the-counter (OTC) contracts that allow two parties to buy or sell a currency at a specified exchange rate on a future date. Some key features are below.

Customisation - Forwards allow customisation of contract terms like amount, maturity date, settlement type, etc. as per user requirements, unlike standardised futures.

Counterparty risk - Forwards carry counterparty risk as the contracts are directly between two parties. If one defaults, the other is affected.

Leverage - Forwards also provide leverage like futures, enabling large currency exposure with margin requirements of 5-20% of contract value.

Maturity - Currency forward maturities can range from few days to multiple years depending on the needs for hedging FX exposure. Futures have fixed maturity cycles.

Settlement - Currency forwards are settled by physical delivery of the currencies or by cash settlement in a specified currency. Settlement mode is mutually agreed.

Private agreements - Forwards are private agreements and do not trade on an exchange. They have no centralised clearing. This leads to limited transparency on pricing.

Hedging tool - Forwards are commonly used as a hedging tool by exporters, importers, and institutional investors to lock in future currency rates and manage FOREX risks.

Read More: 5 Common Risk Factors in Forex Trading

Speculation - Traders also use forwards for speculation to profit from favourable currency rate movements in future.

Cost of carry - Forward rates include adjustments for cost of carry that accounts for interest rate differential between the currencies of the contract.

Difference Between Currency Futures and The Forward Market

The futures market and the forwards market differ on a few fundamental factors. Here are a few significant areas of distinction.

1. Exchange-traded vs OTC Market The futures market is an exchange-traded market, whereas the forward market is an OTC market. This implies that contracts on the currency futures market are often structured by exchanges and guaranteed by their clearing business.

2. Counterparty Risk Since it is a guaranteed market, there is no counterparty risk in the futures market. As was already explained, the clearing organisation guarantees every deal made on the currency futures exchange. Technical counterparty risk exists in the currency forward market since it is an OTC market. The fact that huge banks and organisations are all involved makes this risk more hypothetical than actual.

3. Transaction Lot Size The size of transaction lots on the currency futures exchange is significantly lower. Most banks won't write a forward cover unless it meets a certain size requirement. In order for advance insurance to be financially sustainable for banks and customers, it must have a minimum size.

4. Underlying Requirement You can take forward cover only against an underlying open currency position. Either a foreign currency payment or a foreign currency receivable should exist. The market for currency futures does not have such restrictions. You can also have a stake in futures based on your opinion of the dollar, the pound, or the euro.

5. Delivery Vs Cash Settlement Although you may use the forward market for currency and the currency futures market to manage your currency risk, the forward market is a delivery market, meaning that all transactions must result in the delivery or purchase of actual dollars. On the other hand, all transactions on the currency futures market are paid in cash. As a result, trading in currency futures is simpler.

Comparing Currency Futures And Forward Market

Here’s a quick comparison between currency forward futures and the currency forward market. Here’s a table capturing the noteworthy points.

Conclusion

Currency futures and currency forwards are two avenues of currency derivatives trading. Standardised, exchange-traded currency futures eliminate counterparty risk. These OTC instruments serve several types of market participants, enabling them to participate in anticipation of currency movement with no need for physical foreign exchange holdings. On the other side, currency forwards are an over-the-Counter (OTC) type of agreement, characterised by more flexibility. It means that it entails some level of counterparty risk. Currency forwards provide foreign traders with an effective hedge. They allow exporters and importers to set up a more reliable exchange rate for their future trades. Thus, it effectively mitigates the risk of any kind of exchange rate fluctuation.

The choice between currency forwards and currency futures depends on risk appetite and physical currency delivery requirements. It is easier to speculate on currency futures. Whereas currency forwards offer personalisation but come with a certain degree of counterparty risk.