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 customised 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 traded on stock exchanges. The Securities and Exchange Board of India (SEBI) regulates these contracts under equities and commodities, and the Reserve Bank of India (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, and other financial institutions. 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 rupee and the US Dollar, the Indian rupee and the British Pound, the Indian rupee and the Euro, and the Indian rupee and the Japanese Yen.

Forward Contracts: The opposite end of the spectrum is represented by forward contracts, which are similar to futures contracts but are traded over the counter. Forward contracts are not structured like the futures 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. This is known as counterparty risk. The party to the forward contract consents to enter a performance bond, which is typically given by a third party, to reduce the risk. Even if one party doesn’t uphold their end of the bargain, a bond like this ensures complete payment.

Currency forwards fix the exchange rate for buying or selling a currency at a future date. They are Over-the-counter (OTC) traded forward contracts. Exporters and importers often use currency forward contracts, a sort of currency forward, since they assist in protecting against fluctuations in the exchange rates of the currency.

Currency forward contracts are available from banks in two different forms: optional delivery contracts, which are paid at any time within 12 months, 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 the National Stock Exchange of India (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 the 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: https://www.kotaksecurities.com/investing-guide/currency/hedge-benefits-currency-trading/

Speculation - Traders use currency futures to bet on exchange rate movements and profit from the price difference between the 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 the 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 a 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. The settlement mode is mutually agreed upon.

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 foreign exchange 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 the cost of carry that accounts for the interest rate differential between the currencies of the contract.

Difference Between Currency Futures and The Forward Market

The futures market and the currency 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 exchange-traded, 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. 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.

Who Uses Currency Futures and Forwards?

Currency futures and forwards are ideal for the following:

1. Exporters:

Exporters use currency forwards and futures to protect their revenue from currency fluctuations. By locking in an exchange rate in advance, they can predict future cash flows in their home currency.

2. Importers:

Importers rely on these instruments to stabilise costs when making payments in foreign currencies. If the domestic currency weakens before settlement, the cost of imports increases. By entering into a forward or futures contract, importers secure a fixed exchange rate, allowing them to plan expenses with certainty and avoid unexpected financial strain.

3. Multinational Corporations:

Multinational corporations with subsidiaries in several countries use currency forwards and futures to manage exposure to multiple currencies. These instruments help hedge earnings from overseas operations, intercompany transactions, and cross-border acquisitions.

4. Portfolio Managers:

Portfolio managers investing in international assets, such as stocks or bonds, use these contracts to manage currency exposure. Even if the underlying asset performs well, unfavourable currency changes can erode returns. Hedging with forwards or futures allows managers to focus on the performance of the investment itself without worrying about exchange rate volatility.

5. Speculators:

Speculators participate in currency futures markets to profit from anticipated movements in exchange rates. Unlike hedgers, they do not have underlying exposure to foreign currency transactions. Instead, they seek to earn from price differences by predicting trends.

Risks Involved in Currency Futures vs Forwards

While both currency futures and forwards are useful tools in currency trading, they come with their own set of risks that investors must understand.

Key Risks Involved in Currency Futures

1. Daily Margin Risk

Currency futures require daily mark-to-market settlement. Losses must be covered immediately through margin calls. If prices move unfavourably, traders may face liquidity stress even when their overall position could still be profitable in the long run. This increases short-term cash requirements and can strain financial planning for participants.

2. Market Volatility Risk

Since futures are exchange-traded, they are highly sensitive to short-term price movements influenced by global events, interest rate changes, and geopolitical developments. Sudden volatility may cause rapid swings, forcing participants to exit positions at unfavourable prices. The high leverage used in futures further amplifies potential losses when currency movements deviate sharply from expectations.

3. Basis Risk

Currency futures prices may not always move in perfect alignment with the spot market due to differences in demand, liquidity, and contract maturities. This mismatch is known as basis risk. Even if the spot market aligns with forecasts, differences in futures pricing can lead to unexpected losses or reduced hedging effectiveness.

Key Risks Involved in Currency Forwards

1. Counterparty Credit Risk

In currency forwards, settlement relies entirely on the counterparty fulfilling its obligations at maturity. If the counterparty defaults or delays payment, the hedging party bears direct financial losses. This risk is higher during market stress or when dealing with financially weaker institutions, as there is no clearinghouse to guarantee settlement.

2. Valuation Transparency Risk

Forwards are over-the-counter contracts with no centralised exchange for price discovery. Their valuation depends on individual negotiations between parties, making it difficult to verify whether the rate offered is fair. This lack of transparency can expose participants to unfavourable pricing, especially when they lack strong bargaining power or market expertise.

3. Settlement Date Mismatch

Currency forwards are customised but fixed in terms of settlement. If the underlying cash flow timing changes, the forward contract cannot automatically adjust. For instance, if an importer delays payment for goods, but the forward matures earlier, the mismatch forces premature settlement or the creation of additional contracts, leading to both extra costs and operational inefficiency.

Which Is Better: Currency Futures or Forwards?

Here are a few parameters you can consider when choosing between currency futures and forwards:

• Standardisation

Currency futures are highly standardised contracts traded on exchanges with fixed contract sizes and set expiration dates. Forwards, on the other hand, are private agreements between two parties that can be customised in terms of amount, maturity and currency. This makes forwards more flexible, while futures ensure uniformity and ease of trading.

• Trading Platform

Currency futures are traded on regulated exchanges such as NSE or the Chicago Mercantile Exchange (CME), providing transparency and price discovery. Currency forwards are traded over-the-counter (OTC), negotiated directly between banks, financial institutions, or corporates. While exchanges reduce counterparty risks, OTC markets allow tailored solutions suitable for specific business or hedging requirements.

• Counterparty Risk

Futures contracts are settled via a clearing house, which guarantees performance and eliminates default risk. Forwards lack such intermediaries, making them dependent on the creditworthiness of the counterparty. This exposes forward contracts to counterparty risk, particularly in volatile markets, whereas futures offer stronger security and reliability.

• Liquidity

Futures benefit from higher liquidity due to standardisation and exchange trading, which ensures active participation from traders, hedgers, and speculators. Forwards, being customised and privately negotiated, have relatively lower liquidity. The lack of a centralised market often makes forwards less accessible and harder to exit before maturity.

• Pricing Transparency

Futures prices are publicly available on exchanges, offering transparency and real-time market quotes. This allows participants to evaluate fair value easily. Forwards lack such visibility since pricing depends on bilateral negotiations influenced by interest rate differentials, market expectations and individual bargaining power, which makes them less transparent than futures.

Conclusion

Currency futures and currency forwards are two avenues of currency derivatives trading. When comparing currency futures vs forwards, the key differences lie in their structure, the risks involved, and the level of flexibility they offer. 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 hand, currency forwards are over-the-counter (OTC) agreements that offer 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 lock in a more reliable exchange rate for their future trades. Thus, it effectively mitigates the risk of any exchange rate fluctuation.

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