Currency Futures Market Vs Currency Forward Market

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.

Difference Between Currency Futures And The Forward Market

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

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.

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.

2. 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.

3. 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.

4. 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 more simple.

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.