Future contract is also known as currency futures.
Future contracts are standardized contracts traded in future markets for foreign currency.
Future contracts or currency futures are used for hedging as well as speculation purpose. Participants trading in forex market are known as forex traders.
Future contract is used to hedge foreign exchange risk by creating risk in opposite direction.
If receipt (inflow) is expected, then organization should enter into future contract to sell (outflow) foreign currency in future. If payment (outflow) is required, then organization should enter into future contract to buy (inflow) foreign currency in future.
Risk associated with inflow will cancel risk associated with outflow, which is consistent with the primary rule of hedging.
Speculators have no existing risk. They create risk to earn profits.
Following term are necessary for understanding the trading of future contracts or currency futures.
Future Market
In future market, no physical forex trading take place. Contracts are settled on net basis. It means foreign currency will be transferred to the extent of gain or loss realised at the maturity of the contract. Gain or loss is dependent on the contract price of foreign currency at maturity date.
Agreement Date
Agreement date is the date at which forex trading begins. After that forex trader is bound to keep its promise and cannot move back even organization is likely to gain which is inferred from foreign exchange rate at that moment. In future market, there are four agreement dates in a year at even intervals, which are January, April, July and October.
Settlement Date
Settlement date is the maturity date of future contract at which forex trading ends. However, organization can choose to settle future contract by ending forex trading earlier than maturity date, resulting in either gain or loss, with respect to the contract price at that moment.
In future market there are four settlement dates in a year at even intervals, which are March, June, Sep, and Dec. Business should decide most appropriate settlement date for hedging purpose.
Contract Price
Contract price is the price at which the future contract can be traded.
Contract price constantly changes from time to time. Contract price is determined by the foreign currency rate used for physical buying and selling in the ready market.
Contract price forms the basis for calculating gain or loss on future contract.
Contract Size
Contract size is sum of money required to enter into 1 future contract. Future contracts cannot be traded in fractions such as 3.5 contracts. Business has to choose appropriate number of contracts to hedge the sum of money involved in foreign transaction.
Basis Risk
Basis risk is the difference between contract price and spot price. Basis risk reduces the effectiveness of hedging in that gain realised in future market may not be equal to loss realizes in ready market or opposite may happen.
Difference between contract price and spot price may exist due to difference in expectation of forex traders in future market from forex traders in ready market regarding foreign exchange rate movement.
Tick
Tick is the smallest movement in contract price. 1 tick equals to 0.0001.
