What it means
A currency future works rather like a promise with a referee standing between the two sides. Two parties agree a rate now for an exchange that happens later, and a clearing house guarantees that both sides perform.
That guarantee is why currency futures carry very little counterparty risk compared with a private agreement struck directly with a bank. The appeal for an ordinary business is predictability rather than speculation.
If your company has agreed to pay a European supplier 1,000,000 euros in three months, a currency future fixes the dollar cost of that payment today, so the budget holds whatever the market does in the meantime. Because futures are exchange-traded, the contract size is fixed rather than tailored to your exposure.
A euro contract is commonly 125,000 euros, so you buy whole contracts and accept that the hedge may not match your underlying exposure to the last dollar. Trading a future requires margin, which is a good-faith deposit rather than the full contract value.
Gains and losses are settled in cash every day through a process called marking to market, so a position moving against you generates cash calls long before the contract matures. Treasurers who forget this can find a hedge that is working perfectly on paper still draining the bank account week by week.
The important nuance is that a future removes the downside and the upside alike. If the currency moves in your favour you still transact at the locked rate, which is why some finance teams prefer currency options despite having to pay a premium for them.
In practice
Real-world examples.
Example
A Michigan car parts maker imports gearboxes from Germany and owes 2,000,000 euros in six months. The treasurer buys 16 euro futures contracts at $1.0800, fixing the cost at $2,160,000 and letting the sales team quote firm prices to customers for the whole period.
Example
A software firm in Texas bills its Japanese distributor in yen and expects 300,000,000 yen next quarter. It sells yen futures so that a weakening yen cannot cut the dollar value of that receipt before the money lands.
Example
A commodity trading desk expects the Mexican peso to strengthen against the dollar and buys peso futures purely as a directional bet. It posts $80,000 of margin against a much larger notional position, which magnifies both the profit and the loss on a small rate move.
Formula
Calculation
Contract value = contract size x number of contracts x futures rate
Gain or loss on the hedge = notional amount x (settlement rate - contracted rate)
Worked example: a US manufacturer must pay 1,000,000 euros to a supplier in three months. The euro futures contract size is 125,000 euros, so the company buys 1,000,000 / 125,000 = 8 contracts at a futures rate of $1.1000 per euro. The locked-in cost of the euros is 1,000,000 x $1.1000 = $1,100,000, and that is the figure that goes into the budget.
Three months later the spot rate has risen to $1.1500. Buying the euros in the open market would now cost 1,000,000 x $1.1500 = $1,150,000, which is $50,000 more than budgeted. The futures position gains 1,000,000 x ($1.1500 - $1.1000) = $50,000. Netting the two together, the effective cost is $1,150,000 - $50,000 = $1,100,000, exactly the rate the company locked in at the start.Case study
Seen in the real world.
Northgate Ceramics is an illustrative, entirely fictional tile importer based in Ohio that buys almost all of its stock from Italian and Spanish kilns. For years the finance director simply bought euros at whatever the spot rate happened to be on payment day, and gross margin swung between 28% and 39% from one quarter to the next for reasons that had nothing to do with how well the company sold tiles.
After a particularly painful quarter, the board asked for the currency noise to be taken out of the numbers. The finance director began buying euro futures each time a purchase order was signed, matching contracts to the payment schedule as closely as the 125,000 euro contract size allowed. Roughly 90% of the exposure was hedged, with the residual left unhedged rather than over-hedging with a ninth contract.
The following year the euro rose sharply and Northgate's futures gains offset almost all of the increased purchase cost. Margin settled into a narrow band around 34%, and for the first time the board could look at a margin movement and know it reflected pricing and product mix rather than the foreign exchange market. The finance director noted the trade-off honestly: in a year when the euro fell, the hedge would have cost the company the benefit.
Watch out
Common mistakes.
- Treating a currency future as a way to make money on exchange rates when the business purpose is to remove uncertainty, not to place a bet on direction.
- Assuming the margin deposit is the total cost, then being caught out when daily marking to market demands further cash while the underlying invoice is still months away.
- Hedging the whole exposure without checking that the payment will actually happen, which turns a hedge into a naked speculative position if the order is cancelled.
Questions
People also ask.
How is a currency future different from a currency forward?
A future is standardised, exchange-traded and settled daily through a clearing house, while a forward is a private, fully customisable agreement with a bank that settles only at maturity.
Do I need to take delivery of the currency?
Almost never in practice, because most participants close the position before expiry and settle the cash difference, then buy the currency in the spot market.
Can a small business use currency futures?
Yes, though the fixed contract sizes mean small exposures hedge awkwardly, and many smaller firms find a bank forward contract a better fit.
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