A look at Currency Future TradingCurrency future trading is popular way of speculating on currency movements and hedging foreign exchange risk.A currency futures contract is a contract to exchange a particular currency for another at a specified date in the future. The price is fixed at the time of purchase.
Corporations have the option to use currency futures to hedge their currency risk when doing business abroad. For example let's say a Canadian car exporter is due to export US$1,000,000 worth of cars to American customer in 6 months time. As the American customer is going to pay for the goods in US Dollars, it would hurt the exporter if the Canadian dollar appreciated against the US Dollar. So a currency future could be used to offset this risk.
The pricing of currency futures is purely based on the interest rate differentials between the two country's. This is very important to understand when trading currency futures. For example let's take a look at the current prices of Pound/Yen futures:
Cash (SYY00) 224.428 As you can see the further away the expiry the further the currency future price moves from the cash price. This is because at present the UK benchmark interest rate is 5.5%, whilst the Japanese rate is currently 0.5%. These prices move nearer and nearer to the spot price over time and equal the spot price on expiry.
For those wishing to trade currency futures, they do have the advantage that they are generally less volatile than many of the commodities. However, there are exceptions to this rule. For example in September 1998, the yen carry trade collapsed, and the yen appreciated against many of the major currencies by around 20% in a very short space of time. As with all futures contracts, currency future trading involves a high level of risk and losses in excess of your initial margin requirement can result.
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However, even though the contracts have a fixed expiry date, they can still be closed at any time before the expiration date. If the contract is taken out in a speculative capacity, you may feel after looking at your charts that price isn't likely to move in the direction of your position. In this scenario the contract could be closed. Alternatively you can place a stop loss on a position to limit the risk.