An Introduction to Foreign Exchange Future Market:
Foreign exchange future market refers to a type of financial derivative in which two parties enter into a contract to buy/sell a particular currency at a pre-determined price on a specific future date.
A foreign exchange future market provides an opportunity to hedge risk and speculate against the exchange rate fluctuations.
Evolution of Foreign Exchange Future Market:
Foreign exchange future market were introduced in 1972 by theIMM(International Monetary Market) of the CME(Chicago Mercantile Exchange). It basically replaced the notion of ‘par value exchange rates’ which was followed under the Bretton Woods System. This approach of foreign exchange future market was then adopted by many other exchanges in U.S. and abroad. Financial instruments like futures are nowadays also used in hedging stock exchanges and interest rates.
Foreign Exchange Future Market gains over Traditional futures because:
Foreign exchange future market, also popularly known as forex futures market, constitutes only 1% of the US$ 1 trillion traded in the global foreign exchange market. Foreign exchange future market is same as that of traditional futures contract in the sense that both are used to buy or sell an asset (a specific amount) at an agreed price on a particular future date. The two are however different as in case of a foreign exchange future market, none of the parties involved is actually buying or selling any commodity but currencies. This is because all quotes in case of a foreign exchange future market are made against the U.S. dollar.
Traditional futures are traded on centralized stock exchanges whereas the deal flow of foreign exchange future markets are available through many different exchanges in the home and foreign country. But this doesn’t imply that foreign exchange future markets are quoted in OTC (Over The Counter). They have a designated ‘size per contract’ and are available in whole numbers.
Other features of a Foreign Exchange Future Market:
A foreign exchange future market is ‘marked to market’ thus making it a portfolio of forward contracts that are adjusted daily for cash settlements. This in fact mitigates the credit risk to a very large extent.
These are carried out through the clearing house of the exchange. The margin payments accrue to the exchange and the exchange ensures the proper functioning of the contract.
A foreign exchange future market contract rarely results in a delivery. It is used by parties as it is a highly liquid way of hedging and speculating and efficient transactions can be fixed up without delay.