Last Updated on September 28, 2023
Currency futures are exchange-traded contracts that facilitate the buying or selling a specific amount of a designated currency at a predetermined price and future date. On the other hand, spot forex trading involves the immediate exchange of currencies at the prevailing market rate, known as the spot price.
Both methods involve trading currencies, but their differences lie in their execution and regulation.
This article will take a closer look at currency futures and what kind of an alternative they are to spot forex trading.
Features of Currency Futures Contracts
Currency futures have some characteristics that make them a good option for both investors and traders, such as:
- Standardized contracts: Currency futures have standardized contracts, and each contract is for a fixed amount of currency.
- Fixed expiration date: Each currency futures has an expiration date that indicates when the contract will be settled.
- Organized exchange: Currency futures are traded on regulated exchanges that act as intermediaries.
- Transparent pricing: Currency futures provide real-time pricing and public access to bids and prices.
History of Currency Futures
From post-World War II to the early 70s, the Bretton Woods system provided both a gold standard and fixed exchange rates between nations.
However, in the early 1970s, the gold standard was abandoned.
The change had major impacts. For one, the old system offered stability and rate predictability. Moving to a system where nothing was certain about currencies was an obvious cause for concern.
Leo Melamed, Chairman of the Chicago Mercantile Exchange, then started thinking about adding currency futures to the CME.
Currency futures had already been tried by the International Commercial Exchange in New York. This time, however, the scenario was different because of the abandonment of Bretton Woods.
Yet, Melamed was convinced about the foundational purpose of futures contracts – hedging – and how it could have proved applicable. He foresaw a world where people would increasingly want to hedge against unfavorable movements of particular currencies. He figured this new demand could be high, especially for large financial institutions and wealthy companies.
His vision gave way to a unique proposal by Milton Friedman, a renowned economist whose endorsement of currency futures transformed the financial markets.
Milton Friedman’s Proposal
Milton Friedman, the famous modern economist, met Melamed, and they discussed the idea of currency futures.
Though Friedman had not yet won the Nobel Prize (that would come in 1976), he was still one of the most highly respected voices in economics.
Melamed asked him to write a feasibility study on currency futures. The CME favored the idea, along with bankers across the board.
The CME began trading currency futures in 1972, and they have been a mainstay ever since.
Currently, currency futures trading can easily exceed 700,000 contracts per day. That is for the CME alone, and the amount of currency these contracts are based on can hit $100 billion per day.
You can trade all major currencies in futures contracts, and they are settled monthly.
What Are the Benefits of Currency Futures?
Currency futures are effective in managing FX risks, thereby making it possible for businesses to protect themselves from potential losses related to international transactions.
The transparent and real-time pricing provided by currency futures ensures fair pricing for all participants involved.
Furthermore, currency futures are under strict regulation, proving a secure environment that protects investors.
Currency futures also ensure global accessibility for traders all over the world. This provides an opportunity for global participation.
Also, with the predictable expiration date of currency futures, traders can plan their strategies and positions appropriately.
You may also like: 12 Reasons To Trade Futures Over Stocks and Options
Why Some Traders Prefer Currency Futures Over Spot Forex Trading?
There are two main reasons why some traders consider currency futures as a better option than spot forex trading, including:
Cost-Efficiency
The cost-effectiveness of currency futures is attributed to the fact that traders pay a commission per contract.
However, the cost of the trade is often stated in the bid/ask spread. This is set by the law of supply and demand and the liquidity available.
Most currency futures are highly liquid, and the tight spreads are consistent. This makes it possible for traders to enter and exit the market smoothly, even in volatile or turbulent times.
A Regulated Market
Currency futures are highly regulated and take place at a single exchange where orders are matched and guaranteed to be settled.
Spot forex, on the other hand, has no uniform centralized exchange. They are fragmented across various unconnected forex traders. The trading often occurs on the desk of the broker with no guarantee of a counterparty.
Conclusion
The standardized contracts, fixed expiration dates, and transparent pricing make it an accessible choice that enables global participation.
The design of currency futures makes them a great tool for managing risks and as an effective hedging mechanism against unfavorable currency movements.
