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What is Exchange Traded Currency Futures./ An Overview of Foreign Exchange Derivatives Future.

Currency Futures / Currency futures Derivative

Currency Futures Contract and Its Features | Exchange Traded Currency Futures Derivatives.

 Definition A futures contract is a standardized contract, traded on an exchange, to buy or sell a certain underlying asset or an instrument at a certain date in the future, at a specified price. When the underlying asset is a commodity, e.g. Oil or Wheat, the contract is termed a “commodity futures contract”. When the underlying is an exchange rate, the contract is termed a “currency futures contract”. Both parties of the futures contract must fulfill their obligations on the settlement date. 
Currency Futures Contract and Its Features | Exchange Traded Currency Futures Derivatives.
Currency Futures

 Currency futures are a linear product, and calculating profits or losses on these instruments is similar to calculating profits or losses on Index futures. In determining profits and losses in futures trading, it is essential to know both the contract size  and also the “tick” value. A tick is the minimum size of price change. The market price will change only in multiples of the tick. Tick values differ for different currency pairs and different underlyings. 

 For e.g. in the case of the USDINR currency futures contract the tick size shall be 0.25 paise or 0.0025 Rupee. To demonstrate how a move of one tick affects the price, imagine a trader buys a contract at Rs. 44.7500. One tick move on this contract will translate to Rs.44.7475 or Rs.44.7525 depending on the direction of market movement.
https://finosutra.blogspot.com/2020/05/selection-criteria-nse-national-stock.html

Advantages of Futures: 

• Price transparency.
• Elimination of Counterparty credit risk. 
• Access to all types of market participants. The OTC market is restricted to Authorized Dealers (banks which are licensed by RBI to deal in FX),individuals aand entities with forex exposures. Retail speculators with no exposure to FX cannot trade in OTC market. 
• Generally speaking, futures offer low cost of trading as compared to OTC market. 

Limitations of Futures: 

• The benefit of standardization, though improves liquidity in futures, leads to imperfect hedge since the amount and settlement dates cannot be customized. 
• While margining and daily settlement is a prudent risk management policy, some clients may prefer not to incur this cost in favor of OTC forwards, where collateral is usually not demanded. 

Interest rate parity and pricing of currency futures 

Concept of interest rate parity Let us assume that risk free interest rate for one year deposit in India is 7% and in USA it is 3%. You as smart trader/ investor will raise money from USA and deploy it in India and try to capture the arbitrage of 4%. You could continue to do so and make this transaction as a non ending money making machine. Life is not that simple! And such arbitrages do not exist for very long. We will carry out the above transaction through an example to explain the concept of interest rate parity and derivation of future prices which ensure that arbitrage does not exist. 
https://finosutra.blogspot.com/2020/04/what-are-future-contract.html

Concept of premium and discount 

Therefore one year future price of USDINR pair is 51.94 when spot price is 50. It means that INR is at discount to USD and USD is at premium to INR. Intuitively to understand why INR is called at discount to USD, t

 Think that to buy same 1 USD you had to pay INR76 and you have to pay 77.94 after one year i.e., you have to pay more INR to buy same 1 USD. And therefore future value of INR is at discount to USD. Therefore in any currency pair, future value of a currency with high interest rate is at a discount to the currency with low interest rate. 
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The analogy I have used might not be 100% correct but it’s easy to understand things with a simpler analogy.


That’s it for this post. Do check out my other posts to gain more knowledge about finance.
https://finosutra.blogspot.com/2020/04/types-of-derivative-market.html
https://finosutra.blogspot.com/2020/04/market-participants-in-derative-market.html
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