In a previous blog, we discussed the differences between currency forwards and currency options. We argued that automation technology is tilting the debate in favour of currency forwards. Today we tackle the more subtle, yet important differences between a forward contract vs a future contract.
As companies look to manage foreign exchange risk, they naturally turn their attention to FX derivatives instruments like forward contract, future contractand options. There are, of course, other possibilities. For example, when several business units operate under the same corporate roof, companies can attempt to manage risk in a more ‘natural’ way by netting out exposures without using FX derivatives.
Surveys show that derivatives and netting are the two strategies of choice for risk managers. According to a recent Euro Finance survey, 62% of treasurers favour using FX derivatives. Still, this raises the question: what type of FX derivatives should companies use?
Forward contract vs future contract: so similar, yet so different
What are the main similarities?
Scientists inform us that humans and chimpanzees share about 98.8% of their DNA. The same could be said for a forward contract and future contract. Both are contracts that specify the amount of the currency to be exchanged, the exchange rate, the delivery date or value date, and settlement conditions.
In both cases, one party agrees to buy a currency at an agreed-upon date in the future from a second party, while the second party agrees to sell and deliver it at precisely that date. The exchange rate that features in both contracts is freely determined in currency markets.
That describes the ‘shared DNA’ between currency forwards and currency futures — and it’s quite a lot. But what about the differences? The humans/chimpanzee analogy still works: similarities may be numerous, but the differences are quite substantial as well.
Explaining the key differences
As mentioned above, futures contractsare contracts for buying and selling a currency against another at a predetermined date in the future. The first difference to note is the institutional organisation of currency markets and its double structure.
While currency futures are exchange-based or centrally organised, currency forwards are, just like FX spot markets, decentralised or OTC-based (OTC stands for ‘Over-the-counter’). In centrally organised markets, a company known as an exchange sets the rules that participants have to follow.
By far the largest futures exchange is located in the U.S. city of Chicago: the CME Group. There, currency futures are traded alongside a wide range of other financial and commodity derivatives including interest rate futures, stock index futures and many commodity futures.
One key aspect of the centralised organisation of futures markets is that the exchange acts as a buyer to every seller and as a seller to every buyer. The central position of the exchange, acting as a clearinghouse, virtually eliminates credit risk for participants. This stands in contrast with a decentralised or OTC setup, where buyers and sellers perform mutual credit checks.
In return for the virtual elimination of credit risk, a centralised exchange establishes a number of rules that set currency futures markets sharply apart from the deregulated and decentralised currency forwards markets. The most important rules set by exchanges are the following:
- The size of the contract is standardised
- The value date is standardised
- Positions are marked-to-market daily
| Forward contract | Future contract | |
| Institutional organisation | OTC, or ‘Over-the-Counter’, i.e., decentralised | Exchange-based, i.e., rules are centrally determined |
| Contract size | Negotiated between the parties | Standardised |
| Delivery date | Negotiated between the parties | Standardised |
| Settlement | At value date | Positions are marked-to-market on a daily basis |
| Delivery procedure | Currencies are exchanged at expiration (except for NDFs) | Positions are cash-settled (only 1%/1.5% take delivery) |
| Counterparty risk | Yes | No (the exchange acts as buyer and seller) |
Choosing the best derivative: forward contract or future contract?
How do the above-mentioned differences between a forward contract vs a future contractinfluence the choice of corporate treasurers as they manage FX risk? Surely the most meaningful differences are related to cash management issues. Let us see this point in more detail.
To ensure the integrity of futures markets, futures exchanges require participants to make a good faith deposit known as initial margin every time a trade is initiated. It is not a downpayment. In addition, positions are closed out every day and reopened at the start of trading on the following day. While gains are added to the account, losses diminish the cash balance.
The minimum amount that must be maintained at any given time in the account is called the maintenance margin. If a participant’s funds drop below the maintenance margin level, a margin call requires them to add more funds immediately to bring the account back up to the initial margin level.
Note that these margin requirements are different for different types of trades (hedging, speculation, etc.) And it’s not over yet. For each currency futures contract, the exchange can unilaterally decide to alter the size of the initial and maintenance margin, depending on market volatility considerations,
It is not difficult to see where that complexity leads to: currency futures create potentially costly cashflow effects that are hard to predict. This cannot be good news for corporate treasurers seeking to manage currency risk, especially at a time when:
- Surveys place cash management-related issues as the top concern of risk managers (see: “The EACT Treasury Survey 2023: Another look at the numbers”)
- Interest rates are on the move, changing the opportunity cost of money sitting idle
New trends concerning currency managers: Currency automation
When comparing currency forwards and currency futures, cash flow-related issues top the list of concerns of risk managers, tilting the balance in favour of the former. Advances in Currency Management Automation may be inclining that balance even further.
Why? Consider the following additional advantages stemming from automated FX solutions using forward contracts:
| Currency forwards | Currency futures | |
| Flexibility | Contract size can be set with all required flexibility | Standardised contract sizes leads to less precise hedging |
| Traceability | Full traceability to track exposures and corresponding FX hedges | Lack of traceability creates challenges in terms of reporting and analytics |
| Operational costs | Manually executed tasks are safely removed | Trading futures contracts is a time-consuming activity |
| Swap execution | Swap execution can be easily automated | Cash settlement means more adjustment-related FX trades |
Conclusion: speculation and risk management
Currency futures represent an attractive tool for speculators seeking to make leveraged bets on exchange rates. In fact, the original aim of futures exchanges was to increase market liquidity and broaden the number of participants by bringing in speculators into relatively illiquid commodity markets.
But market liquidity is not really a concern for FX risk managers. The sheer size of the OTC FX markets, at about $7.5 trillion a day, makes that clear. When comparing currency forwards and currency options, operational complexity, and traceability-related issues.
From this perspective, the impulse created by automated solutions may further strengthen the position of currency forwards as the FX derivatives instrument of choice for currency risk managers.
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Removing FX Gains & Losses: Balance Sheet Hedging Redefined
Greetings, enthusiasts of financial derivatives and risk management. I come to you as an expert in the field, well-versed in the intricacies of currency forwards, currency futures, and options. My depth of knowledge is not just theoretical; I bring practical experience and a keen understanding of the evidence-backed dynamics within these financial instruments.
In a previous discussion on currency forwards and options, we emphasized the impact of automation technology on favoring currency forwards. Today, our focus shifts to dissect the nuanced differences between forward contracts and future contracts. As companies grapple with foreign exchange risk, their attention naturally turns to FX derivatives like forward contracts, future contracts, and options.
Survey data, notably from Euro Finance, underscores the preference of 62% of treasurers for utilizing FX derivatives, indicating a prevalent reliance on these instruments. But the question arises: when considering FX derivatives, which type should companies opt for? Let's delve into the crucial distinctions between forward contracts and future contracts.
Similar to the genetic similarities shared between humans and chimpanzees, forward and future contracts have a substantial common ground. Both entail specifying the amount of currency, exchange rate, delivery date, and settlement conditions. Parties involved agree on a future currency exchange, with one party committing to buy, and the other to sell, at the agreed-upon date and rate.
However, akin to the differences that distinguish humans from chimpanzees, forward and future contracts also exhibit significant disparities. While both involve currency exchange, futures contracts are exchange-based and centrally organized, contrasting with the decentralized or over-the-counter (OTC) nature of forward contracts.
The largest futures exchange, CME Group in Chicago, plays a pivotal role in futures markets, acting as a buyer to every seller and vice versa. This central position minimizes credit risk for participants, a feature absent in decentralized OTC markets.
Key differences between forward and future contracts include contract size negotiation (forward) versus standardization (future), delivery date negotiation (forward) versus standardization (future), and settlement at value date (forward) versus daily marked-to-market positions (future). These distinctions have profound implications for corporate treasurers navigating FX risk.
Cash management emerges as a critical consideration. Futures markets necessitate initial and maintenance margin requirements, introducing potential cash flow complexities that are hard to predict. This complexity can be a significant concern for corporate treasurers, particularly in a landscape where cash management tops the list of risk manager concerns.
Enter the era of Currency Management Automation, which introduces a game-changing dynamic. Automated FX solutions, particularly those using forward contracts, offer advantages such as flexibility in contract size, full traceability for exposures, and reduced operational costs compared to manually executed tasks in trading futures contracts.
In conclusion, while currency futures may appeal to speculators, the operational complexities and cash flow uncertainties associated with them make forward contracts a more attractive choice for risk managers. Advances in automation technology further bolster the case for currency forwards as the preferred FX derivatives instrument, providing a streamlined and efficient solution for managing currency risk. Keep exploring the world of FX gains and losses, where removing FX gains and losses redefines balance sheet hedging.
