Yesterday, we looked at the differences between traditional futures and forex futures. Today, we’ll be looking at the one of the main uses for forex futures – namely hedging other positions.
Along with speculating, hedging is one of the main ways in which forex derivatives such as FX futures are used. Forex futures are used by hedgers to reduce, or eliminate, the risk involved with a trade by giving them some protection against future movements in price.
There are several reasons why you might wish to use a hedging strategy when trading forex futures. One would be to cancel out the effect of currency fluctuations on sales revenue, if you were investing on behalf of a company. So, if you were a US-based business that had some overseas operations, you might want to know exactly how many US dollars it will obtain in revenue from its European stores. To achieve this, you could buy a futures contract for the amount of your projected net sales, which would largely eliminate the effect of currency fluctuations.
When you are operating a hedging strategy, you could be torn between using futures or using another type of derivative known as as a forward. While these types of derivative are quite similar, there are a few key differences between the two. These are:
A forward gives the trader more flexibility in terms of settlement dates and contract sizes. This gives you the freedom to tailor the contract to your requirements rather than being stuck with a set contract size, as you would be with futures.
The cash underlying a forward trade does not have to be paid until the contract expires, whereas the cash behind futures is calculated on a daily basis, with the buyer and seller having to settle the differences on a daily basis. This gives you the freedom to re-evaluate your position over the course of the contract, whereas with forwards you would need to wait until the expiry of the contract.