Pricing Currency Futures

  • Currency futures are priced in the same manner as currency forward contracts.
  • Price of a Currency Future with Simple Compounding:

f(0,T)X/Y = S0,X/Y ((1+rX)/(1+rY))T

  • T = total contract length

  • S0 = Spot exchange rate for X/Y (#X units domestic per 1Y foreign) at initiation

  • rX = Risk free rate in country X (domestic currency)

  • rY = Risk free rate in country Y (foreign currency)

  • Price of a Currency Future with Continuous Compounding

f(0,T)X/Y = (S0,X/Y e-ryT ) erxT

  • If the currency future is not "fairly" priced (i.e. not priced based on an arbitrage relationship based on risk free rates), then it is possible for a trader to earn a risk-free arbitrage profit.
  • Futures Market Overvalues a Currency:
  1. Sell the overvalued futures contract
  2. Buy the underlying currency in the spot market
  3. Borrow and invest all cash flows
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