- Currency futures are priced in the same manner as currency forward contracts.
- Price of a Currency Future with Simple Compounding:
- 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 ((1+rX)/(1+rY))T
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:
- Sell the overvalued futures contract
- Buy the underlying currency in the spot market
- Borrow and invest all cash flows