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Thursday, February 22, 2024

From Tekkers to Carry Trades: A Deeper Look into FX Futures Basis


Foreign exchange (FX) futures basis is a term that refers to the difference between the futures price of a currency and its spot price. It is also sometimes referred to as carry. This difference arises because currency futures can expire on different dates than the underlying currency spot contract, which can cause pricing discrepancies. The FX futures basis is an important concept in currency trading, especially for those who engage in carry trades.

Carry trades involve borrowing in a currency with low interest rates, then using the proceeds to invest in a currency with higher interest rates. The difference between the interest rates can be used to generate profit. For example, if the interest rate on the Japanese yen is 0.1%, and the interest rate on the Australian dollar is 2%, an investor could borrow yen, convert them to Australian dollars, and invest them, earning an interest rate differential of 1.9%. However, carry trades are also inherently risky, as currency exchange rates can be volatile and sudden shifts can lead to losses.

To better understand FX futures basis, it’s helpful to understand how currency futures contracts work. Futures are standardized contracts that specify an agreed-upon price for the underlying asset at a future date. In currency futures, the underlying asset is a currency pair, such as USD/EUR. The futures price for this contract reflects the expected exchange rate at the time of expiration. For example, if the current USD/EUR exchange rate is 1.10, and the futures contract for USD/EUR expiring in three months is trading at 1.12, that implies a market expectation that the exchange rate will appreciate to 1.12 over the next three months.

However, because futures contracts have set expiration dates, there can be differences between the futures price and the spot price of a currency pair. For example, if a currency pair has a futures contract expiring in three months, but the underlying spot contract has a maturity of two months, there will be a one-month difference in the expiration dates. This difference can cause pricing discrepancies, which are reflected in the FX futures basis.

A positive FX futures basis occurs when the futures price for a currency pair is higher than its spot price. This can occur when there is high demand for the currency in question, leading to a premium on futures contracts. Conversely, a negative FX futures basis occurs when the futures price is lower than the spot price. This can occur when there is greater demand for the underlying spot contract, leading to a discount on futures contracts.

Carry trades can be impacted by FX futures basis because they involve buying futures contracts for a currency pair with higher interest rates and selling contracts for a currency pair with lower interest rates. If the futures price for the higher interest rate currency is trading at a premium, this can increase the cost of the carry trade. Conversely, if the futures price for the lower interest rate currency is trading at a discount, this can lower the cost of the carry trade.

Overall, understanding FX futures basis is important for currency traders, particularly those who engage in carry trades. Keeping a close eye on the relationship between futures prices and spot prices can provide valuable insight into market demand for currencies and help traders make more informed decisions.

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