Currencies are always priced in terms of other currencies. The resulting price between the two currencies is called the exchange rate, and any two currencies can be part of an exchange rate.  When the euro is quoted as 1.0155, it is the amount of dollars equal to one euro.  

Every exchange rate is a cross rate because it is one currency described in terms of another.  While cross rates can describe any exchange rate, most traders use the term to describe transactions that do not include the dollar. The euro/Japanese yen exchange rate is a cross rate where the price is quoted as 146.89, the amount of Japanese yen equal to one euro. CME Group has a full suite of cross-rate futures including the following:

For example, in September an exporter is exposed to the FX rate between the euro and the Japanese yen. The exporter expects to receive EUR 1,500,000 in December which he’ll want to convert to JPY. Therefore, he has a three-month period of uncertainty relating to FX risk. The FX risk can be hedged with EUR/JPY futures.

The FX component of the transaction can be hedged using the CME EUR/JPY futures contract (Globex product code RY). To determine the hedge transaction required, the exporter needs to determine whether to buy or sell futures and the quantity to be transacted. 

Buying one contract is equivalent to buying EUR in exchange for JPY. Selling the contract is equivalent to selling EUR in exchange for JPY.

For this reason, his FX risk exposure can be hedged by selling EUR/JPY futures contracts. He’ll sell the futures to implement the hedge and buy to close out the position once the FX hedge is no longer required. 

The number of FX futures needed to hedge the transaction can be calculated by considering the currency exposure. The exporter expects to receive EUR 1,500,000 which he’ll later convert to JPY. The contract size of the EUR/JPY futures contract is 125,000, therefore, to hedge the FX exposure, the exporter needs to sell 12 futures contracts:

1,500,000 (EUR) / 125,000 = 12 lots

Once he takes this position, there are a few possible outcomes. 

Outcome one: an appreciation of the JPY

An appreciation of the JPY versus the EUR can also be viewed as a decrease in the value of EUR, measured in JPY. In this example, say the JPY appreciates so the December futures contract goes from JPY 147.25 per EUR to JPY 145.75 per EUR. This represents an appreciation of 1.0%. 

In the cash market, EUR 1,500,000 has a JPY value of JPY 218,625,000, which is less than expected had the exchange rate not changed. This lower outcome is offset by a gain made on the FX futures position. Overall, the cashflow has been maintained in line with expectations because of the hedging strategy.

Outcome two: a depreciation of the JPY

A depreciation of the JPY versus the EUR can also be viewed as an increase in the value of EUR, measured in JPY.  In this example, assume a depreciation of the JPY such that the price of the September futures contract goes from JPY 147.25 per EUR to JPY 149.75 per EUR, which represents a 1.4% depreciation. 

In cash market, EUR 1,500,000 in this scenario has a JPY value of JPY 224,625,000. This is higher than expected had the exchange rate not changed. The EUR/JPY futures hedge position records a loss of JPY 3,750,000 offsetting the gain which maintains the overall return from the transaction.

Cross-rate futures are margined daily and physically delivered

For cross-rate futures, margins are collected in the quote currency (JPY for EUR/JPY futures). Cross-rate futures go through a physical delivery process on the last day of trading through the CLS (Continuous Linked Settlement) Bank System when both currencies are supported by CLS delivery procedures. More information about the settlement process and delivery process for FX futures can be found here.