Introduction
- The pandemic has highlighted our global interdependence. The currency market, also known as Forex, is a place where different currencies are exchanged.
- Although the Indian market is still developing, it is the most liquid globally.
- With round-the-clock trading, currency exchanges have multiplied due to international trade and globalisation.
- However, increased volatility from geopolitical tensions, interest rates, and commodity prices poses financial risks. Hedging with currency derivatives is essential to mitigate these risks.
- In this blog, we will discover how currency derivatives safeguard your investments.
What are Derivatives?
- Derivatives derive their value from underlying assets, like equities, bonds, commodities, and currencies.
- To put it simply, if the price of raw materials for a product rises, the product’s price also increases.
- The same concept applies to derivatives, which makes them an integral part of all financial markets.
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What are Currency Derivatives?
- Currency derivatives, such as futures, options, and swaps, derive their value from underlying assets, specifically currencies.
- For instance, a one-month USD/INR futures contract trades at Rs. 73.3650 and derives its value from the underlying asset, with the USD/INR exchange rate (current) at 73.2450. While the values of the underlying asset and the derivative differ, the derivative’s value depends on and is derived from the USD/INR exchange rate.
What are the Types of Currency Derivatives?
There are different types of currency derivatives:
1. Currency forward contracts
- Currency forward contracts involve transacting currencies at a predetermined rate at a future date. The fixed forward rate determines the exchange, with parties mutually agreeing to terms, making the contracts customisable.
- Settlement can be through delivery, net gain or loss, or adjusting the net position to spot and future contracts.
2. Currency options contract
- A currency options contract grants the right to buy or sell currency at a specified rate at a future date. The buyer holds the contract while the seller writes it. The buyer pays a premium and decides whether to exercise the option.
- It can be 'in the money,' i.e., strike price above spot price; 'out of the money,' i.e., strike price below spot price; or 'at the money,' i.e., strike price equals spot price.
3. Currency Futures Contract
- A currency futures contract, similar to a forward contract, is traded on an exchange. It involves a buyer and a seller, and the exchange sets the lot size, maturity, and delivery dates.
- Only currency pairs available on the exchange can have futures contracts. Settlement of the closure can occur before delivery, with no actual currency delivery upon settlement.
4. Currency swap contract
- A currency swap involves exchanging principal and interest between currencies. Parties agree on principal exchange at the spot rate with interest payments made during the contract.
- Upon completion, the principal is exchanged back at the spot or pre-determined rate, mitigating transaction risk.
- Swap contracts are customisable OTC agreements between counterparties and are often facilitated by a swap bank or broker.
What is the Use of Currency Derivatives?
Traders primarily use currency derivatives for the following purposes:
- Hedging: Using currency derivatives, you can mitigate foreign exchange exposures and limit losses. This way, you tend to take appropriate positions and hedge your risks.
- Arbitrage: Trading currency derivatives helps exploit currency exchange rate differences across markets and exchanges.
- Leverage: Currency derivatives provide benefits from trading with a small margin value instead of paying the full traded value in currency futures and options trading.
How Can You Trade in Currency Derivatives?
- In India, along with the Metropolitan Stock Exchange, the BSE and the NSE stock exchanges also have currency derivatives segments.
- Even though volumes are lower on the latter, brokers can facilitate trading in currency derivatives.
- It resembles equity trading and can be performed through trading apps provided by leading stockbrokers.
- The contract size for a dollar-rupee contract is $1,000, but trading requires only a 2-3% margin payment.
Conclusion
- To sum up, currency derivatives serve as essential instruments for managing currency risks, particularly for exporters and importers facing volatile exchange rates.
- They also provide lucrative opportunities for retail investors.
- However, it is essential to weigh the pros and cons of currency derivatives and possess a solid understanding of the foreign exchange market.
- Knowledge and awareness play a crucial role in making informed decisions in this dynamic and potentially rewarding field.
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