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What are Currency Derivatives

30 Jun 2023

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

  1. 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.
  2. Settlement can be through delivery, net gain or loss, or adjusting the net position to spot and future contracts.

2. Currency options contract

  1. 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.
  2. 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

  1. 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.
  2. 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

  1. 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.
  2. Upon completion, the principal is exchanged back at the spot or pre-determined rate, mitigating transaction risk.
  3. 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:

  1. 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.  
  2. Arbitrage: Trading currency derivatives helps exploit currency exchange rate differences across markets and exchanges. 
  3. 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. 

 

Related Articles: What Are Cross Currency Pairs And What Do They Mean? | How does a Spread Contract Help in Currency Trading | How Currency Fluctuations Impact your Financial Plan | How Global Factors have Influenced the Value of the Rupee | How Domestic Factors Influence the Value of the Rupee

 

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