With globalisation and an increase in exports and imports, the businesses and countries have to be cautious and manage the currency risk. The currency derivatives help them to achieve that, as these financial instruments allow to hedge against fluctuations in exchange rates, speculate on currency movements, or arbitrage price differences. This blog will help you understand what currency derivatives are, their benefits, and the different types available, using simple language and clear examples.
Currency derivatives derive their value from the two currency exchange rates. They are used in managing the risk of currency fluctuations that can affect international trade, investments, and even financial statements. The investors who opt for currency derivatives contract, can lock in an exchange rate for a future date; thereby protecting against unfavourable movement.
Advantages of Currency Derivatives
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Hedging Against Currency Risk
Currency derivatives allow you to hedge against adverse movements in the exchange rate. If you have future cash flows in a foreign currency, you can use derivatives to lock in the current exchange rate.
Example:
Suppose you are an importer who needs to pay $100,000 to a U.S. supplier in three months. The current USD/INR exchange rate is ₹85 per dollar. You are worried that the rupee may weaken to ₹87 per dollar, which will increase your cost. You enter into a currency futures contract to buy $100,000 at ₹85 per dollar in three months. You have locked in your exchange rate and are protected against currency depreciation.
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Speculation Opportunities
You can also use currency derivatives to profit from expected movements in exchange rates. If you expect a certain currency to strengthen or decline, you can take such positions.
Example:
If you believe that euro will strengthen against the dollar, you can buy futures in euros. If the euro indeed appreciates, you'll then have sold the contracts at a profit.
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Arbitrage Opportunities
Currency Derivatives can also help you to gain from the discrepancies between two differently priced markets. The arbitragers make risk-less profit by offsetting purchase or sale on two different markets involving equivalent but different assets.
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Price Discovery
Derivative trading supports effective price information of currency contracts. Prices from derivative contracts serve as expressions of prevailing aggregate opinions of an expectation for some future rates.
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Liquidity and Accessibility
Currency derivative markets are highly liquid, it implies that as a trader you can easily get in and out of positions. This liquidity ensures fair pricing and tight bid-ask spreads.
Types of Currency Derivatives
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Currency Futures
Currency futures are contracts traded on exchanges, where you agree to buy or sell a specific amount of currency at a predetermined exchange rate on a future date.
Example:
You can trade INR/USD futures on the National Stock Exchange (NSE) in India. If you think that the rupee is going to strengthen against the dollar, you can sell USD futures contracts.
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Currency Options
Currency options give you the right, but not the obligation, to buy or sell a currency at a specified exchange rate before a certain date. Options provide flexibility and limited risk (limited to the premium paid).
- Call Option: An option to buy a currency.
- Put Option: An option to sell a currency.
Example:
If you believe that the British pound will appreciate with respect to the dollar, you can buy the call option of the GBP/USD. Once the pound appreciates, you can exercise this call option and then trade off with the favorable rate.
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Currency Swaps
Currency swaps substitute principal and interest payments in one currency for principal and interest payments in another. Companies frequently use currency swaps to get a better loan rate or hedge long-term currency exposures.
Example:
An Indian company with a loan in rupees can enter into a currency swap with a U.S. company that has a loan in dollars. They agree to exchange their loan payments, so each benefits from the other's borrowing terms.
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Currency Forwards
Currency forwards are agreements between two parties that enter into a buy/sell contract to sell or purchase a currency at a future date based on an agreed-upon exchange rate. They differ from futures, as these are over-the-counter and customized based on the specific requirements.
Example:
If you need to receive €500,000 in six months, you can enter a forward contract to sell €500,000 at the current exchange rate. This locks in your revenue in your home currency and therefore eliminates exchange rate risk.
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Currency Forward Rate Agreements (FRAs)
FRAs are agreements by two parties on an interest rate to be paid on a notional amount at a future date. They are applied to hedge interest rate risk linked with foreign currency loans or investments.
Risks of Currency Derivatives
While currency derivatives offer numerous advantages, you should be aware of risks associated with them:
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Market Risk
Exchange rates can go against your position, thus leading to potential losses.
Counterparty Risk
In OTC contracts such as forwards and swaps, there lies the risk that the counterparty will default on a contract.Liquidity Risk
Some currency derivatives are largely illiquid, especially in emerging markets; this may make a position difficult to close.Complexity
Derivatives can be complex instruments to understand their working in financial markets. Regulatory Risk
Variations in laws and regulations can also affect the trading of currency derivatives and their valuation.
Currency derivatives are viable tools for managing exchange rate risk, taking advantage of market opportunities, and enhancing portfolio diversification. With the different types of currency derivatives-futures, options, swaps, and forwards, you will know which ones suit your financial goals and risk appetite.
However, one must be aware of the risk and trade currency derivatives cautiously. Always know what you are trading, and at times, seek professional advice before trading.
By benefiting from the advantages of currency derivatives but managing their risks, you will do well in the foreign exchange market.
Happy Trading!