What are Currency Derivatives & Its Meaning?
Currency derivatives are contracts that derive their value from their underlying asset, the currency. Unlike a forward contract, a currency derivative contract is standardized through a foreign regulatory exchange with an intermediary clearing house. Being traded in the regulated market, the agreement involves minimal counterparty risks as it must honour the rules and regulations of the foreign exchange. Currency derivatives contracts can be of two types – futures and options. Both contracts are margin-based, which means traders place a small portion of the contract value as an initial margin with the exchange. Currency derivatives help protect against price volatility of the underlying asset in the future and are widely used by traders as a risk management financial instrument.
Types of currency derivatives:
Currency derivatives contracts can be of two types. The trader often combines the two types to manage their portfolio risk consistently:
Futures:In this type of contract, the traders lock in a specified price for a particular currency to buy or sell at a future date, regardless of the price of that currency in the open market at that time.
Options:Like futures, options allow counterparties to buy or sell the currency asset at a pre-decided price at a future date. But unlike futures, the counterparties may choose not to trade by the time the contract expires. Thus, options give the rights to buy or sell, but not the obligation.
Options, in turn, are of two types:
Call option:This gives the owner the right to buy the underlying asset at a future date and a pre-decided price, but not obligated.
Put option:Opposite the call option, the put option gives the owner the right to sell the underlying asset at a future date and a pre-decided price, but not the obligation to do so.
Additional read: What are Strike and Premium in an options contract?
Advantages of currency derivatives:
Currency derivatives are financial instruments that help in adapting to market fluctuations through:
Hedging:Traders can monitor their risk exposure by combining options and futures to protect themselves from the price volatility of the foreign currency’s exchange rates.
Speculating:Traders can monitor the direction of the price movement of the currency asset in the future and take appropriate positions.
Arbitrage:Traders make money on the price difference between foreign exchanges for a particular currency by buying on one exchange and selling through another.
Leverage:Traders usually pay only a small margin (5% - 10%) of the total contract value to get exposure to a more significant capital that they otherwise would not have access to.
Disadvantages of currency derivatives:
Despite being a fundamental instrument in modern finance, currency derivatives carry inherent risks of:
High volatility:Though derivatives contracts are designed to hedge market risks (and often profit on the hedge), derivatives are inherently highly volatile. Their risk assessment may not be total despite the hedging. Thus, they need excessive monitoring, which makes the contract very complex.
Incorrect speculation:Price discovery of an underlying asset in the future requires complex speculations, and false speculations may lead to heavy losses.
Leverage:Currency derivatives, especially futures, involve a small margin of the overall contract value. If currency movement is not speculated in the right direction, the margin may drop rapidly below minimum levels leading to immediate margin top-up.
Counterparty risks:There is a possible chance that in currency derivatives contracts, especially in options, the buyer or seller may choose not to exercise their rights, leading to losses to either party.
The derivatives market has modernized finance by opening up the capital market to variously sized businesses. As an underlying asset, a country’s currency has great potential to link a small margin to a much bigger capital. It is, however, not without the risks of systemic failures – like the prolonged downfall of the pound post-Brexit.
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