What are Currency Derivatives?

With the pandemic, the realization of global interdependency has dawned on everyone. The currency market is a global market for the exchange of different currencies. The currency markets are also referred to as FX or Forex Markets. While currency markets in India are relatively underdeveloped, it is the most liquid market in the world.

The currency market trades round the clock each day during the week. With the increase in international trade and globalization, the exchange of foreign currency has multiplied significantly. Lately, there has been an increase in volatility in the currency markets due to geopolitical tensions, interest rates, commodity prices, etc. Traders, investors, firms face financial risk from such volatility. Hence, hedging such risk is the need of the hour. Currency derivatives act as a meaningful tool to mitigate risk arising from currency derivatives contracts.

What are Currency Derivatives?

Before defining currency derivates, let’s begin with understanding derivatives. Derivatives are securities that derive their value from the underlying asset. The underlying asset can be equity shares, commodities, currency, or any other asset which has commercial value. Thus, currency derivatives are positions that obtain their value from the underlying currency. There are various types of currency derivatives contracts. These include forward contracts, futures contracts, options, and swaps.

According to Foreign Exchange Management Regulations, currency derivatives are defined as a financial transaction or arrangement whose value is derived from price movement in one or more underlying assets.

Types of Currency Derivatives

Like derivatives, currency derivatives have types that include the following:

Currency Forward Contracts

This type of currency derivative contract involves transacting in currencies at a pre-determined rate on a specified date in the future. The agreed-upon future date is also referred to as the delivery or maturity date for the contract. The delivery date is more than two business days from the date of executing the contract. The fixed rate at which the two currencies are to be transacted is known as the forward rate.

In a forward contract, the inflow and outflow are known beforehand. The terms of the contracts must be mutually agreed upon by the contracting parties. Since both parties have the prerogative to decide the rate, date, and currency exchange, a forward contract is unique and customized to meet the needs of the contracting parties. Currency forward contracts are over-the-counter and so the counterparty risk involved is high. Typically, at least one of the parties to a currency forward contract is a financial institution or an authorized dealer.

Multiple scenarios can arise while settling currency forward contracts including:

1. The actual delivery of currency on the expiry date.
2. Settlement of the net gain or loss on the date of delivery.
3. An opposite spot position is executed before the expiry of the contract. On the settlement date, the net position (i.e., after considering the spot and futures contract) is adjusted.

Currency Futures Contracts

A currency futures contract is exactly like a currency forward contract except that it is traded on an exchange. Hence, a futures contract has a buyer and seller. The exchange determines the lot size, maturity, and delivery dates. Contracts can be executed only for those pairs which trade on the exchange. A futures contract may be settled or closed off before delivery. However, the actual delivery of currency at the time of settlement does not occur.

For example, the lot size for USD futures on the NSE is $1000 which implies that trades can be executed only in the multiples of $1000. A buyer cannot purchase a contract for $950 or $1200.

Futures contracts are executed through an exchange with virtually zero counterparty risk. The exchange guarantees the performance of the contract. In turn, the exchange requires the buyer and seller to maintain margins as specified by the exchange. Additionally, futures contracts are marked to market i.e., the gain on loss at the end of each trading day is communicated to the buyer and lesser. The closing rate at the end of the trading is considered for the calculations. The exchange may require maintaining an additional margin which is known as a maintenance margin.

Having understood the meaning of currency derivatives, let’s discuss the methods to mitigate the risk associated with foreign exchange transactions. For example, an Indian exporter has entered into a sale transaction of pulses for $20,000 for which the payment will be given after two months. If the exporter expects the USD price to fall within two months, he can enter into a futures contract to sell the dollar. As a result, the rate at which the exporter will receive the USD is fixed. Such a transaction is referred to as a short hedge.

Alternatively, an importer has to make a payment of $5,000 after two months. The importer will lose out on revenue if the USD price increases within two months. Therefore, he enters into a futures contract to buy USD at a fixed rate after two months. In this case, the importer is said to have taken a long hedge.

Currency Options Contract

A currency options contract gives the right (but not an obligation) to buy or sell a currency at a specified rate on an agreed-upon future date. The buyer of the options contract is referred to as the holder of the contract whereas the seller is the writer of the contract. A contract with an option to buy a pre-determined quantity of a currency at a specified rate is called a call option contract. On the other hand, a contract with an option to sell a pre-determined quantity of a currency at a specified rate is called a put option contract. The price at which a call or put option contract is to be executed is called the strike or exercise price.

The buyer has the right to exercise the option before expiry and the seller must fulfill the contract if the buyer exercises his right. The buyer pays the seller a premium in exchange. The buyer decides whether to exercise his option or not by comparing the spot and strike prices. If the strike price of a call option is greater than the spot price, the option is said to be ‘in the money.’ On the other hand, if the strike price is lesser than the spot price of a call option, the option is ‘out of the money.’ Furthermore, if the strike price is the same as the spot price, the option is ‘at the money'.

An option contract may be over-the-counter or exchange-traded. An OTC contract can be customized to the specifications of the buyer and seller.

Currency Swap Contract

A currency swap involves the exchange of principal and interest in one currency against principal and interest in another currency. At the beginning of the contract, an equivalent principal amount is exchanged at the spot rate between the contracting parties. During the tenure of the contract, the contracting parties pay interest on the swapped principal amount. At the end of the contract, the principal amount is swapped back either at the spot rate or a pre-determined exchange rate. This rate may also be the original rate for the principal exchange. In such a case, the transaction risk on the swap is eliminated.

A currency swap is a contractual agreement between two parties wherein the frequency for payment, interest rates, exchange rates, etc. are mutually agreed upon by both parties. Thus, currency swap contracts are over-the-counter contracts and are completely tailored to the needs of the contracting parties. The parties to the contract are referred to as counterparties and generally include a commercial bank (authorized dealer). A middleman facilitates the fixing of terms between the counterparties. Such a broker is referred to as the swap bank or swap facilitator. Often\, a swap facilitator is the counterparty to the swap contract.

The date of execution of a swap contract is the trade date. The date on which the counterparties first exchange the principal amount is called the origination date. The principal is exchanged at the spot rate prevalent in the market. The dates on which the accrued interest accrued on the principal is exchanged are referred to as trade or value dates. The date of completion of the swap contract is the maturity date or far date.

Final Word

The essence of hedging and trading in currency derivatives lies in the use of a combination of derivatives products. Participants in the forex markets formulate various strategies to maximize the profits earned and minimize the risks involved. The sky is the limit for strategies in currency derivatives.