Devoid of jargon, currency derivatives can be described as contracts between the sellers and buyers, whose values are to be derived from the underlying assets, the currency amounts.
These are basically risk management tools in forex and money markets used for hedging risks and act as insurance against unforeseen and unpredictable currency and interest rate movements. Any individual or corporate expecting to receive or pay certain amounts in foreign currencies at future date can use these products to opt for a fixed rate - at which the currencies can be exchanged now itself. Risks arising out of borrowings, in foreign currency, due to currency rate and interest rate movements can be contained. If receivables or payments or are denominated or to be incurred in multiple currencies, derivatives can be used for matching the inflows and outflows.
The FX contract capitalized on the U.S. abandonment of the Bretton Woods agreement, which had fixed world exchange rates to a gold standard after World War II. The abandonment of the Bretton Woods agreement resulted in currency values being allowed to float, increasing the risk of doing business. By creating another type of market in which futures could be traded, CME currency futures extended the reach of risk management beyond commodities, which were the main derivative contracts traded at CME until then. The concept of currency futures at CME was revolutionary, and gained credibility through endorsement of Nobel-prize-winning economist Milton Friedman.
Today, CME offers 41 individual FX futures and 31 options contracts on 19 currencies, all of which trade electronically on the exchange's CME Globex platform. It is the largest regulated marketplace for FX trading. Traders of CME FX futures are a diverse group that includes multinational corporations, hedge funds, commercial banks, investment banks, financial managers, commodity trading advisors (CTAs), proprietary trading firms, currency overlay managers and individual investors. They trade in order to transact business, hedge against unfavorable changes in currency rates, or to speculate on rate fluctuations.
Currency Derivatives Product
Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. We take a brief look at various derivatives contracts that have come to be used.
The basic objective of a forward market in any underlying asset is to fix a price for a contract to be carried through on the future agreed date and is intended to free both A forward contract is customized contract between two entities, where settlement takes place on a specific date in the future at today's pre-agreed price. The exchange rate is fixed at the time the contract is entered into. This is known as forward exchange rate or simply forward rate.
A currency futures contract provides a simultaneous right and obligation to buy and sell a particular currency at a specified future date, a specified price and a standard quantity. In another word, a future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Future contracts are special types of forward contracts in the sense that they are standardized exchange-traded contracts.
Swap is private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolio of forward contracts. The currency swap entails swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. There are a various types of currency swaps like as fixed-to-fixed currency swap, floating to floating swap, fixed to floating currency swap. In a swap normally three basic steps are involve
(1) Initial exchange of principal amount
(2) Ongoing exchange of interest
(3) Re - exchange of principal amount on maturity.
Currency option is a financial instrument that give the option holder a right and not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period ( until the expiration date ). In other words, a foreign currency option is a contract for future delivery of a specified currency in exchange for another in which buyer of the option has to right to buy (call) or sell (put) a particular currency at an agreed price for or within specified period. The seller of the option gets the premium from the buyer of the option for the obligation undertaken in the contract. Options generally have lives of up to one year; the majority of options traded on options exchanges having a maximum maturity of nine months. Longer dated options are called warrants and are generally traded OTC. Currency Futures
A futures contract is a standardized contract, traded on an exchange, to buy or sell a certain underlying asset or an instrument at a certain date in the future, at a specified price. When the underlying asset is a commodity, e.g. Oil or Wheat, the contract is termed a "commodity futures contract". When the underlying is an exchange rate, the contract is termed a "currency futures contract".
In other words, it is an agreement between two parties to buy or sell a standard quantity of currency at a certain time in future at a predetermined price on the floor of an organized futures exchange.
Therefore, the buyer and the seller lock themselves into an exchange rate for a specific value or delivery date. Both parties of the futures contract must fulfill their obligations on the settlement date.
Currency futures can be cash settled or settled by delivering the respective obligation of the seller and buyer. All settlements however, unlike in the case of OTC markets, go through the exchange.
Advantages of Futures:
• Transparency and efficient price discovery. The market brings together divergent categories of buyers and sellers.
• Elimination of Counterparty credit risk.
• Access to all types of market participants. (Currently, in the Foreign Exchange OTC markets one side of the transaction has to compulsorily be an Authorized Dealer - i.e. Bank).
• Standardized products.
• Transparent trading platform.
Limitations of Futures:
• The benefit of standardization which often leads to improving liquidity in futures, works against this product when a client needs to hedge a specific amount to a date for which there is no standard contract
• While margining and daily settlement is a prudent risk management policy, some clients may prefer not to incur this cost in favor of OTC forwards, where collateral is usually not demanded