Here, let us understand more about Currency Derivatives.
Currency Derivatives are exchange-traded contracts deriving their value from their underlying asset, i.e., the currency. The investor buys or sells specific units of fixed currency on a pre-specified date and rate. These contracts are actively traded on the stock exchanges and are mainly used by importers and exporters to hedge against domestic currency fluctuation.
Currency derivative contracts are standardised through a foreign regulatory exchange with an intermediary clearing house. Since derivatives are traded in a regulated market, the contract does not leave a window for buying or selling current assets at a specific date and rate, expelling the chance of counterparty risk.
Here are four popular currency pairs that are underlying assets for the actively traded Currency Derivatives:
The three types of currency derivatives in India are:
They are contracts to buy or sell a definite amount of a currency at a predetermined price on a set date. You agree to exchange currencies at this future date, regardless of the market rate at that time. This helps you hedge against currency fluctuations or speculate on currency movements.
When you enter a currency futures contract, you lock in the exchange rate, providing certainty for future transactions. The contract is standardised and traded on exchanges, which reduces counterparty risk and provides liquidity. If the currency’s value moves unfavourably, you may incur a loss, while favourable movements can lead to gains.
Currency Options share similarities with Currency Futures in that they involve trading underlying currency pairs. However, unlike Futures, you are not obligated to buy or sell the currency pairs upon expiry. This makes Currency Options more flexible than Futures, where trading on the expiry date is mandatory. Currency Options come in two main types:
A currency Swap is an important derivative exchanging interest rates of a bank or other lending institution in one currency for another. In this manner, the two parties can switch their interest rates from fixed to floating and vice versa.
It is an agreement to exchange interest and principal payments in distinct currencies between two parties. You agree to exchange a set amount of one currency for another at the start and reverse the exchange at a later date. This helps manage currency risk by locking in exchange rates for future transactions.
You exchange interest payments in the two currencies based on agreed rates during the swap period. At maturity, you swap back the principal amounts. This arrangement can benefit you by providing access to foreign currencies at fixed rates and managing exposure to exchange rate fluctuations.
Cross-currency swap pairs include:
Having known the Currency Swap meaning, let us understand the same with an example:
A US Company X lends USD 1 Million to an Indian Company Y in exchange for ₹7 Crore. This implies that the USD INR exchange rate has been set at 70. The two countries will form a contract, at the end of which the two companies will repay the principal amounts to each other. That way, the two companies remain immune to exchange rate volatility.
Another possibility is that the two companies can form a contract for a Cross-Currency interest rate swap. Here, there is no exchange of principal amount; however, a legal contract where the interest rate payments can be fixed or variable. Companies exchange interest rate payments so that the cost of securing a loan is less.
Currency Derivatives are considered effective tools to counter currency conversion rate fluctuations. Traders can hedge against exchange rate risk by combining Currency Futures and Currency Options. By monitoring a currency's price movement, you can access a larger capital value with minimal margin.
Tip: A Demat Account can come in handy while trading Currency Derivatives.
To open a Demat Account with HDFC Bank, click here!