If you are new to Currency Derivatives, you may be clueless about all the fuss. They may seem a complex investment. Let us break down the basics of it and explore the different types.
Meaning
Currency Derivatives are financial contracts that derive their value from underlying assets denominated in foreign currencies. The most common type is the Forward Contract, which stops two parties from exchanging a specified amount of currency at a specified price on a fixed date. Other Currency Derivatives include FuturesContracts, Options, and Swaps.
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Currency Derivatives can be used for hedging purposes, which means they can be used to protect against adverse changes in the currency value.For example, suppose a company expects to receive payment in U.S. Dollars in the future but is concerned about the possibility of a decline in the Dollar value. In that case, it could enter a Currency Derivative contract to hedge against this risk.
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Such Derivatives can also be used for speculative purposes, which means betting on the future direction of a currency’s exchange rate. Speculators typically use leverage when trading Currency Derivatives, i.e., they only place a small amount to control a larger amount of currency. Leverage magnifies profits and losses, so speculators should be careful when using this strategy.
However, due to their high leverage degree, Currency Derivatives can be highly volatile and risky investments. As such, they should get traded by experienced investors with a strong understanding of the risks involved.
Types
Future Contracts: A Future Contract is an agreement to buy or sell an asset at a future date. They are traded on exchanges and can be used to hedge against price fluctuations. Unlike other Derivatives, Future Contracts do not give the holder the right to buy or sell the underlying asset.They merely obligate the holder to do so at the specified price. This contract is commonly used for oil, gold, and wheat commodities.
However, they can also be used for financial instruments such as Bonds and Currencies. Future contracts are typically settled in cash but can also be settled in the underlying asset.
Options Contracts:These are agreements between two parties that grant the holder the right, but not the obligation, to buy or sell a security at a fixed price within a specific time frame. Options Contracts can hedge against risk or speculate on the future price of a security. Since they are derived from underlying securities, they are often referred to as Derivatives. This contract is traded on exchanges and can be bought and sold through brokerage accounts.
The Options Contract’s value depends on the underlying security’s price and the time remaining until expiration. These are versatile tools used in various ways by investors and traders.
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Forward Contracts: An agreement between two parties to buy or sell an asset at a future date for a predetermined price. They can be used for different assets, including commodities, currencies, and financial instruments. Unlike other Derivatives, Forward Contracts are not traded on exchanges. Instead, they are privately negotiated between the two parties involved. This contract can hedge against price movements in the underlying asset or speculate on future price movements.
They are also often used in conjunction with other Derivatives, such as Futures & Options, to create more sophisticated trading strategies.
Swaps:They are financial Derivatives used for trading risk between two parties. The most common type is the interest rate swap,which includes swapping a fixed interest rate for a floating rate, or vice versa. Swaps hedge against changes in interest rates orspeculates on the direction of interest rates. They can also be used to trade credit, currency, or commodity risks.
Swaps are complex instruments, and their prices are determined by several factors, including the creditworthiness of the parties involved, the underlying assets being traded, and the prevailing market conditions. Swaps are typically traded over the counter and are not regulated by any central exchanges. As such, they carry a higher level of risk than other financial instruments.
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