Currency Derivative

A currency derivative is basically a risk management instrument that allows entities with Fx-fluctuations risk the ability to take long or small positions to hedge against opposite short/long positions.

Companies are exposed to foreign currency risk in a competitive market where imports and exports are integral parts of a business's operations.

Instruments to hedge foreign exchange risk

Forward: An OTC contract that is customized between two parties, where settlement occurs at a predetermined date and price. Banks deal in it.

Futures This is an exchange-traded standardized contract between two people that allows them to buy and sell underlying at a certain price.

Options This is an exchange-traded contract that gives you the option to buy or sell the underlying without any obligation.

Swaps This is an agreement between two people to swap principal and interest. The cash flow in one direction will be in a different currency than the other.

Foreign Exchange Risk for Entities

Exporters A weakening Rupee can adversely impact the exporter's profit margin, but a strengthening Rupee will boost it.

Importers A strengthening of Rupee can positively affect an importer's payments for goods, as they fall when Rupee appreciates.

BorrowersIn today's globalized world, Indian companies prefer loans in foreign currencies to rupee loans. Accepting a loan comes with risk due to fluctuations in the exchange rate.

A business must sell foreign currency: This includes Indian exporters and companies receiving capital infusions. Repatriation from abroad of investment money i.e. Company that has raised money abroad.

Businesses need to purchase foreign currency: This applies to importers of goods and services into India. A company must repay capital raised from overseas, as well as individuals who plan to spend in foreign currencies.

Below are some entities that are at risk from Fx-fluctuations.

• For travel, education, treatment, payment, and employees based overseas, you can pay in foreign currency.
• Foreign currency loans are paid
• Repatriation of capital or investment in assets outside India
• Person earning foreign currency can pay INR for loan installments
• De-risking US equity portfolios from USD/INR currency risks

Significance of Currency Derivatives:

Portfolio diversification, price discovery and hedge

Futures vs. Cash:

Futures > Cash + Carry (i.e. Interest rate; Sell Futures and Buy Cash Options Cash + Cost Of Carry (i.e. Interest rate; Buy Futures and Cash

Calendar Spread:

Futures 2 > Futures 1 + Cost of Carry; Sell Futures 2 and Buy Futures 1 Futures 2 < Futures 1 + Cost of Carry; Buy Futures 2 and Sell Futures 1

As with all assets, the value of a currency depends on the forces of supply and demand. The currency's value is also affected by a variety of factors. It will fluctuate depending on economic conditions, general market conditions, future interest rates, changes in prices, performance of stock markets, and performances of Asian currencies.

Currency Futures Trading Strategies

1. To protect themselves against the appreciation of foreign currencies, traders can lock-in a predetermined buying price. Base currencies can be locked-in at a pre-determined price.

2. Trader who want to avoid depreciation of foreign currencies. Base currencies can be locked-in at a pre-determined selling price

Specification of Currency Futures Contracts:

Specifications for Currency Options:

Forex Option Trading Strategies

One currency can be bought and sold in every currency transaction. For example, You can buy USD for INR with a USD call or INR put. An INR Put and a USD Put are also available to sell USD for INR.
Other basic options, such as Strike price, Expiration date, and Style, are identical to any other underlying option.

Strategies:

A trader with a long directional view on currency can either buy or sell a Call option. A trader with a short directional view of currency can also sell Call option or purchase Put option.
If Call and Put are purchased, the downside risk is only limited to the premium paid. However, upside risk is unlimited and vice versa.

Combination strategies:

Options combinations strategies work best when the market view is moderately bearish/bullish, rangebound or uncertain. The goal is to lower the overall premium.
Bull & Bear Call - Put spread, Straddle, Butterfly and Covered Protective Call are some examples of instruments.