- What are Currency Derivatives?
- How Do Currency Derivatives Work?
- What are the Types of Currency Derivatives?
- What are the Uses of Currency Derivatives?
- How are Currency Derivatives Settled?
- What are the Advantages and Disadvantages of Currency Derivatives?
- Why are Currency Derivatives Popular in India?
- Frequently Asked Questions
What are Currency Derivatives?
Derivatives are instruments that derive their value from the underlying assets. An equity derivative will derive its value from stocks and securities. Furthermore, it is a contract that parties enter into with a specific date for a specific price. Now, these derivatives can be traded just like stocks on the exchange market. Otherwise, these derivatives can be transacted privately over the counter.
Currency derivatives are a type of derivative that derives its value from the underlying asset, which is a currency such as INR, USD, Euro, and so on. Such currency derivatives include forward, futures and options, and swaps. Hence, currency derivatives are largely impacted by international economic factors. Currency derivatives are largely traded by traders involved in import, export, international transactions, etc.
How Do Currency Derivatives Work?
Currency derivatives are dependent on their assets for their price and valuation. The trade on derivatives largely depends on the asset that the trader wants to secure for. For instance, the currency exchange value of EUR/INR on 17th December 2022 is 1/87.65. This means that 1 Euro is equal to INR 87.65. The EUR/INR futures with an expiry of 28 days are trading at INR 87.96. This futures contract derives its value from the valuation of EUR/INR.
However, there is a difference between the exact value of the EUR/INR exchange rate today and the EUR/INR 28 days futures price. Now, if a trader is expecting a huge payout against an import, then the trader can secure their payout through a currency derivative. The trader will agree to a futures contract for a future date at a specific price. Even if the actual currency exchange rate fluctuations, the trader will be secured, and the payout will not fluctuate.
What are the Types of Currency Derivatives?
Currency futures are contracts for the purchase or sale of a specific underlying currency at a specific future date and at a specific price. Exchange-traded contracts known as currency futures are standardized in terms of the delivery date, contract value, and other criteria.
Investors can hedge themselves against foreign exchange risk by using currency futures contracts. Investors can exit from their commitment to buy or sell the currency before the contract’s delivery date. This is done by closing out their position because these contracts are marked-to-market every day.
Futures contracts are exchange-traded, with very low counterparty risk. The transaction promises that the contract will be carried out. The exchange in turn expects the buyer and seller to keep their margins within the limits set by the exchange. Additionally, futures contracts are marked to market. This means that the buyer and the seller are informed of the gain or loss at the conclusion of each trading day. The calculations take into account the closing rate at the end of trading. The exchange could ask the trader to maintain an additional maintenance margin.
Currency options are the right (but not the duty) to purchase or sell a currency at a predetermined rate on a certain future date. The option contract’s buyer is referred to as the contract’s holder, while the seller is referred to as the contract’s writer. A call option contract is one that includes the opportunity to purchase a predetermined amount of a currency at a specific rate. On the other hand, a put option contract is one that includes the option to sell a predetermined amount of a currency at a specific rate. The strike or exercise price refers to the price at which a call or put option contract is to be executed.
Before the option expires, the buyer has the opportunity to exercise it, and if he does, the seller must execute the terms of the agreement. In return, the buyer gives the seller a premium. The buyer compares the spot and strike prices before deciding whether or not to exercise his option. An option is considered to be “in the money” if the strike price of a call option is higher than the current market price. On the other hand, a call option is said to be “out of the money” if the strike price is less than the current market price. Additionally, the option is “at the money” if the strike price and the spot price are identical.
In a currency swap, the principal and interest from one currency are exchanged for the principal and interest from another currency. The contractual parties exchange an equivalent principal amount at the spot rate at the start of the transaction. The parties to the contract pay interest on the swap principal amount throughout the term of the agreement. The principal amount is returned at either the spot rate or a pre-decided exchange rate at the completion of the contract. It’s possible that this rate was the original rate for the swap of the principal amount. In this scenario, the swap’s transaction risk is eliminated.
What are the Uses of Currency Derivatives?
Traders use currency derivatives for the following purposes:
A trade that is made with the intention of reducing the risk of unfavourable price changes in another currency is known as a hedge. A hedge often involves taking the opposite position in a currency. The aim of hedging is to protect the trade from the potential risk of price fluctuations.
For instance, Ashok and Company imports batteries worth Euros 6000 from Europe at an exchange rate of EUR/INR 87.65. Hence, for this exchange rate, the company needs to pay INR 5,25,900. However, the company needs to pay this amount after 3 months. The company is afraid that this exchange rate might rise upto EUR/INR 90.85 in the next 3 months. In this case, the company might end up paying INR 5,45,100 which is a loss of INR 19,200.
The company will now enter into a hedge and buy 6 lots of EUR/INR at a rate of INR 87.85.
Number of lots to be purchased = (INR 5,45,100 / 87.85)1 lot = 1000 derivatives
After 3 months even if the exchange rate rises up to EUR/INR 90.85, it has already secured its position against the possible loss.
The goal of speculation is to profit from a currency’s price movement, whereas the goal of hedging is to lower the risk or volatility related to a currency’s price change. Hence, speculation is exposed to the upside and downside of a trader.
For instance, Miss Kajal expects the EUR/INR rate to decrease from 87.25 to 85.80 due to the ongoing war and shortage of oil in Europe after 1 month. She takes a short position on EUR/INR at a rate of EUR/INR 87.25 for 20 lots. This means that she will sell at this rate. After 1 month the actual rate turned out to be EUR/INR 86.10. She buys 20 lots at a rate of EUR/INR 86.10 in the intraday. Hence, she gains INR 23,000 (EUR/INR 87.25 – EUR/INR 86.10) * 20 lots.
Arbitrage involves buying and selling the same currency on different markets and exchanges to gain from the price difference. The price difference might seem very low. However, given the lot size, the gain can be higher. In India, currency derivatives trade on NSE, BSE, and MCX-SX. A trader will buy on one exchange and sell on another for even a very small price difference.
For instance, on NSE futures EUR/INR is traded at a rate of EUR/INR 87.25. The same futures trade on BSE at a rate of EUR/INR 87.27. Mr Akash notices an arbitrage opportunity between these 2 stock exchange listings. He buys 100 lots from NSE and sells these lots on BSE. He makes a profit of INR 2,000 (EUR/INR 87.27 – EUR/INR 87.25) *100 lots.
How are Currency Derivatives Settled?
Daily Mark To Market Settlement
At the end of each trading day, each clearing member’s positions in the contracts are marked-to-market in accordance with the daily settlement price of the futures contracts.
The profits or losses are calculated as the difference between the trade price or the settlement price from the previous day’s settlement price. The mark-to-market loss amount must be paid by the CMs who suffered a loss. All open positions are reset to the daily settlement price after the daily settlement. A CM is a clearing manager who is responsible for clearing trades everyday.
A clearing member’s holdings are all marked to the final settlement price at the time of the futures contracts’ expiration by the clearing agency. Any resulting profit or loss is settled in cash.
The difference between the transaction price or the previous trading day’s settlement price and the RBI reference rate of the relevant futures contract on the last trading day is used to calculate the final settlement profit or loss.
On T+2 day (T = last trading day), the final settlement loss or profit amount is debited or paid to the applicable clearing member’s bank account.
What are the Advantages and Disadvantages of Currency Derivatives?
Advantages of Currency Derivatives
- Trading in currency derivatives is exempt from STT. Unlike trading in equity or commodity derivatives, where STT and CTT are applicable. As a result, Lower transaction costs translate to the potential for higher profitability on trader sizes.
- With trading currency options, the tick size is 1/4 of a rupee, or 0.0025, and the contracts are also quite liquid. As a result, traders can earn more from a small change in the underlying currencies.
- Currency derivatives allow traders, businesses and retail investors to hedge against price fluctuations, gain from speculations, and provide arbitrage opportunities.
Disadvantages of Currency Derivatives
- Currency derivatives are intended to hedge market risks and frequently benefit from hedging. Despite the hedging, their estimate of the risks may not be accurate. To spot an opportunity, a trader or investor must analyse the market and its trends in-depth. This demands technical knowledge, know-how, and time.
- An estimation of the future price or value of an exchange currency requires extensive speculations. Moreover, incorrect speculations can result in significant losses.
- Currency futures involve a small margin of the total contract value. If the correct direction of currency movement is not predicted, the margin may drop quickly below the minimal levels. This will result in the need for additional margin top-ups.
- In currency options, there is a possibility that the buyer or seller may decide not to exercise their rights. This will result in losses for either the buyer or seller leading to counterparty risk.
Why are Currency Derivatives Popular in India?
Currency derivatives have the potential to provide profitable investment opportunities for small-scale investors. It provides a closed and transparent market where the majority of banks and financial institutions can trade. The currency derivatives are based on foreign exchange which is regulated and transparent. Currency derivatives are seen as useful tools to protect against fluctuations in exchange rates. By combining Currency Futures and Currency Options, traders can insure against exchange rate risk. By keeping an eye on a currency’s price changes, traders can access higher funds with marginal additional risk.
Frequently Asked Questions
No, derivatives are not meant only for importers and exporters. Investors, traders, businesses, and financial institutions such as banks, use derivatives to hedge the risk of price fluctuations in the underlying asset, speculate and gain from arbitrage opportunities.
A currency futures contract expires on the last working day on which the final trade has to take place in the specified contract. It takes 2 days for every trade to settle for currency derivatives.
You can trade in currency derivatives in India through either stock exchanges like NSE and BSE or through brokers and intermediaries.
Yes, currency swaps are always in different currencies like INR/EUR, USD/INR, SGD/USD.
The buyer has the right to sell the underlying currency on the expiry date. However, the buyer has no obligation to sell the underlying currency.
A call option means that the buyer of the derivative has a right to buy the underlying currency. However, there is no obligation to buy.
A lot size of currency derivatives comprises 1,000 units.
In the case of a currency futures contract, a spread is a difference between the futures price and the spot price.