Derivatives are contracts that get their value from an underlying asset – equities, bonds, commodities, and currencies, among many. In layman terms, if the cost of raw material of a particular product increase, the price of that product will also rise. The same principle applies to derivatives.
Here, let us understand more about Currency Derivatives.
What are 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:
- USD – INR
- EUR – INR
- JPY – INR
- GBP – INR
Currency Derivatives in India
Currency Futures: Like Stock Future, Currency Futures are contracts that allows you to buy and sell an underlying currency at a pre-determined date. Moreover, the buy and seller can lock in the exchange rate in the present time itself. Therefore, both the buyers and sellers can avoid currency depreciation. Currency Futures is more frequently used by banks, importers, and exporters.
Currency Options: They are similar to Currency Futures when it comes to trading the underlying currency. The difference, however, is that it is not mandatory for you to buy or sell the underlying currency pairs on expiry. Therefore, Currency Options are flexible than Futures, where you must trade the derivatives on a specified date. Currency Options are classified into two types:
- Call Option: The buyer has the right but no obligation to buy the underlying currency on expiry
- Put Option: The buyer has the right but no obligation to sell the underlying currency on expiry.
Currency Swap: A currency Swap is an important derivative that exchanges interest rates of a bank or other lending institution in one currency for another currency. In this manner, the two parties can switch their interest rates from fixed to floating and vice versa.
Understanding Currency Swap
A currency swap, also called Cross-Currency Swap, is a contract between two parties involving the exchange of interest rate, principal amounts, and interest payment in two different currencies at a pre-determined exchange rate. Currency Swaps lock in a fixed exchange rate or hedge against currency fluctuations. Cross-Currency Swap pairs include:
- EUR – USD
- GBP – USD
- USD – JPY
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 INR 7 Cr. 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 involved in securing a loan is lesser.
Why are Currency Derivatives Popular?
Currency Derivatives are considered effective tools to counter the currency conversion rate fluctuations. Traders can hedge against exchange rate risk by combining Currency Futures and Currency Options. By monitoring the price movement of a currency, you can get access to 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!
*Terms and conditions apply. This is an information communication from HDFC bank and should not be considered as a suggestion for investment. Investments in securities market are subject to market risks, read all the related documents carefully before investing.
