Derivatives In Currency Trading And Why?

Derivatives In Currency Trading And Why?

11 Aug 2020 07:01 PM
 

What is Currency Trading?

Due to the advancement of technology and online currency trading platforms and a reduced barrier to entry, Forex or currency trading has witnessed a surge in individual investors' participation. Currency trading entails the sale and purchase of foreign currencies with the objective of making profits from the volatility of currency rates. One of the most critical benefits that currency trading offers is liquidity which allows investors to easily enter and exit a position within a fraction of a second in any major currency pair. However, the risks associated with forex trading that can get further elevated in the absence of a right trading strategy cannot be neglected. Understanding the fundamentals that drive currency fluctuations and technical analysis of the currency pairs can increase the possible returns from forex trading, making it more profitable.

What are Currency Derivatives?

Financial contracts or financial instruments whose value is linked to an underlying asset's value is called derivatives that can be used for multiple purposes, including hedging. In the case of currency or Forex trading, currency pairs are the underlying assets. Forex risk management, speculation, and leveraging a position are the varied purposes for which derivatives are found useful. Currency derivatives are forwards, futures, swaps and options contracts using which one can buy or sell specific quantities of a particular currency pair on a predetermined future date.

Currency Forward Contracts

Forward contracts are traded over-the-counter with an authorized counter-party wherein its terms, including the exchange rate, size, currency pair, settlement process and due date, are set as per the agreement between the two parties involved. The forward contracts involve the exchange of currencies at a predetermined rate at a specified date in the future that extends the benefit of enhanced protection against unfavourable forex rate volatility. Due to the non-standardized nature of the forward contracts, they expose the market participants to counterparty risk upon entering a forward contract. 

Currency Future Contracts

An agreement between two parties to exchange currencies at a specified date in the future utilizing a predetermined exchange rate is known as future contracts. Since they are traded on an exchange, they are standardized and do not expose the market participants entering a future contract to counterparty risk. The parties that are involved in the future contracts are under an obligation to fulfil the commitment of buying and selling the specified currency pair. An initial margin is kept as collateral in case of future contracts to establish the future position where margins are required of all the participants.

Currency Option Contracts

The option contracts have some similarities to futures contracts since both entail an agreement to exchange currency at a specified date in the future at a predetermined exchange rate. However, the options contracts differ on account of flexibility as they don't impose an obligation for the fulfilment of the contract on the parties involved. One can either fulfil the contract or withdraw from it depending upon whether the forex market movements are favourable to them.

Currency Swaps

Swaps are over-the-counter contracts that do not trade on exchanges and are generally utilized between financial institutions or businesses rather than by retail investors. They are customized to the needs of the parties involved in the swap contract. Swap transactions refer to the purchase in the spot market and sale in the forward market or sale in the spot market and purchase in the forward market, which involves simultaneous borrowing and lending of two different currencies between two different investors. The funds available in the currency withheld by the participants can be utilized to pay off their obligations that are denominated in a different currency.  For example, swap contracts can be beneficial for a company paying a variable rate of interest. The company may swap its interest payment with another company which will pay the first company a fixed rate.

Advantages of Derivatives

  1. Hedging Foreign Exchange Risks - By taking appropriate positions through hedging, individuals and corporations can minimize the losses caused by foreign currency exchange rate fluctuations. Derivatives can be used to enhance protection against forex exposure and hedge any potential losses. For example, An importer has to make USD payments to an overseas buyer on a future date. In that case, the forex exposure risks that might be encountered due to the forex market volatility can be hedged by buying USDINR and fixing the exchange rate to be used during the transaction settlement. Moreover, the derivative contract's profits can be used to offset the losses in the underlying asset by purchasing a derivative, the value of which moves in the opposite direction of the underlying asset.
  2. Leverage: Increasing the potential return of an investment by using different financial instruments or borrowed capital is called leverage. The benefit extended to investors here includes the availability of required capital through borrowing that does not limit the returns on investments. By paying a % value called the margin, one can trade in the currency derivatives instead of the need to pay the full traded value.
  3. Speculation: The attempt to make profits from short or medium-term fluctuations by utilizing financial instruments is speculation. This is one benefit that currency derivatives extend by allowing speculations on the short term market movements. For example, One can buy USDINR if they expect oil prices to rise and INR to depreciate. 
  4. Arbitrage : One can take advantage of the price differences between two separate markets and by purchasing and selling the same currency pairs at the same time in different markets to exploit price disparity.

Derivatives and, in general, the forex market can be difficult to interpret, especially for smaller organizations with no time to spare to sharpen their forex understanding. Taking the assistance of professionals like Myfrexeye can enable one to get the maximum benefits from using derivatives correctly. Myforexeye provides services like Dr. Forex ( Forex Risk Advisory) and Forex Risk Management, through which we offer our clients' technical and fundamental analysis based forex reports, strategic recommendations for hedging foreign exchange risks, including the right way to use derivatives. While extending expert assistance, special emphasis is laid on building the client's understanding too through explanatory sessions via phone and video call. Besides enabling robust forex risk management against forex risks for your business while considering company objectives, we also offer services like transaction process outsourcing, live forex updates, smooth and quick trade finance, overseas money transfer and regular market updates to simplify forex for individuals, traders and firms while enhancing the savings on their forex transactions.  

Conclusion

Myforexeye is committed to providing a resolution to your Forex and trade finance needs and filling the gap of the unmet demands in terms of credit and financial guidance to MSMEs and larger corporates. Through our team of experienced professionals and consultants well versed in the field of forex and trade finance, we provide streamlined forex solutions for one’s convenience and at their disposal. Corroborating our efforts of providing solutions that are effective to companies for realizing their maximum potential are the latest technology and assistance from the veterans of the forex and trade finance industry. It is our objective to aid our clients in making savings and eliminating the aspect of hidden commission fees payable to the bank. Our user-friendly digital platforms - web portal and mobile app, enables one to access the best quotes for all types of forex conversions as well as avail import and export finance and calculate interest costs to make informed decisions. 

Speak to one of our specialists to acquire a detailed understanding of forex solutions offered by Myforexeye. 

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