Derivatives In Currency  Trading And Why?

Derivatives In Currency Trading And Why?

11 Aug 2020 07:01 PM

Currency Trading

Currency trading, often referred to as foreign exchange or Forex, is the purchase and sale of currencies in the foreign exchange market, with the objective of making profits. It is the largest market in the world, with nearly $2 trillion traded on a daily basis. Liquidity is the main factor that differentiates currency trading from other types of trading.

Currency Derivatives

Currency derivatives are forwards, futures, swaps and options contracts by which youcan buy or sell specific quantities of a particular currency pair on a predetermined future date. It is similar to Stock Derivatives trading, except, the underlying assets are currency pairs instead of stocks. Currency Derivatives trading is either done in the Foreign Exchange Market or Over-the-Counter (OTCs). Banks, corporations, importers and exporters are major participants of currency trading in India.

  • Currency Forward Contract: The transaction involves exchange of two currencies at an agreed on price (Forward Rate) on a predetermined date of the contract, for value or delivery at some time in future. Forward contracts are traded on OTCs in which at least one of the parties involved is a financial institution. The currency pair, the amount of foreign currency to be exchanged, and the date of exchange are mutually decided upon by both the parties. In case of Forward contracts, counter-party risk is high, as contract execution is not guaranteed.
  • Currency Futures Contract: These contracts are entered into on a currency exchange which involves exchange of two currencies at a predetermined price on a predetermined future date. A future contract involves a buyer and a seller. Specific rules are imposed by the exchange with respect to the currency pair in which the contract is available, minimum contract size, maturity date and delivery date. Each leg of the trade is guaranteed by the exchange. Initial margin is levied and maintenance margins are specified, for both the parties, by the exchange.
  • Currency Options Contract: An options contract gives the buyer of the contract the right, and not the obligation, to buy or sell a currency in exchange for another, at a specified exchange rate on a predetermined future date. An upfront premium is paid by the buyer of the option contract. The decision to exercise the option is made by comparing the spot on expiration date with the exercise price (predetermined price). In an exchange traded options contract, the spot month, maturity date, the currency pairs that can be exchanged, and the minimum contract size are decided by the exchange. But an OTC options contract is custom-made to suit both the parties.
  • Currency Swaps: These contracts involve the actual exchange of two currencies at a rate agreed at the time of conclusion (the short leg) and a reverse of the same two currencies at a date further in future and at a rate agreed (different from the short-leg-rate) at the time of the contract (the long leg). It is an OTC contract, mutually agreed on by both parties- in which one of them is usually a commercial bank. The cash flows may relate to a loan—exchange of the periodic interest, exchange of principaland the re-exchange of principal.

Why Currency Derivatives?

  • Hedging: With the help of currency derivatives, companies exposed to foreign exchange risk can avail protection and minimize losses by taking appropriate positions through hedging. By using currency derivatives they lock in a future rate today, and can be protected from adverse fluctuation in the exchange rate.
  • Trading: By taking view on directional movement, one can trade on short-term fluctuations in markets. Derivatives can be used to easily trade in illiquid currencies.
  • Fixed Lot Size: A lot size refers to the number of currency units per lot. The biggest advantage to this is that traders can trade multiple lots per contractin these contracts.
  • No Manipulation:It’s impossible to manipulate the market due to the giant size of the market and numerous players involved. Even centralized banks with their high-volume of transactions can’t make any favored altercations, let alone a single entity.
  • Arbitrage:Make money hand over fist by taking advantage of the currency exchange rates in different markets and exchanges.
  • Leverage: With currency futures trading and options trading, you can just pay a percentage of the value while trading currency derivatives instead of the full traded value. The percentage value is referred to as the margin amount.
  • Speculation:short term movement in the markets can be speculated byusing currency futures. For example. If you’ve a hunch that oil prices are going to rise and impact India’s import bill, then you would buy USD expecting that INR would depreciate.

If these benefits look appealing to you then you can enter an agreement with another trader and reap the benefits of trading currencies through derivatives. One thing to keep in mind is that, derivatives can be complex instruments to interpret. To enjoy the benefits of using derivatives it is better to take advice from a professional- when and how to use them. Myforexeye Team provides guidance to its clients on how and when to use derivatives and thus achieve the desired outcome.

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