What Are Currency Derivatives?
To understand currency derivatives in depth, it is necessary first to grasp the concept of derivatives.
Derivatives are financial contracts that do not have a value of their own. Derivatives derive their value from underlying assets. These underlying assets can be commodities, bonds, stocks or currencies. If the prices of these underlying assets increase, there will be a corresponding rise in derivatives prices.
Similarly, currency derivatives have currencies as their underlying asset. Keep reading to learn about these financial instruments.
What Is the Meaning of Currency Derivatives?
Like any derivative, currency derivatives are contracts whose value is based on an underlying asset, a particular currency pair. With these contracts, traders agree to exchange a certain currency pair like EUR/INR or USD/INR on a specified date at the exchange rate. These are the primary instruments used for currency trading.
Traders use currency futures to speculate on the value of currencies. In India, companies, banks, importers and exporters majorly participate in currency trading. Since these financial instruments are regulated and standardised at a foreign regulatory exchange, there is no chance of counterparty risk.
You can participate in trading with currency derivatives to make profits or hedge your finances against market fluctuations with currencies like the Yen, Dollar and Euro.
The Foreign Exchange Management Regulations define currency derivatives as financial arrangements or contracts that derive value from the price fluctuations in their underlying currencies.
What Are the Types of Currency Derivatives in India?
The popular types of currency derivatives are given below:
- Currency Swap
In a currency swap, traders exchange the principal and/or interest rates of a bank or financial institution from one currency to another. This allows two traders to lock in a trade at a fixed exchange rate to mitigate the effects of currency fluctuations. While trading with currency swaps, entities usually switch interest between floating and fixed interest rates.
- Currency Futures
Currency futures act as contracts for purchasing or selling underlying currencies on a predetermined date and time. Interested parties can choose to lock the exchange rate on the present day to avoid the depreciation of their assets. Also, currency futures follow the market trend. Therefore, all buyers and sellers receive notifications of profits and losses every trading day.
Furthermore, these contracts carry low counterparty risk and a promise that the deal will be executed on a known future date. Sellers and buyers must adhere to the limit that the exchange sets while pricing their currency futures.
- Currency Options
With currency option contracts, traders can buy or sell a currency pair at a given price on a specific future date. Its main difference is that the contract buyers are not obligated to execute it.
Buyers can exercise their option anytime before the expiry date of the contract. The seller on the other end of the contract must be available for the buyer to exercise their option. The buyer must pay the seller a certain ‘premium’ amount in exchange.
In currency options, the buyer is addressed as the contract holder. In contrast, the seller is referred to as the writer. When the holder has the right to buy an option, it is a call option. On the other hand, when the holder possesses the right but not an obligation to sell the option, it is called a put option.
How to Trade Currency Derivatives in India?
You can trade with currency derivatives via major stock exchanges like the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE).
NSE allows trading in 4 currency futures (USD/INR, GBP/INR, JPY/INR and EUR/INR), 3 cross-currency F&Os (EUR/USD, USD/JPY, GBP/USD) and interest rate futures on 10 Y G-Sec and 91 D T-Bills. On the other hand, BSE permits trading of currency futures in USD/INR, GBP/INR and JPY/INR) and commodity options on USD/INR with Interest Rate Futures contracts on 91 day Treasury Bill Futures.
These are nationally recognised foreign exchange platforms. Additionally, you can also opt for intermediaries and brokers to trade with currency derivatives. Most of the leading stock brokers in India provide this service to investors.
What Are the Benefits of Currency Derivatives in India?
Here are certain benefits of currency derivatives for investors in India.
- With currency derivatives, you can capitalise on short-term market shifts and observe the pattern and direction of market movements.
- Traders can profit from currency derivatives by strategising their investments per the market movements.
- Businesses, retail investors and traders can hedge against the rise and fall of prices. One can also gain from speculation with currency derivatives.
- The tick size for USD/INR is 1/4th of a Rupee or 0.25 Paise with currency options. These contracts are also highly liquid. Consequently, a small change in the market can bring in substantial profits for currency derivative traders.
- Arbitrators can take advantage of price differences of currencies in different exchanges. Due to the size of the trades, even a small difference can yield significant profits.
What Are the Problems Associated with Currency Derivatives in India?
The points below highlight the risks associated with trading with currency derivatives in India.
- Although currency derivatives offer the benefits of hedging, it carries chances of inaccurate estimation. A trader must have proper knowledge about trading patterns to better predict risk. Thus, trading with currency derivatives may not be a wise option for novice traders.
- Analysing the market movements and spotting risk is also a strenuous and time-consuming process. Therefore this involves in-depth knowledge and close study.
- Trading with currency options is not obligatory. Therefore, there is always a looming risk of either buyer or seller changing their mind. This carries a risk for both parties.
- There is a small margin of the total contract value in currency futures. If one does not predict the accurate direction or pattern of currency movement, the margin may drop below the minimum. To raise this, you must pay additional charges.
Currency derivatives are popular financial tools used mainly by exporters and importers exposed to high currency fluctuations risks. Retail investors/traders, too, can profit massively from currency trading. However, one must consider the pros and cons of currency derivatives before actively participating in currency trading. Having a comprehensive knowledge of the foreign exchange market is also recommended.
Frequently Asked Questions
- What are the uses of currency derivatives in India?
Currency derivatives are primarily used for hedging, speculating and arbitraging in the forex market.
- How do currency derivatives help with hedging?
Using currency derivatives, you can protect your finances from losses due to fluctuations in foreign exchanges. These financial instruments also allow exporters and importers to cover their losses and earn more profits during market fluctuations.
- What are currency forward contracts?
Currency forward contracts are a type of currency derivative. Using these, traders can participate in currency transactions at a previously determined rate on a fixed future date. This future date is referred to as the maturity or delivery date.
- What are the things I need to trade with currency derivatives?
To start trading with currency derivatives, you first need to open a currency trading account with a reputed broker. Next, you need to submit essential documents for KYC verification. Finally, you must deposit a margin amount and collect the required credentials and documents from the broker. This margin amount may vary between brokers.