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If you think derivatives are just for stocks, think again. You see, derivatives are not just for stocks; they can also be applied to other instruments like commodities and currencies.
In this article, we’re diving into the exciting world of currency derivatives. Whether you’re an experienced trader or just starting, exploring currency derivatives provides opportunities to leverage macroeconomic factors for enhanced returns. Curious to know more? Let’s kick things off with the basics of currency derivatives in India.
What are currency derivatives?
Currency derivatives are derivatives contracts whose value is based on the exchange rates between different currencies. They allow individuals and businesses to hedge or speculate on future currency movements.
Common types of derivative instruments include futures and options, providing a way to manage risks associated with fluctuating exchange rates. For example, a company may use currency derivatives to protect itself from potential losses due to currency value changes when conducting international trade.
In India, there are four currency pairs that are actively traded as underlying assets for currency derivatives:
- USD/INR
- EUR/INR
- GBP/INR
- JPY/INR
Participants can benefit from potential gains or protect against adverse currency changes, making it a crucial aspect of managing international trade and investments.
Currency derivatives are customised over-the-counter (OTC) contracts between two parties. Settlement happens at the agreed-upon price today on a specific date in the future. There is no third-party authority standardizing or regulating these contracts.
The evolution and popularity of currency derivatives in India
Derivatives markets have been around in India since the 19th century, with the Bombay Cotton Trade Association starting futures trading in 1875. Derivatives were introduced as exchange-traded financial instruments in June 2000.
In 1952, the government abolished cash settlement and options trading. As a result, trading in derivatives moved to unofficial forward markets.
In 2008, SEBI allowed NSE to launch currency derivatives trading in India. On August 29, 2008, NSE currency derivatives started trading in USDINR Futures and subsequently allowed trading in EURINR, GBPINR, and JPYINR. Currency derivatives were introduced in BSE on October 1, 2008.
In the last 10 years, the number of contracts traded has increased 7 times, from 27 lakh in 2014 to 1.92 crore in 2022-2023.
Types of currency derivatives
There are several types of currency derivatives, with the most common ones being:
1. Forward contracts
Forward contracts are agreements between two parties to exchange a specific contract of currency at a future date at an agreed-upon rate.
Unlike standardised futures contracts, forwards are customisable and traded directly between parties. They help manage currency risk, allowing businesses to secure future exchange rates, but they lack the daily market pricing and standardisation found in exchange-traded futures.
2. Futures contracts
Futures Contracts are standardised agreements to buy or sell a specific contract of currency at a predetermined exchange rate, traded on organised exchanges.
Unlike forward contracts, futures are uniform and regulated. They require both parties to fulfil the contract, and daily mark-to-market adjustments help manage risk.
3. Options contracts
Options contracts give the holder the choice to buy (call option) or sell (put option) a specific contract of currency at a predetermined price before or at the contract’s expiration.
Options offer flexibility and can be traded on exchanges or over the counter, providing a way for investors to hedge against currency risk or speculate on price movements with limited risk exposure.
4. Currency swaps
Currency swaps involve exchanging currencies between two parties, typically to manage interest rates and currency risks. In this arrangement, both parties agree to swap back the currencies at a future date.
These swaps are beneficial for entities needing access to foreign currency derivatives or aiming to hedge against exchange rate fluctuations, providing a combination of a spot transaction and a forward contract.
How to trade currency derivatives in India?
BSE and NSE are two major stock exchanges in India, and they both have segments for currency derivatives. The Metropolitan Stock Exchange of India also has a similar section, but its trading volumes are lower compared to the BSE and NSE. You can use brokers to trade in currency derivatives, and most leading stock broker companies provide services for currency trading.
Trading in currency derivatives is similar to trading in stocks and their derivatives. You can use the broker’s trading app for this. The contract size for a dollar-rupee contract is $1,000, but you only need to pay a 2-3% margin to trade in it, also known as currency derivatives margin NSE.
However, the NISM Currency Derivatives Certification Exam is mandatory for anyone who works as a sales representative or approved user of a Currency Derivatives Market Segment trading member.
Uses of currency derivatives
Currency derivatives are used for various purposes in financial markets. Here are some common uses of these derivatives:
1. Hedging against currency risk
Currency derivatives are used to manage currency risk for businesses engaged in international trade. When companies buy or sell goods in different currencies, they face the risk of exchange rate fluctuations affecting their profits.
By using currency derivatives, like forward contracts or options, businesses can hedge against these risks. This means they lock in a specific exchange rate for a future date, providing a level of certainty and protecting their bottom line from potential adverse currency movements.
2. Profit potential
Currency derivatives are used for speculation, allowing traders to bet on future currency price movements.
Traders can take “long” positions, expecting a currency to appreciate, or “short” positions, anticipating depreciation. Profits result from correctly predicting exchange rate changes.
This speculative use provides an avenue for individuals and institutions to capitalise on currency market fluctuations, potentially generating financial gains based on their forecasts of currency value shifts.
3. Arbitrage opportunity
Arbitrage involves exploiting currency price differences in different markets for riskless profit. Traders engage in arbitrage by buying a currency at a lower price in one market and simultaneously selling it at a higher price in another.
This simultaneous buying and selling takes advantage of temporary imbalances in exchange rates, providing an opportunity for traders to make quick, guaranteed profits.
Arbitrage helps ensure that currency prices in different markets remain closely aligned, contributing to market efficiency.
Conclusion
Currency derivatives are financial tools that help manage risks associated with currency fluctuations. They provide a way for businesses and traders to safeguard against exchange rate volatility. Understanding these instruments is crucial for making informed financial decisions.
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FAQs
Currency derivatives help traders and businesses manage the risk of currency fluctuations when dealing with international transactions.
Businesses engaged in international trade, investors, and financial institutions often use currency derivatives to protect against currency risks.
Currency derivatives derive their value from the underlying currency’s exchange rate. As the exchange rate changes, the value of the derivative contract also changes. Traders profit based on the favourability of their trade.
Hedging involves using currency derivatives to offset potential losses from adverse currency movements, providing a form of insurance.
While currency derivatives help manage risk, they also carry the risk of losses as their value depends on the accuracy of predicting currency.