Currency Derivatives

DERIVATIVES

What are derivatives? 

A derivative is a security whose price ultimately depends on that of another assets (called underlying assets) i.e. its value is entirely `derived' from the value of the underlying asset.

Types of derivative contracts    

FORWARDS FUTURES OPTION SWAPS

FORWARDS

FORWARDS 

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In a Forward contract, the contracts are made to buy or sell currencies at a future date. The rates of exchange are agreed upon on the very day the deal is finalized by the buyer and seller.

Forward market hedging 

Forward market hedging is generally undertaken to reduce the risk due the changes in the exchange rate.

Example: An Indian exporter exports goods worth $1000 to USA and the payment will be received after 3months. SPOT & Forward rate : Rs 40/$ Rate After 3 Months : Rs 39/$ Thus the loss occurring due to the fall in the value of $ is met through Forward contract.

Speculation in Forwards 

Speculation in forward market is done to reap the benefits of the changes in the exchange rate i.e. diff between the forward rate and the future SPOT rate.

FUTURES

Futures 

A Future contract is an agreement between two parties to exchange one asset to another with the actual exchange taking place at a specified date in the future but with the terms of Exchange.

Features of a Future Contract     

Organized Exchanges Standardization Clearing House Initial Margin Money Marking to Market

OPTIONS

OPTIONS 

An Option is a financial contract in which a buyer of the option has the right to buy or sell an asset at a prescribed price on a specified date however there is no obligation for him to do so. The seller has an obligation to execute the contract if the buyer wishes to do so.

Types of Option Market   

Listed currency option Market : First set up at the Philadelphia Stock Exchange. Small fee for facilitating such contracts.

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Over-the-Counter options market :

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The size of the contract is large. European options are found in OTC market

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Currency Future options Market : Mixture of currency options and currency futures The options are Marked to Market.

Option Strategies  

Call Option Put Option

Call Option Buyer Gain = Spot price > Strike price =S - X - C Where :S = Spot price ; X = Strike price C = Premium Paid 

Sellers Gain = Spot price < Strike price = Strike Price – Spot Price If the Buyer executes the contract 

Contd… Example: A firm buys a call option. Contract Size : 62500 Strike price = Rs.60.50 per pound Premium = Rs.0.06 per pound Spot rate at maturity = Rs.60.60 Total Premium paid = 0.06*62500 = Rs.3750 Gain to the option Buyer : (60.60 - 60.50 - 0.06) * 62500 = Rs.2500 If the spot price is below Rs.60.50per pound The maximum loss to the buyer = Rs.3750

Contd… If the buyer does not execute the Contract : Gain for the seller = Amt of Premium Received

Put Option 

Buyers gain = Spot price < Strike price =X–S–C Where : S = Spot price ; X = Strike price C = Premium Paid

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Seller gain = Spot price > Strike price =S-X

American option v/s European option 

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The Buyer of an American option has the right to exercise the contract on or before the maturity date. The buyer of a European option can execute the contract only on the maturity of the contract date.

SWAPS

SWAPS 

In SWAP two parties come into an agreement to exchange the currencies at the prevailing rate and again reverse the transaction at the same rate at an agreed upon future date.

Types of SWAPS  

Interest rate Swaps Currency Swaps

Over-The-Counter Derivatives "Swaps" Currency Sw aps 12%

Interest-Rate Sw aps 88%

Interest rate Swaps 

An interest rate swap is a swap in which counterparties exchange cash flows of a floating rate for cash flows of a fixed rate or viceversa. No notional principal changes hands, but it is a reference amount against which interest is calculated. Interest swaps can be international or

Currency swap 

A Currency swap is a swap in which one party provides a certain principal in one currency to its counterparty in exchange for an equivalent amount in a different currency

CONCLUSION

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