What is Currency Derivatives?
Currency derivatives are essential for managing foreign exchange rate volatility. They work like stock options and futures but trade currency pairs. These contracts lock in exchange rates for the future to protect against currency fluctuations. Banks, exporters, importers, and corporations trade the euro, pound, dollar, and yen in India.
Understanding Currency Derivatives
Currency derivatives are mostly currency pair futures and options. You can exchange currencies at a predetermined price in the future with a currency futures contract. Foreign Exchange (Forex) Markets measure currency values relative to domestic currency. Businesses that trade internationally need these contracts to hedge against currency fluctuations. These contracts are usually settled in Indian rupees, but SEBI recently introduced euro-dollar, dollar-yen, and pound-dollar contracts, expanding trading options.
Currency derivatives trading
Currency derivatives can be traded on the BSE, NSE, and Metropolitan Stock Exchange of India, but the latter has lower volumes. A broker’s trading app makes trading these derivatives similar to trading equity and its derivatives. The standard dollar-rupee contract is $1,000, but traders only pay 2-3% to participate. Most top stockbrokers offer currency trading, making it accessible to many investors.
Reasons for Introducing Currency Derivatives on Exchanges
Before the introduction of currency derivatives on exchange platforms, individuals and businesses had to rely on the over-the-counter (OTC) market to manage currency risk. This OTC market was less accessible, and primarily used by banks and financial institutions. The introduction of exchange-based currency derivatives created a more transparent, regulated, and accessible market, allowing small businesses and individuals to minimise their exposure to currency risks effectively.
Uses of Currency Derivatives
Currency derivatives serve multiple purposes:
- Hedging: You can protect against foreign exchange exposure and limit potential losses by hedging through currency derivatives.
- Trading: These instruments allow you to capitalise on short-term market movements by tracking currency trends.
- Arbitrage: By exploiting differences in currency exchange rates across markets, you can generate profits through arbitrage.
- Leverage: In currency futures and options trading, you only need to pay a small margin instead of the full traded value, allowing you to control a larger position with less capital.
Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. It is based on several secondary sources on the internet and is subject to changes. Please consult an expert before making related decisions.