What Are Foreign Currency Derivatives?
The foreign currency market is the world’s largest and the biggest market no doubt. Forex exchange is often known as Forex or FX. Both terms are quite common for foreign exchange market. When we look at this market, it becomes clear that the market itself is based on trading the different currencies. We can take some example like U.S dollars are exchanged for Euros. This market is also involved in trading the currency derivatives. Currency derivatives are the financial instruments that are based on the foreign currency.
What is a Derivative?
Derivatives are the financial instruments that do not possess a value themselves like currency notes. But their value resides on the value of something else like a stock, bond etc. So in reality, derivative is based on some other unit and its value and it has no value itself.
Types of Derivative Strategies in the Foreign Exchange Market:
In foreign market, the currency derivatives are based on two main strategies. These contracts basically facilitate the traders to hedge or speculate. Speculation takes place when a trader claims or bets that a particular currency will decrease or rise and he agrees upon a contract to buy or sell the particular amount of the currency at some specified time in future. And hedging is exercised to reduce the risk by the traders. For example, a trader can buy a foreign currency A to counterbalance the risk of having only foreign currency B. So, the potential losses from one currency may be offset against the gains of the other.
Foreign currency strategies are actually pursued with the help of two ways and the first way is call an option. Options can be defined as the right to buy and sell the specific amount of money at some previously defined prices. A trader has a right to buy that option from the market and he may or may not use it by considering the trends of the market. For example, a trader who has purchased an option to sell the foreign currency A at $10 and after buying that option the price of that currency dropped to $5 then will have right to sell it at $10. This is because he had purchased an option from the market already. So in this way the trader will gain the benefit.
The second method through which the derivatives are being utilized in the foreign exchange market is known as the Future contracts. A futures contract demands that a trader has to deliver a specified amount at some specific date. So the difference between the option and the futures contract is that options are willingly whereas futures contract are obligatory. An example can illustrate futures contract in a better way. If a trader provides his consent to sell a foreign currency for example that is A at a price of $20 in two months then he has to do this. He cannot refuse whether the price of the currency falls or rises because he has provided his consent already.