In my previous articles, I covered the topic of OTC derivative and its types that are Credit Derivatives and Interest Rate Derivatives . Continuing with our coverage on Derivatives,today,I take up Currency and Commodity derivatives as the next topic of discussion.
What are currency derivatives?
Currency derivatives are defined as the Future and Options contracts that one can buy or sell in specific quantity of a particular currency pair at a future date (Wikipedia). The underlying would be a currency exchange rate. It is generally unlisted and thereby traded OTC (over the counter).
In the Indian markets, Currency Derivatives are available on four currency pairs namely US Dollars (USD), Euro (EUR), Great Britain Pound (GBP) and Japanese Yen (JPY). Currency options are currently available on US Dollars.
Foreign exchange (FOREX) is the simultaneous buying of one currency and selling in another.
Forex derivatives are defined as type of a financial derivative in which the payoff depends on the foreign exchange rate of two or more currencies. It basically helps in locking the future foreign exchange rate. It is used to transfer liquidity from one currency to another keeping the currency risk aside.
Types of Forex Derivatives
- Forex swaps
- Forex future contracts
- Forex currency swaps
- Forward purchase or sales
Different products of the currency derivatives segment
The trading can be in futures and options or carry forwards or could be intraday depending when the position is to be squared off.
Forward markets facilitate the trading of forward contract on currencies. When one can anticipate future need or receipt of foreign currency, forward contracts can be set up to lock-in the exchange rate.
Currency future contracts can be used to hedge currency positions or capitalize on expected exchange rate movements. Currency derivative contracts are traded in pairs like Rupee-Dollar, Rupee-British pound or Rupee-Euro. Price fluctuations in the currency contracts are linked to the economic indicators of the particular country of which the currency is being traded. Thereby, trade balance, interest rates, inflation and political risks affects the movement of the currency futures contracts.
Types of currency derivatives
Currency options: It gives the right but not obligation to buy /sell currency in exchange for another currency at a predetermined price and date.
Currency forwards: It is a contract between two parties to buy / sell underlying asset at a predetermined price at a later date.
Currency swaps: It is an agreement to exchange payment flows in two different currencies with each other on different dates.
Benefits of currency derivatives
- They are efficient risk management instruments
- They can be used for hedging as well as to speculate on short term movements in the market
- They are widely used arbitrage instruments
- They can be used to leverage by paying the margin money and not the full traded value
- They can be used to protect holding
Disadvantages of currency derivatives
- There is high risk of loss when options are issued
- Extensive monitoring of the price performance needs to be done
What are Commodity Derivatives?
A commodity is defined as a basic good that is used as an input in the manufacturing of other goods or services.
Commodity derivatives are defined as the exchange traded or OTC like futures, forwards and swaps with the underlying being non financial commodities.
The underlying could be:
- Metals (gold, silver)
- Agro products (coffee, wheat)
- Energy products (crude oil, natural gas)
There are exchanges dedicated to the trading of commodity derivatives which facilitate the settlement and clearing of the contracts. Commodities are traded on exchanges based on margins which change based on the market volatility as well as the face value of the contract.
Commodity derivatives can be structured as
- Commodity future: It is the agreement to buy /sell fixed amount of commodity at a predetermined price and date.
- Commodity forward: It is a forward contract / agreement between two parties to exchange given quantity of a commodity at a fixed future date for a price predefined in the contract.
- Commodity option: call/put: It is a contract that gives the holder the right but not obligation to buy (for a call) or sell (for a put) a futures contract on a certain commodity at a given strike price on or before the expiration date.
- Commodity swap: These are of two types namely fixed floating and commodity for interest. It is an agreement where a floating price based on an underlying commodity is traded for a fixed price over a specified period of the contract.
Why do we need commodity derivatives?
With the prices of commodities fluctuating over time, adverse price changes in future create risk for the business. This risk can be dealt with the help of commodities future or options contracts which will help in hedging the price risk and on the other hand also provide investment opportunity to speculators for a possible return. They are generally traded by the investors who have no need for the commodity itself.
E.g. Gold producer will want to hedge losses related to fall in gold prices for the current inventory that he is holding. This can be done by entering into commodity derivative form.
Commodity derivatives allow investors to invest in non-financial resources without actually owning it or spending too much money on it. They largely depend on the demand and supply and thereby predicting the fluctuations in the value of the commodity derivatives is comparatively easier.
Crude oil producer and refiner may enter into swap contract on crude oil prices. Normally banks and financial institutions act as the counterparty of the swap deal. Similarly a swap dealer and natural gas producer can enter into a contract to swap natural gas price.
Currency derivatives help in mitigating the risk associated with the currency fluctuations. On the other hand, commodity derivatives have a lot of potential in strengthening the Indian economy. These are alternative sources of investment for investors which if done systematically can help earn well in the long run.