Currency Derivatives

Following on from our discussion of interest rate derivatives, which hedge against fluctuations in interest rates, we now consider currency derivatives. Just as interest rate derivatives are a hedge against movements in rates, currency derivatives are an important tool to manage the risks and opportunities presented by changes in exchange rates.

These are widely becoming an important instrument in world financial markets to help businesses and investors hedge foreign exchange risks or speculate on fluctuations in the values of currencies. As the integration of the Indian economy with the world market proceeds, so is the popularity of currency derivatives growing. Whether corporate treasurer, exporter, or a mere investor, the key aspect in learning how these instruments will help in a way forward through currency volatility with a purpose of optimizing your returns.

What are currency derivatives?

Currency derivatives are contracts whose value is directly determined through the exchange rate of two currencies. Major types include:

1. Currency Futures: These are standardized contracts traded on the Exchanges like NSE or BSE. Participants agree to buy or sell a currency at a predetermined rate on a future date.
   

2. Currency Forward: A customized contract between two parties in order to exchange currency at a set rate on a future date. Unlike the future, forwards are over-the-counter traded and not standardized.
   

3. Currency Options: These provide the right but not the obligation to buy or sell a currency at a predetermined exchange rate prior to a given expiry date. Options are valuable in hedging and speculation with limited risk, as opposed to the commitments involved in futures and forwards.
   

Why are currency derivatives important?

With the Indian economy increasingly opening up to the rest of the world, the rupee is becoming increasingly volatile. The derivatives on currency help to hedge risks that come with the volatility, especially for a company dealing in international trade.

1. Hedging Against Currency Risk: It may involve setting a fixed exchange rate for future dates with the use of a currency forward. For instance, an Indian exporter who receives payments in U.S. dollars could hedge against that currency risk by locking in an exchange rate in order to avoid losing money on a weaker rupee. This would guarantee revenue predictability regardless of unexpected changes in the currency.
   

2. Currency Movement Speculation: The investor can speculate on the movement of currencies with the help of these currency derivatives. In other words, if the investor expects rupee to appreciate against dollar he would buy currency futures. However, speculation carries a lot of risk, more so in a volatile forex market.

3. Diversification: The derivatives on currencies represent one more avenue for diversification of the portfolio. Because currencies move contrary to the stock and bond markets more often, they reduce risk in an overall portfolio that could otherwise rise amid economic uncertainty.
   

Regulatory Framework in India

The RBI and the SEBI are the two most prominent regulators for the currency derivatives market in India. While the RBI prescribes guidelines on forward contracts and governs the forex market, it is the SEBI that regulates the trading in currency futures and options on exchanges.

The introduction of currency futures on Indian exchanges in the year 2008 brought more transparency and liquidity into the markets. The emergence of NSE as one of the single largest currency future exchanges in the world helped Indian market participants to diversify into a wide range of currency derivatives.

Conclusion

As Currency derivatives play a key role in the market for traders and investors. Commodity derivatives are extensions of the concept of risk management and offer similar benefits to companies and investors facing commodity price volatility. Be it agricultural products, energy, or metals, commodity derivatives have emerged as an efficient means of hedging against the volatility of prices. In this context, as India remains one of the key players in global commodity markets, learning how to use these derivatives will be paramount for hedging and investment strategies in the future.