Currency Trading – Introduction to Derivative instruments Part I | Trade Samaritan

Currency Trading – Introduction to Derivative instruments Part I

Foreign exchange trading market happens to be one of the largest financial markets in the world. On an average, foreign exchange worth $5.3 trillion is traded every day.

Increasing globalization is leading to an increase in exchange of goods and services (current account) as well as increase in investment related (capital account) transactions between economies. Such an exchange of goods, services and investments between economies is facilitated by exchange of price in different currencies depending upon the countries involved in the transactions. For current account transactions (exchange of goods and services), the exporters usually prefer payment in the currency of their resident country but if that currency is not freely convertible, for example Renminbi or Indian Rupee, the transaction is settled in any other freely convertible currency such as a US Dollar, Great Britain Pound, Japanese Yen or Euro.

With developing countries ever expanding their activities, the volumes of currency trading in the world market are always on an upward trend. Currency market depends on several factors and economies. For instance, one pip (smallest amount of change in the price say 0.0001) worth of change in the major currencies such as the US Dollar, Euro, Japanese Yen and Great Britain Pound leads to rippling effect on the foreign exchange market. Financial investors such as Hedge funds and Institutional investors also play a big role in impacting the market.

There are five financial (derivative) products commonly used to buy/sell/trade in foreign exchange.

Let us discuss these derivative instruments from the currency market perspective as to how do these five products function in a foreign exchange or a currency transaction. In the real world, most of the derivative instruments are simply used for speculation and hedging and the right may not even get exercised. It all depends upon the information available, market movement, view of the investor and the current prices. We shall be discussing these derivative instruments with examples, these examples may at times look theoretical compared to the real world as the currency and information sharing platforms are entirely computerized with high speed, volatility and communication. But please note that these examples will be useful to understand the underlying instrument and the fundamentals in detail.

currency trading

Spot

Spot transaction involves an exchange of two currencies. Delivery or settlement in a spot transaction occurs within two business days of the trade date. Spot transactions are single outright transactions involving exchange of currencies in pairs, for example USD/JPY or EUR/USD or USD/INR. The transaction is settled at a rate agreed on the date of the contract with a cash settlement. Such a settlement takes place within two business days.

Example of a Spot transaction

Mr. Abe a U.S. citizen buys a rupee bond issued in India, he needs to exchange U.S$ for the Indian Rupee to pay for it. So he engages with City Bank California for a spot transaction, the bank debits Mr. Abe’s account for equivalent US$ at the spot rate and remits the INR amount to India on his behalf.

Forward

Forward contract is an over-the-counter instrument which allows the parties to exchange a specified amount of different currencies at a pre-determined future date at a pre-determined exchange rate set the time of entering the contract. The exchange rate to be used to settle the transaction on the future date is decided on the date the contract is entered into. Companies usually enter into the forward contracts to prevent their profits from getting wiped off on account of an adverse currency movement. Companies hedge more than 40% of their currency exposure with forwards. Company if paying or receiving in foreign currency on any future date can simply lock the exchange rate with the help of a forward contract. Exporters can prevent the loss arising from devaluation and importers can prevent the loss arising from re-valuation or appreciation. Forward rates of the currencies depend on the prevailing interest rates in their respective home country and the foreign currency country.

Example of a Forward transaction

Xing Foods Limited is an exporter of bananas; the company has exported $1000.00 worth bananas to an importer in Bangladesh. Terms are 60 days net and an invoice for $1000 has been raised on the importer which has been accepted for payment. Xing Foods anticipates a downward movement in US$ and enters into a forward contract with its bank at the rate of 130.00. On the due date

If the US$ to Sri Lankan Rupee is 128.00, Xing Food will gain 2 points over the spot rate which will be bank’s loss.

If the US$ to Sri Lankan Rupee is 133.00, Xing Food will lose 2 points over the spot rate which will be bank’s profit.

Interest rate parity explained

Forward rate premium introduces a concept known as ‘Interest rate parity’. It relates interest rate differentials between home country and foreign country to the forward premium/discount on the foreign currency. The size of the forward premium or discount on the foreign currency should be equal to the interest rate differential between the countries of concern. If nominal interest rates are higher in country X than country Y, the forward rate for country Y’s currency should be at a premium sufficient to prevent arbitrage.  If domestic interest rates are lower than foreign interest rates, foreign currency must trade at a forward discount to offset any benefit of higher interest rates in foreign country to prevent arbitrage. If a foreign currency does not trade at a forward discount or if the forward discount is not large enough to offset the interest rate advantage of foreign country, arbitrage opportunity exists for domestic investors.  Domestic investors can benefit by investing in the foreign market. Hence investors get squared off for ‘giving up’ or ‘gaining’ interest depending on the currencies involved.

In case of a Euro and US$, the forward rate to buy USD against Euro will be at a discount against the spot rate. This is because of the interest rates prevailing in Europe and U.S., in this case Europe’s rate of interest is higher say 5% than U.S say 2%.  The investor is sacrificing investing in Europe at a higher interest rate which is compensated by a discount in the forward rate. So forward points adjustment will equalize this interest rate differential and compensate the investor for giving up the interest bearing currency.

 

Spot and Forward transactions are relatively simple and straightforward, both the products are over-the-counter products. In Part II we shall be discussing balance three derivative products namely; Futures, Options and Swaps.

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