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

Currency Trading – Introduction to Derivative instruments Part II

In today’s global markets a good understanding of how foreign exchange can affect your business and investment decisions is crucial. Derivative products facilitate hedging of currency volatility risk and opportunity to make speculative profits. In this part we shall discuss Futures, Option and Swaps with examples.

In Part I, we discussed along with examples the two most commonly used currency trading products; Spot and Forward. Now let us discuss Futures, Option and Swaps with examples.

currency trading

Futures

Chicago Mercantile Exchange introduced currency futures in the year 1972 immediately after the gold standard was abandoned by the U.S President Richard Nixon. Currency futures contract is an agreement between two parties made through an organized exchange. Investors typically use a futures contract to hedge the currency risk and traders use them to make speculative profits. Futures contract have to abide rules and regulations laid down by the futures exchange and the regulating bodies. The contract is for a specific amount of a specific currency to be bought or sold at a specific future time determined by the exchange. Inter-day losses and gains are posted each day during the life of the futures contract. This process is known as marking to market. The difference between today’s futures price and yesterday’s futures price is the inter-day or intermediate loss or gains. Futures contracts can be traded on any day or on the range of dates even before the expiry. Every futures exchange as a clearing house that takes care of the transaction once the trade is completed. Parties entering into a futures contract are required to deposit margins with the exchange to demonstrate their ability and capacity to pay and fulfill their contractual obligation.

Option

Currency option is a popular foreign exchange instrument used in the financial markets. It is a contract that grants the holder of the option the right, but not the obligation to buy or sell a currency at as a specified exchange rate during the specified period of time. Call option is the right to buy the currency and a Put option is the right to sell the currency. It is important to remember that the holder of an option be it Call or Put has the right to exercise it but is not obliged to do so. The seller or the writer of the option is liable to take the delivery if the buyer decides to exercise the option he holds. The buyer of the option pays a premium to buy a call option from the seller of the option. It is also important to note that the holder of the option is bearing almost no risk as if the market price of the said currency is more favorable compared to the option price, he will lose the premium/cost he paid to buy an option, however if the market price of the currency is adverse compared to the option price, the holder of the option will exercise the option and the seller of the option will incur to the tune of the difference between the option price and the market price.

American style – This type of option can be exercised at any point up until expiration.

European style – This type of option can be exercised only at the time of expiration.

Example of an Option transaction

Mr. Xavier M sells the below option to Miss Lin Fin Tau:

Face amount US$ 50,000.00; option type Yen Put (buy US$ for Yen), tenor 30 days, strike price 101.00, cost JPY 500.00 and it is a European style option.

Miss Lin Fin Tau has bought this put option from Mr. Xavier as she assumes that the Yen will fall not only below US$101.00 and but also below the spot rate 100.00. She will still be able to buy US$ 50,000.00 at 101.00 and make an excellent profit. Let us look at some scenarios now:-

If USD/JPY market or the spot price on the 30th day is 99.00; this means that Yen has strengthened against the US$, Miss Lin Fin Tau will not exercise the put option and buy US$ at the spot price of 99.00 which is 2.00 points higher than her option price. Mr. Xavier gains a profit of JPY 500.00 which is the cost (premium) of the option he sold, which is the same as the amount lost by Miss Lin Fin Tau in this entire transaction.

If USD/JPY spot price on the 30th day is 102.00 this means that Yen has weakened against US$;   Miss Lin Fin Tau on the 30th day will surely exercise the put option and buy US$ 50,000.00 at an option price of 101.00 which is now 1.00 point higher or stronger than the spot price of 102.00.  So the net profit of Miss Lin Fin Yuan is:

50000 X (102 – 101) – 500.00 (premium paid for the un-exercised option)  = JPY 45,000.00. This is the amount lost by Mr Xavier.

Swap

A foreign exchange swap is an over-the-counter and a short term derivative instrument. In foreign exchange swap, one currency is swapped against another for a short period of time, and then the same is swapped back, this creates an exchange and re-exchange. A transaction under foreign exchange swap has two separate legs settling on two different value dates. The transaction however is recorded as a single transaction. In principle a foreign exchange swap is a combination of a spot and a future transaction as it has one deal rate for the ‘near date’ and another deal rate at the ‘far date’. The ‘far date’ deal is to reverse the ‘near date’ deal. The tenor of a foreign exchange swap varies between a few weeks to three months and hence this is a short term derivative. Foreign exchange swaps are most suited to companies who have an excess of one convertible currency and need another convertible currency. The interest rates in the countries of the two currencies decide the cost of the swap.

Example of a Swap transaction

Bell Company based in Europe has Euro 100000 in the bank and has a short term funding requirement USD 75000 for a joint venture it is establishing with a U.S. based company Bliss Inc. Bell Company does not wish to take any foreign exchange risk and wishes to hedge the transaction entirely. So Bell Company decides to enter into a foreign exchange swap with Welcome Bank in Europe. So Bell Company will enter into a foreign exchange swap with the Welcome bank in Europe. The foreign exchange swap is recorded as one transaction but has two underlying exchanges or deals. Bell Company will sign up two contracts spot and forward at the same time to be executed on different dates.

Deal 1:  Bell Company to sell the Euro 100000 it has to the bank at 0.75 spot rate on the ‘near date’

Deal 2: Bell Company to exchange the USD back with the bank on the ‘far date’ at the forward rate of 0.7455 (forward points of -0.0045 are adjusted as explained earlier in the forwards section). Here’s what happens:

On the ‘near date’; Bell Company gives the Welcome bank Euro 100000 and Welcome bank remits USD 75000 to Bliss Inc. in the U.S on Bell Company’s behalf.

On the ‘far date’; Bell Company will pay USD 74,550 (Euro 100000 x 0.7455) to Welcome bank and the bank will credit Bell Company’s account with Euro 100000.

Foreign exchange swap is an excellent and most flexible derivative instrument available over-the-counter. It is widely used for purposes like hedging, funding, speculations and also for regulating the markets. This derivative instrument is commonly by the regulating bodies of the economies to manage their monetary policy, for instance, governing and regulating authorities can restrict and inject the circulation of the desired currencies in the markets by entering into foreign exchange swap transactions with the banks.

Currency trading is becoming increasing popular as the investors who are disappointed with bonds and securities are usually keen to try their luck in the currency market. It will be seen that currency trading is not only done for hedging the currency risk but also to gain a speculative profit. 60% – 65% of the currency transactions are speculation driven.

 

References:

Bloomberg

Foreign Exchange, An introduction to the core concepts by Mark Mobius

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