Currency Derivatives

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Currency derivatives

Introduction

Currency derivatives come in to existences as a hedging tool. As against unfavourable appreciation and depreciation of a single currency. Exporter, importer and financial investor have developed a vast range of currency derivative instruments are also used by speculators willing to arrange future currency selling or buying contracts while hoping hoping to buy or sell the currency at favourable anticipated exchange rates in the future. This act of speculator exposed them to the risk of financial fluctuation.

Currency based derivatives are complex financial instruments that are “derived” from the underlying currency exchange rate. They includes currency forward “buying” or “selling” contract, “buy” or “sell” currency future, call and put options, currency swaps and various combination of these instruments.

Brief overview

As currency based derivatives are defined as complex financial instruments that are “derived” from the underlying exchange rate. As any other financial product they can be used for risk hedging or speculation. When the underlying exchange rate exhibits a higher degree of fluctuation. Thus generating financial risk. Therefore currency based derivatives are not possible in fixed exchange rate system. Currency derivative has a significant role to play as hedging and speculative instruments in floating exchange rate system. Especially if currency spot rate is very volatile.

Currency based derivatives are used by exporters invoicing receivables in foreign currency, to protect their earning from the foreign currency depreciation by locking the currency conversion rate at a higher level. Currency based derivatives are used by importer hedging foreign currency payable is expected to appreciate and the importers would like to guarantee a lower conversion rate.

Investor in foreign currency denominated securities would like to secure strong foreign earning b obtaining the right to sell foreign currency at a high conversion rate. Thus defending their revenue from the foreign currency depreciation. Multinational companies use currency derivatives being engaged in direct foreign currency for various payments related to the installation of a foreign branch, or to a joint venture with a foreign partner.

A high degree of volatility of exchange rate creates a ground for foreign exchange speculator. Their objective is to guarantee a high selling rate of foreign currency by obtaining a derivative contract hoping to buy the currency at a low rate in the future. Alternatively they wish to obtain a foreign currency forward buying contract, expecting to sell appreciating currency at a higher future rate. In both the cases they are exposed to risk of fluctuation. Speculative action may have a stabilizing character on exchange rate when observed trends of the exchange rate is expected to be reversed. Eg.when the foreign currency has been depreciating in domestic currency terms but it is expected to appreciate in the foreseeable future, speculators will aggressively buy it, thus contributing to the currency advanced appreciation. Adversely, when the foreign currency has been appreciating but it is expected to depreciate, speculative selling may speed up its depreciation or stabilize the currency rate.

History of Derivatives Markets in India

Derivatives markets in India have been in existence in one form or the other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading way back in 1875. In 1952, the Government of India banned cash settlement and options trading. Derivatives trading shifted to informal forwards markets. In recent years, government policy has shifted in favour of an increased role of market-based pricing and less suspicious derivatives trading. The first step towards introduction of financial derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995. It provided...
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