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.
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