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What are Currency Derivatives?

John Lister
John Lister

Currency derivatives are a type of financial agreement that is based around the relationship between two foreign currencies. The agreement usually involves two traders making a deal to exchange currencies at a fixed rate on a future date. The difference between this rate and the actual market rate on this date will determine who comes off better from the agreement. Either party can sell his position in the agreement to a third party before the agreed completion date, thus making the agreement itself a financial asset.

The most basic of all currency derivatives is the forex swap. This is simply an agreement to exchange a set amount of one currency for a set amount of another currency on a future date. For example, it might involve exchanging $100,000 US Dollars (USD) for 150,000 euros. Unless the actual exchange rate on that date is 1.5 euros to the dollar, one trader will be better off, as he can immediately exchange the money back at a more favorable rate, while the other trader will be worse off.

Various types of currency, including US dollars, pounds sterling, and euros.
Various types of currency, including US dollars, pounds sterling, and euros.

In some forms of forex swap, the two traders may agree in advance to simply calculate the amount by which each side would effectively profit or lose by completing the deal. Rather than the two sides actually exchanging the amounts listed in the agreement, known as the nominal, the losing trader will make a payment to the winning trader to achieve the same overall outcome. This set up appeals to many traders, as it does not require them to have the nominal amount in cash, which can limit the size of the speculation.

Other variants include the forex option and the binary option. The forex option means that one party in the agreement has the right to decide whether to complete the deal. This is a major advantage because the trader will only do so if the final position is favorable, and so the trader holding the option will usually pay a fee to the other trader to set up the deal. A binary option is where the final exchange is only made if the market exchange rate is at or above a particular level on the agreed completion date. In some forms of binary option, the exchange is made immediately if this level is reached at any point before the completion date.

There are several reasons traders engage in currency derivatives. One is simply as a form of financial speculation. Another is to hedge against other financial investments, to take a position that will pay off under circumstances that mean other investments have gone badly, thus mitigating the losses. Some businesses also use currency derivatives to provide more certainty. For example, a business exporting goods at the present time but receiving payment in a foreign currency at a later date might set up a forex swap so it can guarantee getting a set amount in its domestic currency.

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    • Various types of currency, including US dollars, pounds sterling, and euros.
      By: Joop Hoek
      Various types of currency, including US dollars, pounds sterling, and euros.