Derivatives - Financial "Power Tools" To Manage Forex Risk
Assuming you’ve read our post about the basic of hedging, you’re probably now asking the key question, “how?” How do you implement a Forex (foreign exchange) hedging strategy for your business? That conversation begins with derivatives.
What Are Derivatives?
Derivatives are a value derived from something else. In the financial world, derivatives are contracts whose value depends on an underlying asset. These assets can include stocks, bonds, commodities, currencies, interest rates, market indexes, or even crypto.
In the foreign exchange market, derivatives obtain their value from currency exchange rates. The two primary purposes of derivatives are hedging (mitigating risk in pursuit of predictability) and speculation (taking on risk in pursuit of profit).
Four commonly used derivatives are:
We will provide you with a basic overview of the four major derivative contract types here, but we will dive deeper into each kind in future posts.
The two primary purposes of derivatives are hedging and speculation.
FORWARDS
Forwards are the bread and butter of the hedging market. They offer a simple contract that brings a buyer and seller together in an exchange of goods. Both parties agree to an exact price and delivery date for the goods. Forwards are made over-the-counter (OTC), an industry term meaning the contracts are privately negotiated, more flexible, and less regulated.
A currency forward is a contract that locks in today’s exchange rate for the purchase or sale of a currency on a future date. Because you know the foreign currency’s future price, you can feel secure that unexpected movement will not harm tomorrow’s profits or expenses.
FUTURES
Futures are the forwards’ twin. Again, it involves a buyer and seller negotiating a specific future price and date for goods. The big difference is that futures contracts are standardized and traded on centralized exchanges. Because they are regulated, they come with fixed maturity dates and terms. The exchange guarantees the contract, eliminating counterparty risk. In other words, they are less customizable but more flexible to enter and exit.
Currency futures contracts allow you to lock in the exchange rate between two currencies. They protect against either upside or downside currency moves. Futures contracts include all the “major” currencies, including the euro (EUR), British pound (GBP), Australian dollar (AUD), Japanese yen (JPY), Canadian dollar (CAD), and Mexican peso (MXN), and some minor currencies.
OPTIONS
Options contracts provide the opportunity to buy (or sell) something at a specific price on or before a particular date. There is a big difference between the contractual obligations of the buyer and the seller.
- The buyer pays a fee called the premium, like insurance, for the opportunity to buy or sell something at a pre-agreed price. However, they have no obligation to exercise their contract.
- The seller incurs an obligation. They agree to grant the right to the buyer to purchase or sell something at a pre-agreed price. They have no choice but to honor the contract if the buyer exercises it.
- Like futures and forwards, currency options provide the buyer an opportunity to make a future purchase of a currency at today’s rate. However, since they offer the option and not the obligation to buy or sell, they come at a higher cost due to the built-in flexibility of the product.
SWAPS
A currency swap, sometimes referred to as a cross-currency swap, involves the exchange of interest and principal in one currency for the same in another. Interest payments are exchanged several times throughout the life of the contract.
The significant difference between swaps and forwards is that swaps result in several payments in the future. In contrast, a forward contract will result in a single future payment.
Major corporations typically enter into swaps for large sums, often in conjunction with cross-border debt obligations. You won't encounter them much in the normal course of business.
Why Use Derivatives?
You can use derivatives in two ways:
- to mitigate risk (hedging) or
- to accept risk (speculation)
Hedging
Derivatives can help limit your risk by reducing the impact of market volatility. For example, say the ACME Corp, based in the U.S., has 12 employees based in Europe.
The company is worried the euro (EUR) will rise, so they use a futures contract to lock in today's euro price before it rises. Therefore, the cost of paying the employees in Europe will remain the same throughout the year. The futures contract has eliminated the euro-dollar volatility.
Speculation
Speculators use derivatives to make a profit. Let's say a speculator believes the euro (EUR) will rebound and go higher in the next year. They can purchase a call option at today's price and make a profit if the euro (EUR) goes up.
What's Next?
So now you have an overview of the four main types of derivatives used in forex. The next step is determining your forex exposure and which strategy is best suited to help mitigate that risk. An in-depth explanation of each type will help you decide which method to deploy.
Takeaways
- There are four types of forex derivatives: forwards, futures, options, and swaps.
- These products allow you to lock in an asset's current price to be paid at an agreed date.
- Each type of contract is unique but based on a buyer/seller relationship and has an agreed price and maturity date.
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