Nur Afni Latin

C1B014024
International Financial Management

Currency Derivatives
Currency derivatives are complex financial instrumens and this is a collective term for
instruments such as options, futures and swaps. The derivatives value is based on he underlying
assets; the price is influenced partly by the interest rate, remaining maturity and volatility. The
characteristic of a derivative is that it is linked to events or conditions at a specified time or
period in the future.
How currency derivatives work ? currency derivatives are used to hedge a future payment
or receivable in a foreign currency or to change a currency exposure over time. A currency
derivative primarily reflecs the interest spread between its component currencies. A currency
derivative is tailored to customer needs regarding maturity, level, amount, and more. It is usually
an unlisted instrument and is traded Over The Counter (OTC).
Basic of currency trading :
Forward Contract : agreements to exchange currencies at an agreed rate on a specified
future date, actual settlement date is more than two working days after he deal date, forward
contracts are privately negotiated, traded outside an exchange and suffer from counter party and
liquidity risks. Forward contracs are often valued at $1 million or more, and not normally used
by consumers or small firms. As with the case of spot rates, there is a bid/ask spread on forward
rates. Forward rates may also contain a premium or discount, if the forward rate ecxceeds the
existing spot rate, it contains a premium; if the forward rate is less than the existing spot rate, it
contain a discount.
Annualized

forward

premium/discount

forward ratespot rate

360
x
spot rate
n (number of day maturity )
Future Contracts : these are agreements to buy or sell an asset for a certain price at a
future time, exchange traded and standardized contracts, no counter party risk as settlement is
guaranteed by the exchange. To minimize its risk in such a guarantee, the exchange imposes
margin requirements to cover fluctuations in he value of the contracts. Future contacts specify a
standard volume of a particular currency to be exchanged on a specific settlement date, typically
the third Wednesday in March, June, September and December. They are used by MNCs to

hedge their currency positions, and by speculators who hope to capitalize on heir expectation of
exchange rate movements.
Option Contracts : traders can also buy currency option contracts, and here he commits
for a future exchange of currency with an agreement that the contract will be valid only if the
price is favorable. Pays a premium for this.
Strategis using currency trading :
1. Hedging, means taking a position in the future market that is opposite to a
position in the physical market with a view to reduce or limit the risk associated
with the unpredictable changes in the exchange rate.
Types of hedging : short hedge and long hedge.
2. Speculation, is to take risks and profit from anticipated price changes in futures
price of an asset.
Types of speculation : long position and short position.
Advantages and disadvantages of currency derivatives :
1. A currency forward enables you to avoid currency risk during the hedge period.
2. With a currency swap, you can change currency flows over time.
3. Currency forwards and currency swaps are not traded over a marketplace, but are
tailored a specified risk
4. They can produce yields regardless of whether he market rises, falls or remains
unchanged.
5. Currency swaps are appropriate as a risk distribution tool, since they;
6. Can be used to protect a holding
7. Can produce a higher yield with a lower capital investment than normally
required for an equivalent transaction directly in the underlying currency pair.
8. Create the opportunity to realize a profit in an underlying asset, while also
profiting from further prices rises.
9. They require extensive monitoring of the price performance in the derivative
instrument and the underlying exchange rate.
10. The risk of loss may be unlimited when issuing options.