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Ten Things About Currency Derivatives

currency-derivativesThe rupee has been volatile for many months now, with newspaper headlines highlighting terms like ‘hedging’ and ‘currency risk management’ on a regular basis. In such critical times, investors need to protect themselves off the currency risk while investing across countries, and that is where currency derivatives comes into picture. Currency derivatives allow investors to hedge their existing positions against a possible fall or rise in the value.

Through this article, we’ll look at the some of the key points that one should be aware of before investing in currency derivatives.

Understanding The Financial Jargon Used In This Article

Hedging: Investment used to reduce any substantial losses

Currency Risk Management: Risk that arises from the change in price of one currency against another

Currency Derivatives: Transferable futures contract that specifies the rate at which currency can be bought or sold at a future date

10 Points To Know About Investment In Currency Derivatives

  1. A currency market is one of the most vibrant markets world-over. The value of one currency is expressed in terms of another. A currency derivative market is an extension of this market, except that it trades in currency futures. A currency future is when a trader fixes the transaction value of a currency to be bought or sold at a later period.
  2. In India, the rupee can be traded with the US dollar, the Great Britain pound, the Japanese Yen and the euro. The value of a currency in the derivatives market closely follows that in the active spot market.
  3. While the equities market is huge, it is the currency market – spot and derivatives included – that sees volumes as large as $4 trillion in a day, more so because it is always active. It also needs a lower minimum trading amount of $1,000 or Rs 55,000, while trading in shares needs Rs 2 lakh. However, you can invest in currency derivatives only through a broker.
  4. Some –especially importers and exporters– use the derivatives market for hedging against forex fluctuations. If you expect to receive payments in foreign currency, you bet against any rise in the rupee value. If you expect to make payments in foreign currency, you may need to hedge against a fall in the rupee value. Typically, investors use currency futures and options for this purpose.
  5. It can also be used for speculative purposes as a profitable investment option, using ‘Forward’ and ‘Future’ contracts.
  6. Considering the high volatility in the rupee, especially against the dollar, even a 10-paise change can add great value to one’s portfolio.
  7. Take a scenario where an investor purchases 100 USD-INR contracts (each contract size is $1000) in May for Rs 55,90,000 or Rs 55.90 a piece to be sold in June. Here, the investor is speculating that the rupee might depreciate. If, as foreseen, it weakens by 10 paise to 56 by the date of the derivative’s expiry, then the investor earns Rs 56, 00,000. Thus, he sees a profit of Rs 10,000 despite a weaker valuation of rupee. Had he been trading in the spot market, it would have meant losses. Similarly, traders can also speculate, and bet, against a possible appreciation in the Indian currency.
  8. Often, investors dabble in both the spot and futures market – buying in one, and selling in the other – to minimise any potential losses. For example, a trader buys $100 in the spot market, but is unsure if the dollar will strengthen against the rupee over the short term. So he sells a similar amount in the futures market. Just as he feared, the rupee appreciates by 10 paise. In such a case, any losses in the spot markets will be offset by proportionate gains in the derivatives market, thus acting as safety net.
  9. A contract is valid up to 12 months. However, liquidity would be an issue if it is held over 6 months. Nearer the expiry, higher is the value you get, as predicting in the short term is easy.
  10. A dollar-rupee pair easily moves up 4-6% in a year. This is similar to returns from a savings bank rate (4%) and debt mutual fund (6%), but has a lot more risk.

Do you invest in currency derivatives or are planning to? Do you have some tips or information to share with us? Please leave them in the comment section below. Also check our other articles on investment and stock market.

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