Heard about foreign exchange derivatives? Can’t wrap your head around what they are and how they work? Read on for a simple, no-nonsense explanation.
What is a foreign exchange derivative?
A derivative is a contract between parties, the value of which is based on an underlying asset, security or index (often known simply as the ‘underlying’). A foreign exchange derivative is a contract to sell or buy foreign currencies at a set point in time.
When are Forex derivatives used?
A foreign exchange derivative contract essentially locks in that future exchange rate
, and it’s used by Forex traders to ‘hedge’ (that is, seeking to lock in a price to diminish the risk of a future price change) or ‘speculate’ (that is, entering into a trade to seek potential gains) against potential future changes in the market. From a buying trader’s perspective, it transfers some of the risk to someone who’s more willing to carry that risk until the settlement date.
Types of foreign exchange derivatives
Four of the most common derivative contracts within the foreign exchange environment are futures, forwards, options and swaps:
Future contracts are arrangements to buy or sell quantities of a currency on a certain date at a pre-arranged price. The related profits or losses are realised and paid at the end of every day. They are one of the most standard foreign exchange derivative types.
Forward contracts are similar to futures, except that related profits and losses are realised and paid out at the end of the contract. These are not an overly common option for Forex traders.
Option contracts form an arrangement in which the holder can choose to buy or sell a quantity of currency at a set price at any time leading up to an expiration date. Holding a ‘call’ option gives you the right to buy (which can mitigate the risk of a rising exchange rate
), while a ‘pull’ option gives you the right to sell (which can mitigate the risk of a falling exchange rate
). These options may be simple ‘vanilla’ options, or ‘exotic’ options with additional terms.
A swap is an arrangement where two parties agree to simultaneously buy and sell the same amount of two given currencies, essentially exchanging the terms of interest rates payments. This may occur when one party is looking for a steady yield when the other seeks a floating-rate payment that they believe may improve in yield. A swap can be a swap against a forward contract.