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Derivatives for Beginners: Foreign Derivatives Explained

When dealing with foreign exchange, derivatives have always been in the picture. But what are derivatives? To understand what foreign derivatives are, an individual must know the general sense of the derivative market.

What Are Derivatives?

A product that derives its value from other assets or groups of assets such as bonds, stocks, commodities, interest rates, currencies, and market indexes is called derivatives.

It is a contract between two or more parties that depends on other assets. These assets are often referred to as the “underlying asset,” and their value fluctuates. When the underlying asset’s value fluctuates, the worth of the derivatives changes as well.

There are four major classifications of derivatives.

1. Forward Contracts or Forwards

Forwards have a pre-agreed price that the buyer is obligated to pay at an agreed future date no matter what the asset’s current value may be and vice versa. The parties involved are private parties who can customize the contract, and there’s always the possibility of one party defaulting.  Forwards are settled at the end of the contract. 

2. Futures Contracts or Futures

Futures, unlike forwards, have values that are determined day by day until the contract reaches its end. This is also known as “Marked-to-Market” daily. These contracts are traded on exchanges and are considered standardized contracts.

3. Options

Options, like its name, give the buyer the right, but not the obligation — to buy or sell the underlying asset. To accommodate the transaction, a premium must be paid whenever an individual wants to buy an option.

There are two types of options: call and put.

4. Swaps

Swaps are exchanges of cash flows between parties.

The most common swaps are:

  • Commodity Swaps
  • Currency Swaps
  • Interest Rate Swaps

These derivatives classifications have different advantages and disadvantages. All of which can contribute to their attractiveness to an investor with their specific objective in mind.

Why Choose Derivatives?

Among the securities accessible in the financial market, derivatives have been utilized by almost every trader. With the availability of more than 600 trillion derivatives outstanding, a trader can exchange with others easily.

Derivatives help investors manage and tailor their underlying assets to their best advantage, to get to their investment goals. It can be through:

  • Interest rate swaps
  • Credit derivatives
  • Equity options

Derivatives are important in trading as they help in finding the right strategy for each trader. But mostly, they do two things.

Derivatives Manage or Hedge Risk

“Hedging” is a strategy that refers to the goal of minimizing existing risks in the market.

One side of the parties can benefit greatly when the price of a commodity fluctuates, but at the same time, they can also lose a lot if the fluctuation didn’t go in their favor. This is also referred to as the “Zero-Sum Game” as there is a definite winner and a definite loser. The parties involved are aware of this risk, so they come together and agree on a contract to essentially pick a price that benefits both of them.

With a derivative contract that hedges the price, quantity, and date where they exchange assets, all parties can become winners as they avoid the effect of fluctuation. By hedging the risk of fluctuating prices, an individual can mitigate the many risk exposures he’s subjected to.

Derivatives Help in Speculating Profits

Aside from mitigating risks, derivatives can also be used in speculating prices. The idea of profit drives this. The profit comes from the additional value of the asset in the future.

What Are Foreign Derivatives?

Foreign derivatives are financial derivatives that depend on the exchange rates of currencies involved. These derivative contracts can sell or purchase currency at any time in the future. Importers and exporters usually use them to redistribute the risk of changing currency values.

Some specific Forex derivatives are the following:

  • Foreign currency forward contracts
  • Foreign currency futures
  • Foreign currency swaps
  • Currency options
  • Foreign exchange binary options

These derivatives can be used as a stand-alone or a mix of two or more.

Foreign Exchange Risks

An individual might find themselves dealing with different currencies depending on their investment or business. When two or more currencies are used for the transaction, there is always the risk of the value of the currencies changing. What can be $2 today can be $1, $3, or remain as $2 tomorrow.

Although the difference in the values is minor, the impact becomes great when multiplied by many assets and affects the individual’s portfolio. Both individuals and corporations use derivatives to hedge this risk.

Should You Invest in Derivatives?

The trading volume of derivatives is only increasing as the days go by, with individuals and companies buying and selling their derivatives to take advantage of what these financial securities can do. Derivatives are a powerful tool that can help the trader reach his goals, and investing in them is a smart way to manage your currencies.

 

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