It is a contract between two traders mutually agreeing to exchange currency at a fixed price in the future. ‘Derivatives’ means it derives value from underling value and also that it doesn’t have any independent value.
What are currency derivatives?
Underlying can be bullion, securities, currency, commodities, stock market index or something else. From the point of view of currency derivatives, underlying would mean the currency exchange rate. Derivatives help in hedging your portfolio against any risk, they can also be used productively for speculation and arbitrage.
Benefits of currency derivatives
Hedging – The primary reason why people enter into an agreement is hedging. For the uninitiated, hedging is a risk management instrument against any undesirable fluctuations in currency rates in the future.
Example – A company from India (XYZ Ltd) is conducting its business as usual with a company from America (ABC Ltd) and XYZ Ltd generally receives its payment after 2 weeks of the delivery date. If there is an unstable economic condition in the US, then there is a threat of currency value depreciation in the future which may result in a loss. To avoid such scenarios the companies will enter into a currency derivative agreement and ensure that it gets a fixed rate of exchange.
- Highly Liquid – The most liquid market in the world is said to be the foreign exchange market. Traders have the ability to enter and exit the market whenever they want without worrying about the market conditions. This is due to the availability of numerous traders and buyers.
- Fixed Lot Size – A lot size means the number of currency units per lot. The biggest advantage to this is that traders who participate in these contracts can trade multiple lots per contract.
- No Manipulation – Due to the giant size of the market and numerous players involved, it’s impossible to manipulate the market. Forget a single entity, even centralized banks with their high-volume of transactions can’t make any favored altercations.
- Arbitrage – You can make money hand over fist by taking advantage of the currency exchange rates in different markets and exchanges.
- Leverage – You can just pay a percentage of the value while trading currency derivatives instead of the full traded value. The percentage value is called the margin amount.
- Speculation – Using currency futures you can speculate short term movement in the markets. For example. If you’ve a hunch that oil prices are going to surge and impact India’s import bill, then you would buy USD expecting that INR would depreciate.
If these benefits look appealing to you then you can enter an agreement with another trader and reap the benefits by investing in currency derivatives, Know more about currency derivatives.
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