While derivatives are commonly associated with equities, investors have the opportunity to trade derivatives across various financial instruments, including commodities, bonds, and currencies. This article delves into derivative trading within the currency segment in India, providing insights for those already engaged in diverse asset classes. Understanding currency derivatives not only opens avenues for portfolio diversification but also empowers investors to leverage macroeconomic factors for possible enhanced returns. To embark on this exploration, let’s start by unravelling the concept of currency derivatives.
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Defining Currency Derivatives
A derivative contract derives its value from an underlying asset like stocks or an index; or, in the case of currency derivatives, a currency. Transacting these derivatives allows you to buy or sell currencies on a future date at a fixed price. Currency derivatives are standardised on the basis of the foreign exchange market. There are four main types of derivatives in the currency segment: futures, options, forwards, and swaps.
In India, we have four currency pairs as underlying assets for actively traded currency derivatives:
- USD/INR
- EUR/INR
- GBP/INR
- JPY/INR
These contracts can help investors hedge against currency exchange rate fluctuations or speculate on the exchange rates in currencies like the Dollar, Euro, British Pound, and Yen. With Share India’s options calculator, you can see how changes in the underlying stock price, volatility, and time to expiration will affect the value of your options.
Types of Currency Derivatives in the Indian Market
The exchange-traded derivatives—currency futures and currency options—are the two currency derivatives primarily traded in India. However, the institutions may also trade less mainstream contracts like currency swaps. However, since the retail segment primarily trades futures and options, we will cover them in detail.
Currency Futures
- These contracts allow you to buy or sell a specific quantity of an underlying currency on a future date at a predetermined exchange rate.
- If you continue to hold the contract until the predetermined date, you are obliged to settle the contract.
- However, unlike stock futures, currency futures do not require you to take delivery of the underlying currency but instead oblige you to settle the difference in Indian Rupees.
- Speculators actively engage in trading currency futures but are likely to close their positions before expiry.
Currency Options
- Currency options function like other option contracts; i.e., the option buyer has the right to buy or sell a specific quantity of the underlying asset on a future date at a predetermined exchange rate.
- However, if the option buyer chooses to exercise the contract, similar to futures, the contract is settled in Indian Rupees.
- The seller is obliged to honour the buyer’s exercising right and settle the contract if the buyer exercises their right.
- The buyer pays the seller a fee called the options premium to purchase currency options.
Types
There are two types of options contracts, call options and put options; the former allows the options buyer to buy the underlying asset, while the latter allows the options buyer to sell the underlying asset.
- An options buyer would buy call options when they expect the price of the currency pair to rise. On the other hand, they may buy currency puts when they expect the price of the currency pair to fall. For example, if an options buyer expects the USD/INR to appreciate from 81.71 INR to 82.79 INR, they may consider buying USD/INR call options.
- An options seller would sell calls when they expect the currency pair to depreciate and sell puts when they expect the price to rise.
Currency Swap
A currency swap is a derivative that can help exchange the interest rate imposed by a lender in one currency for another currency. Swaps are complex derivatives that are traded over the counter, generally by institutions (also known as institutional investors).
Benefits of Currency Derivatives
By trading currency derivatives, you can hedge against exchange rate fluctuations, speculate, and find arbitrage opportunities in the currency market, which is the largest financial market in the world.
Hedging
As an investor, you could protect your investments from foreign currency exposure and fluctuations by trading currency derivatives to take a hedging position. Generally, you may want to trade currency options to hedge against currency fluctuations. Even institutions, importers, and exporters partake in hedging to generate profits or minimise losses due to fluctuating interest rates.
Speculating/Trading
Traders and speculators trade currency derivative contracts to capitalise on short-term fluctuations in the forex markets. They may employ various strategies to maximise their profits.
Arbitrages
In some markets, traders are not restrained from capitalising on price discrepancies of a particular currency pair in different markets. This strategy is called currency arbitrage, where the buyer buys a currency pair and instantly sells it in another market at a higher rate.
How to Trade in Currency Derivatives in India?
● To start trading currency derivatives in India, you will need to open a currency trading account with a licensed SEBI-registered broker.
● If you already have a trading account but can’t access the currency segment, there is nothing to panic about; simply activate the segment. Then, you can start trading currency derivatives in India using your trading app.
● You must remember that derivative trading involves high risks, and hence it’s essential to understand the ins and outs of derivatives before you start trading.
Conclusion
Exploring currency derivatives provides investors with a valuable avenue to diversify their portfolios and capitalise on macroeconomic factors. The types and benefits of currency derivatives open doors to strategic trading in the dynamic foreign exchange market. By understanding how to trade currency derivatives, investors can navigate the complexities of this financial instrument, making informed decisions to optimise their investment returns. Engaging in currency derivatives adds a layer of versatility to an investor’s toolkit, enabling them to adapt to changing market conditions and potentially enhance their overall financial performance.
