What are Currency Derivatives?

Currency derivatives are contracts to buy or sell currencies at a future date. The major types of currency derivatives are forward contracts, futures contracts, options and swaps.

Despite having an average daily turnover of Rs 44,859 crores, currency derivatives in India are largely unknown to small retail investors.

The currency derivatives trading segment in India is dominated by importers, exporters, central banks, banks and corporations.

While currency derivatives in India are primarily used for hedging, retail investors can create wealth in the currency derivatives segment by speculating and arbitraging.

In this article, we will discuss:

  • What are Derivatives?

  • What is the meaning of Currency Derivatives?

  • What are Currency Futures?

  • What are Currency Options?

  • Are Currency Derivatives Popular in India?

  • What are the uses of Currency Derivatives?

  • How can you trade in Currency Derivatives?

  • FAQs

What are Derivatives?

Derivatives are financial contracts that derive their value from the value of the underlying asset. The underlying asset can be equity, bonds, currencies, commodities or other assets.

Examples of Derivatives

Let’s look at a simple example to understand the complex world of derivatives.

  • Do you remember your mother or spouse complaining that the cost of milk has gone up from Rs 59/litre to Rs 61/litre?
  • The next day, the cost of curd went up from Rs 58/400 grams to Rs 60/400 grams!
  • Then came cheese, which would now cost Rs 150/200 grams instead of Rs 145 /200 grams!

Is this a universal conspiracy by the milk agents?

No. This is pure ‘derivatives’.

Curd and cheese have no value of their own. They derive their value from the value of the underlying asset i.e. ‘milk’.

So, derivatives are financial contracts, which have no value of their own but they derive their value from the price of the underlying asset. An increase in the price of the underlying asset will lead to an increase in the price of its derivative.

So, expensive milk equals expensive curd.

What is the meaning of Currency Derivatives?

Currency derivatives are financial contracts (futures, options and swaps) which have no value of their own. They derive their value from the value of the underlying asset, in this case, currencies.

For example, assume that the current USD/INR rate is 73.2450. A 1 month USD/INR futures contract is trading at Rs 73.3650.

Here, the underlying asset is the USD/INR exchange rate and the 1 month futures contract being traded is the currency derivative.

The underlying asset and the derivatives contract have different values. But the value of the derivative is dependent and derived from the value of the USD/INR current exchange rate.

What are Currency Futures?

Currency futures are exchange traded futures contracts which specify the quantity, the date, and the price at which currencies will be exchanged in the future. Speculators are the most active participants in the futures market but close their positions before expiry.

So, in reality, they do not physically deliver the currencies, rather they make or lose money based on the price changes of the futures contract.

What are Currency Options?

Currency options are contracts that give the buyer the right, but not the obligation, to buy or sell a certain currency on a future date at a pre-decided price. There are two types of currency options: ‘Call’ option and ‘Put’ option.

The below table demonstrates the relationship between options and currency pairs.

Buy a call option The price of the currency pair is expected to rise
Buy a put option The price of the currency pair is expected to fall
Sell a call option The price of the currency pair is expected to fall
Sell a put option The price of the currency pair is expected to rise

While currency futures were introduced in India in 2008 and currency options in 2010, currency derivatives in India are still mostly dominated by central banks and importers-exporters.

The daily volume of 44,859 Crores is mostly contributed by banks, corporations, importers and exporters. But speculators and arbitrageurs have also increased their participation in the currency markets.

As more retail investors begin to discover the scope of profit generation in the forex market, the popularity and demand for currency derivatives in India will witness a substantial growth.

What are the uses of Currency Derivatives in India?

Currency derivatives in India are primarily used for:

  • Hedging: By importers / exporters and other hedgers
  • Speculating: By speculative traders
  • Arbitraging: By arbitrage traders

How hedgers use currency derivatives?

Mr Agarwal imports 10,000 kgs of Washington apples from the US worth Rs 14,64,900 at the current USD/INR rate of 73.2450.

If he were to make the payment today, then he will have to shell out Rs 14,64,900. But the payment has to be made after 2 months.

Mr Agarwal is worried. He is expecting the USD/INR rate to go up from 73.2450 to 75.2450 in the next couple of months. This means that Mr Agarwal will now end up paying Rs 15,04,900 instead of Rs 14,64,900 i.e. Rs 40,000 more!

Such losses can be disastrous for his business.

But Mr Agarwal can hedge this Rs 40,000 loss by using currency derivatives. As he expects the USD/INR to increase, he can buy 22 lots of currency futures of USD/INR at the current rate of 73.3650.

By buying 22 lots, he has taken a position of Rs 16,14,030 (covering his purchase cost). Let’s say his prediction comes true and the USD/INR rate appreciates to 75.2450. Then he will end up making a profit of Rs 41,360 by closing his position. So, his Rs 40,000 loss is offset by his Rs 41,360 profit.

This is how currency derivatives help importers and exporters hedge against currency fluctuations.

How speculators use currency derivatives?

Mr Sharma, a teacher, wants to make some quick profit and decides to try his luck at currency derivatives trading.

He is bearish about USD/INR and believes that a poor US unemployment data will result in the USD/INR rate falling from 73.2450 to 72.2450 in the coming weeks.

So, he shorts (sells) 10 lots of USD/INR at Rs 73.2450. He has now taken a position of Rs 7,32,450. After the data is released, there is volatility in the USD/INR rate and USD/INR falls to 71.2450 intraday.

Mr Sharma, quickly covers his short position by buying back the 10 lots at 71.2450. He ends up making a profit of Rs 20,000 in intraday!

Speculators use various indicators and forex trading strategies to identify profit making opportunities in the forex markets using currency derivatives.

[Suggested Reading: Top 10 Tips for Forex Trading in India]

How arbitrageurs use currency derivatives?

In India, Currency derivatives are traded on NSE, BSE and MCX-SX platforms. There is always a small price difference between the price of the same currency contract between the three exchanges. Arbitrageurs make money using this small price difference.

Mr Verma noticed that the USD/INR October futures was trading at 73.39 on NSE and at 73.35 on BSE.

So, he decided to buy 25 lots from BSE and sell them on the NSE. By capitalising on the spread between the two exchanges, Mr Verma made 7.4% on his investment of Rs 20,000 in a matter of minutes!

Buy on BSE Rs 73.33/lot
Total position taken Rs 18,33,250
Sell on NSE Rs 73.39/lot
Total Sell Value Rs 18,34,750
Profit Rs 1,500
Less: Brokerage Rs 20
Realised Profit Rs 1,480
Profit % 7.72%

Now that we understand how various market participants use currency derivatives in India to their advantage, let us look at how you can trade currency derivatives in India.

How to trade Currency derivatives in India?

Currency derivatives trading is no longer a difficult task and can be done from the comfort of your home, with the best forex broker in India - Samco.

Samco is a SEBI authorised currency broker, with a flat brokerage charge of Rs 20/trade irrespective of the trade size.

Samco’s trading platform works at lightning speed so you do not miss any action. Samco also offers the best leverage ratio, which can maximise your profits.

You can read the detailed benefits of opening a currency trading account with Samco to ease your decision making.

The bottom line is that although currency derivatives are not popular among retail investors, they provide excellent wealth creation opportunities and deserve to be a part of a retail investor’s portfolio.

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FAQs

Q
What are the various types of currency derivatives?
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A
Forwards, futures, options and swaps are the primary types of currency derivatives in India.
Q
How can I trade currency derivatives in India?
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A
You can trade currency derivatives in India only via SEBI authorised forex brokers like Samco.
Q
Are derivatives only for importers and exporters?
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A
No. Currency derivatives can also be used by retail investors to diversify their investment portfolio.
Q
When does a currency futures contract expire?
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A
Currency derivatives contracts expire two working days prior to the last business day of the expiry month.
Q
How are currency derivatives settled?
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A
All currency derivatives contracts are cash settled in India.