What are Currency Derivatives?

Introduction

Derivatives let you predict the price of an underlying asset and enter into an agreement with buyers or sellers to purchase or sell the underlying asset at a future date. The underlying asset may be stocks, commodities, indices, currencies, interest rates, etc. Although stocks and indices are the most commonly traded derivatives in the Indian market, currency derivatives trading is fast catching pace. This article explains the meaning and types of currency derivatives for you to trade efficiently.

What is the Meaning of Currency Derivatives?

Currency derivatives are financial contracts that get their value from currency pairs. Currency derivatives trading is managed and overseen by stock exchanges like the National Stock Exchange or NSE. NSE’s currency derivatives segment allows cross-currency futures and options on three (3) currency pairs, futures trading on four (4) currency pairs, and interest rate futures trading on 91-day treasury bills and 10-year government securities. The most popular currency derivatives in India are USDINR, JPYINR, GBPINR, and EURINR. The most popular cross-currency derivatives on NSE are EURUSD, GBPUSD, and USDJPY.    

Since a stock exchange facilitates currency derivatives trading, the counterparty risks are minimum. Through currency derivatives, traders enter into an agreement to exchange one currency (e.g., JPY) with another (e.g., INR) at a future date for a specified price. Currency derivatives trading is margin-based, meaning you have to pay a fraction of the total contract cost while opening a trade. However, depending on the type of contract, you may have to arrange for the full contract amount on or before the expiry date. 

Top financial institutions widely use currency derivatives for hedging purposes since it reduces their risks of currency rate fluctuations. 

What are the Types of Currency Derivatives in India?

The following are the most common types of currency derivatives in India:

1. Currency Forwards 

Currency forward derivatives trading occurs between two parties over the counter. These trades do not take place through a stock exchange but a network of broker-dealers, so the counterparty risks are high. Here, two parties (generally, financial institutions) decide the currency rate, execution date, and currency exchange rate. 

2. Currency Futures

Currency futures derivatives trading occurs through stock exchanges. These are standardised contracts between two parties who meet through the exchange. Since the exchange acts as a facilitator or counterparty, the risks are minimal. The buyer can choose the available contracts, select the lot size (read, quantity), and pay the initial margin to initiate the trade.    

3. Currency Options

While currency futures transfers the right and obligation to the parties, options provide the right but not obligation to buy or sell the currency pair(s) on or before the contract execution date. Like futures trading, these contracts occur through an exchange and are standardised. 

4. Currency Swaps

In currency swap derivatives trading, the parties exchange one currency’s principal and interest with another currency’s principal and interest. Before entering into a swap contract, the parties discuss the payment frequency, interest rate, exchange rate, etc. Unlike futures and options, these are over-the-counter trades.  

Trade Currency Derivatives Like a Pro With 5paisa

Now that you know the meaning and types of currency derivatives, the next step must be opening a free Demat and trading account to test your knowledge and grow your capital wisely. 5paisa is a renowned name in the list of Indian stockbrokers offering unparalleled services and real-time software for trading. So, what are you waiting for? Open a 5paisa account to experience low-brokerage currency derivatives trading.