The introduction of Currency Derivatives in India is a landmark decision which is likely to be a boon for importers, exporters and companies with Forex exposure. These Derivative products have a wide scope with their special features tailored to match customer requirements. As Currency Derivatives are new in India, we have taken on the task to explain them in more detail. Currency Derivatives are similar to many other Derivatives, Stocks, and Indices, etc. It is just that the underlying assets of Currency Derivatives are Currencies. The value of the Currencies determines the value of the Currency Derivatives.
As it is universally accepted that market risks cannot be eliminated in full efforts need to be undertaken to manage them. Currency Derivatives are efficient risk management tools in the Forex market. The need to protect exposure against unforeseen and unpredictable Currency movements and interest rates changes has contributed to Derivatives being developed. Exporters and importers incur huge obligations in terms of foreign Currencies and they can guard their interests by buying appropriate Derivative products.
Derivatives based on Currency exchange rates are known as Forward contracts, which determine the rate at which exchanges take place between two Currencies on a particular date in the future. These Derivatives are sought after by the exporters and importers to safe guard their positions by entering into contracts with banks. It is important to understand that on the agreed date the contracts have to be honoured and the difference between the market rate prevailing on that date and the contracted rate has to be paid. If the parties agree to postpone the date the difference has to be paid then.
The basic difference between a Forward contract and an Option is that a Forward contract is characterised by an obligation as well as a right. For Options there is no obligation to buy or sell on a particular date. Thus, the buyer of a Forward contract can make a gain or loss, depending on the situation of the Currency market at the time of the transaction. The buyer of a Currency Option can decide to let the date pass as they are not placed under any obligation.