Foreign Currency Derivatives

Foreign currency derivatives are essentially the same as futures. It is not a large part of the currency trading market, consisting of about one percent of all trading.

Foreign currency derivatives are most often used for hedging and speculating. Hedging involves the use of futures contracts to insulate against losses that could result from future rate changes. Speculating involves taking a calculated risk in the hopes of reaping excellent profits.

The advantages of using foreign currency derivatives include spreads that are normally lower, often less than three points. The cost of the transaction is usually lower, and the buyer typically has more leverage, which can often amount to more than $500 for each contract. The disadvantages of using foreign currency derivatives include the need to invest more capital than many small investors can muster, the fees that can apply, and the time limitations due to activity being limited to the times of the exchange’s session.

When using foreign currency derivatives for speculation, the strategies are basically identical to standard trading methods. Trend analysis is most commonly used to evaluate the history and pivot points of the currency under consideration. There are also more complex methods that take into account the country’s economic indicators and political climate.

Foreign currency derivatives are often used for hedging to protect revenue received from sales. For example, an American company with stores in England will be making sales in pounds but needs to receive the income in dollars. A derivative allows it to purchase a contract in the amount of predicted sales so that revenue will not be affected by changes in the currency market.

Another example would be that of a cruise line operating out of England that makes payment for its fuel in American dollars. It can enter into a contract guaranteeing the price of the fuel in dollars. If the currency exchange rates change, the fuel cost can still go up due to this change. Before the cruise line can sell tickets, it must know what its costs will be. Taking foreign currency derivatives lets the cruise line lock in an exchange rate and therefore more accurately predict its costs.

In addition to futures, foreign currency derivatives may be in the form of forwards. They are similar to futures, but have two main differences. First, the cash underlying a forward is not paid until the expiration date, while cash is posted daily for futures. The second difference is that a forward offers more options for date selection and the size of the contract.

Foreign currency derivatives have sometimes been used to circumvent laws in certain countries that restrict outright purchases of currency. For example, a company can incur debt in one country and then trade the debt for another one in a different country and currency.

Like futures, trading in foreign currency derivatives carries more risk than traditional currency trading. Since it is higher risk, it is not a suitable choice for retirement accounts. It is also not recommended for novices to the foreign currency market. Few individuals engage in this aspect of the market, due to the risks involved and the higher capital funding needed.

Foreign currency derivatives can also be used for arbitrage. This allows the traders to take advantage of price variations on an asset. This can permit the parties involved to receive a settlement under better terms, perhaps because of tax consequences.

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