Currency Derivatives

Author

Raquel Fonseca

Keywords

Derivatives, Currencies, Foreign Exchange Rates

Review Status

Unreviewed


Definition

There is currently a significant number of financial derivatives instruments directed at the hedging of a specific number of risks. Several situations may arise in which the agent is interested in eliminating his exposure to currency risk. We assume that our investor is expecting to receive a certain amount of foreign currency at a certain point in the future and he wishes to hedge his gain from any depreciations in the foreign exchange rate.

The motivation behind hedging is clear: international investors are mainly worried about their asset investments and do not want to be concerned with movements of the foreign currencies, which are very volatile and difficult to forecast. On the other hand, a disadvantageous movement in the foreign exchange rate may completely offset local asset gains, and therefore must be taken into consideration.

The most commonly used instruments for hedging are forward exchange rates agreements, futures contracts and currency options. A forward contract is an agreement to buy or sell a certain asset at a designated price at some designated time in the future. Forwards are traded over-the-counter and are a very simple instrument to use. By entering into a forward agreement, the agent is in fact locking the foreign exchange rate to be applied in the future. In this way the downside risk is completely eliminated, but at the same time all benefits from an increase in the exchange rate are foregone.

Futures contracts work in quite a similar way to forwards, but are a standardized instrument, available only for specific currencies, at specific prices and delivery dates. This may not be however the most advantageous instrument to hedge the currency risk. Not only the contract size may not be the most adequate size for the investor needs (therefore not allowing a complete hedge), but also the margin accounting may prove to be difficult to maintain. It is shown in fact that in certain circumstances, the use of forwards or futures contracts is equivalent in terms of end result.

The most complex instrument are options. Although in their essence similar to forwards, options are a right, not an obligation to buy or sell a particular asset, at a specified price at a certain time in the future. Because they are clearly more flexible than forwards, options have a cost, which is defined as the premium of the option. The Black-Scholes pricing model is the one widely used for options, and the specific pricing model used for currency options which, though based on the same assumptions, differs slightly from the Black-Scholes model is based on the work of Garman and Kohlhagen.

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Currency Futures
Currency Options
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References
1. Garman, M.; and Kohlhagen, S. Foreign Currency Option Values. Journal of International Money and Finance, 2, 231-237, 1983.
2. Hull, John C. Options, Futures and Other Derivatives. Pearson International Edition, 2006.
3. Luenberger, D. Investment Science. Oxford University Press, 1998.
4. Wystup, U. FX options and structured products. Wiley Finance, 2006.
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