1.1 Currency Basics
Currency is any money that is acceptable as a medium of exchange. Typically, that means a government-backed money, issued either in paper or metal coins. And whenever you travel or trade between countries you need currency.
And just like there is market for everything- there is market for currency as well. And in this market the participants are buying or selling one currency in exchange for another. It's the most heavily traded market in the world because people, businesses, and countries all participate in it, and it's an easy market to get into without much capital.
When you go on a trip and convert your U.S. dollars for euros, you're participating in the global foreign exchange market. At any time, the demand for a certain currency will push it either up or down in value relative to other currencies.
In ancient times, people use to operate on the principle of barter and traded goods with each other as forms of payment. Today, the world runs on the power of currency, and there is a large variety of it across the world. Thus they are bought and sold in a market.
The participants in this market are from around the world. They buy and sell different currencies. Currency trading participants comprise banks, corporations, central banks (like RBI in India), investment management firms, hedge funds, retail forex brokers, and investors.
Significance of Currency market:
The currency market is essentially a global, decentralized market for the trading of currencies. The foreign exchange rates for every currency are determined by the currency market. It includes all matters of currency trading such as the buying, selling, or exchanging of currencies at their present value or a decided value.
It is important to note that the currency market is not a single place or location, but is rather used to refer to a system. It is made up of a number of financial centers where foreign exchange transactions take place round the clock.
The foreign exchange market is also an important reflection of the economies around the world. The price of one currency compared in terms of another currency is known as its exchange rate. This exchange rate is a vital indication of the economic health of the country the currency belongs to. A high exchange rate for a currency gives more economic advantage to that country while a low exchange rate denotes the opposite.
1.2 Meaning of Exchange Rates
An exchange rate is the value of a country's currency vs. that of another country or economic zone. It is used to determine the value of various currencies in relation to each other and is important in determining trade and capital flow dynamics.
Currencies are traded in the foreign exchange market. Like any other market, when something is exchanged there is a price. In the foreign exchange market, a currency is being bought and sold, and the price of that currency is given in some other currency. That price is expressed as an exchange rate.
This rate depends on the local demand for foreign Currencies and their local supply, country's trade balance, strength of its economy, and other such factors. An exchange rate is how much it costs to exchange one currency for another. Exchange rates fluctuate constantly throughout the week as currencies are actively traded. This pushes the price up and down, similar to other assets such as gold or stocks.
If the USD/CAD exchange rate is 1.0950, that means it costs 1.0950 Canadian dollars for 1 U.S. dollar. The first currency listed (USD) always stands for one unit of that currency; the exchange rate shows how much of the second currency (CAD) is needed to purchase that one unit of the first (USD). This rate tells you how much it costs to buy one U.S. dollar using Canadian dollars. To find out how much it costs to buy one Canadian dollar using U.S. dollars use the following formula: 1/exchange rate. In this case, 1 / 1.0950 = 0.9132. It costs 0.9132 U.S. dollars to buy one Canadian dollar. This price would be reflected by the CAD/USD pair; notice the position of the currencies has switched.
The rates are impacted by two factors:
- The domestic currency value
- The foreign currency value
1.3 Concept of Derivative
Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate). The underlying asset can be equity, foreign exchange, commodity or any other asset. For example, rice farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of rice which is the "underlying".
Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity linked derivatives remained the sole form of such products for almost three hundred years. Financial derivatives came into spotlight in the post 1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover.
In the Indian context the Securities Contracts (Regulation) Act, 1956 [SC(R)A] defines "derivative" to include 1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2. A contract which derives its value from the prices, or index of prices, of underlying securities. Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A.
1.4 Meaning of Currency Derivative
Currency derivatives are financial contracts between the buyer and seller involving the exchange of two currencies at a future date, and at a stipulated rate.
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.
Currency derivatives are popularly known as one of the best options if you wish to contain the volatility risk that foreign currency exchange rate have.