MODULE 5 - CURRENCY DERIVATIVES

5.1 FOREX TRANSACTIONS AND DERIVATIVES INSTRUMENTS TRADED

IN FOREX MARKET SUCH AS FORWARD, FUTURE, SWAPS AND OPTION
(CURRENCY FUTURE MARKET AND CURRENCY OPTIONS MARKET)

5.2 MANAGING FINANCIAL RISK WITH DERIVATIVES, CORPORATE

GOVERNANCE AND ETHICAL BUSINESS STRATEGY.
FOREX TRANSACTIONS

Foreign exchange, also termed Forex, refers

to converting one country’s currency into
another country’s currency.
A single country’s currency is valued against
another’s currency or against a basket of
currencies.
The global foreign exchange market involves daily
volumes ranging in trillions of dollars, thereby
making it the largest international financial market
in the world.
Foreign exchange transactions are executed over
the counter, and there is no specific centralized
market for the same.
FOREIGN EXCHANGE MARKET

The foreign exchange market is a floor provided for

buying, selling, exchanging, and speculation of
currencies.
The forex market also undertakes currency conversion for
investments and international trade.
The Forex markets, also termed, Forex markets, consist of
investment management firms, central banks,
commercial companies, retail forex brokers, and
investors.
TYPES OF FOREIGN EXCHANGE TRANSACTIONS

1. Spot Transactions
 This method of transaction is the fastest way to exchange
currencies.
 Spot transaction refers to the exchange or settlement of the
currencies by the buyer and seller within two days of the
deal without a signed contract.
 The Spot Exchange Rate is the prevailing exchange rate in
the market.
Typically, cash settlement is made two business
days (excluding holidays of either the buyer or the
seller) after the transaction for trades between the
Indian rupee and foreign currency.
For regular spot trades between the US dollar and
the Mexican peso or the Canadian dollar,
settlement takes only one business day.
2 .Forward Transactions
 Forward transactions are future transactions when the
buyer and seller enter into an agreement of purchase
and sale of currency for a future date.
 The agreement is framed on the basis of a fixed
exchange rate for a definite date in the future.
 The rate at which the deal is fixed is termed as Forward
Exchange Rate.
3. Future Transaction
 Future transactions also deal with contracts in the same
manner as forward transactions.
 However, in the case of future transactions, standardized
contracts in terms of features, date, and size should be
followed.
 At the same time, regular forward transactions have flexibility
and can be customized.
 In future transactions, an initial margin is fixed and kept as
collateral in order to establish a future position.
4. Swap Transactions
Simultaneous lending and borrowing of two different
currencies between two investors are called swap
transactions.
One investor borrows a currency and repays it in the form
of a second currency to the second investor.
Swap transactions are done to pay off obligations without
suffering a foreign exchange risk.
5. Option Transactions
The exchange of currency from one denomination
to another at an agreed rate on a specific date is
an option for an investor.
Every investor owns the right to convert the
currency but is not obligated to do so.
FOREIGN EXCHANGE RISK

 Foreign exchange risk refers to the risk that a business’

financial performance or financial position will be affected
by changes in the exchange rates between currencies.
 The three types of foreign exchange risk include
transaction risk, economic risk, and translation
risk.
 Foreign exchange risk is a major risk to consider for
exporters/importers and businesses that trade in
international markets.
1. TRANSACTION RISK

 Transaction risk is the risk faced by a company when

making financial transactions between jurisdictions.
 The risk is the change in the exchange rate before
transaction settlement.
 Essentially, the time delay between transaction and
settlement is the source of transaction risk.
 Transaction risk can be mitigated using forward
contracts and options.
2. ECONOMIC RISK

Economic risk, also known as forecast risk, is the

risk that a company’s market value is
impacted by unavoidable exposure to
exchange rate fluctuations.
Such a type of risk is usually created by
macroeconomic conditions such as geopolitical
instability and/or government regulations.
3. TRANSLATION RISK

Translation risk, also known as translation exposure,

refers to the risk faced by a company headquartered
domestically but conducting business in a foreign
jurisdiction, and of which the company’s financial
performance is denoted in its domestic currency.
 Translation risk is higher when a company holds a
greater portion of its assets, liabilities, or equities in
a foreign currency.
MANAGING FINANCIAL RISK WITH DERIVATIVES
 Derivatives are financial instruments that have values
derived from other assets like stocks, bonds, or foreign
exchange.
 Derivatives are sometimes used to hedge a position
(protecting against the risk of an adverse move in an
asset) or to speculate on future moves in the underlying
instrument such as forex.
 Hedging is a form of risk management that is common in
the forex market, where investors use derivatives to
protect business transactions involving foreign currency.
USES OF CURRENCY DERIVATIVES

 Currency Derivatives are considered effective tools to

counter the currency conversion rate fluctuations.
 Traders can hedge against exchange rate risk by
combining Currency Futures and Currency Options.
 By monitoring the price movement of a currency, you can
get access to a larger capital value with minimal margin.
ADVANTAGES OF DERIVATIVES

 1. Risk Management:
 The best tool for risk hedging, or the process of reducing risk
in one investment by making another, is a derivative.
Derivatives are commonly utilized as a kind of risk insurance
and as a way to lower currency risk.
2. Liquidity:
 Due to their great liquidity, derivatives are simple to buy and
sell on the open market. This enables investors to profit from
price fluctuations rapidly and without having to spend a lot of
money.
3. Leverage:
 Derivatives can be used to increase leverage and amplify
returns. By using derivatives, investors can borrow money,
allowing them to place larger trades than they would
otherwise be able to.
4. Access:
 Derivatives provide access to a variety of markets, allowing
investors to trade in a range of asset classes. Investors that
desire to diversify their portfolios may benefit from this.
5. Low Transaction Costs:
 Trading in the derivatives markets has reduced transaction
costs as compared to traditional assets as shares or
bonds.
 Lower transaction costs are made possible by derivatives
because they effectively act as a risk management tool.
BENEFITS OF CURRENCY DERIVATIVES

 Hedging – Hedging protects the trader from foreign

currency exposure and reduces losses by using currency
derivatives.
 It also helps exporters and importers to generate profits or
cover up losses during currency fluctuations.
 Trading – In trading, Currency and futures options allow
you to trade on short-term market movements while
keeping an eye on the direction of movement.
 Currency Derivatives help traders to yield profits from the
forex market by simply strategizing the investments.
Arbitrators - Some markets and exchanges allow
you to take advantage of currency exchange rates
by trading currency derivatives.
Even a minimal price difference can yield profits in
currency derivatives.
CURRENCY DERIVATIVES IN INDIA
 In India, Currency derivatives are used to safeguard businesses
against currency fluctuations from foreign currencies such as the
euro, dollar, and yen.
 Corporate societies often use these contracts for certain currencies
if they are repeatedly subject to imports and exports.
 Currency derivatives in the Indian market are still largely
dominated by central banks and importers-exporters.
 The daily volume of 44,859 Cr. is mainly supplied by banks,
companies, importers, and exporters.
 But speculators and arbitrageurs are also increasing their
participation in the currency market.
 As more retail investors begin to discover the extent of
profit gains in the forex market, the popularity and
demand for currency derivatives in India will witness
substantial growth.
CORPORATE GOVERNANCE AND ETHICAL BUSINESS
STRATEGY.

 The balance of pursuing market opportunities while

maintaining accountability and ethical integrity has
proved a defining challenge for business enterprise since the
arrival of the joint- stock company in the early years of
industrialism.
 The accountability and responsibility of business enterprise is
constantly subject to question.
 The manifest failures of corporate governance and
business ethics in the global financial crisis has increased
the urgency of the search for a better ethical framework and
governance for business.
 A substantial increase in the range, significance and
impact of corporate social and environmental initiatives in
recent years suggests the growing materiality of a more
ethically-informed approach.
 However challenging the prospects, there are growing
indications of large corporations taking their social and
environmental responsibilities more seriously, and of
these issues becoming more critical in the business
agenda.
IMPORTANCE OF CORPORATE GOVERNANCE.

 corporations capable of working in investors’,

stakeholders’, and society’s interests in a collaborative,
creative and productive way would require a further
fundamental redesign of the concept of the
corporation and the institution of the market.
 It is possible that confronting the dilemmas of social,
economic and ecological survival which governments,
business and communities face, will force the rethinking
of corporate objectives, structures, and activities
that is necessary.
Corporate governance essentially will involve
sustained and responsible monitoring of not
just the financial health of the company,
but the social and environmental impact
of the company.