International Finance For Dummies by Ayse Evrensel

Author:Ayse Evrensel
Language: eng
Format: epub, pdf
Publisher: Wiley
Published: 2013-04-02T16:00:00+00:00

Chapter 10

Minimizing the FX Risk: FX Derivatives

In This Chapter

Defining FX derivatives

Identifying who uses FX derivatives

Determining the purpose of FX derivatives

Spotting differences between FX derivatives

Calculating gain or loss when using FX derivatives

You’re likely happy to know that this chapter isn’t about calculus! You don’t have to take the derivative of a function. Whew! In finance, a derivative implies a contract to buy or sell a financial instrument at a future date and a price specified today. Because you get the contract today to engage in a future buying or selling activity, derivatives involve betting on the future price of a financial instrument.

In international finance, derivative instruments imply contracts based on which you can purchase or sell currency at a future date. In this chapter, I explore three major types of FX derivatives: forward contracts, futures contracts, and options. They have important differences, which changes their attractiveness to a specific FX market participant.

Note three points while reading through this chapter:

As discussed in Chapter 3, spot FX markets are highly volatile. Because relying solely on the spot FX market is associated with higher risk, FX derivatives reduce some of the market participants’ exposure to risk, among them, the MNCs (multinational companies).

Every time a multinational company uses an FX derivative, the outcome will not be better than the alternative of using the future spot market. While numerical examples on this issue call this outcome an unsuccessful hedge, it doesn’t reduce the usefulness of FX derivatives. A multinational company’s losses would likely be higher, if the company relies exclusively on the spot market for all its FX transactions.

The numerical examples in this chapter are all about shorter-term transactions for days or a couple months. Essentially, in an effort to reduce their exposure, market participants don’t want to put their guess about the future exchange rates to a long-term test.

For simplicity, we assume no transactions costs throughout this chapter, whereas, in real life, certain fees may be added to the price of an FX derivative.

Checking Out FX Derivatives

FX derivatives are contracts to buy or sell foreign currencies at a future date. Table 10-1 summarizes the relevant characteristics of three types of FX derivatives: forward contracts, futures contracts, and options. Because the types of FX derivatives closely correspond to the identity of the FX market participant, Table 10-1 is based on the derivative type-market participant relationship.

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