FX Derivatives

Derivatives are instruments and typically used by investors for speculation and arbitrage or hedging against possible future changes.  Generally, they took a form of contract under which parties agreed on payments, dates, amounts, obligations between the parties.

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The most commonly used foreign exchange derivatives are forward contracts, future contracts, options and swaps. I will make a brief introduction for each derivative with example below.

FX Spot

Spot trades also known as cash trades represents direct exchange between two currencies with two business days delivery. In other words two parties agrees to buy one currency against selling another at the agreed rate for settlement date on the spot date. So whenever you go to the bank to exchange currency you are participating in FX spot market.

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Example #1:
  • Open long position EUR/USD 1,000,000 EUR at 1.1367.
    • Buy 1 mio EUR.
    • Sell 1,136,700 USD.
  • Close position at 1.1372.
    • Sell 1 mio EUR.
    • Buy 1,137,200 USD.
  • P&L =  (1.1372 -1.1367) * 1,000,000 EUR = 500 USD.
Example #2:
  • Open short position EUR/USD 1,000,000 EUR at 1.1367.
    • Borrow and sell 1,000,000 EUR.
    • Buy 1,136,700 USD.
  • Close position at 1.1372.
    • Buy 1,000,000 EUR.
    • Sell 1,137,200 USD.
    • Return 1 mio EUR loan.
  • P&L = (1.1367 – 1.1372) * 1,000,000 EUR = -500 USD.

FX Forward / FX Futures

A FX forward contract is a simple way to protect investor from rate fluctuations. The contract allows you to lock the currency exchange rate with settlement on future date. For instance, a company wants to sell 1,000,000 USD and buy Russian roubles in 2 month. Let’s assume that the current rate is 64.46, so in 2 month the company would expect 1,000,000 USD * 64.46/RUB = 64,460,000 RUB.

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The advantage of FX forward contract is that the company can make a profit if in 2 month the rate will be below 64.46. For instance, if rate is 63.27 the company’s profit would be 64,460,000 RUB – ( 1,000,000 USD * 63.27/RUB) =-1190000. Potentially, the company can loss if rate would be higher 64.46.

Typically, there are two types of FX forward contracts: outright forwards and non-deliverable forwards. An Outright Forward is an obligation for a physical exchange at a future date at an agreed on rate. There is no payment upfront. In case of NDF there are no physical exchange of currency. The parties agreed to pay difference between locked rate and current exchange rate.

The forward exchange rate depends on FX Spot rate and interest rate between the two currencies. The formula used is:

FXfwd = FXspot * [(1 + AFd * Rd) / (1 + AFf * Rf)]

For a numerical calculation the following need to be defined:

  • FXfwd = fair forward rate (units of domestic currency / unit of foreign).
  • FXspot = spot FX rate (units of domestic currency / unit of foreign).
  • Rd = domestic annual interest rate.
  • Rf = foreign annual interest rate.
  • AFd = domestic accrual factor (days interest is accrued over days in year).
  • AFf = foreign accrual factor.
FX Forward example:
  1. A 90-day forward contract for USD / EUR exchange.
    1. Spot rate = 1.4000 USD / EUR.
    2. USD 90-day LIBOR = 3.50%.
    3. EUR 90-day Euribor = 4.50%.
  2. FXfwd = 1.4000 * (1 + 90/360*0.035) / (1 + 90/360*0.045) FXfwd = 1.3965 USD/EUR.
FX Forward vs FX Futures

The main difference between these two instruments is that FX Forward contracts are traded over-the-counter while FX Futures are exchange-traded. As a result, futures are highly standardized and there is always exchange between parties.

FX Swap

The FX Swap is an agreement between two parties in which one party simultaneously borrows one currency and lends another currency to another party. The most common use of FX Swap is a situation when two companies in two different countries loan each other their national currency because of high interest rate for foreign companies. As a result, a company borrows money from another company with a lower rate. Basically, the FX Swap agreement has two transactions in one that executed simultaneously for the same currency and therefore overlap each other:

  1. FX Spot is also known as near leg.
  2. FX Forward is also known as far leg.

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The “swap points” indicate the difference between the spot rate and the forward rate.

Fx Option

Forex Options give you exactly what their name suggests – options in FX trading. Options gives you the right but not obligation to change one currency for another at an agreed price (also known as strike) and on agreed date in the future (expiration date). But for the right you have to pay option premium.

Call / Put options

In FX Option terminology a call option is a right but not an obligation to buy an agreed amount of currency at a certain time for a certain price. The buyer of the option will make a profit in case if rate at the expiration date will be higher than strike. In this situation the seller has obligation to sell currency.

A put option is a right but not an obligation to sell an agreed amount of currency at a certain time for a certain price. In this the seller will make a profit in case if the rate would be lower that agreed strike.

American / European

The options are very flexible and in some option styles the parties can make an agreement to exercise an option at any trading date or only at expiration date. American option – an option that may be exercised on any trading day on or before expiration. European option – an option that may only be exercised on expiry.

Plain vanilla  / Exotic

Plain vanilla options are American or European options that agreed strike, expiration date, notional and that’s all. Options with additional agreements like Bermudan option which may be exercised only on specified dates on or before expiration are called exotic options.

Here go some popular exotic options:

  • Asian option – an option whose payoff is determined by the average underlying price over some preset time period.
  • Barrier option – an option which can be exercised only if the price passes a certain level or “barrier”.
  • Binary option – An all-or-nothing option that pays the full amount if the underlying security meets the defined condition on expiration otherwise it expires.

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