Within the fields of trading and finance, a derivative is considered to be an instrument used for investment via a contract. Its value is "derived" from (or based upon) that of another asset, typically referred to as the underlying asset or simply "the underlying." In other words, a derivative contract is an agreement that allows for the possibility to purchase or sell some other type of financial instrument or non-financial asset. Common types of derivative contracts include options, forwards, futures and swaps.
Among the many types of underlying assets that are commonly used with derivatives include equities or equity indices, fixed-income securities, currencies, commodities, credit events and even other types of derivatives. Derivative contracts are typically used by investors for the purpose of speculating, or hedging, against possible future changes in market factors, and thus against the future market value of an underlying asset.
The special value of derivatives contracts compared to contracts for direct trade of underlying assets is that they allow transference of risks from individuals or entities less willing or able to manage them to those more willing or able to manage them. Also, derivatives contracts often require only small or even no initial monetary investment, and they're settled at a future date from the buyers' and sellers' adherence to the contract.
Derivatives are subject to "net settlement" through delivery, or non-delivery, of the underlying asset. However, positions in transactions involving derivatives contracts are frequently closed before an underlying asset is delivered to a buyer.
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Use of Derivatives in Forex Trading
Much of currency trading is done on what is called the spot, or "cash," market where currency pairs are bought and sold at their present value and delivered within a two-day period. The period is based on the time for the transaction to clear in the accounts of the respective participants in the trade. Currencies, however, are commonly traded as part of derivative contracts in futures, forwards, options and swaps.
Types of Forex Derivatives
A futures contract is an agreement to buy or sell a quantity of a currency at a pre-established price on a particular date in the future. Profits and losses on a futures contract are realised and paid out at the end each day. Currency futures contracts are traded in standard sizes and have set maturity dates, generally falling on the third Wednesday of March, June, September and December. Participants in currency futures contracts can be "hedgers" seeking to lock in a price to diminish the risk of a future price change, or they can be "speculators" who enter into a trade seeking potential gains.
Like a futures contract, a forward contract is an agreement to buy or sell a quantity of a currency at a pre-established price on a particular date in the future. Differently from a futures contract, however, profits and losses on a forward contract are realised and paid out only when the contract expires. Forward contracts are traded on an over-the-counter basis between two parties, and unlike futures contracts, these are not regularly bought and sold on exchanges.
A currency option gives an investor the right, but not the obligation, to buy or sell a quantity of currency at a pre-established price on or before the date that the option expires. The right to sell a currency is known as a "call option" and the right to buy is known as a "put option." Options can be understood as a type of insurance where buyers or sellers can take advantage of more favourable prices should market conditions change after the option is purchased.
Buying a call option, for example, can be used as insurance against the risk of a rising exchange rate, whereas buying a put option can be used against the risk of a falling exchange rate. Options are traded on both the over-the-counter market and also on exchanges. In addition to use as a means to buy or sell currency, options can also used to buy or sell other derivatives such as futures.
A currency swap is an agreement between two parties to exchange flows of payments in two different currencies on different dates. Participants in currency swap agreements typically seek to exchange the terms of interest repayments available to the respective counter-parties to the agreement.
The payment flows are based on the exchange, or "swap," of a defined amount known as the principal, or notional, amount. Often one party to the agreement will seek a fixed-rate interest payment at a steady yield while the other party seeks a floating-rate payment that could offer an opportunity for an improving yield.
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