FUTURE & OPTIONS ON FOREIGN
EXCHANGE CURRENCY & SWAP
A derivative is a financial instrument
whose value is derived from the underlying asset,
which in this case is foreign exchange. The pace
of financial innovation has been very swift and it
has resulted in the emergence of newer and
flexible financial instruments that are used
actively to manage risk.
There exists a number of instruments
that can be used manage and hedge risk and
• An option is a financial contract that gives the
holder the right but not the obligation to buy or
sell the underlying asset at a prestated price, on or
up to a specified date. In a currency option the
underlying asset is the foreign exchange.
• The buyer of option has the right but no
obligation to enter into a contract with the seller.
• In a currency option , there are two currencies
involved e.g. an option to buy US dollars (USD)
for Japanese Yen (JPY) is a USD call and a JPY
• The price at which the option buyer purchases the right
to buy or sell the currency is called as the strike price
or exercise price.
• The buyer can exercise the option on the specified date.
Such an option is called as an European option.
• In case the buyer has the right to exercise the option on
any business day from initiation to maturity, then such
an option contract is the American option.
• While entering into the contract the buyer has to pay a
fee to the option writer is called option premium.
TYPES OF OPTIONS
• In this option buyer has the right , but not
the obligation to purchase a currency
against the other at a specified price. This
option can be an European call option or
an American call option.
• A put option gives the holder the right,
but no obligation to sell the underlying
currency at a pre specified rate on or up
to a pre-specified rate. The same situation
can be reversed for a put option.
USES OF CURRENCY OPTIONS
• The currency options help an exporter or an
importer in providing cover to their trade
exposure that arises due to uncertain foreign
exchange cash flows.
• They provide cover against contingent currency
exposures, such as a tender to contract in foreign
• Currency options are also used to provide cover
against currency fluctuations that have an effect
on the value of balance sheet assets and
• The birth of futures contract coincides with the
death of the fixed exchange rate system. In
1972 the International Monetary
Market(IMM),a division of the Chicago
Mercantile Exchange , was formed to offer
futures contract in foreign currencies: British
pound, Canadian dollar, west German mark,
Japanese yen, Mexican peso, and Swiss franc.
In 1973 Western economics allowed currency
exchange rate to float free.
• Futures are standardized contracts having
a fixed size, value and expiration date. It
is a transferable obligation between two
parties to exchange currencies at a
specified rate during a specified delivery
month in multiples of standard amounts.
Essential Features Of Currency Futures
• They are purchased and traded on a regulated
• A key features of the futures contract is the
• The futures trading process is characterized
by the presence of a clearing house.
• The members trading in futures have to post
an initial margin with the clearing house.
FUTURE TRADING PROCESS
• Trading in futures takes place at an exchange
with members of the exchange alone trading
through the system of open cry. The process
starts with member posting an initial margin.
This margin amount is usually between 5-15%
of the value of the contracts in my deal.
• Once a deal is reached between two parties, it
is replaced by two deals , with the clearing
house interposing between the two parties.
• If the price of the underlying commodity or
financial instrument rises the contract holder
can make a profit and the same is credited to
• If the price falls , a loss will be incurred and
the required amount will be debited from the
contract holders account. These are known as
• In case the amount falls beyond a particular
amount, known as maintenance margin.
• The trader receives a margin call and is
required to make up the amount.
Globalisation of the financial markets has
resulted into the emergence of another type of
financial instrument namely, swaps. They
allow a borrower to exchange his liability with
another type of liability.
There are various types of swaps
1.INTEREST RATE SWAP
INTEREST RATE SWAP
• An interest rate swap is a cotractual agreement between
two parties under which each agrees to make periodic
payment to the other for an agreed period of time based
upon a national amount of principal.
• The principal amount is national because there is no
need to exchange actual amounts of principal when
there is no foreign exchange component to be take
• However ,a national amount of principal is required in
order to compute the actual cash amounts that will be
• A currency swap involves an exchange of two payments
denominated in two different currencies.
• Let us assume that there are two firms X and Y. Firm X ,a US
firm, has gone for a 10 year fixed rate loan of $20 million at an
interest rate of 10% while firm Y, German firm,has gone for a
EUR25 million at 9.6 % for a 10 year period at fixed interest
liability. Under a currency swap the two firms agree to
exchange the repayment liability of each other’s loan. Thus
firm A will receive a payment of $2 million in the each year
and $22 million in the last year from firm B. At the same time,
firm B will receive a payment of EUR 2.4 million each year
and EUR27.4 in the last year from firm A. Thus both the firms
have managed to exchange the currency denomination of their
ADVANTAGES OF SWAP
• They provide greater options to the firm
to manage their assets and liabilities.
• Swap often have the positive impact of
lowering the total cost of funding.
• Swap allow success to markets which
otherwise may not be available to firm.