Question

Critically evaluate alternative derivatives including forwards, futures, options and swaps available in the market to minimise risk when paying in international currencies.

Answer 1

Derivatives are financial contracts whose value depends on the value of the underlying asset.

There are mainly of 4 types:

1. Forward Contracts
2. Futures Contracts
3. Swaps
4. Options

Derivatives are tools for speculation & risk management/Hedging.

Let us evaluate how derivatives can be used to minimise risk when paying in international currencies.

• Forward Contracts: Forward Contracts are derivative contracts where there is a agreement to buy or sell an asset at a pre-determined price at a future date.Forwards are a great tool to minimise the risk when paying in international currencies as it eliminates the uncertainty regarding future fluctuations in the exchange rate.So the person/company can plan ahead knowing exactly how much it has to pay in the future and it does not have to worry about the exchange rate fluctuations.

Example : Suppose an importer wants to purchase goods worth $100,000 from India with delivery after 3 months.At the time of placing the order in the spot market, 1$ = Rs. 70. However suppose the Indian Rupee depreciates to Rs.72 when the payment is due after 3 months, the value of the payment of the importer goes up to Rs.7,200,000 from Rs.7,000,000.

The importer will make a loss of Rs. 200,000 on account of exchange fluctuations.

In order to hedge against the above loss, the importer could had entered into a forward contract. Say 3 months forward rate for 1$ was Rs. 71. By buying the forward, the importer has fixed the price.Whatever may be the exchange currency after 3 months it has to pay 100,000* Rs. 71 = Rs. 7,100,000

The uncertainty about exchange fluctuations have been reduced to a great extent and the importer knows exactly how much it has to pay after 3 months.

• Futures Contract: Futures contracts are similar to forward contracts except you have to purchase these from the exchange . Other key features of Futures contract are that you can opt to sell your contract before the maturity date as these are traded in the exchange.Also futures contract are traded in Fixed amounts known as the LOT size.
• Options: It is an agreement between a buyer and seller that gives the purchaser of the option the right to buy or sell a particular asset at a later date at an agreed upon price.

In the importer example given in Forward Contracts, assume that the importer buys a USD-INR pair call option.

So if Indian Rupee depreciates after 3 months the US$ will appreciate and the USD-INR call option will rise.So the loss that the importer will face on account of Rupee depreciating will be compensated from the income it will generate from the USD-INR call option. Hence the loss will be reduced and the risk will be minimised to a certain extent.

• Swaps : Currency Swaps can be used to minimise risk when paying in international currencies. A currency swap is a financial instrument which involves the exchange of interest in one currency for the same in another currency.Currency swaps involve 2 notional principles on which the exchanged interest payments are based.