Question

When would you use forwards, futures and options, in respect to a depreciating currency

Answer 1

Forwards – With respect to depreciating currency forwards can be used to eliminate the risk of potential losses from adverse market movements. Using forwards you can buy currencies at a fixed price and a fixed date. Suppose that you are supposed to receive 500 USD after six months and you live in Japan. This amount will be credited to your bank account in JPY terms. The USD is depreciating against JPY and so to hedge your risk of loss you enter into a forward contract. So even if the USD is depreciating the forward contract that you will enter will fix the JPY/USD rate and will ensure that you will still receive the same amount of JPY. You will enter into a forward contract with a local bank for a payment in Japanese yen that you'll receive in six months. This will protect you from losses from depreciation of USD against JPY.

Futures – Currency futures are exchange-traded futures contract that specify the price in one currency at which another currency can be bought or sold at a future date. Now suppose that an exporter in India is set to receive $10,000 after a period of two months. The current exchange rate is 1 USD = 65 INR but there is a risk that it may go to 1 USD = 62 INR. If this happens then there will be a loss to the exporter. So the exporter will hedge his risk by selling 10 lots (of $1,000 each) of the USD INR pair at INR 65. Thus in this case the futures will be short.

Options – In this case a currency put option will be used. This will give the holder the right (but not the obligation) to sell a specific currency at a specific price within a defined period of time. In case the currency depreciates below the specified put option price the put option will provide protection.