6.3 Currency derivatives and risk management

Currency derivatives are powerful tools for managing foreign exchange risk in international trade and finance. These financial instruments allow businesses and investors to protect against adverse currency movements while maintaining flexibility.

Forward contracts, futures, options, and swaps each offer unique advantages for hedging currency exposure. Understanding their mechanics, pricing, and strategic applications is crucial for effective risk management in global markets.

Currency Derivatives

Types of currency derivatives

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• Forward contracts lock in a specific exchange rate for a future date to hedge against currency fluctuations
• Currency futures are standardized, exchange-traded contracts similar to forwards but with more liquidity and transparency (Chicago Mercantile Exchange)
• Currency options give the holder the right to buy (call option) or sell (put option) currency at a set price (strike price) by a certain date (expiration), providing hedging flexibility
• Currency swaps involve exchanging principal and interest payments in different currencies to manage long-term exposure and access foreign capital

Mechanics of forward contracts

• Forward contract terms include notional amount (currency quantity), forward rate (agreed exchange rate), and maturity date (settlement date)
• Exporters sell foreign currency forwards to lock in rates and protect against depreciation, while importers buy forwards to guard against appreciation
• Forward pricing is based on interest rate differentials between currencies, calculated using the covered interest rate parity formula: $Forward rate = Spot rate × \frac{(1 + r_d)^t}{(1 + r_f)^t}$, where $r_d$ is domestic rate, $r_f$ is foreign rate, and $t$ is time to maturity

Currency futures vs forward contracts

• Currency futures have standardized notional amounts, maturity dates, and are exchange-traded, providing liquidity and transparency
• Futures require initial and maintenance margins to ensure contract fulfillment and reduce counterparty risk
• Futures positions can be closed before maturity by taking an offsetting position, offering flexibility compared to forwards
• Daily marking to market of futures contracts settles gains and losses, reducing default risk

Structure of currency options

• Call options grant the right to buy currency at a strike price, while put options allow selling at a strike price
• Option premiums, paid by the buyer to the seller, are determined by factors like exchange rates, strike prices, expiration, interest rates, and implied volatility
• Protective puts hedge against depreciation while allowing gains from appreciation, and covered calls generate income to offset hedging costs
• Strategies like zero-cost collars (put purchase + call sale) and participating forwards (forward + option) provide customized risk management

Effectiveness of derivative strategies

1. Hedging ratio determines the proportion of foreign currency exposure hedged, balancing protection and potential gains
2. Hedge effectiveness measures how well the derivative offsets changes in the hedged item's value, assessed through regression analysis or value-at-risk (VaR) models
3. Strategy selection depends on risk tolerance, hedging costs, liquidity, accounting treatment, and tax implications
4. Regular monitoring and adjustment of hedges is crucial to adapt to changing market conditions, exposure levels, and instrument-exposure correlations