Foreign Currency Derivatives

Abstract

A foreign currency derivative is a financial derivative whose payoff depends on the foreign exchange rates of two (or more) currencies. These instruments are commonly used for hedging foreign exchange risk or for currency speculation and arbitrage. Specific foreign exchange derivatives include: foreign currency forward contracts, foreign currency futures, foreign currency swaps, currency options, and foreign exchange binary options. These instruments are called derivatives because their value is derived from an underlying asset, a foreign currency. The financial managers of MNCs purchase these financial derivatives in order to reduce the risk associated with cash flows denominated in foreign currency, hedging this exchange rate risk or to take positions in the expectation of profit, speculation, or arbitrage. Financial derivatives are powerful tools of hedging (redistributing) foreign exchange risk, but at the same time, they are very risky instruments for inexperienced financial managers. Lately, there were many cases in which financial managers generated enormous losses for their companies (mostly banks) and led them to bankruptcy. Of course, the rule is always moderation and prudence. If we want to go one step further, the rule is the maximization of the social welfare of a nation. 5.1 Foreign Currency Forward and Futures Contracts In finance, a forward contract or simply a forward is a nonstandardized contract between two parties to buy or sell an asset (foreign currency) at a specified future time at a price agreed upon today. This is in contrast to a spot contract, which is an agreement to buy or sell a foreign currency today. The party agreeing to buy the underlying currency in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price (exchange rate), which is equal to the forward exchange rate at