What are exchange-traded currency futures and options?
Investors look for price fluctuation in any security or a commodity that can be traded to make profits. The Indian investment market thus offers numerous ways by leveraging various tradable commodities. One such elaborative method investors use is Exchange Traded Derivatives. This blog details Exchange Trade Derivatives and their widely used types: Exchange Traded Currency Futures and Options.
What are Exchange Traded Derivatives?
An Exchange Traded Derivative is a standardized financial contract that is traded in stock exchanges in a regulated manner. They are subject to the rules framed by market regulators such as the Securities and Exchange Board of India (SEBI) in India or the Securities and Exchange Commission in the USA.
They are essentially contracts, deriving values from the price fluctuations of their underlying assets. Here, there are two types of derivatives: one that is subject to standardized terms and conditions, and hence being traded in the stock exchanges, and the second type being traded between private counter-parties, in the absence of a formal intermediary. While the first type is known as Exchange Traded Derivatives (ETDs), the second is known as Over the Counter (OTC) derivatives.
Types of Exchange Traded Derivatives
- Stock ETDs: The first in the list of Exchange Traded Derivatives is the stock segment. The Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) deal exclusively in stock derivatives in India. The types of stock derivatives are Stock Forwards and Stock Options.
- Index ETDs: These types of Exchange Traded Derivatives trade on the major stock indices. You can purchase or sell both index forwards and index options. However, unlike stock options where you can opt for settlement either in cash or via delivery of stocks, index options have to settle in cash. Some of the popular traded Index ETDs in India and across the globe include Nifty50, Sensex, Nifty Next 50, etc.
- Currency ETDs: Here, you have the option to trade as per the price movement of the currencies in the stock exchange. Unlike OTC derivatives trade in currency, ETDs allow for standardized contracts only across the specified pairs of currencies.
- Commodity ETDs: These types of Exchange Traded Derivatives are traded on the price fluctuations of scores of commodities. In India, you can trade in commodities futures at the Multi Commodity Exchange of India Ltd (MCX). Some of the examples of standardized contracts on commodities include gold, crude oil, silver, natural gas, copper, zinc, etc.
- Bond ETDs: These types of Exchange Traded Derivatives involve trading in bonds. For instance, the NSE has an exclusive platform to trade in bond derivatives products. You can use this platform to trade in interest rate futures. The NSE provides for two instruments in the segment for interest rate futures: NBF II - Futures on Govt. of India securities for 6,10 and 13 years and 91 DTB -Futures on Govt. of India treasury bill for 91 days.
Exchange-Traded Currency Futures and Options
Every country has a currency, and its value fluctuates based on the value of other countries' currencies. For example, the price of INR keeps fluctuating compared to USD, and you see daily that it is derived from its value against 1 USD. Investors use these fluctuations to trade in currencies and profit from the fluctuation.
How do exchange-traded currency contracts work?
Exchange-traded currency contracts work on the same principle of buying at a low price and selling at a higher price. However, exchange-traded currency contracts are always bought in pairs. For example:
- Indian Rupee vs United States Dollar (USD-INR)
- Indian Rupee vs Euro (EUR-INR)
- Indian Rupee vs Great Britain Pound (GBP-INR)
- Indian Rupee vs Japan’s Yen (JPY-INR)
Suppose you buy the first pair of USD-INR, you are referred to as going long, i.e. you are buying the numerator (the base currency), which is USD, and selling the denominator, which is the INR. It means that you are using INR to purchase USD. However, when you sell the pair, you are selling USD and buying INR again.
You can trade in the exchange-traded currency derivatives through methods: Exchange-traded Currency Futures and Options.
Exchange-Traded Currency Futures
Exchange-traded currency futures refer to a legal contract where one party agrees to sell a specific amount of any particular currency at a predetermined price on a specific future date. These contracts are traded in currency exchanges and do not necessarily mean that the currency will be delivered to the investor. The investor can settle the contract before the expiry date to realize profit or loss.
For example, suppose a trading company wants to mitigate its losses about international trade if the Indian currency strengthens in the future against the US dollar. For the current exchange rate of INR 70 to the USD, it can buy a futures contract of 1 lakh worth, valuing the contract at Rs 70 lakh with an expiry date of 3 months. If at the end of the 3 months, the INR strengthens against the USD and reaches Rs 65, the trading company can exercise its contract and save a loss of Rs 5 lakhs as 1 lakh worth of contract would have been valued at Rs 65 lakh currently.
In India, exchange-traded currency futures were first introduced by the National Stock Exchange in the year 2008. Currently, the trading process has been extended to other stock exchanges such as the Bombay Stock Exchange and MCX-SX.
Exchange Traded Currency Options Meaning
Exchange-traded currency options refer to a legal derivative contract wherein the investor has the right, but not the obligation to exchange a specific currency for another at a future date. These options put one party (the buyer) in a privileged position as it can sell the contract if it is profitable before the expiration date or just ignore the locked-in price if that is more profitable (the right, but not the obligation to sell). However, the buyer has to pay a premium price to the seller to enjoy the right. There are two types of currency options: Currency Put and Currency Call.
For example, suppose an IT company has a client in the US and knows that they will be settling the payment in 3 months. Fearing that INR can strengthen to Rs 60 from the current value of 70, it buys a currency option at the current price of Rs 70, giving it the right but not the obligation to sell the contract after the expiry date of 3 months. If the INR strengthens to Rs 60, the IT company can sell the contract at the predetermined price of Rs 70 and offset the losses of Rs 10.
However, if the INR weakens to Rs 80, the IT company would incur a loss of Rs 10 if it decides to sell the contract. As under the options contract, it is not obliged to sell, it can just forgo the whole contract, thus offsetting the loss of Rs 10. The only loss it would incur would be the premium amount is paid to exercise the contract.
The National Stock Exchange first introduced Exchange-traded currency options in the year 2010. You can purchase currency options using INR against other currencies such as the US dollar, Euros, Pound sterling, etc., on NSE, BSE, and MCX-SX.
For investors looking to diversify their portfolios, exchange-traded currency futures and options can make up for an ideal way. As the currency price fluctuates almost every day, the profit-making opportunities are immense. Although it is always wise that you research and analyze the factors that can drive currency prices. As the trading style is risky, you can consult an experienced stockbroker such as IIFL to guide you in the process of currency trading.
Frequently Asked Questions Expand All
You can trade currency derivatives in the following pairs: US Dollar –Indian Rupee Contract (USD-INR)
British Pound –Indian Rupee Contract (GBP –INR)
Japanese Yen –Indian Rupee Contract (JPY-INR)
Euro –Indian Rupee Contract (EUR-INR)
Currency call options are entered by the inventors to benefit from the increase in the price of the currency pair. On the other hand, currency put options are leveraged by investors to benefit from the decrease in the price of the commodity pair.
For currency trading, you can open a demat account along with the best online trading account with a reputable brokerage house such as IIFL. Start with an IIFL demat and trading account and trade in options, futures, equities, mutual funds and currencies with the help of a next-gen trading platform and IIFL’s award-winning research team. You can also download IIFL’s market app from the app store.