The derivatives market is huge — much bigger than the stock market when measured in terms of underlying assets. Derivatives can be used for hedging or speculation or arbitrage. They play a key role in transferring a wide range of risks in the economy from one entity to another.
A derivative can be defined as a financial instrument whose value depends on (or derives from) the values of other, more basic, underlying variables. Very often the variables underlying derivatives are the prices of traded assets. From a foreign exchange market standpoint, a derivative contract is an agreement between two parties, which specifies that an amount of cash may be exchanged at a later date, set at a price fixed today. The value of the contract is derived from the current spot rate and a forward rate, which takes into consideration the interest rate differential between the two counterparty’s countries.
Given this short introduction, let’s say you've decided to use hedging to protect your firm or investors against currency fluctuations. There are many derivatives to choose from.
FX hedging Instruments include:
1. Using Forward Contracts
A non-deliverable forward (NDF) is an agreement between two parties to buy or sell an agreed amount (of the non-convertible currency), on a specific due date, and at a defined forward rate. At its maturity, the forward rate is compared against the reference rate of that day. The difference between the pre-agreed forward rate and the fixing rate is settled in the convertible currency on your account at the due date. Therefore, you will either pay or receive the difference. As with a forward transaction, the cost of an NDF corresponds to the interest differential between the two currencies.
2. Using Futures
Like a forward contract, a futures contract is an agreement between two parties to buy or sell an asset (in this case, the exchange rate) at a certain time in the future for a certain rate. Unlike forward contracts, futures contracts are normally traded on an exchange, and they are also a standardized contract, meaning, having an exchange-specified contract unit, expiration, tick size, and notional value. The counterparty risk is low as they are exchange-traded. However, rigid contract sizes and daily margin requirements can make them hard to manage.
3. Using Option Contracts
An option on a futures contract is the right, but not the obligation, to buy or sell a particular futures contract at a specific price, on or before a certain expiration date. There are two types of options: call options and put options.
4. Using Long-term debt instruments
For long-term exposures which are long the local currency (e.g. a U.S. firm selling products or services in the EU), the use of debt instruments (bonds, loans) can offset FX risk. The process is simple. The firm takes out a local currency (LC) obligation, such as a bond, and converts the proceeds to its reporting currency (RC). The proceeds can be used to fund operations, R&D, and so on. Instead of hedging or converting its LC revenues to RC, it uses them to service the LC debt obligation. In this way, it eliminates the FX risk of its revenues and the debt instrument simultaneously.
Selecting the size of the debt instrument is based on the long-term baseline value of LC revenues, so there will always be residual LC revenues that still are at risk, but the net is much lower.
5. Using Cross-currency swaps
Cross-border investments and cross-border issuance are exposed to interest rate risk and FX risk. It is similar to an Interest Rate Swap, except each leg of the swap is denominated in a different currency. A Cross Currency Swap, therefore, has two principal amounts, one for each currency. Using cross-currency swaps can help institutions retain core longer-duration assets to manage interest and currency rate risk.
The key lesson to be learned here is the importance of choosing the right derivative for hedging your FX exposure. The derivatives are available for everyone, but how to use them properly will depend on the Finance team’s capability to understand the risks and the benefits associated with.
If you have any questions, feel free to contact us today.