With a foreign exchange (forex) derivative, the owner has the right but not the obligation to exchange money denominated in one currency for another currency at a pre-determined exchange rate and date. The forex derivatives market is the largest market in the world, with over $1 trillion traded every single day.
Speculation and Hedging
Forex derivatives are principally used for speculation and hedging. Hedgers use forex financial futures contracts to mitigate risk by insulating themselves against potential price shifts in the future. One the other hand, speculators take risks of potential price shifts with profit as their objective.
One of the major advantages of using forex derivatives is the availability of trade spreads that are normally lower, often less than three points. The spread is the difference between the bid and ask price. Transaction costs are also usually lower with the buyer enjoying more leverage for each contract.
On the demerit front, there is a need for higher capital investments which may not be affordable for retail investors. There are mandatory fees and time limitations as forex derivatives can only be used during an exchange trading session.
Trading strategies are generally the same as standard trading methods while using forex derivatives for speculation. The history and turning points of the currency are evaluated by the method of trend analysis. However, more complex methods are also used to determine the country’s economic indicators and political climate.
Forex derivatives are often used for hedging to protect sales revenue. For example, an Indian company with stores in England will be making sales in pounds but needs to receive the income in rupees. In such situations, a forex derivative will allow the firm to purchase a contract in the amount of expected sales in order to erase any changes in the currency market. Forex derivatives may also be in the form of forwards where the underlying cash is not paid until the date of expiry.