Foreign Exchange Markets: Instruments, Risks and Derivatives
Prof. P C Narayan
Week 4
Foreign Exchange Markets: Concepts, Instruments, Risks and
Derivatives
Week 04 – Summary
Currency Derivatives Market: An Overview
Currency Derivatives such as currency options, currency futures and currency swaps as well
as the markets where they are traded have evolved rapidly over the last few decades primarily
to enable companies and other entities either to hedge their risks against or to speculate and
gain from swings and volatilities in exchange rates.
Such heightened volatilities are a result of the exponential growth (both in volume and value
terms) of a very complex eco system of increasing global trade, cross-border flow of funds,
technology-based trading & settlement, etc.
By definition, "Derivative" means a forward, a future, an option or a swap contract of pre-
determined fixed duration, linked for the purpose of contract fulfilment to the value of
specified real or financial asset or to an index of securities” (LC Gupta Committee, 1998).
Currency Derivative instruments such as swaps are structured as over-the-counter (OTC)
transactions whereas futures and options are traded in Exchanges.
Participants in the currency derivative markets include: Hedgers, Speculators and Arbitragers.
© All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign
Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document,
including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any
means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Foreign Exchange Markets: Instruments, Risks and Derivatives
Prof. P C Narayan
Week 4
Currency Options
‘Options contracts’ are very versatile instruments, manifested in the holders’ right, but no
obligation, to exercise the contract. Hence, options are among the most widely traded
derivative instruments around the world. In the global financial market, Option contracts exist
on several asset classes such as equity stocks, currencies, and financial assets such as treasury
bonds (also called interest rate options), etc.
The specific and important terminology used in the options markets include:
Call Option: A Call Option gives the buyer of the Option the right, but no obligation,to
purchase currency ‘X’ against a currency ‘Y’ at a stated price of say ‘K’ units of ‘Y’ per
unit of ‘X’ on or before a stated date.
Put Option: A Put Option gives the buyer of the option the right , but no obligation, to
sell currency ‘X’ against currency ‘Y’ at a stated price of say ‘K’ units of ‘Y’ per unit of
‘X’ on or before a stated date.
Strike Price: Strike price is the price ‘K’ specified in the option contract, i.e. the price
at which the option can be exercised if the holder of the Option so wishes.
Maturity: This is the date of expiry of the option contract
European Option: A European Option can be exercised by the option buyer only on the
© All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign
Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document,
including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any
means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Foreign Exchange Markets: Instruments, Risks and Derivatives
Prof. P C Narayan
Week 4
maturity date.
American Option: An American Option, unlike a European Option, can be exercised by
the option buyer on any business day from the contract date to maturity date of the
option.
Premium: Premium is the fee that the option seller (also called the option writer)
receives from the option buyer up-front for granting the option buyer the right,
without the obligation, to exercise the option.
The premium payable upfront for every options contract is governed by the ‘Black Scholes
Options Pricing model’.
Currency Futures
In recent years, Currency Futures (or Foreign Exchange Futures) are being traded extensively in
the future markets around the world. Futures contracts are legally binding agreements to buy/sell
a standard quantity of a specified asset (such as equity stock, currency, commodity, etc.) at a pre-
determined future date and at a price agreed between the counterparties.
Futures contracts therefore specify the quantity, the price and the date of delivery.
Currency Futures Markets have broadly two types of participants:
© All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign
Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document,
including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any
means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Foreign Exchange Markets: Instruments, Risks and Derivatives
Prof. P C Narayan
Week 4
(1) ‘Hedgers’ who wish to lock-in an exchange rate for their foreign currency transactions in
the future, thereby eliminating currency risks.
(2) ‘Speculators’ who participate in the futures market merely to make a profit by taking
positions based on their ‘view’ on the expected fluctuations in exchange rates.
Currency Swaps
A Currency Swap is a foreign exchange derivative in whichtwo
counterparties exchange their principal and interest cash
flows in two different currencies for equivalent amounts.
Currency Swaps are based on the concept of ‘absolute
advantage’ and ‘comparative advantage’, the primary
objective being to reduce the interest cost for both counterparties involving large value - long
maturity borrowings in two different currencies.
© All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign
Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document,
including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any
means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.
Foreign Exchange Markets: Instruments, Risks and Derivatives
Prof. P C Narayan
Week 4
A ‘currency swap’ essentially makes effective use of the ‘Comparative advantage’ principleand
enables both counterparties to:
Borrow the required amount in their respective countries
‘SWAP’ the principle amounts to meet their respective capital expenditure
requirements in the foreign currency
Exchange the interest cash flows periodically
Principal
Counterparty 1 (Amount to be borrowed Counterparty 2
in two currencies)
Sourced &
Returned
Exchanged
CURRENCY
ExchangedSWAP
Counterparty 1 Start Maturity Counterparty 2
A swap is set up based on the exchange rates prevailing on the date the swap is written. It is
intrinsically unaffected by the exchange rate fluctuations over the life of the swap. As a result
of the ‘swap’, the borrowing cost for both the counterparties reduces.
In the Global financial Markets, it is not uncommon to see ‘Currency Swaps’ bundled with
‘Interest Rate Swaps’, thereby the exchange of cash flows are not only in different currencies
but one leg of the transactions would be in fixed rate and other leg in floating rate.
© All Rights Reserved. This document has been authored by Professor P C Narayan and is permitted for use only within the course "Foreign
Exchange Market: Instruments, Risks and Derivatives" delivered in the online course format by IIM Bangalore. No part of this document,
including any logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any
means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.
