Introduction to Foreign Exchange Derivatives

The financial markets are everchanging and therefore to counter the risks which are involved in foreign exchange transactions, foreign exchange derivatives are used by businesses. Most of the countries and traders are engaged in foreign exchanges and the same leads to globalization (Hudson 2017). In this context, businesses use foreign exchange derivatives for the purpose of minimizing the risks which are associated with such foreign exchanges. The concept of foreign exchange derivatives is derived from international finance where the term generally applies to simple contracts which are entered by individuals for buying or selling currency at a future date.

In financial markets, trade involving foreign exchange is very common and this has opened new dimensions for businesses across the world. The foreign exchange trade involves use of currency of foreign countries which fluctuate on regular basis and therefore there is significant risk on businesses due to such factors. Any financial market instrument which can lock in foreign exchange rates and there also minimize the risks of fall in the value of currency are known as foreign exchange derivatives (Hirsa and Neftci 2013). A foreign company, in domestic markets, is able to reduce its risk exposure in one currency by increasing its certainty in another. These allow investors to buy or sell foreign currencies at any future date (Bryan and Rafferty 2014). There are four types of financial derivatives which are used by different individuals and they are currency option contracts, currency swap contracts, forward contracts and future contracts (Donohoe 2015). The assessment considers a company which is engaged in the export fashion goods in foreign markets and the company is exporting goods to USA. The assessment would be assessing different types of derivative instruments along with their merits and demerits and also suggest the best option which is available to the business engaged in exports of fashion products. The choice of derivatives is on the individual and his requirements. The different types of derivatives which are available to the business are listed below in details along with their respective advantages and disadvantages.

One of the most popular form of derivatives which are available in the market is forward contracts. In a forward contract situation, an agreement is made between two parties for either buying or selling a product at a specific price, however, the actual transaction takes place at a future date and this a main feature of a forward contract (Wong 2013). Forward contracts can be effectively be compared to futures the difference being the over the counter market is present in case of foreign clothes. The benefit of forward contract is that the same allows the investors to lock in the product or the assets which the other party wants at a specific price when the agreement is made (Boroumand et al. 2015). The price at which such an agreement is made is considered when the actual transaction takes place (Gupta 2017). In such a situation the price which was finalized at the time of agreement is always considered to be actual and legitimate when the actual performance of the contract takes place. The main advantages which can be identified in case of forward contract are listed below in details:

• Protection Against Exchange rate Fluctuations: Forward contracts can be used as an instrument for managing the risks of the foreign exchanges and can be effectively used as hedges in industries such as agriculture. The instrument can be effectively used for the purpose of making arrangements for future in case the prices of the products drops in future.
• Hedging against risks: Another important benefit which can be identified for forward contracts is that the instrument gives immense protection against risks of fall in prices of a product or asset (Bielecki and Rutkowski 2013). The instruments can be used effectively for applying hedging techniques for neutralizing the risks of a business.

Forward Contracts

In addition to the above discussion there are other merits which is associated with forward contracts such as the same are easy to set up and maintain and are particularly inexpensive in nature. The disadvantages which can be identified in relation to forward contracts are listed below in details:

• Possibility of Defaults: The main disadvantage which can be pointed out regarding forward contracts is that there is always a possibility of non-performance of the contract which can lead to serious losses for the parties. The agreement is private in nature and has no standardization. They are not traded and are made different for different parties and therefore third parties do not have any interest in such contracts as the same cannot be sold. The main demerit is that forward contracts suffers from risks of defaults and thereby are suitable for most.
• Product Quality Variations: Forward contracts often in many cases covers agricultural products and precious metals trade. Therefore, in many situations the product which the buyer is suppose to purchase is not seen till the contract date. This creates a huge risk regarding non-performance of the contract. In addition to this, there is also an issue relating to quality variation in the product. In agricultural terms, a particular wool quality differs entirely from year to year because there are quality variations from season to season. The quality is a major factor in a trade and therefore there is often disagreement between parties for performing.

In case of a fashion industry, the quality of the products are important determinants and the above merits and demerits are to considered by the business before arriving at any appropriate decision relating to the financial derivate which can be used by the business.

These are a type of contracts which are generally on currencies, tock markets or some commodities. When an individual is dealing with futures contract that the person is going to deliver a specified amount of a good or receive a certain amount of goods which is determined in some future period. A foreign company, in domestic markets, is able to reduce its risk exposure in one currency by increasing its certainty in another. A foreign company, in domestic markets, is able to reduce its risk exposure in one currency by increasing its certainty in another. The instruments of future contracts are used for the purpose of hedging and therefore they are considered to be a very good option for traders (Schepker  et al. 2014). Trading in future contracts is very great way for the purpose of investing money in order to protect the currency of traders. Future contracts are quite different from forward contract which is the first thing to recognize. A forward is mainly used for the purpose of hedging while on the other hand, the future contract is used mainly for the purpose of making speculations. The advantages which can be pointed out in case of future contracts are listed below in details:

• Futures are highly leveraged investment: Future contracts can be obtained easily by the investors and a much larger amount can be invested in a future contract for the purpose of investment. In case of future contracts, the actual trade in most cases are rarely undertaken and therefore, the investors who have undertaken future contracts are mainly speculators and the future contracts are considered to be mainly to be paper currency for a business (Sousa, Lopes and Santana 2015).
• Liquidity and Cost Effective: Future contracts are traded on regular basis in financial markets and therefore the derivative is considered to be highly liquid in nature. This is considered to be a major advantage for individuals and the same can be traded effectively in the market. In case of future contracts, there is a surety that there will always be a buyer a seller for the derivate and therefore it is considered to be preferred choice. The commission charges which are associated with a future contract is low and is mostly paid after the position has ended. Thus, from the perspective of economy, futures contracts are considered to be favorable.

Some other advantage which is associated with futures is that the derivates requires a very low margin and therefore it is a preferred choice. The disadvantages which are associated with a futures contract are listed below in details:

• Leverage Effect and Short term: Future contracts generally uses leverage in order to maximize the returns and make the investment attractive. However, the same can also going in adverse manner and the riskiness can enhance accordingly. In addition to this, futures contracts are used mainly for short term purpose and therefore the same cannot be used for long term purpose.
• Monitoring Trading futures: Future contracts are traded on a continuous basis and therefore are applicable in short run. The prices of futures contracts are changing on a regular basis and therefore the prices need to be monitored regularly which is a rigorous process.

Options contracts are a type of derivatives which allows the businesses to enter into an agreement which allows buyers and seller to have a right to option to purchase or sell the product at an agreed price. Such options are generally applied to securities, commodities and real estate transactions. In case of an option, buyers have the right but does not have any obligation to buy or sell. There are two types of options which are available to the investors and the same depends on the needs of the individuals (Bodnar et al. 2013). The terms and agreements of an option contract specify the underlying security and the price of underlying security which can be transacted and the price is considered to be the strike price depending on the expiry date of contracts. Option contracts are considered to be an appropriate choice as the same can help to reduce the riskiness of an foreign exchange transaction. The advantages of selecting an option contract are listed below in details:

• Cost Effectiveness: One of the main advantages of using an option contract, is that the contracts are every much cost effective in nature. Options can be said to be an inexpensive technique to gain access to underlying investments without having the need to purchase any stocks. In addition to this, option allows individuals to stump up less amount of money and end with more gains (White 2014). Thus, it can be said that options are an effectively way for the business to maintain costs as well as gain more from the investments.
• Marketability and Diversification: The options contracts are easily marketable in the financial markets. Options can be traded freely in the market and also are standardized. In addition to this, option contracts also facilitate hedging which allows the individual to effectively manage the risks of the business and also make gains for the individual from the options contract. An individual can opt for options contract by replicating his actual stock portfolio with options.

Futures Contracts

In addition to the above advantage which is mentioned above, there are other miscellaneous advantages of opting for options as the financial derivatives. There are certain listed options which can be regulated. The disadvantages which can be identified in the case of option contracts are listed below:

• Leverage effect: Options are leveraged contracts which means that they take help of dent capital. While there are a lot of favorable aspects of options being leveraged, there are certain negative impacts and too much leverage would result in increase in risks for the individual. In addition to this, as option contracts are regulated therefore the same is always under the risk that more regulations would be brought in the contracts (Hull et al. 2013). The leverage aspects can both favorable and unfavorable.
• Time delay and Liquidity: Option Contracts are very much complicated in nature for any investor and its is very difficult to understand for most of the investors. The decay time for option contracts is high and most of the investors loses out on the advantage of time value of money and therefore they are not easy to accept. The liquidity of an investor is also affected if lumpsum amount is invested in a options contract.

Swap contracts are a form of currency-based contracts which allow the individuals to appropriately take precautionary measures against fluctuations which takes place in prices. A foreign company, in domestic markets, is able to reduce its risk exposure in one currency by increasing its certainty in another. Swap contracts allow individuals to effectively enter into new markets for investment purposes.

The basic advantage which can be identified form a swap contract is that the contract enables both the parities in a contract to make gains in a market. In most cases, it is the foreign country engage in a trade tries to enter into a currency swap agreement which allow the business. The most difficult phase in such a contract is finding the domestic country party and therefore the process can be described as rigorous part. In addition to this, the choice of options are not effective in nature in terms of costs and are considered to be an expensive option.

The above analysis suggests that the best option which is available to the UK fashion business in terms of derivatives is future contracts. Future contacts would enable the business to enter into contracts with clients at a date while the actual transaction will be taking place at a future date. Futures contracts are cost effective in nature and therefore are a preferable option for the business. The other options which are available to the business of Forward and option contracts which have certain limitations and the same are also not suitable for the business. The future contracts allow businesses to operate in short run and thereby it is profitable in nature.

Conclusion

The analysis which is conducted above shows the overall importance of financial derivatives in financial markets and the same allows the investors of the business to effectively recognize the risks of currency fluctuations and make preparations for minimizing such a risk. The application of derivatives would help the British company which is engaged in the business of exporting fashion products to effectively managing risks associated with currency fluctuations in the nation. The management of the company has the option of selecting either futures, forward, options swap form of contracts and the same is to be selected on the basis of the requirement of the individual. Therefore, the above discussion makes it clear that financial derivatives have an impact role in the market for investors and for the purpose of speculations and hedging.

Reference

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