A derivative is a type of financial contract that gets its value from an underlying asset. In foreign exchange transactions, the underlying asset is typically a currency’s exchange rate.
There are four main types of derivative, each having different characteristics and uses:
An option is a contract that gives you the right — but not the obligation — to buy or sell foreign currency at a predetermined exchange rate at a future date. This means you only go ahead with the sale or purchase if you want to.
Options that give you the right to sell are called put options, while options that give you the right to buy are called call options.
Options are useful because they act as insurance and give you certainty. If the exchange rate becomes too unfavourable, you can exercise your option and buy or sell at a better rate than you’d get on the open market.
You can also keep your exchange rate risk within a certain range by having an option to buy if the exchange rate goes below a certain threshold, and an option to sell if the exchange rate goes above a certain threshold. This technique is called a collar.
Like options, futures are agreements to buy or sell at a predetermined rate at a date in the future. But while options give you a choice, futures create a legally binding obligation to buy or sell on the specified date.
Futures are popular with speculators. That said, they can also be a useful risk management technique, especially if you operate in a volatile market.
Imagine you’re a company that does business in a part of the world that has become politically unstable. You’re due a large payment from a customer, but the political instability risks hurting the exchange rate, which means you could end up with less money in your pocket.
By locking in a good exchange rate, you no longer have to worry about how the political situation could affect your income.
Forward contracts are a type of futures contract. The main difference is that, while futures are typically traded on exchanges, forwards are private agreements between two specific parties.
A forward contract’s main advantage is that you can customise it to your exact requirements. In comparison, because futures are traded on exchanges, their terms tend to be standardised.
Forward contracts are especially useful if you’re in the import/export business. Here, exchange rate fluctuations can have a significant effect on your profit margin. So, having a tailored agreement in place with your most important buyers or suppliers gives you certainty and peace of mind.
A swap is an exchange of debts in different currencies. This type of agreement is useful if you need financing in a foreign country and want to get a better interest rate than you’d get if you’d applied directly.
Imagine you’re a UK business that wants to set up shop in Canada. You need a loan of CAD$50,000 to cover startup costs. But, unfortunately, no bank will give you a good rate because you’re new to Canada and your business doesn’t have a credit history.
As it happens, a Canadian business would like to set up shop in the UK and needs £50,000 to cover startup costs. They also have the same difficulty obtaining credit.
A swap could be the solution.
You’d take out a £50,000 loan, the Canadian business would take out a CAD$50,000 loan, and you’d swap loans at a pre-agreed rate, giving you both cheaper credit.
- Derivatives became popular in the late 1970s as a means of managing the increased risk caused by the end of the Bretton Woods system. But the first recorded derivative dates back to 600 BC when, having used his astronomical knowledge to predict a bumper olive crop, a Greek philosopher called Thales of Miletus negotiated a series of call options on olive presses.
- Miletus’ gamble paid off, and he cornered the olive oil market. Thereafter, contracts that fixed future prices became commonplace. Greek shippers used contracts that resembled forwards. Similarly, merchants in medieval Europe used ‘fair letters’ — so called because they were exchanged at fairs — to buy and sell produce.
- Warren Buffet famously called derivatives “financial weapons of mass destruction”. But the truth is that they’re one of the cornerstones of international financial markets. Big banks, large international companies, and even governments use derivatives to manage risk and take advantage of new opportunities.
Want to know more?
- This article is a fascinating look at the history of derivatives, from 8000 BC Sumer to the present day.
- If international markets wouldn’t function without derivatives, there have also been times when they’ve hit the headlines for all the wrong reasons. This paper takes a clear-headed look at the role of derivatives in financial crises.
“While they’ve earned a bad rap in some quarters, derivatives are a powerful and effective risk management tool. The key is to choose carefully. Whether you’re best off with a forward contract, future, option, or swap depends on your particular circumstances and the kind of risk you want to hedge against.”