Currency Derivatives: A Simple Overview

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Introduction to Currency Derivatives 

Foreign Currency (FX) is the value of one country’s currency against that of another. This arises due to the need to exchange from one currency to another during cross-border trade. Gold was used as the benchmark for valuation until the Bretton Woods system was introduced between 1944 and 1971. This system combines the gold method of valuation with a floating rate system. All currencies were pegged to the USD, and the USD was pegged to gold. The US made a guarantee that other central banks can convert their money to USD at any point in time. Countries agreed to maintain the exchange rate in the range of plus or minus 1% of the fixed parity of the US dollar. In this way, the US currency became the dominant currency.

Bretton Woods was eventually suspended, with all countries adopting the floating rate system. Developed countries eventually moved to a market determined exchange rate.  Developing countries adopted a system of pegged currency or managed rate.

Major Currency Pairs (Follow Free float method)
  • Euro (EUR)
  • US Dollar (USD) – Substantive role as investment, transaction, invoice, vehicle and reserve currency. 
  • Japanese Yen (JPY) – third most traded currency; smaller international presence.
  • Pound Sterling (GBP) – aka cable 
  • Australian Dollar (AUD)
  • Canadian Dollar (CAD)
  • Swiss Franc (CHF) – only currency of a major European nation that belongs neither to European Monetary Union or G-7.

Most active pairs:

  • EURUSD
  • USDJPY
  • GBPUSD
  • AUDUSD
  • CADUSD
  • USDCHF

Miscellaneous points
  • Currencies in the global market have a daily turnover of 3.9 trillion dollars, making it the largest traded asset class.
  • Every currency in FX market is a currency pair. 
    • Base currency (BC) – Currency that is priced; its amount is fixed at one unit. 
    • Quoting currency (QC) – Currency that prices BC; its amount varies according to BC price. 
    • What is quoted is the price of BC expressed in QC.
  • There are two distinct segments of OTC forex market:
    • Interbank – market between banks where dealers simultaneously quote prices for both buying and selling the currency. 
      • This mechanism is called market making. 
      • Such a quote is called two-way quote. 
      • The prices quoted for buying are called bid price, and for selling are called offer or ask price.  
      • The difference between bid and ask prices is called spread. A narrow spread indicates higher liquidity and efficiency of the market.
    • Merchant
  • In the interbank market, USD is the universal base currency, other than quoted against EUR, GBP, AUD, CAD, and NZD.
Market timing: 9:00 am to 5:00 pm. 
  • Merchants – 9:00 am to 4:30 pm
  • Interbank dealings to square off excess positions: 4:30 pm – 5:00 pm.
Price Benchmarks 

  • Interbank rate (IBR): 
    • Used for large value merchant transactions. 
    • Price available to the bank in the interbank market. Therefore, it would change from bank to bank. 
  • Card rate 
    • Standard price for the day 
    • Small value transactions 
    • Usually the same throughout a day, but may be revised multiple times when there is high volatility. 
    • Could vary significantly from bank to bank. 

The difference between the card rate and IBR is high in order to cover price fluctuations.

RBI Reference Rate: Rate published daily by the RBI for spot rate for various currency pairs. The rates are arrived at by:
- averaging the mean of the bid/ offer rates
- polled from a few select banks
- during a random 5 minute window between 11:45 am and 12:15 pm
To be issued every weekday (except Saturday) around 12:30 pm.

OTC Forward market – requirement of underlying trade contract before executing forward contract.
Factors such as GDP growth rate, balance of payment, deficit, inflation, interest rate and foreign capital policies can all influence GDP. x

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