If you have indeed spent enough time in any financial market, including the forex market, then you must have heard the term derivative more often than not. A term, in fact, that is used on many occasions many have come to confuse its definition and function.
That is why in this article, we intend to bring the notion of derivative in all financial market under close speculation. Of course we are also going to pay extra and special dedication to the use and application of derivatives in the foreign exchange market and its application in forex.
A Basic Understanding of Derivatives in Financial Markets
The basic idea of a derivative is to use a financial instrument for trading or investing in the form of a contract and without the direct need to apply or use the original asset for the purposes mentioned.
The reason such assets are called derivatives is that they derive their worth from the original asset that we discussed above. So, basically a derivative is a financial contract that gives trades the capability to buy or sell certain financial assets, especially at a future date.
You may have even heard the names of such derivatives, including options contracts or futures contracts. But perhaps you did not know that these are derivatives. We will discuss these and their relationship with the forex market in later sections.
Given their special nature and function, traders would normally apply derivatives where they want to speculate on the price of an asset or more. Derivatives are also used in hedging. Naturally, derivatives provide an excellent vehicle for the purpose of hedging specifically. Since they allow traders to speculate on future prices with the use of contracts, traders can make sure they are ready for any undesirable change that might take place in the market.
Different Aspects Associated with Derivate
As we have discussed the notion of derivatives so far, one can easily see just how applicable they are to practically every single financial market in the world. As a result a rather complex field is created around derivatives.
While derivatives in various financial markets might differ from one another in their application and also complexity, they do however have certain features in common.
- Derivatives & Liquidity: a special feature of almost all derivatives is that they garner a stupendous amount of liquidity to their market of choice. Of course, it is obviously different from market to market, but true by and large nonetheless. For instance, the speculative market of foreign currencies, composed of currency pairs which are basically derivatives, amasses a vastly high amount of liquidity to the market on a daily basis. The same is true for other derivatives as well.
- Derivatives & Leverage: another feature of derivative markets is leverage. In essence, leverage is the extra boost that the broker will give you as a trader so that you can trade with multiple times your initial equity. In this situation you will put a down payment, or margin, and in exchange will receive the amount of leverage to trade with.
- Derivatives & Volatility: although we mentioned that derivatives are an excellent choice when it comes to hedging, you need to know that they are also tied to great bouts of volatility. The reason is that they represent an asset through a contract for a future buy or sell action. As a result, unexpected price changes can occur at any time and these changes can at times be really sharp.
The Application of Derivatives in the Forex Market
They are different forms of trading when it comes to foreign currencies. The forex market usually would consist of spot trading. In this form of trading, as the name suggests, traders would engage in the trading of currencies according to their spot price or their currency price. Then it would take at most a couple days for the trade to settle between the parties involved.
However, there are other trading types that are also associated with the trading of foreign currencies. These types would include options, forwards, and futures contracts. In these following sections, we are going to discuss each one of these trading methods separately and see how they play a role in the massive world of foreign currency exchange.
How Many Types of Derivatives are in Forex?
A great deal of all foreign currency trades are carried out with the help of derivatives and other similar contracts.
Derivatives in Forex: Futures Contract
Futures contracts are perhaps the most quintessential form of derivatives. In the case of foreign currency futures contracts, a buyer and a seller enter into a contract based on an agreed upon amount of currency, which is usually in a standard size.
These contracts have a predetermined price at the time of creating the contract and also a predetermined time in the future when the trade will be executed.
As such, it can be seen that forex futures contracts are a great idea for those traders who want to steer clear of unfavorable price changes in the future. So they set out to lock in the price of the trade much sooner in the form of a futures contract.
It is also used by those traders who might anticipate upcoming price increases. So they also lock in the price early, hoping for the predicted price increase.
Derivatives in Forex: Forward Contract
Forward contracts are almost exactly like futures contracts. The only difference is that in futures contract benefits and losses are settled on a daily basis. However, with forward contracts, benefits and losses are settled at the time of expiry for the forward contract.
Derivatives in Forex: Option Contract
Options are especially ideal for hiding. How? Well, there are basically two forms of option contract; one is called a call option and the other is called a put option. The former is the option to sell and the latter is the option to purchase a currency at a predetermined price and at a predetermined time in the future.
Naturally, you can see how options are ideal for hedging. It is also similar to locking in the price early, thus preparing yourself for what is about to come in the market.
For instance, put options can be useful in anticipation of rising prices and call options can be useful when traders predict upcoming drop in prices.
So as we discussed in this article, a derivative, in any financial market, is a contract or financial instrument which does not carry inherent value in and of itself. Rather, a derivative would derive its value, as it is so called, from another underlying financial instrument.
As a result, they will provide this capability for traders to speculate on future prices for the purposes of hedging, among others. This way they can steer clear of price decreases as well as profiting from upcoming price increases.
The foreign currency market consists of a great deal of derivative trading in the form of various contracts, including futures, options, and forwards, all of which operate based on the underlying asset that is a foreign currency pair.