What are Foreign Exchange Derivatives?

Investment products whose payment stream depends on the movement of an exchange rate are foreign exchange derivatives. This class of products includes puts, calls, swaps, forwards and futures. Foreign exchange derivatives are also called FX derivatives or forex derivatives.

The exchange rate on which a derivative is based is referred to as its underlying. Foreign exchange derivatives function in the same way as traditional derivatives do, but their underlyings are exchange rates rather than common stock. Currency exchanges can be thought of as transactions in which each party sells a certain amount of one currency and is paid in another. Currency-based derivatives are non-equity derivatives because they are not based on equity, like stock.

There are two types of options: puts and calls. A put allows the holder to sell a certain amount of the specified currency at a designated exchange rate, or the strike price. A call guarantees the holder the ability to buy a certain amount of the currency at the strike price. The ability to exercise an option expires at a date agreed upon in the option contract. If the option is American-style, the holder may exercise the option at any date on or before the expiration date; European-style options give holders the choice to buy or sell at the strike price only on the expiration date.

Currency swaps are agreements between two parties to trade currencies on certain dates. Swaps specify certain conditions, including whether the exchange rate over the life of the swap is fixed or floating. Sometimes, currency and interest rate swaps are combined. In these instruments, two parties trade the payment streams of loans in different currencies. A swaption is another type of derivative that gives the holder the option of entering a swap.

Forwards and futures are contracts in which one party agrees to deliver a certain amount of a commodity, or in this case a certain amount of currency, for a predetermined price. The most important difference between the two classes of derivatives is that forwards are negotiated between private parties, while futures have standardized terms and are traded on exchanges. International corporations trade in these foreign exchange derivatives to hedge against unfavorable changes in the exchange rates between the currency in which they pay the production costs and the currency in which they receive payments. By purchasing futures, the company locks in an exchange rate in the future, so they are protected from losses in profits caused by changes in the exchange rate.