Forward Currency Contracts and Currency Options Are the Same
The main difference is that option buyers are not required to buy or sell the long currency – futures traders are. Options sellers may need to buy or sell the underlying asset if the trades are directed against them. Option buyers do not have to pay margin and their potential loss is limited to the purchase cost or the premium of the option. Option sellers and futures traders need to make margins and have virtually unlimited risk. After all, the premium of an options contract is almost always less than the margin required for a similar futures contract. For many companies, a combination of both types of contracts is ultimately used to manage currency risk as effectively as possible. As mentioned earlier, currency futures can provide a clear way to manage downside risks for topics where cash flow forecasting is secure, such as payments and receivables. For problems related to more uncertain cash flow forecasts, . B such as hedging year-end results, mergers and acquisitions, or even the sale of fixed assets, options can provide a more advantageous structure to deal with relevant currency risks. Pricing: The « forward rate » or the price of an outright futures contract is based on the spot rate at the time of accounting for the transaction, with an adjustment for « term points » representing the difference in interest rate between the two currencies concerned.
Futures and call options are various financial instruments that allow two parties to buy or sell assets at certain prices at future dates. Futures and call options can be used to hedge assets or speculate on future asset prices. Currency options and futures are both derivative contracts – they derive their values from the underlying asset – in this case, currency pairs. Currencies are always traded in pairs. For example, the Euro/US dollar pair is called EUR/USD. Buying this pair means going for a long time or buying the numerator or the base currency – the euro – and selling the denominator or the quote currency – the dollar. If you were to sell the couple, these relationships would reverse. You earn money when the long currency appreciates against the short currency. The buyer of a currency pair call option may decide to execute or sell the option no later than the expiry date. The option has an strike price that indicates a specific exchange ratio for the pair. If the actual price of the currency pair exceeds the strike price, the call holder can sell the option at a profit or execute the base call option and sell the price on profitable terms. A buyer could bet that the quote currency will appreciate against the base currency.
Forward processing of currency can be carried out in cash or delivery, provided that the option is acceptable to both parties and has been previously specified in the contract. Currency futures are over-the-counter (OTC) instruments because they are not traded on a central exchange and are also referred to as « pure and simple futures ». Forex futures are only used in a situation where exchange rates can affect the price of goods sold. In an NDF, the forward price used follows the same methodology as the outright forward, but the funds actually traded at maturity on the value date depend on the prevailing spot rate. How does a currency date work as a hedging mechanism? Suppose a Canadian exporter sells goods worth $1 million to a U.S. company and expects to receive export products in a year. The exporter is concerned that in a year`s time, the Canadian dollar will have strengthened against its current rate (1.0500), meaning it would receive fewer Canadian dollars per U.S. dollar.
The Canadian exporter therefore enters into a futures contract to sell $1 million per year at a forward rate of $1 = $1.0655 in the future. Taking the example of the US dollar and the Ethiopian birr with a spot rate of USD-ETB = 9.8600 and one-year interest rates of 3.23% and 3.23% respectively. 6.50% for the United States and Ethiopia, we can calculate the one-year term rate as follows: If, in the meantime and at the time of the actual transaction date, the market exchange rate is 1.33 US dollars to 1 euro, the buyer has benefited by setting the rate of 1.3. On the other hand, if the exchange rate in effect at that time is 1.22 US dollars to 1 euro, the seller benefits from the currency futures contract. However, both parties have benefited from the purchase price freeze, so the seller knows his costs in his own currency and the buyer knows exactly how much he will receive in his currency. If, in a year, the spot rate is US$1 = C$1.0300 – meaning that the C$was appreciated as expected by the exporter – by setting the forward rate, the exporter received C$35,500 (by selling the US$1 million at C$1.0655 instead of the cash rate of C$1.0300). On the other hand, if the spot rate is C$1.0800 per year (i.e., the Canadian dollar has weakened contrary to the exporter`s expectations), the exporter suffers a notional loss of C$14,500. The main difference is that futures are standardized and traded on a public exchange, while futures can be tailored to the specific needs of the buyer or seller and are not traded on an exchange. The normalization of futures contracts usually refers to the expiration date and the amount contracted. For example, euro (EUR) futures are available with quarterly expiration dates: March, June, September and December, while the contract size of each euro futures contract is EUR 125,000.
On the other hand, forex futures are not limited by size or value date and can therefore often more accurately meet the needs of investors. A currency date is a personalized written contract between two parties that sets a fixed exchange rate for a transaction that will take place on a specific future date. The future date for which the exchange rate is set is usually the date on which both parties plan to enter into a transaction of buying/selling goods. Currency futures are most often used in connection with a sale of goods between a buyer in one country and a seller in another country. The contract specifies the amount of money that will be paid by the buyer and received by the seller. Thus, both parties can proceed with a solid knowledge of the cost/value of the transaction. Unlike call options, futures contracts are binding agreements between two parties to buy or sell an asset at a specific price at a specific time. Futures are not traded on a central exchange instead of trading over-the-counter (OTC).
These instruments are not often used or are available to retail investors. Futures are also different from exchange-traded futures. In an NDF, a nominal amount, a forward rate, a set date and a date on the trading day are agreed and form the basis of the net settlement, which is made in a fully convertible currency at maturity. On the date of fixing, the difference between the forward rate and the applicable spot rate is deducted, resulting in the net amount to be paid by one party to the other as settlement of the NDF on the value date (delivery). Forward foreign exchange contracts are mainly used to hedge against currency risks. It protects the buyer or seller from adverse exchange rate events that may occur between the conclusion of a sale and the actual sale. However, parties entering into a currency futures contract waive the potential benefit of exchange rate movements that may occur between the contraction and closing of a transaction in their favour. .