It is important to understand the meaning of the topic in this case. The word ‘derivative’ implies that the component is gotten out of something else. The underlying item could be securities, stock market index, bullion, currency or any other thing from which the former can be obtained. In this case, the underlying factor is currency. Currency derivatives can be classified as currency forward, currency future, SWAPS or even currency warrants. In this case, an analysis of the currency derivatives in India is critically conducted.
India has not been running a currency derivatives market until late in the 20th Century. The introduction of the market in India was an important landmark towards attracting importers, exporters, and companies with foreign exchange exposure. The derivative products have a wide scope with their special features that are designed to meet specific customers’ needs. Like in the case of any country, the currency derivatives’ market that was introduced in India came in various types.
The derivatives that are based on currency exchange rates are known as forward contracts. These determine the rate at which exchanges will take place sometime in the future between two countries, in this case India and another country (Alpari, 2013). These contracts are often gotten into by importers and exporters to secure their business profits in future.
The other form of currency derivative that was entered into by India is options. The major difference that exists between forward contracts and options is that forward contracts are associated with both an obligation and a right. Therefore, a buyer in forward contract can make a gain or loss, but this depends on the state of the currency exchange rate. In the case of an option, the buyer may decide to let the date pass until that time that is more convenient to them since they are not placed under an obligation.
In India, currency derivatives come in four categories. These include exchange rates with the US dollars, the Euro, Great Britain Pound and the Japanese Yen (NSE, 2012). There is a reason behind India choosing these four major currencies. The currencies are linked to strong economies with relatively stable economic situations. By getting into a currency derivative contract against the U.S dollar, the traders are sure that there will be no severe deviations in the rates of exchange in the pre-determined dates.
There are several benefits that come out of participation in currency derivatives of various kinds. To begin with, there is a benefit that comes in the form of hedging (Marcus, 2010). This means that the participants will be secured against potential losses by taking appropriate positions in the contracts. The dates are set in favor of both the members of the contract, and this is to the benefit of both. Movement in currency exchange rates does very little in affecting the profitability that is realized out of these contracts.
The other reason as to why these forms of contracts are beneficial to the participants is that there is a possibility of speculation. The movements in currency exchange rates can be speculated on using the currency futures. This helps in making decisions as to whether to get into these contracts or not.
The benefit or arbitrage also makes it enabling for the traders to sign these contracts. It is possible to make lump-sum profits as a result of correct predictions in the future rates of exchange. The profits that come from foreign exchange trade are far much higher than those that are obtained from ordinary commodity markets. There are few charges and deductions that are derived out of their transactions.
Leveraging brings about benefits to the traders. In leveraging, it is possible to pay just a portion of the total agreed amount. This comes in the form of an agreed percentage, in the satisfaction of the parties involved in the agreement. When the due date comes, it may be possible to pay just part of the whole amount as per the financial position of the payer. This, however, only takes place in the event that there was an initial formal agreement to cater for this provision in the contract.
The derivatives are not free of risks, in spite of the several benefits that they are associated with. To begin, with, there is a possibility of the currency exchange rates moving in the opposite direction from the speculated projections. This leads to huge losses in the event that the contract is not revised appropriately.
There are also chances of one party breaching the contract. In the event that this happens, there are losses that come as well. The outcome of such depends on the nature of the contracts and the decisions made by the legal bodies regarding any case filed towards the same.
Finally, there is risk of change of legal doctrines governing the contracts. If this happens prior to the maturity date of the contracts, either party is bound to make losses. This is because the law will distort most of the components of the contract.
Currency derivatives have benefits as well as risks associated with them. In spite of the several benefits, it is necessary to weigh them against the possible risks so as to come up with the right decisions regarding the most appropriate of these derivatives to get into. The legal provisions also have to be taken into account while signing these contracts.