Currency Derivatives

Section: Currency Derivatives Estimated study time: 45 minutes Content: Currency derivatives — forwards, futures, options, and swaps — are used to manage foreign exchange risk in international portfolios. The choice among instruments depends on the investor's need for customization, desire for optionality (asymmetric payoffs), cost constraints, and counterparty risk tolerance. Currency forwards are the dominant hedging instrument for institutional investors. A forward contract locks in an exchange rate for a future date. The forward rate is determined by covered interest rate parity (CIP): F = S × (1 + r_domestic) / (1 + r_foreign), where S is the spot rate, r_domestic is the domestic risk-free rate, and r_foreign is the foreign risk-free rate. If the foreign rate is higher, the foreign currency is at a forward discount — its forward price in domestic terms is below the spot rate. Hedging in this case "costs" the interest rate differential (the investor forgoes the higher foreign rate). Currency futures are exchange-traded, standardized contracts. They offer superior liquidity and lower counterparty risk (centrally cleared) compared to forwards, but less customization. Currency options give the holder the right to exchange currencies at a specified rate — the strike price — paying a premium. Call options give the right to buy the foreign currency; put options give the right to sell the foreign currency. Options are used when the investor wants downside protection without giving up upside — for example, buying USD call/foreign currency put options to protect against foreign currency depreciation while retaining the ability to benefit if the foreign currency appreciates. Dynamic currency option strategies: A risk reversal buys an out-of-the-money put and sells an out-of-the-money call on the foreign currency, creating…