Derivatives * Derivatives are used to reduce the risk of both foreign exchange rate & interest rate. There are Foreign exchange derivatives & Interest rate derivatives. * Foreign exchange derivatives:

I. Currency futures: It is a standardized contract for the sale or purchase at a set future date of set quantity of currency. Currency Futures Forward contract * It is a standardized contract. * It is a bespoke contract. * It is traded on the open market. * It is traded on OVER-THE-COUNTER (OTC) * It is contracted in US $ * It is contracted in any currency. * Flexible close-out dates (contract settlement). * Fixed close-out dates (contract settlement). * It is cheaper. * It is expensive. Futures Adv Futures Disadv * Transaction costs should be lower than other hedging methods. * The contract cannot be tailored to the users requirements. * It is traded on the open market. * There is a risk that futures contract price may move by a different amount from the price of the contract. * The exact date of receipt or payment is not known. * Only a limited number of currencies are the subject of future contracts. * It doesnt allow to take advantage of favourable currency movements.

II. Currency options: It gives protection against adverse exchange rate risk movements while allowing the investor to take advantage of favourable exchange rate movements. It is particularly used in the case of uncertain cashflow.

Disadvantages of Currency options: (i) They have a cost (Option Premium). (ii) Options must be paid as soon as they are bought. (iii) Traded options are not available in every currency. (iv) Tailor-made options lack negotiability. III. Currency swaps: It involves exchange of debts of one currency to another currency. Example: Spot rate: GBP 1- $1.60 X, a parent company needs $1.6m to purchase another subsidiary company & Y, a subsidiary company needs GBP 1m to purchase a machinery from UK. So X company can borrow GBP 1m & Y company can borrow $1.6m.

Advantages of Currency swaps: (i) It is easy to arrange & are flexible. (ii) Transaction costs are low. (iii) It is used to reduce Forex risk. (iv) The company can gain access to debt finance in another country. (v) It is used to restructure the currency base.

* Interest rate derivatives: I. Interest rate futures: It is quite similar to FRA. II. Interest rate options (right): It gives protection against adverse interest rate risk movements while allowing the investor to take advantage of favourable interest rate movements. III. Interest rate swaps: It is an agreement where two parties agree to exchange interest payments. IV. Interest rate caps, collars & floor: Caps= Maximum limit of interest rate Floor= Minimum limit of interest rate Collars= Purchase of Caps & sale of floor.

Prepared by Khandaker Naimul Alam ACCA Lecturer