After the collapse of Bretton Woods system in the early 1970, the exchange rates of major currencies became floating, thus leaving the supply and demand to adjust foreign exchange rates in accordance to their perceived values. The increase in volatility of the exchange rates, together with the increase in the volume of world trade led to the escalation of foreign-exchange risk.

Currency risk is part of the operational and financial risk associated with the risks of adverse movements in the exchange rate of one particular currency against another. In comparison with investments in local assets, the freely fluctuating currency rates represent an additional risk factor for investors who want to diversify their portfolios internationally. Therefore, the control and management of the currency exchange rate risk is an integral part of business management with a view to improve the effectiveness of international investments.

One effective and generally accepted method for this type of risk management is the use of derivative financial instruments (derivatives) such as futures, forwards, options and swaps. Although derivatives are extremely diverse, by their legal nature all of them constitute a contract between the buyer and seller, concluded in present, while the performance will take place at some time in the future. The value of the derivative contract depends on the price movement of the base or “underlying” security.

1. Using Derivatives for Elimination of Uncertainty (Hedging)

Derivative financial instruments are widely used tools for management and protection against various types of risk and are an integral part of numerous innovative investment strategies. They make future risks negotiable, which leads to the removal of uncertainty through the exchange of market risks, known as hedging. Corporations and financial institutions, for example, are using derivatives to protect themselves against changes in the prices of raw materials, forex exchange rates, stocks, interest rates, etc. They serve as insurance against adverse movements in prices and as a reduction of price fluctuations, which in turn leads to more reliable forecasts, lower capital requirements and higher capital efficiency. These advantages are led to the extensive use of derivative financial instruments: according to ISDA over 94% of the largest companies in USA and Europe manage their risk exposures, through the usage of derivatives.

In summary – an investor that has decided to hedge the risk will become a party to a derivative contract, which leads to the financial result, the exact opposite of the financial result generated by the risk. That is, when the value of the hedged asset falls, then the value of the derivative security must increase and vice versa.

2. Using Derivatives for Providing Protection with Minimal Initial Investment

In addition, derivatives provide protection against currency risks with minimal initial investment and consumption of capital at the exceptionally high adaptability of the contractual terms and conditions in relation to the specific needs of each contracting party. They also enable investors to trade future price expectations buying or selling derivative asset instead of the base security at a very low cost in comparison with the direct investment in the underlying asset. The total value of the transaction for the purchase of a derivative on the major currencies is about 80 per cent lower than that of the purchase of a portfolio of relevant basic currencies. If compared with the costs of exposure in less liquid assets such as real estate, the difference in costs between derivative and direct investment in the underlying asset is even significantly higher.

3. Using Derivatives as an Investment

Another way to use derivatives is as an investment. Derivatives are an alternative to investing directly in assets without purchasing the base security. They also allow investments in securities, which cannot be purchased directly. Examples include credit derivatives, which provide payment if the creditor cannot fulfill its bond obligations.

4. Using Derivatives for Speculative Purposes

Although most participants in the market are using derivatives to hedge risks, some of them frequently trade derivatives for the purpose of generating profit at favorable price movements and without any offset positions. Usually, investors open positions in derivative contracts to sell an asset, which in their opinion is overestimated in predetermined period or date in the future. This trading strategy is profitable if the value of underlying assets actually falls. Such trading strategies are extremely important for the efficient functioning of financial markets, thus reducing the risk of a significant understatement or overstatement of the underlying assets.

The use of derivatives for risk management is nowadays widespread in developed economies and is considered to be a routine part of the business of financial institutions and companies. The derivative financial instruments serve mainly as insurance against adverse movements in prices and as a tool for reducing price fluctuations, which in turn leads to more reliable forecasts, lower capital requirements and higher productivity.

Furthermore the derivatives provide protection against currency exchange risk with minimal initial investment and consumption of capital at exceptionally high adaptability of the contractual terms and conditions meeting the requirements and needs of investors. They also enable market participants to trade future price expectations, this way purchasing a derivative financial asset instead of the base security at a very low cost in comparison with the total transaction if investing directly in the underlying asset.

Author's Bio: 

Nelly Naneva works as CEO of the Financial Institution Freetrade JSC, Sofia, Bulgaria and as Editor of the Online Financial Magazine Markets Weekly http://marketsweekly.net.
She holds Masters' Degrees in Law from Sofia University St. Kliment Ohridski, Bulgaria and in Banking and FInance from Institute of Financial Services, School of Finance, London, Great Britain.