Role of currency futures in risk management Essay

Role of currency futures in risk management - Essay Example Forward contracts have certain advantages over currency futures but their disadvantages cannot supersede the advantages provided by currency futures. Because of their standardized features and a high liquidity in the market, currency futures have gained widespread importance. Even with the advent of sophisticated derivative instruments such as options, yet the currency futures lie ahead of them because of the cost factors and their advantages in providing superior performances in covered hedges. Introduction In the contemporary world, currency risk management is gaining a widespread importance because of the globalization. Companies and individuals who are exposed to foreign exchange risk, which implies that either they have imports or exports which will cause their domestic purchasing power to decline by converting a foreign currency to a home currency will always aim to minimize this risk. These currency risks arise during certain conditions; when the firm or businesses have assets or liabilities which are expressed in terms of foreign currency. We can define foreign exchange risk more specifically as the risk faced due to fluctuating exchange rates. For instance, if a Malaysian businessman exports palm oil to one of the European countries and if he expects payments to be made in Euros, than he is exposed to considerable amount of foreign exchange risk if the Euro depreciates against the Malaysian Ringgit. In case if it happens, the Malaysian trader will get fewer amounts of Ringgits in exchange of Euros thus a successful business venture might turn out to a blunder because of poor risk management practices. The trade transactions are shelved between the countries as businesses are unwilling to bear foreign exchange risk. As the fear of foreign currency risk looms over the businesses, it can reduce its trade with these countries. But as the world has stepped ahead in the technological breakthroughs, so it has been able to develop financial tools which can hel p the traders to minimize the risk faced in the businesses. The derivatives market primarily consists of many instruments such as forwards, futures, swaps and options. The aim of this paper is to discuss about the role of currency futures and how they provide an advantage over other derivative instruments in managing foreign exchange risk. A currency futures contract is an agreement between two parties to buy a particular currency at a specific rate in the future. Future contracts are identical to forward contracts but they differ in a sense that they are traded on the exchange and are more liquid than forwards. Futures are liquid as they have a formal exchange like stocks where you can trade your legal contracts. Similarly, they are standardized contracts like shares and you can remove them from your portfolio in certain chunks. We can illustrate futures currency with the help of an example involving two parties who are exposed to foreign exchange risk. The party which is exposed t o the risk of an appreciation of value in a currency will buy futures to protect. These are usually parties who have revenues or exports and they feel that the value of their home currency appreciates making the currency in which the sales are denominated weak thus resulting in lower revenues. To hedge their position, they enter in to a futures contract and buy a certain amount of