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What are Foreign Currency Derivatives?

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  • Written By: Dana DeCecco
  • Edited By: A. Joseph
  • Last Modified Date: 07 September 2016
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Foreign currency derivatives are financial contracts derived from the spot price of currencies. The spot price of a currency is a relative value derived from the price relationship to other currencies. Futures and options contracts on an underlying currency are foreign currency derivatives. Exchange traded funds (ETFs) on currency pairs are also considered foreign currency derivatives.

The futures market offers contracts on specific currency pairs. Futures contracts have an expiration date specified in the contract. The price of a currency futures contract might differ from the spot price of the currency pair. The futures contract must consider the relative interest of the currency pairs and adjust the contract accordingly.

Options on currency futures are a form of foreign currency derivatives. An option is a contract written on the performance of an underlying asset. In this case, the asset is the futures contract, which is also a derivative. Both the futures contract and the options contract have independent expiration dates. The investor should have a comprehensive understanding of how these contracts work before trading these foreign currency derivatives.

Over-the-counter (OTC) options are available on currency pairs in many countries. Exotic options can be traded in the OTC market. Exotic options are non-standardized options with special features. Strike prices and expiration dates can be modified to suit the investor's needs.

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Exchange traded binary options are the most simple and straightforward type of foreign currency derivative. This type of investment requires the trader to select an options contract with a fixed cost, strike price, expiration and payoff. After the contract is selected, the currency pair might finish in the money at expiration, and the trader will be paid a premium. If the pair does not finish in the money, the trader will be paid nothing and will lose the premium paid. A few variations of this "all or nothing" approach are available through different brokers.

Traders who have stock market accounts can trade foreign currency derivatives within their equity account. Currency ETFs are available on many currency pairs. These derivatives are generally priced at the exchange rate multiplied by 100. They are bought and sold like stocks. Options are also available on many currency ETFs.

Exchange traded futures options and ETF options are known as plain vanilla options. Puts and calls are bought and sold at certain strike prices and expiration dates. The term "plain vanilla" refers to the options being standardized with no exotic features.

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