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What is a foreign exchange derivative?
Derivatives like forward contracts, futures contracts and options let you bet on the future value of currency.
A term you’ll hear in forex is the foreign exchange derivative. While it sounds scary, it’s not nearly as complicated as you may think — it’s just a contract to buy or sell a currency at a specific time in the future.
There are 3 kinds of foreign exchange derivatives:
- Forward contracts
- Futures contracts
Forward contracts are typically used by investors who want to limit their risk to exchange rate volatility. For example, if you’ve sold goods to someone and agreed to get paid 6 months in the future, you might choose to enter a forward contract. You don’t want to lose your shirt if the exchange rate moves against you — you just want the money you’re owed.
Futures contracts are typically used by speculators who are looking for large returns on their investments. These speculators try to make money based on the strengthening or weakening of a currency. Of course, the prospect of bigger profits is accompanied by greater risk.
Forex options give you the option (not obligation) to buy or sell a currency at a certain price. You can do so at any point up until the option expires.
- If you have the right to buy a currency, you have a call option.
- If you have the right to sell a currency, you have a put option.
In the world of options, you’ll often hear the terms long position and short position.
- If you buy an option, you’re taking a long position. You’re hoping a currency will go up in value so you can buy it at a price that’s under its current value.
- If you’re the one writing the option (for example, you’re selling it to someone), you’re taking the short position. You’re hoping a currency goes down in value so that the other party won’t exercise their option.
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