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What is a foreign exchange derivative?
Learn about the three types of foreign exchange derivatives.
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 three kinds of foreign exchange derivatives:
Forward contracts
Futures contracts
Options
Forward 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 six 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.
An option gives you the option to buy or sell a currency at a certain price, and 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.
Futures contracts and options are investment vehicles typically used on forex trading platforms. You may see forward contracts on some money transfer platforms, however. Check with your money transfer service, and consider using a forward contract if you’re moving large amounts of money.
Check the mid-market rate between the two currencies you’re trading. The mid-market rate is what your money’s actually worth on the global market compared to another currency. It’s the midpoint between worldwide supply and demand for that currency — and the rate banks and transfer services use when they trade among themselves.
Use the mid-market rate as a baseline to compare against the rates provided by your bank or transfer service.
Compare multiple money transfer providers. You may find a good rate at one provider but later find an even better rate elsewhere. We’ve compared the top money transfer providers to help you find the best rates.
Kevin Joey Chen is a credit cards, banking and investments writer whose work and analysis have appeared on CNN, U.S. News & World Report, Business.com, Lifehacker and CreditCards.com. He's passionate about helping you get your finances in order by expertly navigating cutting-edge financial tools — including credit cards, apps and budgeting software.
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