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Understanding Currency Derivatives By Prof. Simply Simple TM

Hopefully the lessons onWeather Derivatives helped youget a good idea about the concept.

One of the most exotic terms inderivative trading is Currency

Derivatives.

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But what are currencyderivatives? And how are they

transacted?

Let me try & simplify the termfor you over the next few

slides

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Lets say there is a farmerwho grows tea in India, which

is exported to the USA.

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And there is an importerof tea in the USA.

Lets assume the currentrate of exchange is Rs. 45

for 1 USD.

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Let us also assume that the teagrower agrees to supply 10

quintals of tea to the importer at 10dollars a quintal three months

down the line upon harvesting.

(1 Quintal = 100 kgs)

It is important tounderstand that theimporter buys tea at 10

dollars a quintal, no matterwhat the exchange rate is.

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The tea grower thinks that the rate of exchange,which is currently trading at Rs. 45 to a US

dollar, could fall to Rs. 44 in 3 months.

This would mean that while the importerwould pay her 100 dollars ( $10 per quintal x 10quintals = $ 100), as per their business deal, she

would earn only Rs. 4400 ( $100 x Rs 44 per

dollar) instead of Rs 4500 ( $100 x Rs 45 per

dollar) thus incurring a loss of Rs. 100. ( Rs 4500

Rs 4400)

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In such a scenario, the tea grower goesto a currency trader and signs a

forward contract which says that at the

end of 3 months the currency trader

would hedge her against a possibledecrease in exchange rates.

This means that, at the end of 3 months,

the currency trader would pay her Rs.

4500 for her 100 USD, no matter what

the prevailing exchange rate.

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Such a contract is calleda Currency Derivativescontract because it is a

currency contract that hasto be executed at some

future date.

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In this case the farmer will take the100 USD she has received from the

importer & go to the currencytrader.

The trader will pay her Rs. 4500, asper the contract.

So the tea grower makes Rs. 4500 in

all.

Now, lets look at 3 different scenarios:

Say that after 3 months the rate ofexchange remains Rs. 45 to a USD.

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Now, lets look at the 2 nd scenario:

Say that after 3 months the rate ofexchange reaches Rs. 46 to a USD

(i.e. $100 = Rs 4600)

In this case the farmers call waswrong. She will take the 100 USD

she has received from the importer& go to the currency trader.

The trader will pay her Rs. 4500, asper the contract and would sell off

the 100 USD in the market forRs. 4600, thus making a profit of

Rs. 100.

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Now, lets look at the 3 rd scenario:

Say that after 3 months the rate ofexchange drops to Rs. 44 to a USD.

($100 = Rs 4400)

In this case the farmers call wasright. She will take the 100 USD

she has received from the importer& go to the currency trader.

The trader will pay her Rs. 4500, asper the contract thus incurring a

loss of Rs. 100.

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Hope you have now clearlyunderstood the meaning of currency

derivatives and its practicalapplication.

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Hope this story succeeded in clarifying the conceptof Currency Derivatives

Please give us your feedback atprofessor@tataamc.com

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The views expressed in these lessons are for information purposes onlyand do not construe to be of any investment, legal or taxation

advice. The contents are topical in nature & held true at the time of

creation of the lesson. They are not indicative of future markettrends, nor is Tata Asset Management Ltd. attempting to predict thesame. Reprinting any part of this presentation will be at your own

risk and Tata Asset Management Ltd. will not be liable for theconsequences of any such action.

Disclaimer