Handbook of Finance: Financial Markets and Instruments

Chapter 65. An Introduction to Foreign Exchange Derivatives

SHANI SHAMAH

Consultant, E J Consultants

Abstract: Not surprisingly, over the past few years the financial markets have responded to increasing price volatility and there are now a range of financial instruments and strategies that can be used to manage the resulting exposures to financial price risk. At one level, there are now financial instruments that permit the direct transfer of financial price risk to a third party, who is more willing to accept that risk. At another level, the financial markets have evolved to the point whereby financial instruments can be combined with other instruments to unbundled financial price risk from the other risks inherent in the process, for example, raising capital.

Keywords: forward contracts, interest rate differentials, short-dated contracts, long-dated contracts, broken-dated contracts, nondeliverable forward (NDF), foreign exchange swaps, currency swaps, foreign exchange futures, exchange for physical (EFP), currency options, forward points, forward pips or swap points, premium, discount, bids, offers

In today's business world, unpredictable movements in exchange rates, interest rates and commodity prices cannot only affect a company's performance but may even determine whether a firm survives. Over the past couple of decades, companies have been increasingly challenged by financial price risks. It is no longer enough to be the company with the most advanced production technology, ...