Financial Derivatives and Futures Contract in Financial Management

The uncertainty about the exchange rate that will prevail on a future date leads to ‘exchange risk’. Any person who has dealings designated in foreign currency or who owns assets abroad is exposed to exchange risk. Hedging refers to the method adopted to cover this exchange risk.

Forward contract is an effective and easily available tool for covering exchange risk. New instruments like options, futures and swaps can also be used to cover exchange risks. These instruments are called financial derivatives as their value is derived from the value of some other financial contract or asset.

When these instruments are bought or sold for covering exchange risk they are used for ‘hedging’ the exchange risk. When they are dealt in with a view to derive profit from unexpected movements in their prices or other changes in the exchange market, they are being used for speculative purposes. The scope for using these instruments for speculative purposes is very much limited in India.

Currency Futures

A futures contract is a form of forward contract in that it conveys the right to purchase or sell a specified quantity of a foreign currency at a fixed exchange rate on a fixed future date. Whereas in a forward contract the quantum of foreign currency and the due date are determined by the customer, in a futures contract these are standardised.

For instance at LIFFE the contract in sterling can be only in multiples of GBP 62,500 and that in Deutsche mark in multiples of DEM 125,000. The due dates of the contracts are generally in specified months, say March, June, September and December and within these months the dates are also fixed. While forward contract can be entered into by a person with any bank at any place, the futures contracts can be entered into only with the financial futures exchanges.

There are over 50 future exchanges over the world, important among which are the International Monetary Market (IMM)–a part of Chicago Board of Trade, and London International Financial Futures Exchange (LIFFE). Currency futures are not available in India.

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