Derivatives and Their Types Explained

What are derivatives? The question many beginners ask when getting involved in the Forex market. Derivatives appear to be a complex instrument used on the financial market by traders who generally deal with indices, commodities, and currency pairs. The name of the term comes from the ability to derive the value considering the currency exchange rate fluctuation, supposing that you trade at least two or more currency pairs at a time.

As a rule, the instrument applies to speculators who initially use it to hedge the risk and make a profit on a price difference as well as when arbitraging. In this review, we will share some major facts about these instruments, you will find out what is a derivative, where did it come from, and what types of derivatives have.

A Quick Flashback into Derivatives History

The instrument originated from the time when the Bretton Woods Agreement collapsed forcing many countries to move to float exchange rates. In other words, they established a milder control over the interest rate. On the other hand, this fact put markets at a greater risk that involved capital inflow and increased exchange. It was actually the starting point for the financial market globalization that prevented foreign investors from entering the scene. It was a perfect time for derivatives to flourish.

They became even more popular at the time of the Argentine peso and Asian currency crisis back in the 1990s and 2000s. Today, they are an inevitable part of the traders’ toolkit letting them counter price risks to exposure. What’s more, a good idea is to use them with other financial tools to improve the trading tactics.

Major Types of Derivatives

When it comes to foreign exchange, traders should take into account four major types of derivatives. They include:

• Forward contracts – one of the longest-running and well-known Forex strategies to trade on the Forex market. To make it simple, you get a chance to exchange money only upon the mutual agreement with a fixed date indicated in advance. Forward contracts also mean a fixed exchange rate no matter what happens until the date of order execution. The contract may come with different time frames. It may last for a few days, weeks, months, or even years.
• Future contracts – this type is similar to forward contracts but with some slight differences. Besides, it looks more standardized if compared to the previous one. The average time frame for future contracts is about 3 months with fixed interest rates already included in the agreement. At the same time, they also apply to those who prefer trading daily. The type suits speculators ready to trade riskier currency pairs with a higher ROI.   
• Options – this type is initiated with two major options” “call” and “put”. The first one makes it possible for yarders to enter the market with a buy position, while the second one gives the right to sell currencies. If a trader decides to enter with a long position (call), the main goal is to purchase the asset at a lower price if compared to its current value. And vice versa, a person with a short position hopes to sell the asset at a high price as possible.
• Swaps – they are used to get potentially profitable loans in the financial market. As a rule, traders opt for the cross-currency swap to make the operation as favorable as possible considering the interest rate as the key factor to watch for. As a rule, different companies and banks use swaps to take advantage of decreased interest rates.

Conclusion 

Now, when you know all major derivatives’ types, you also need to learn more about potential Forex market risks. Forex rate fluctuation can be quite unexpected. It may influence the value of a company in the market. In other words, derivatives are closely connected with economic risks. So, you need to implement proper risk management tools and sharpen your trading strategies using a risk-free Demo account. It helps to try out different tactics without losing cash and enter a real market with a ready-to-use trading modality. 

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.