This forex course basics section covers the nature of more exotic foreign exchange derivatives traded in the OTC market.
The forex market continues proving itself to be an innovator in developing new types of derivative products for hedgers and trader to use to manage and take foreign exchange risk.
Most of these derivatives, such as the interest rate and exotic options products, primarily trade in the Over the Counter (OTC) market among the major banks and their corporate and institutional customers.
In general, these derivative contracts obtain or derive at least a portion of their value from the prevailing spot exchange rate which often acts as their underlying asset.
In the sections below you will find coverage of some of the less common forex derivatives, as distinguished from the more common forex derivative products like currency futures, forwards and swaps.
CFDs or Forex Contracts for Difference
Contracts for Difference or CFDs consist of foreign exchange contracts which cash settle on the maturity date.
In other words, only the net value of the position is paid out and not the principal currency amount on the maturity date of the contract. Also, whichever party to the CFD has the profitable position at maturity will be delivered the difference by their counterparty.
CFD forex contracts usually have their value based on the spot rate, although some other possibilities exist.
Exotic Currency Options
Unlike their counterparts the vanilla currency options that also trade on centralized exchanges such as the Chicago IMM or the Philadelphia Stock Exchange, exotic currency options trade almost exclusively in the forex OTC Interbank market among major banks and their clients.
Some of the more popular exotic options include:
- Basket Options – comparable to plain vanilla European style options, with the exception that their underlying rate and strike price are determined by a basket of currencies that can each be present in differing amounts. The size-weighted values of the basket’s counter currencies are converted into its base currency.
- Binary Options – also known as digital options, the usual kind provides the buyer with a fixed payout if the strike price of the option is better than the market price at expiration. One touch or no touch binaries also exist with values that depend on whether a particular trigger level trades during the option’s lifetime. Also, boundary binary contracts depend on a range holding or being broken.
- Average Strike Options – have the strike price determined through an averaging process of the exchange rate sampled over periodic intervals.
- Average Rate Options – have the underlying rate determined by an averaging process of the exchange rate sampled over periodic intervals.
- Knockout Option – cancel out when a pre-determined trigger level is attained during the life of the option.
- Knockin Options – come into existence when a pre-determined trigger level is attained during the life of the option.
Currency Interest Rate Derivatives
This type of product includes a form of interest rate risk, in addition to foreign exchange risk. They include:
- Currency Swaptions – options which grant the buyer the right but not the obligation of entering into a currency interest rate swap. The swap consists of an agreement between counterparties to exchange interest rate payments on an amount of different currencies for a specified period, and also to exchange the principal amounts of the different currencies at a pre-determined exchange rate on the date the contract matures.
- Currency Interest Rate Swap – an agreement between two counterparties to exchange the periodic interest rate payments between currencies. The interest rate can be fixed, floating or floating based on different indexes. These contracts include swaps which have their notional principal amortized on a fixed schedule independent of interest rates.