What are Exchange traded currency derivatives – ETCDs

Question

I read in a news article that, Reserve Bank of India has issued a directive requiring traders to have underlying exposure to a currency to trade in the currency’s derivative. What does this statement mean? What is exposure ? What are derivatives basically? Why is this important and What is the significance of regulating this for a country?

In: Economics

Answer 1

A “Derivative” is a financial asset which is not the primary asset, but which has it’s value based on the movements of the price in the underlying asset.

So, a base financial asset might be stocks. Say, AAPL – Apple Inc.

A derivative might be options – the right to buy (Call Option) or Sell (Put Option) a certain number of AAPL shares from/to someone else.

Currency Derivatives are financial instruments which are derivatives from Currencies. For example, you might have currency options – the right to buy or sell a currency at a certain price of another currency.

Here’s a paper with significantly more depth on Currency Derivatives – https://www.philadelphiafed.org/-/media/frbp/assets/economy/articles/business-review/1995/brmj95gh.pdf

Exchange Traded simply means that the derivatives in question can be bought and sold at a major stock exchange, which generally makes it easier to buy and sell them.

Exposure to the underlying means that you must control the requisite amount of the underlying asset. Let’s say I think that the Indian Rupee is going to weaken in value relative to the US Dollar. I could acquire a bunch of US Dollars and wait to trade them, or I could sell someone the right to buy Rupees for US Dollars at Today’s exchange rate. Let’s pretend that’s 1,000 Rupees to 1 Dollar.

You might not realize it, but that derivative creates something called “undefined risk” – if I don’t have Rupees, and then the Rupee actually gets stronger against the US Dollar, I could not just lose money, but the potential loss is infinite. If I agreed to sell someone 100,000 Rupees for 100 USD, but then the exchange rate becomes 1:1, I’ve lost 99,900 USD.

So under the new rule I need to add exposure to rupees, either I must have the right to buy 100,000 rupees for a defined price, limiting my potential loss, or I must hold 100,000 rupees, allowing me to fulfill the contract when called for.