Different types of Foreign Exchange Instruments:
Foreign Exchange Forwards
A forward foreign exchange contract is a deal to exchange currencies - to buy or sell a particular currency - at an agreed date in the future, at a rate, i.e. a price, agreed now. This rate is called the forward rate.
A currency future or foreign exchange future, is a futures contract to exchange one currency for another at a specified date in the future at a future exchange rate. A futures contract is similar to a forward contract, with some exceptions.
Futures contracts are traded on exchange markets, whereas forward contracts typically trade on over-the-counter markets (OTC). Also, futures contracts are settled daily on marked-to-market (M2M) basis, whereas forwards are settled only at expiration.
Most contracts have physical delivery, so for those held till the last trading day, actual payments are made in respective currencies. However, most contracts are closed out before that. Investors can close out the contract at any time prior to the contract's delivery date. Investors enter into currency futures contract for hedging and speculation purpose.
Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps A foreign currency swap is an "exchange of borrowings", where the principal and interest payments in one currency are exchanged for principal and interest payments in another currency. Mostly corporates with long-term foreign liability enters into currency swaps to get cheaper debt and to hedge against exchange rate fluctuations.
The best example of swap transaction is paying fixed rupee interest and receiving floating foreign currency interest.
Unlike futures or forwards, which confer obligations on both parties, an option contract confers a right on one party and an obligation on the other. The seller of the option grants the buyer of the option the right to purchase from, or sell to, the seller a designated instrument (currency) at specified price within a specified period of time. If the option buyer exercises that right, the option seller is obligated.
Investors can hedge against foreign currency risk by purchasing a currency option put or call. For example, assume that an investor believes that the USD/INR rate is going to increase from 64 to 68, implies that it will become more expensive for an Indian investor to buy U.S dollars.
In this case, the investor would buy a call option on USD/INR so that he or she could stand to gain from an increase in the exchange rate. The call option gives buyer of the option the right (but not the obligation) to buy currency on the expiration date.