A financial instrument whose characteristics and value depend upon the characteristics and value of an underlier, typically a commodity, bond, equity or currency, these are all known as currency derivatives. There are many kinds of derivatives, with the most notable being swaps, futures, and options.

Swap: An exchange of streams of payments over time according to specified terms.

Futures: A standardized, transferable, exchange-traded contract that requires delivery of a commodity, bond, currency, or stock index, at a specified price, on a specified future date.

Options: The right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a given stock, commodity, currency, index, or debt, at a specified price (the strike price) during a specified period of time.

The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. Each country has its own currency through which both national & international transactions are performed. If any Indian firm borrows funds from international financial market in US dollars for short or long term then at maturity the same would be refunded in particular agreed currency along with accrued interest on borrowed money. It means that the borrowed foreign currency brought in the country will be converted into Indian currency, and when borrowed fund are paid to the lender then the home currency will be converted into foreign lender’s currency. Thus, the currency units of a country involve an exchange of one currency for another. The price of one currency in terms of other currency is known as exchange rate.

Despite the fear and criticism with which the derivative markets are commonly looked at, currency derivatives perform a number of economic functions.

• The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for risks.

• Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.

• Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets.

• Currency Derivatives have a stabilizing effect on the economy by reducing the number of businesses that go under due to volatile market forces.

• Derivatives can be used with respect to commodity price, interest and exchange rates and equity price. They can be used in many ways.