Foreign exchange derivative

A foreign exchange derivative is a financial derivative whose payoff depends on the foreign exchange rate(s) of two (or more) currencies. These instruments are commonly used for currency speculation and arbitrage or for hedging foreign exchange risk.

Foreign exchange transactions can be traced back to the fourteenth Century in the UK, but the coming into being and development of foreign exchange derivatives market was in the 70s of last century with the historical background and economic environment. Firstly, after the collapse of the Bretton Woods system, in 1976, IMF held a meeting in Jamaica and reached the Jamaica agreement. When floating exchange rate system replacing a fixed exchange rate system, many countries had gradually relaxed the control of interest rate and the risk of financial market increased. In order to reduce and avoid risks and achieve the purpose of hedging, modern financial derivatives came into being. Secondly, economic globalization promoted the globalization of financial activities and financial markets. After the collapse of the Bretton Woods system, a large number of capitals flew across the world. Countries generally relaxed restrictions on domestic and foreign financial institutions and foreign investors. Changes in macroeconomic factors led to the market risk and the demand for foreign exchange derivatives market increasing further, what promoted the development of the derivatives market. Under such circumstances, financial institutions continue to create new financial tools to meet the needs of traders for avoiding the risk. Therefore, a large number of foreign exchange derivatives was widely used, making the foreign exchange market expanded from the traditional transactions market to the derivatives market, and develop rapidly.（Unknown,2012）

Margin trading，which means you could pay part of margin but make full transaction without the practically transferring of your principal. The end of contract mostly adopt the settlement for differences. At the same time, the buyers need not to present full payment only when the physical delivery gets performed on the maturity date. Therefore, the characters of trading financial derivatives include the lever effect. When margin decreases, the risk of trading will increase, as the lever effect will increase. (Ma Qianli, 2011)

【Avoiding and managing systemically financial risk.】 According to statistics, the systemic risk accounts for 50% in the risk of financial market investment in developed countries, so preventing and mitigating systemic financial risks would be vital in management of financial institutions. All of traditional risk-management tools (insurance, asset-liability management, portfolio and etc.) cannot prevent systemic risk, while foreign exchange derivatives can efficiently avoid systemic risk, which is brought by the adverse change of the prices in basic goods market, by its specific hedging function.

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