One of the most significant developments in the financial world in recent times has been a phenomenal proliferation of derivative securities and their widespread use in trading and risk management.
Before the proliferation of financial derivatives, foreign exchange forward transactions were the only derivatives instrument active in forex market.
Over a period, various financial derivative instruments have emerged and been transacted in the forex markets in huge quantity. “In contrast to forex forwards, the working of newly emerged derivatives seem to be technical, trivial and on the face of it, sophisticated.
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The widespread use of derivatives makes the market more complete and competitive on the one hand, and creates vast and complicated new financial management tasks and techniques on the other.” Three major types of derivatives securities widely used in risk management are swap, forwards/futures and options.
Table 11.6: Difference between Forwards and Futures:
| Forwards | Futures |
| OTC/Private contracts between two parties. Customised Usually one specified delivery date Settled at maturity ADVERTISEMENTS: Delivery or final cash settlement usually takes place | Exchange traded involving a clearing house. Standardised A range of delivery dates Daily resettlement Contracts usually closed out prior to maturity |
The global financial market offers a wide range of instruments, mostly derivatives to manage or mitigate unwanted risks. “Interest rate risk can be hedged through interest rate swaps or by operating in futures market.
Forward exchange rate transactions or foreign exchange options can be used to deal with exchange rate risk. Credit risk can be transferred to other market participants or investors via securitisation including the use of structured financial products such as asset-backed securities (ABS), collateralised debt obligation (CDO) or through the purchase of credit default swaps (CDS).”