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Sir can you please explain me the difference between money market instruments & derivatives? What are the characteristics that can distinguish between them?
Derivatives are used to hedge interest rate risk movements such as Future, Options, Swaps?
Derivatives get their value from something else.
So, for example, money market hedging is using real borrowing and investing at real interest rates in order to hedge against risk.
Interest rate futures are also used to hedge against risk, but their values are determined by whatever interest rates are – they get their value (derive their value) from interest rates, and so they are derivatives.
Sir, I still have some doubts:
1) Derivatives get their value from something else BUT what exactly (underlying asset)?
2) Is it true that currency futures, currency options & currency swaps are all derivatives because they all get their value from something else and they all are used to hedge foreign currency risk?
3) Is it also true that [Invoicing in home currency, Leading & lagging, Netting and Matching] are all hedging techniques used to hedge foreign currency risk (but not interest rate risk) because Foreign Currency deals with exchange rate risk BUT in interest rate risk it deals with interest rates movements?
4) Sir could you please briefly point out the currency futures, currency options & currency swaps. I watched ur lecture BUT I couldn’t get the whole reason for using them!
1. As I wrote before, interest rate futures (and you were asking about interest rate hedging) derive their value from whatever the current interest rates are. Foreign exchange futures derive their value from whatever the current spot exchange rates are.
2. No. Futures derive their value as explained above. Options are used to limit the worst outcome in terms of the spot rate or the interest rate. Swaps are not derivatives – they are simply swapping borrowings with someone else.
3. Yes. Foreign exchange risk is the risk of exchange rates changing. Interest rate risk is the risk of interest rates changing.
4. Currency futures are used to ‘cancel’ the effect of exchange rate movements on an underlying transaction so the net result is that there is no risk (movements in exchange rates have no net effect). Options are used to limit the worst outcome if the exchange rates move against us (but allow us to get the benefit of exchange rates moving in our favour). Currency swaps are used when two parties want to borrow money in the other parties currency rather than in their own currency. By borrowing in their own currency but then paying each others interest they are likely to be charged lower interest rates.
I do explain all of this in my lectures on the management of foreign exchange risk, and I do suggest that you watch them again.
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