Hedge and Derivatives in the Money Market

Running Head: Money market hedge and derivatives

Money market hedge and derivatives 3

Money Market Hedge and Derivatives

Introduction

A money market hedge is a boundary that protects against the possible exposure to the risks associated with foreign currency; the hedge is created through depositing or borrowing sums of capital to cater for the settlement of regular bills or receipts incurred in domestic currency. Money market hedge generally aims to protect one from possible financial loss or any other adverse circumstances in a business enterprise; for example, a business that is frequently involved in exchange and transaction of foreign currency is likely to experience losses whenever the value of the currency changes between the dates of transaction and payment dates due to delay.

Foreign exchange market

The foreign exchange market is an online marketing platform that allows individuals to deal in buying and selling foreign currencies; it is also referred to as the forex market. It is approximated that 6.4 million dollars are transacted in one day by traders under this marketing platform.

The exchange program involves the establishment of a binding contract in which two parties are involved in the trading, three types of traders are involved in the currency exchange process; the price at the time of the exchange is referred to as spot market, the forward market refers to the binding agreement under which the trading exchange is to be done at a specific agreed price. The trading process usually involves traders who interchangeably buy and sell to each other in a swap method (Pilbeam & K.,2019). Dealers are often obligated to buy the currencies on the spot market with an expectation to sell when the price has fallen or standardized; this way, they spread the risk of incurring loss in whichever price they sell the currencies in the future.

Organization

The foreign exchange market is comprised of two tiers, that is; the interbank market in which different large banks are directly involved in the exchange of foreign currency with each other, this tier normally has a few numbers of members involved, over-the-counter in which different companies and individual traders are involved in the selling and buying of foreign currencies, this is the most popular mode of foreign exchange mode as it has many companies that are integrated and involved in the online money exchange platform.

Interbank market

Different banks are involved in creating a favorable network and a reputable platform to trade in currency exchange legitimately; this tier has the advantage of stabilization and standardization of the exchange rates worldwide. The banks involved in this trading platform aim to make profits satisfactory to them and their clients at large. The groups targeted by the banks include the rich individuals, the governments, and the expanded parastatals and corporations (Pilbeam & K.,2019).

Amongst the renowned banks involved in the online currency exchange are JP Morgan Chase, BS, XTX Markets, Standard Chartered, HSBC, Citi, Bank of America.

The central banks are not commonly involved in trading currencies; nevertheless, they significantly impact the online currency exchange trade. A greater sum of capital belongs to the central banks within the exchange stocks.

Retail market

This level of currency trade market involves small agents buying and selling foreign capital. However, the number of traders involved is many compared to that of the interbank; the overall currency traded is less and doesn’t directly impact the currency exchange rates.

Wholesale tier

An informal and geographically dispersed network in which banks and other currency companies are involved in the selling and buying of foreign currencies, the market is usually open at an estimated time of 24 hours a day. The centers are usually split into different zones. This platform usually doesn’t involve exchanging real money; every transaction involved is operated electronically using the approved international clearing system.

Operation

The exchange market involves different activities such as, speculation; in which the possibility of a significant reduction or increment in currency exchange rates is expected; this reduces chances of incurring losses in the market, hedging; in which the transaction of foreign currency is suited to cover the risks of currency in another position, arbitrage; an individual or a business firm takes advantage of the prevailing currency rate fluctuations to make a profit when the rates are high (Pilbeam & K.,2019).

Location

The forex market has no physical location; its operation is geographically distributed worldwide and operates for 24 hours a day starting from 5 p.m. EST on Sunday to 4 p.m. EST on Friday; this is because the demand for the currency is usually high.

Derivatives

A derivative implies a binding contract that obtains its utility from the execution of an underlying entity. This entity can either be an asset or an interest that is expected to have accrued within a specified period according to the binding contract so signed.

Essentially, derivative contracts specify the time at which a commodity may be sold or exchanged; usually, in the future time, quotation of the price of the given commodity and the entire trading process forms the hallmark of a contract business derivative.

Types of derivatives

There are four commonly known derivative contracts as far as business transactions are concerned;

Future contract derivative; this is a type of agreement that mandates the selling of a specified commodity at a future date; the decision on the price of the commodity to be exchanged is usually made during the present times when the parties involved cordially sign the contract. This particular contract’s nature requires strict adherence to the exchange terms under which the losses and gains realized on the contracts have to be settled on the exchange day (Vo et al.,.2020).

Forward contract derivative; this is a binding agreement between the buyer and the seller of a particular product to perform the actual exchange business later. The price of the commodity and the entire transaction is decided at present. Because the agreement occurs between the two involved counterparts, the exchange is usually not the intermediary, thereby increasing credit risk chances.

Option derivative contract; this is whereby the two counterparts involved in the exchange of the commodity have different obligations; that is; one party is obligated to decide on the date of the transaction while the other party is left with an option to choose a later date different to the present time.

Swap derivative contract enables its participants to exchange their capital actively; either party is obligated to switch an uncertain cash flow. Individuals involved are at the will of swapping their interest rates or the currency involved.

Derivatives market

In the financial economics department, a derivative means a financial contract whose worth is obtained from a particular asset. Many financial assets have been used to preferentially describe the derivative markets, including the equity indices, fixed incomes, foreign currencies, commodities, and credit services.

Derivatives trading involves the organization of exchange platforms or in over-the-counter markets. In the exchange-traded market derivatives or rather contracts, there is a standardization of the commodities and their prices within the specific terms and conditions, there is an open floor negotiation on the prices and the terms of sales, with the increased popularity of the electronic trading system, instances of exchange-traded programs are beginning to collapse as people prefer the most recent electronic technique (Vo et al.,.2020).

Over-the-counter trading techniques directly involve both the parties in the process of negotiations, pricing of the commodities, decisions on the quality and quantity of the products, location, and the dates of transactions. However, the transactions can be made via telephone communication, and the prices kept confidential.

Derivatives create a platform in which the users will meet the demands and the effective e protection from the associated risks of overcharging or price overexploitation. They protect the fluctuation of prices, commodity qualities, and interest rates.