The foreign exchange market has proven itself to be fertile ground when it comes to developing new types of derivatives for traders and hedgers to use to take or manage currency risk.

Most of these more unusual derivatives, especially the exotic options and interest rate products, currently trade primarily in the Over-the-Counter or OTC forex market between major banks and their corporate and institutional clients.

The list below covers some of the more unusual and even downright exotic forex derivatives, other than the plain vanilla currency options and currency futures that have already been discussed in previous sections.

Forex Contracts for Difference or CFDs

CFDs are foreign exchange agreements that are cash settled on their maturity date. This means that just the net value of the contract, and not the principal currency amounts, will be delivered to the counterparty showing the profit at maturity.

CFDs can be traded for value spot or for value on some other selected business day in the future.

Vanilla Currency Option Variations

The OTC vanilla currency option market has provided some creative solutions for the needs of speculators and hedgers. Some of the more common choices are described further below.

• Currency Warrant - a currency option contract traded in the OTC market and often for longer maturity dates of more than one year.

• Currency Collar - A popular option combination involving the simultaneous purchase of a call and the sale of a put, or vice versa. The strike prices are usually set out of the money and at a similar distance from the forward rate in order for the strategy to have no net cost. Also sometimes called a risk reversal.

Exotic Currency Options

Unlike vanilla currency options, which also trade on exchanges like the Philadelphia Stock Exchange and the Chicago IMM, most exotic currency options are traded almost exclusively in the OTC market. Some of the more common exotic varieties include:

• Average Rate Options - Have their underlying rate determined by a process that involves averaging some observed exchange rate sampled at periodic intervals.

• Average Strike Option - Have their strike prices determined by a process that involves averaging some observed exchange rate sampled at periodic intervals.

• Binary Options - Also sometimes called digital options, they provide a holder with a fixed payoff if their strike price is better than the prevailing market at expiration, for European style binaries, or at any point during their lifetime, for American style binaries.

• Knockout Options- Ceases to exist when a pre-determined trigger level trades during their lifetime.

• Knockin Options - Starts to exist when a pre-determined trigger level trades during their lifetime.

• Basket Options - Are similar to vanilla European style options, except that their strike price and their underlying rate are determined by reference to a basket of currencies for which the weighted value of the option's several component counter currencies will be computed in its base currency.

Currency Interest Rate Derivatives

These products generally involve taking on some form of interest rate exposure, in addition to currency risk.

• Currency Interest rate swap: Agreement to exchange periodic payments related to interest rates between currencies. Can be fixed for floating, or floating for floating based on different indices. This group includes those swaps whose notional principal is amortized according to a fixed schedule independent of interest rates.

• Currency Swaption - an OTC option granting the buyer the right but not the obligation to enter into a currency interest rate swap. Such a swap involves a commitment between counterparties to exchange interest payment streams in different currencies for a set time frame and also to exchange the principal amounts in different currencies at a set exchange rate on the maturity date.

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.