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  • 1. 1
  • 3. CERTIFICATE This is to certify that a group report on “FOREIGN EXCHANGE & THE IMPLICATIONS OF DERIVATIVES ON FOREX” has been submitted by the following students of L.J. Institute of Business Administration for the year 201011 in partial fulfillment of Gujarat University requirement for the award of the degree of BBA. Name SHIKHA KOTHARI BINAL PATEL RISHITA KAYASTH AMI KHANDHEDIYA MUNIRA CHHAYANWALA Roll no 36 57 30 32 13 Division TY.BBA-A TY.BBA-A TY.BBA-A TY.BBA-A TY.BBA-A NIRALI CHOVATIA AADIL PATHAN ADITYA KAPOOR NAMAN SHAH PRATIK BAJAJ 15 70 29 94 4 TY.BBA-A TY.BBA-A TY.BBA-A TY.BBA-A TY.BBA-A Director Project In charge _____________ External Evaluator _____________ Place: Ahmedabad Date: 9th February, 2010 3 _______________
  • 4. PREFACE “Life is a series of experience, each one of which makes us bigger” - Henry Ford A management study is a bridge between the world of business education and management and the world of practice. This helps the student to move over to the professional life with facility. "Learning is born out of experience and observation'. Learning is most effective when put into practice. The management students can perform better in an organization because of their familiarity with various techniques of management, compared to those who merely obtain theoretical knowledge. The practical training is an essential feature of business studies. The current rapidly changing businesses demand for dynamic youths and personnel. During the academic year 2010-2011, we have undertaken the project research work on the topic ‘Foreign Exchange & Implication of Derivatives on Forex’. This project helped us to gain knowledge on what is forex? How does forex market works? What are its constituents? We also gained practical knowledge of how we can be participants in the forex market. It is a matter of pride for our group to explain this project work where in we have put our earnest efforts. 4
  • 5. ACKNOWLEDGEMENT This report could not have been accomplished without the splendid support and hard work of the entire group members and guidance of our Professors and the Institute. Invaluable assistance was provided by Prof. Nihar Nanavati , Prof. Saurin Shah and Prof. Chintan Devalia. A special thanks to them for their constant encouragement in preparation of this project. We are thankful to each and everyone who have directly or indirectly helped us in preparation of this project. We are also grateful to all of them who have spent their precious time to provide us information. We would specially like to thanks all the Companies who gave us their precious time to tell us about their company and services provided by them. We extend us sincere thanks to all… THE GROUP OF INTEGRITY 5
  • 6. Table of Content Sr. No Content Pg.no 1 Objectives of study 7 2 Problem statement 8 3 Barter System 9 4 Money and Metals 12 5 Paper and plastic money 17 6 Bretton Woods system 19 7 Evolution of foreign Exchange 23 8 Exchange Rate 28 9 Dollar as vehicle Currency 32 10 Other major currencies 35 11 Derivatives 37 12 Forex and derivatives 50 13 Analysis of brokers’ Questionnaires 90 14 Analysis of customers’ Questionaires 97 15 Findings 110 16 Limitations 111 17 Suggestions 112 18 Observations 113 19 Conclusion 114 20 Bibliography 116 21 Declaration 117 6
  • 7. OBJECTIVE OF STUDY 1. The basic idea behind undertaking this project the is to attempt study the intricacies of the foreign exchange market. The main purpose of this study is to get a better knowledge of the various concepts and technicalities in foreign market. 2. Foreign exchange in derivatives particularly shows how their trading is being carried out and analyze the the result in relation of Indian economy. Also, to analyse different currency derivative products. 3. How they contribute to the extent in change in the global and national economy? How derivatives Are useful as a trading tool inspite of many other tools in market and the basic need to fabricate derivatives? How would derivatives affect future market economy? 4. The objective of studying derivatives is to get the overall ken of what derivatives basically meant and its role in detail. 5. How they are being dealt with specifically in local and regional market, how they affect the market, individuals and business. 6. One of the objective for its study is one can take up trading as a professional business by studying and getting preview of the derivatives and its impact in the market. 7
  • 8. PROBLEM STATEMENT This project attempt to study the intricacies of the foreign exchange market. The main purpose of this study is to get a better idea and the comprehensive details of foreign exchange risk management. SUB OBJECTIVES To know about the various concept and technicalities in foreign exchange. To know the various functions of forex market. To get the knowledge about the hedging tools used in foreign exchange. 8
  • 9. Money, as we know it today, is the result of a long process. At the beginning, there was no money. People engaged in barter, the exchange of merchandise for merchandise, without value equivalence. Then, a person catching more fish than the necessary for himself and his group exchanged his excess fish for the surplus of another person who, for instance, had planted and harvested more corn that what he would need. Barter system is an age-old method that was adopted by people to exchange their services and goods. This system was used for centuries, before the invention of money. People used to exchange the goods or services for other goods or services in return. The barter system was one of the earliest forms of trading. It facilitated exchange of goods and services, as money was not invented in those times. The history of bartering can be traced back to 6000 BC. It is believed that barter system was introduced by the tribes of Mesopotamia. People used to exchange their goods for weapons, tea, spices, and food items. Sometimes, even human skulls were used for barter. Another popular item used for exchange was salt. Salt was so valuable at that time, that the salary of Roman soldiers was paid in salt. Goods used in barter are generally in their natural state, in line with the environment conditions and activities developed by the group, corresponding to elementary needs of the group‘s members. Due to the wasteful nature of barter, the amount of trade that could be carried out by this method of exchange was limited. The utility gained from 9
  • 10. trade would be outweighed by the utility lost in the process of making the trade. Following were the limitations of barter system:1. Double Coincidence of Wants: Exchange can take place between two persons only if each possesses the goods which the other wants e.g., if a weaver needs shoes and he has cloth to offer in exchange he should not only find a cobbler who makes shoes, but find such cobbler who needs cloth and is prepared to give shoes in exchange for it. In this case, it was difficult to find such a person. 2. Absence of Standard Value: Under barter system there was no measure of value. Even if two persons met together who wanted each other goods, they could not find a satisfactory equilibrium price. Under such conditions one party had to suffer. 3. Indivisibility of Commodities: It was difficult to divide a commodity without loss in its value e.g., a man who wants to purchase cloth equal to half the value of his cow and other commodities for the rest half value of cow; he could not divide his cow. 4. Absence of Store of Value: Wealth cannot be easily stored for future use in the form of commodities because they perish in the long run. However, store of wealth in terms of goods or commodities is subject to some problems such as cost of storage, loss of value, difficulty in quick disposition of loss. 10
  • 11. Barter system has been in use throughout the world for centuries. The invention of money did not result in the end of bartering services. Sometimes, monetary crises fueled the revival of the barter system, and the current recession has once again set a stage for its comeback. Even though money is there for trading and for business, barter system still exists and has become more strong and organized. 11
  • 12. The first form of metal money made its appearance in China sometime around the end of the Stone Age in 1,000 B.C. with the production of fake cowry shells. Apart from these, tools like knives and spades made of metals used in ancient China may also be considered as earliest forms of metal money. The Chinese coins were made from base metals and were normally punctured in the middle so that they could be threaded into a chain. In fact, these early Chinese metal coins served as prototypes for the modern-day coinage designing. The silver coins made their first appearance some time around 500 B.C. in the form of silver pieces and bullions, and gradually evolved to its present manifestation. They were the first coins made of precious metals and carried impressions of Gods and emperors who issued them to demonstrate their value as currency. 12
  • 13. It is believed that the silver coins made their maiden appearance in Lydia or Turkey and their techniques were used repeatedly until they were bettered by the Persian, Greek, Macedonian and Roman empires. Unlike, the coins produced by the Chinese, these coins were made from precious and semi-precious metals such as gold, silver and bronze and carried substantial inherent value. A Lydian gold coin Greek coin from Coinage was widely adopted across Ionia and mainland Greece during the 6th century B.C., eventually leading to the Athenian Empire's 5th century B.C., dominance of the region through their export of silver coinage, mined in southern Attica at Laurium and Thorikos. A major silver vein discovery at Laurium in 483 BC led to the huge expansion of the Athenian military fleet. Competing coinage standards at the time were maintained by Mytilene and Phokaia using coins of Electrum; Aegina used silver. 13
  • 14. Soon other people learned to use coins, and gradually coins became common all over Europe, Asia, and Africa ( except for central Africa and South Africa). The governments that minted these coins figured out that if they didn't have enough money, they could mix the gold with more silver to make it go further, or mix the silver with more bronze. That way they could make more coins with the same amount of metal, and have more money to pay their soldiers with. The Romans did this in the 200's AD. Although gold and silver were commonly used to mint coins, other metals could be used. For instance, Ancient Sparta minted coins from iron to discourage its citizens from engaging in foreign trade. In the early seventeenth century Sweden lacked more precious metal and so produced "plate money", which were large slabs of copper approximately 50 cm or more in length and width, appropriately stamped with indications of their value. It was the discovery of the touchstone which led the way for metal-based commodity money and coinage. Any soft metal can be tested for purity on a touchstone, allowing one to quickly calculate the total content of a particular metal in a lump. Gold is a soft metal, which is also hard to come by, dense, and storable. As a result, monetary gold spread very quickly from Asia Minor, where it first gained wide usage, to the entire world. Metal based coins had the advantage of carrying their value within the coins themselves on the other hand, they induced manipulations: the clipping of coins in the attempt to get and recycle the precious metal. A greater problem was the simultaneous co-existence of gold, silver and copper coins in Europe. 14
  • 15. English and Spanish traders valued gold coins more than silver coins, as many of their neighbors did, with the effect that the English gold-based guinea coin began to rise against the English silver based crown in the 1670s and 1680s. Consequently, silver was ultimately pulled out of England for dubious amounts of gold coming into the country at a rate no other European nation would share. The effect was worsened with Asian traders not sharing the European appreciation of gold altogether — gold left Asia and silver left Europe in quantities European observers like Isaac Newton, Master of the Royal Mint observed with unease. Throughout the 18th century; huge quantities of guineas were put into circulation, with the mint often striking three to four million annually; virtually no silver was coined. Not since Roman times had gold been so widely used and accepted both in Britain and abroad, although most other nations stayed with silver coinage. The sovereign, which replaced the guinea under the Coinage Act of 1816, made the gold standard official. The sovereign, of 0.25 troy oz (7.77 grams) at 916 fine, was the sole standard of value and had unlimited legal tender. 15
  • 16. The final triumph for gold coinage followed the gold rushes in the United States and Australia after 1848, as gold production rose five-fold. Gold coin minting soared in France and the United States in the 1850s and ultimately most nations switched from silver to gold coinage by 1900, when the United States finally switched to the single gold standard from a bimetallic gold and silver policy. Virtually all gold mined during the 19th Century was turned into coins. Sovereigns in Britain and Australia, Eagles in the United States, Marks in Germany, Roubles in Russia, Crowns in Austria, Florins in Hungary and Napoleons in France accounted for over 13,000 tonnes (418 million troy oz) in the classic period of the gold standard prior to World War I. But when the world went to war in 1914, governments started to husband their gold, the minting of gold coinage largely stopped. In 1933 during the Great Depression, the U.S. recalled all gold and gold coins from their citizens. After that, the era of almost universal gold coinage was over. 16
  • 17. The history of paper currency is rooted in the monetary exchange system, which replaced bartering for goods. Coins created with a specific amount of gold, silver or bronze established a uniform measurement of exchange, which was difficult to transport because of the weight. In the 19th century, paper money began appearing to replace varying coin systems, often as a result of regime changes but sometimes because of war. Early paper money was placed on the gold or silver standard, which allowed equal exchange of gold for the value printed on the paper. In premodern China, the need for credit and for circulating a medium that was less of a burden than exchanging thousands of copper coins led to the introduction of paper money, commonly known today as banknotes. This economic phenomenon was a slow and gradual process that took place from the late Tang Dynasty (618–907) into the Song Dynasty (960–1279). It began as a means for merchants to exchange heavy coinage for receipts of deposit issued as promissory notes from shops of wholesalers, notes that were valid for temporary use in a small regional territory. With the introduction of paper currency and non-precious coinage, commodity money evolved into representative money. This meant that what money itself was made of no longer had to be very valuable. 17
  • 18. Representative money was backed by a government or bank's promise to exchange it for a certain amount of silver or gold. For example, the old British Pound bill or Pound Sterling was once guaranteed to be redeemable for a pound of sterling silver. The evolution of plastic money dates back to the 1920s, when the first payment card was introduced in the USA. Diners Club and American Express launched the world's first plastic card in the USA, in 1950. The first credit card was introduced by Diners Club in 1951. However, the plastic cards began to be widely used only after 1970, when the specific standards for magnetic strip were set. In the late 1990s, plastic cards became very common and by 2001, plastic money had become an essential form of 'ready money' 18
  • 19. 1. Introduction In times of globalisation the economic environment changes rapidly. Capital movements become larger and at the same time less controllable. Therefore, the need for a stabilizing system becomes more and more apparent. In the past such a system has been established at the conference of Bretton Woods. 2. Development of the system 2.1. The international economic situation After World War I most countries wanted to return to the old financial security and stable situation of pre-war times as soon as possible. Discussions about a return to the gold standard began and by 1926 all leading economies had re-established the system, according to which every nation‘s circulating money had to be backed by reserves of gold and foreign currencies to a certain extent. But several mistakes in implementing the gold standard (mainly that a weakened Great Britain had to take the leading part and that a number of main currencies where over- or undervalued) led to a collapse of the economic and financial relations, peaking in the Great Depression in 1929. Every single country tried to increase the competitiveness of its export products in order to reduce its payment balance deficit by deflating its currency. This fact resulted in an international deflation competition that caused mass unemployment, bankruptcy of enterprises, the failing of credit institutions, as well as hyper inflations in the countries concerned. 19
  • 20. 2.2. The conference of Bretton Woods In 1944 an international conference took place in Bretton Woods, New Hampshire (USA). 44 countries attended this conference in order to restructure international finance and currency relationships. The participants of this conference created the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD/World Bank). Additionally, they agreed on implementing a system of fixed exchange rates with the U.S. dollar as the key currency. 20
  • 21. 2.3. The dominant role of the USA The USA has been and still is the dominating power of the Bretton Woods system. After World War II the United States was the country with the biggest economic potential. The U.S. dollar was the currency with the most purchasing power and it was the only currency that was backed by gold. Additionally, all European nations that had been involved in World War II were highly in debt and transferred large amounts of gold into the United States, a fact that contributed to the supremacy of the USA. Thus, the U.S. dollar was strongly appreciated in the rest of the world and therefore became the key currency of the Bretton Woods system. 3. The International Monetary Fund The IMF was officially established on December 27, 1945, when the 29 participating countries at the conference of Bretton Woods signed its Articles of Agreement. It commenced its financial operations on March 1, 1947. The IMF is an international organisation, which today consists of 183 member countries. The purposes of the IMF are to promote international monetary cooperation by establishing a global monitoring agency that supervises, consults, and collaborates on monetary problems. It facilitates world trade expansion and thereby contributes to the promotion and maintenance of high levels of employment and real income. Furthermore, the IMF ensures exchange rate stability to avoid competitive exchange depreciation. 4. Crisis of the system In the 1960s and 1970s enduring imbalances of payments between the Western industrialized countries weakened the system of Bretton Woods. One substantial problem was that one national currency (the U.S. dollar) had to be an international reserve currency at the same time. This made the national monetary and fiscal policy of the United States free from 10 external economic pressures, while heavily influencing those external economies. To ensure international liquidity the USA were forced to run deficits in their balance of 21
  • 22. payments, otherwise a world inflation would have been caused. However, in the 1960s they ran a very inflationary policy and limited the convertibility of the U.S. dollar because the reserves were insufficient to meet the demand for their currency. The other member countries were not willing to accept the high inflation rates that the par value system would have caused and ―the dollar ended up being weak and unwanted, just as predicted by Gresham‘s law: Bad money drives out good money.‖ The system of Bretton Woods collapsed. 5. Conclusion The system of Bretton Woods of 1944 with its fixed exchange rates does not exist anymore today. Its institutions and procedures had to adjust to market forces to survive but still its goals are as valid today as they have been in the past. The benefits of the Bretton Woods system were a significant expansion of international trade and investment as well as a notable macroeconomic performance: the rate of inflation was lower on average for every industrialised country except Japan than during the period of floating exchange rates that followed, the real per capita income growth was higher than in any monetary regime since 1879 and the interest rates were low and stable. Weaknesses of the system were capital movement restrictions throughout the Bretton Woods years (governments needed to limit capital flows in order to have a certain extent of control) as well as the fact that parities were only adjusted after speculative and financial crises. 22
  • 23. Although the fixed exchange system served well during the 1950 and early 1960, it came under increasing strain in the late 1960s and by 1971 the order was almost collapsed. Most economists trace the breakup of the fixed exchange rate system to the US macroeconomic policy package of 1965-68 to finance both the Vietnam conflict and its welfare programs. Instead, it was financed by an increase in money supply, which in turn, led to rise in price inflation from less than 4 percent in 1966 to close to 9 percent by 1968. With more money in their pockets the American spent more, particularly on imports, from here the US trade balance started to deteriorate rapidly. The rise in inflation and the worsening of US trade position gave support to the speculation in the foreign exchange market that the dollar would be devalued. Things came to a head on spring 1971, when US trade figures were released, which showed that for the first time since 1945, the United States was importing more than it was exporting. This set off the massive purchases of deutsche marks by the speculators who guessed that the DM would revalue against the dollar. At that point, the Bundesbank faced the inevitable and allowed its currency to float. 23
  • 24. In the weeks following the decision to float the DM, the market became increasingly convinced that the dollar would have to be devalued. However, devaluation of the dollar was not an easy matter. Under the Bretton Woods provisions, any other country could change its exchange rates against all currencies simply by fixing its dollar rate at a new level. But as the key currency in the system, the dollar could be devalued only if all countries agreed to simultaneously revalue against the dollar. And many countries did not want this since it would make their products more expensive relative to US products. The problem was not solved, however. The US balance of Payment position continued to deteriorate throughout 1972, while the money supply continued to expand at inflationary rate, given the more solid reason to believe that the dollar was overvalued. After a massive wave of speculation in February, this culminated with European Central banks spending up to $3.6 billion. On March 1 to try to prevent their currencies form appreciating, the foreign exchange market was closed down. When the market reopened on March 19, the currencies of Japan and most European countries were floating against the dollar. After Bretton Woods switching away from the fixed currency system after 27 years out of necessity, not by choice was a difficult task. The Smithsonian agreement reached in Washington in December 1971 had a transactional role to the free-floating markets. This agreement failed to address the real cause behind the international economic and financial pressure, focusing instead on increasing 24
  • 25. the range of currency fluctuation. From 1 percent the band of foreign currencies fluctuation was expanded to 4.5 percent. Parallel to Washington‘s efforts, the European Economic Community, established in 1957, tried to move away from the US dollar block toward the Deutsche mark block, by designing its own monetary system. In April 1972, West Germany, France, Italy, the Netherlands, Belgium and Luxembourg developed the European joint Float. Under this system the member countries were allowed to move between 2.25 percent band, known as the snake, against each other, and collectively within 4.5 percent band, known as the tunnel, against the US dollar. Unfortunately, both the Smithsonian Institution Agreement and the European Joint Float did not address the independent domestic problems of the member countries from the bottom up, attempting instead to focus solely on the large international picture and maintain it by artificially enforcing the intervention points. By 1973, both systems collapsed under heavy market pressures. The idea of regional currency stability with the goal of financial independence from the US dollar block persisted. By July 1978, the members of the European Community approved the plans for the European Monetary System: West Germany, France, Italy, Netherlands, Belgium, Great Britain, Denmark, Ireland and Luxembourg. The system was launched in March 1979, as a revamped European Joint Float, or a MINI Bretton Woods Accord. The Floating Exchange Rate Regime : The floating exchange rate regime that followed the collapse of the fixed exchange rate system was formalized in January 1976 when IMF members met in Jamaica and agreed to the rules for the international monetary system that are in place today. 25
  • 26. The Jamaica Agreement: The purpose of the Jamaica meeting was to revise the IMF‘s Articles of Agreement to reflect the new reality of floating exchange rate. The main elements of the Jamaica agreement include the following:    Floating rates were declared acceptable. IMF members were permitted to enter the foreign exchange market to even out ―unwarranted‖ speculative fluctuations. Gold was abandoned as reserve assets. The IMF returned its gold reserve to members at the current market price, placing the proceeds in a help fund to help poor nations. Total IMF quotas- the amount member countries contribute to IMF – were increased to $41 billion. Since then they have been increased to $180 billion. Exchange Rates since 1973: Since March 1973 exchange rates have become much more volatile and far less predictable than they were between 1945 and 1973. This volatility has been partly due to a number of unexpected shocks to the world monetary system, including:      The oil crisis in 1971, when OPEC quadrupled the price of oil. The harmful effect of this on the US inflation rate and trade position resulted in further decline in the value of the dollar. The loss of confidence in the dollar that followed the rise of US inflation in 1977 and 1978. The oil crisis of 1979, when OPEC once again increased the price of oil dramatically- this time it was doubled. The unexpected rise in the dollar between 1980 and 1985, despite a worsening balance of payment picture. The rapid fall of the US dollar between 1985 and 1987. 26
  • 27. Free Floating The major currencies such as US dollar move independently of the other currencies. The currency may be traded by anybody so inclined. Its value is a function of the current supply and demand forces in the market, and there are no specific intervention points that have to be observed. Of course, the Federal Reserve Bank irregularly intervenes to change the value of the US dollar, but specific levels are ever imposed. Naturally, free-floating currencies are in the heaviest trading demand. This system of free floating of currencies against the dollar provides ample opportunities to the investors to judge and trade these currencies. This system of free floating proves to be the best market available all around the world with same kind of exposure and opportunities to trade and make full use of foreign exchange market. 27
  • 28. The exchange rate is a price - The number of units of one nation‘s currency that must be surrendered in order to acquire one unit of another nation‘s currency. There are scores of ―exchange rates‖ for INR and other currencies, say US Dollar. In the spot market, there is an exchange rate for every other national currency traded in that market, as well as for various composite currencies or constructed monetary units such as the Euro or the International Monetary Fund‘s ―SDR‖. There are also various ―trade-weighted‖ or ―effective‖ rates designed to show a currency‘s movements against an average of various other currencies. Apart from the spot rates, there are additional exchange rates for other delivery dates in the forward markets. The market price is determined by the interaction of buyers and sellers in that market, and a market exchange rate between two currencies is determined by the interaction of the official and private participants in the foreign exchange rate market. For a currency with an exchange rate that is fixed, or set by the monetary authorities, the central bank or another official body is a participant in the market, standing ready to buy or sell the currency as necessary to maintain the authorized pegged rate or range. But in countries like the United States, which follows a complete free floating regime, the authorities are not known to intervene in the foreign exchange market on a continuous basis to influence the exchange rate. The market participation is made up of individuals, non-financial firms, banks, official bodies, and other private institutions from all over the world that are buying and selling US Dollars at that particular time. 28
  • 29. The participants in the foreign exchange market are thus a heterogeneous group. The various investors, hedgers, and speculators may be focused on any time period, from a few minutes to several years. But, whatever is the constitution of participants, and whether their motive is investing, hedging, speculating, arbitraging, paying for imports, or seeking to influence the rate, they are all part of the aggregate demand for and supply of the currencies involved, and they all play a role in determining the market price at that instant. Given the diverse views, interests, and time frames of the participants, predicting the future course of exchange rates is a particularly complex and uncertain exercise. At the same time, since the exchange rate influences such a vast array of participants and business decisions, it is a pervasive and singularly important price in an open economy, influencing consumer prices, investment decisions, interest rates, economic growth, the location of industry, and much more. The role of the foreign exchange market in the determination of that price is critically important. 29
  • 30. A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold. A fixed exchange rate is usually used to stabilize the value of a currency against the currency it is pegged to. This makes trade and investments between the two countries easier and more predictable, and is especially useful for small economies where external trade forms a large part of their GDP. It can also be used as a means to control inflation. However, as the reference value rises and falls, so does the currency pegged to it. In addition, according to the Mundell-Fleming model, with perfect capital mobility, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability. There are no major economic players that use a fixed exchange rate (except the countries using the Euro). The currencies of the countries that now use the euro are still existing (e.g. for old bonds). The rates of these currencies are fixed with respect to the euro and to each other. The most recent such country to discontinue their fixed exchange rate was the People's Republic of China, which did so in July 2005. 30
  • 31. A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency. It is not possible for a developing country to maintain the stability in the rate of exchange for its currency in the exchange market. There are economists who think that, in most circumstances, floating exchange rates are preferable to fixed exchange rates. As floating exchange rates automatically adjust, they enable a country to dampen the impact of shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis. However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty. This may not necessarily be true, considering the results of countries that attempt to keep the prices of their currency "strong" or "high" relative to others, such as the UK or the Southeast Asia countries before the Asian currency crisis. The debate of making a choice between fixed and floating exchange rate regimes is set forth by the Mundell-Fleming model, which argues that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It can choose any two for control, and leave third to the market forces. In cases of extreme appreciation or depreciation, a central bank will normally intervene to stabilize the currency. Thus, the exchange rate regimes of floating currencies may more technically be known as a managed float. A central bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price "ceiling" and "floor". Management by the central bank may take the form of buying or selling large lots in order to provide price support or resistance, or, in the case of some national currencies, there may be legal penalties for trading outside these bounds. 31
  • 32. The US Dollar is by far the most widely traded currency. In part, the widespread use of the US Dollar reflects its substantial international role as ―investment‖ currency in many capital markets, ―reserve‖ currency held by many central banks, ―transaction‖ currency in many international commodity markets, ―invoice‖ currency in many contracts, and ―intervention‖ currency employed by monetary authorities in market operations to influence their own exchange rates. In addition, the widespread trading of the US Dollar reflects its use as a ―vehicle‖ currency in foreign exchange transactions, a use that reinforces its international role in trade and finance. For most pairs of currencies, the market practice is to trade each of the two currencies against a common third currency as a vehicle, rather than to trade the two currencies directly against each other. The vehicle currency used most often is the US Dollar, although very recently euro also has become an important vehicle currency. 32
  • 33. Thus, a trader who wants to shift funds from one currency to another, say from Indian Rupees to Philippine Pesos, will probably sell INR for US Dollars and then sell the US Dollars for Pesos. Although this approach results in two transactions rather than one, it may be the preferred way, since the US Dollar/INR market and the US Dollar/Philippine Peso market are much more active and liquid and have much better information than a bilateral market for the two currencies directly against each other. By using the US Dollar or some other currency as a vehicle, banks and other foreign exchange market participants can limit more of their working balances to the vehicle currency, rather than holding and managing many currencies, and can concentrate their research and information sources on the vehicle currency. Use of a vehicle currency greatly reduces the number of exchange rates that must be dealt with in a multilateral system. In a system of 10 currencies, if one currency is selected as the vehicle currency and used for all transactions, there would be a total of nine currency pairs or exchange rates to be dealt with (i.e. one exchange rate for the vehicle currency against each of the others), whereas if no vehicle currency were used, there would be 45 exchange rates to be dealt with. In a system of 100 currencies with no vehicle currencies, potentially there would be 4,950 currency pairs or exchange rates [the formula is: n(n1)/2]. Thus, using a vehicle currency can yield the advantages of fewer, larger, and more liquid markets with fewer currency balances, reduced informational needs, and simpler operations. The US Dollar took on a major vehicle currency role with the introduction of the Bretton Woods par value system, in which most nations met their IMF exchange rate obligations by buying and selling US Dollars to maintain a par value relationship for their own currency against the US Dollar. The US Dollar was a convenient vehicle because of its central role in the exchange rate system and its widespread use as a reserve currency. 33
  • 34. The US Dollar‘s vehicle currency role was also due to the presence of large and liquid US Dollar money and other financial markets, and, in time, the Euro-US Dollar markets, where the US Dollars needed for (or resulting from) foreign exchange transactions could conveniently be borrowed (or placed). 34
  • 35. The Euro: Like the US Dollar, the Euro has a strong international presence and over the years has emerged as a premier currency, second only to the US Dollar. The Japanese Yen: The Japanese Yen is the third most traded currency in the world. It has a much smaller international presence than the US Dollar or the Euro. The Yen is very liquid around the world, practically around the clock. The British Pound: Until the end of World War II, the Pound was the currency of reference. The nickname Cable is derived from the telegrams used to update the GBP/USD rates across the Atlantic. The currency is heavily traded against the Euro and the US Dollar, but it has a spotty presence against other currencies. The two-year bout with the Exchange Rate Mechanism, between 1990 and 1992, had a soothing effect on the British Pound, as it generally had to follow the Deutsche Mark's fluctuations, but the crisis conditions that precipitated the pound's withdrawal from the Exchange Rate Mechanism had a psychological effect on the currency. 35
  • 36. The Swiss Franc: The Swiss Franc is the only currency of a major European country that belongs neither to the European Monetary Union nor to the G-7 countries. Although the Swiss economy is relatively small, the Swiss Franc is one of the major currencies, closely resembling the strength and quality of the Swiss economy and finance. Switzerland has a very close economic relationship with Germany, and thus to the Euro zone. Typically, it is believed that the Swiss Franc is a stable currency. Actually, from a foreign exchange point of view, the Swiss Franc closely resembles the patterns of the Euro, but lacks its liquidity. 36
  • 37. The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. 1.1 DERIVATIVES DEFINED Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the "underlying". In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines "derivative" to include1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2. A contract which derives its value from the prices, or index of prices, of underlying securities. Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A. 37
  • 38. Emergence Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity-linked derivatives remained the sole form of such products for almost three hundred years. Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives the world over, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. 38
  • 39. Participants and functions NSE admits members on its derivatives segment in accordance with the rules and regulations of the exchange and the norms specified by SEBI. NSE follows 2-tier membership structure stipulated by SEBI to enable wider participation. Those interested in taking membership on F&O segment are required to take membership of CM and F&O segment or CM, WDM and F&O segment. Trading and clearing members are admitted separately. Essentially, a clearing member (CM) does clearing for all his trading members (TMs), undertakes risk management and performs actual settlement. There are three types of CMs: • Self Clearing Member: A SCM clears and settles trades executed by him only either on his own account or on account of his clients. • Trading Member Clearing Member: TM-CM is a CM who is also a TM. TM-CM may clear and settle his own proprietary trades and client's trades as well as clear and settle for other TMs. • Professional Clearing Member PCM is a CM who is not a TM. Typically, banks or custodians could become a PCM and clear and settle for TMs. Details of the eligibility criteria for membership on the F&O segment are provided in Tables 7.1 and 7.2 (Chapter 7). The TM-CM and the PCM are required to bring in additional security deposit in respect of every TM whose trades they undertake to clear and settle. Besides this, trading members are required to have qualified users and sales persons, who have passed a certification program approved by SEBI. 39
  • 40. Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. We take a brief look at various derivatives contracts that have come to be used. Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today's pre-agreed price. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized Exchange-traded contracts. Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of upto three years. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options. Swaps: Swaps are private agreements between two parties to exchange cash flows 40
  • 41. in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: · Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. · Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating. 41
  • 42. Derivatives have probably been around for as long as people have been trading With one another. Forward contracting dates back at least to the 12th century, and may well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. As the word suggests, derivatives that trade on an exchange are called exchange traded derivatives, whereas privately negotiated derivative contracts are called OTC contracts. The OTC derivatives markets have witnessed rather sharp growth over the last few years, which has accompanied the modernization of commercial and investment banking and globalisation of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter. It has been widely discussed that the highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed to market stability originating in features of OTC derivative instruments and markets.The OTC derivatives markets have the following features compared to exchange traded derivatives: 1. The management of counter-party (credit) risk is decentralized and located within individual institutions, 2. There are no formal centralized limits on individual positions, leverage, or margining, 3. There are no formal rules for risk and burden-sharing, 42
  • 43. 4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and 5. The OTC contracts are generally not regulated by a regulatory authority and the exchange's self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance. Some of the features of OTC derivatives markets embody risks to financial market stability. The following features of OTC derivatives markets can give rise to instability in institutions, markets, and the international financial system: (i) the dynamic nature of gross credit exposures; (ii) information asymmetries; (iii) the effects of OTC derivative activities on available aggregate credit; (iv) the high concentration of OTC derivative activities in major institutions; and (v) the central role of OTC derivatives markets in the global financial system. Instability arises when shocks, such as counter-party credit events and sharp movements in asset prices that underlie derivative contracts occur, which significantly alter the perceptions of current and potential future credit exposures. When asset prices change rapidly, the size and configuration of counter-party exposures can become unsustainably large and provoke a rapid unwinding of positions. There has been some progress in addressing these risks and perceptions. However, the progress has been limited in implementing reforms in risk management, including counter-party, liquidity and operational risks, and OTC derivatives markets continue to pose a threat to international financial stability. The problem is more acute as heavy reliance on OTC derivatives creates the possibility of systemic financial events, which fall outside the more formal clearing house structures. Moreover, those who provide OTC derivative products, hedge their risks through the use of exchange traded derivatives. In view of the inherent risks associated with OTC derivatives, and their dependence on exchange traded derivatives, Indian law considers them illegal. 43
  • 44. Some of the applications of financial derivatives can be enumerated as follows: 1. Management of risk: This is most important function of derivatives. Risk management is not about the elimination of risk rather it is about the management of risk. Financial derivatives provide a powerful tool for limiting risks that individuals and organizations face in the ordinary conduct of their businesses. It requires a thorough understanding of the basic principles that regulate the pricing of financial derivatives. Effective use of derivatives can save cost, and it can increase returns for the organisations. 2. Efficiency in trading: Financial derivatives allow for free trading of risk components and that leads to improving market efficiency. Traders can use a position in one or more financial derivatives as a substitute for a position in the underlying instruments. In many instances, traders find financial derivatives to be a more attractive instrument than the underlying security. This is mainly because of the greater amount of liquidity in the market offered by derivatives as well as the lower transaction costs associated with trading a financial derivative as compared to the costs of trading the underlying instrument in cash market. 3. Speculation: This is not the only use, and probably not the most important use, of financial derivatives. Financial derivatives are considered to be risky. If not used properly, these can leads to financial destruction in an organisation like what happened in Barings Plc. However, these instruments act as a powerful instrument for knowledgeable traders to expose themselves to calculated and well understood risks in search of a reward, that is, profit. 4. Price discover: Another important application of derivatives is the price discovery which means revealing information about future cash market prices through the futures market. Derivatives markets provide a mechanism by which diverse and scattered opinions of future are collected into one readily discernible number which provides a consensus of knowledgeable thinking. 44
  • 45. 5. Price stabilization function: Derivative market helps to keep a stabilising influence on spot prices by reducing the short-term fluctuations. In other words, derivative reduces both peak and depth and leads to price stabilisation effect in the cash market for underlying asset. 45
  • 46. Derivatives markets in India have been in existence in one form or the other for a long time. In the area of commodities, the Bombay Cotton Trade Association started futures trading way back in 1875. In 1952, the Government of India banned cash settlement and options trading. Derivatives trading shifted to informal forwards markets. In recent years, government policy has shifted in favour of an increased role of market-based pricing and less suspicious derivatives trading. The first step towards introduction of financial derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995. It provided for withdrawal of prohibition on options in securities. The last decade, beginning the year 2000, saw lifting of ban on futures trading in many commodities. Around the same period, national electronic commodity exchanges were also set up. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001 on the recommendation of L. C Gupta committee. Securities and Exchange Board of India (SEBI) permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. Initially, SEBI approved trading in index futures contracts based on various stock market indices such as, S&P CNX, Nifty and Sensex. Subsequently, index-based trading was permitted in options as well as individual securities. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and 46
  • 47. trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX. In June 2003, NSE introduced Interest Rate Futures which were subsequently banned due to pricing issue. Derivatives in India: A Chronology 47
  • 48. Futures contracts in pepper, turmeric, gur (jaggery), hessian (jute fabric), jute sacking, castor seed, potato, coffee, cotton, and soybean and its derivatives are traded in 18 commodity exchanges located in various parts of the country. Futures trading in other edible oils, oilseeds and oil cakes have been permitted. Trading in futures in the new commodities, especially in edible oils, is expected to commence in the near future. The sugar industry is exploring the merits of trading sugar futures contracts. The policy initiatives and the modernisation programme include extensive training, structuring a reliable clearinghouse, establishment of a system of warehouse receipts, and the thrust towards the establishment of a national commodity exchange. The Government of India has constituted a committee to explore and evaluate issues pertinent to the establishment and funding of the proposed national commodity exchange for the nationwide trading of commodity futures contracts, and the other institutions and institutional processes such as warehousing and clearinghouses. With commodity futures, delivery is best effected using warehouse receipts (which are like dematerialised securities). Warehousing functions have enabled viable exchanges to augment their strengths in contract design and trading. The viability of the national commodity exchange is predicated on the reliability of the warehousing functions. The programme for establishing a system of warehouse receipts is in progress. The Coffee Futures Exchange India (COFEI) has operated a system of warehouse receipts since 1998 48
  • 49. Equity derivatives market in India has registered an "explosive growth" and is expected to continue the same in the years to come. Introduced in 2000, financial derivatives market in India has shown a remarkable growth both in terms of volumes and numbers of traded contracts. NSE alone accounts for 99 percent of the derivatives trading in Indian markets. The introduction of derivatives has been well received by stock market players. Trading in derivatives gained popularity soon after its introduction. In due course, the turnover of the NSE derivatives market exceeded the turnover of the NSE cash market. For example, in 2008, the value of the NSE derivatives markets was Rs. 130, 90,477.75 Cr. whereas the value of the NSE cash markets was only Rs. 3,551,038 Cr. If we compare the trading figures of NSE and BSE, performance of BSE is not encouraging both in terms of volumes and numbers of contracts traded in all product categories. Among all the products traded on NSE in F& O segment, single stock futures also known as equity futures, are most popular in terms of volumes and number of contract traded, followed by index futures with turnover shares of 52 percent and 31 percent, respectively. Derivatives Growth 49
  • 50. FOREX IN INDIA Evolution: The growth of the Indian Forex market owes to the tremendous growth of the Indian economy in the last few years. Today India holds a significant position in the Global economic scenario and it is considered to be one of the emerging economies in the World. The steady growth of the Indian economy and diversification of the industrial sectors in India has contributed significantly to the rapid growth of the Indian Forex market. Let us take a watch on the Indian Forex trading scenario since the early days. The Forex trading history of India dates back to 1978, when Reserve Bank of India took a step towards allowing the banks to undertake intra-day trading in Foreign exchange. It is during the period of 1975-1992 when Reserve Bank of India, officially determined the exchange rate of rupee according to the weighed basket of currencies with the significant business partners of India. But it needs to be mentioned that there are too many restrictions on these banks during this period for trading in the Forex market. The introduction of the open market policy in the year 1991 and implementation of the new economic policy by the Govt. of India brought a comprehensive change in the Forex market of India. It is during the month of July 1991, that the rupee undergone a two fold downward adjustment and this was in line with inflation differential to ensure competitiveness in exports. Then as per the recommendation of a high level committee set up to review the Balance of Payment position, the Liberalized Exchange Rate Management System or the LERMS was introduced in 1992. The method of dual exchange rate mechanism that was part of the LERMS also came into effect 1993. It is during this time that uniform exchange rate came into effect and that started demand and supply controlled exchange rate regime in Indian. This ultimately 50
  • 51. progressed towards the current account convertibility that was a part of the Articles of Agreement with the International Monetary Fund. It was the report and recommendations of the Expert Group on Foreign Exchange, formed to judge the Forex market in India that actually helped to widen the Forex trading practices in the country. As per the recommendations of the expert committee, Reserve bank of India and the Government took so many significant steps that ultimately gave freedom to the banks in many ways. Apart from the banks corporate bodies were also given certain relaxation that also played an instrumental role in spread of Forex trading in India. It is during the year 2008 that Indian Forex market has seen a great advancement that took the Indian Forex trading at par with the global Forex markets. It is the introduction of future derivative segment in Forex trading through the largest stock exchange in country – National Stock Exchange or NSE. This step not only increased the Indian Forex market volume too many folds also gave the individual and retail investor a chance to trade at the Forex market, that was till this time remained a forte of the banks and large corporate. Indian Forex market got yet another boost recently when the SEBI and Reserve Bank of India permitted the trade of derivative contract at the leading stock exchanges NSE and MCX for three new currency pairs. In its recent circulars Reserve Bank of India accepting the proposal of SEBI, permitted the trade of INRGBP (Indian Rupee and Great Britain Pound), INREUR (Indian Rupee and Euro) and INRYEN (Indian Rupee and Japanese Yen). This was in addition with the existing pair of currencies that is US$ and INR. From inclusion of these three currency pairs in the Indian Forex circuit the Indian Forex scene is expected to boost even further as these are some of the most widely traded currency pairs in the world. As in the rest of the world, in India too, foreign exchange market is the largest financial market in existence. The phenomenon that has dramatically changed India‘s foreign exchange market was liberalization of economy started during early 90′s. In 1993, central government replaced the prevailing fixed exchange rate system with a less regulated ―market driven‖ arrangement. Even though this cannot be called as a fully floating exchange rate system like the U.S., in the 51
  • 52. Indian scenario it is working well. In the current system, the Reserve Bank of India and its affiliates intervene in the market whenever they decide it is necessary. The major participants in Indian FX market are the buyers, sellers, market mediators and the authorities. Besides the country‘s commercial capital Mumbai, centers for foreign exchange transactions in India include Kolkata, New Delhi, Chennai, Bangalore, Pondicherry and Cochin. The FX market in India is regulated by The Foreign Exchange Management Act, 1999 or FEMA, which replaced the old Foreign Exchange Regulation Act, 1947. Now, the regulators have introduced several innovations to promote the growth of FX market in India. The introduction of currency futures in India in 2009 was such as step. This has given the FX market participants in India a new kind of financial instrument, which is available in developed markets. Although no one expects the transformation of India to a fully market driven floating foreign exchange system any time soon, there are many possibilities for further loosening of controls. The permission for the introduction of new FX derivatives following the path of currency futures is also expected. 52
  • 53. The foreign exchange market has acquired a distinct vibrancy as evident from the range of products, participation, liquidity and turnover. The currency trading (FOREX) market is the biggest and the fastest growing market globally. Its daily turnover is more than 2.5 - 3 trillion dollars, which is far greater than the NASDAQ daily turnover. The average daily turnover increased from US $ 23.7 Billion in March 2006 to US $ 33 Billion in March 2007. As such, it has been referred to as the market closest to the ideal perfect competition, notwithstanding market manipulation by central banks. Just like how Markets are places to trade goods, the same goes with FOREX Markets. The FOREX goods are the currencies of various countries which are traded. You buy Euro, by paying US dollars, or you buy Dollar by paying INR or you sell Japanese Yens for Canadian dollars. Largest globally traded currencies are US $ (86%), Euro (37%), Japanese Yen (16.5%), Pound Sterling (15%), Swiss Franc (6.8%), Australian $ (6.7%), (April 2010 % Daily Share). Present scenario of forex: The daily turnover of the Global Forex market is presently estimated at US$ 3 trillion. Presently the Indian Forex market is the 16th largest Forex market in the world in terms of daily turnover as the BIS Triennial Survey report. As per this report the daily turnover of the Indian Forex market is US$ 34 billion in the year 2007. Besides the OTC derivative segment of the Indian Forex market has also increased significantly since its commencement in the year 2007. During the year 2007-08 the daily turnover of the derivative segment in the Indian Forex market stands at US$ 48 billion. 53
  • 54. MARKET SIZE & LIQUIDITY 1. Turnover in April 2010 1. Global foreign exchange market turnover was 20% higher in April 2010 than in April 2007, with average daily turnover of $4.0 trillion compared with $3.3 trillion. The increase was driven by the 48% growth in turnover of spot transactions, which represent 37% of foreign exchange market turnover. Spot turnover rose to $1.5 trillion in April 2010 from $1.0 trillion in April 2007. 2. The increase in turnover of other foreign exchange instruments was more modest at 7%, with average daily turnover of $2.5 trillion in April 2010. Turnover in outright forwards and currency swaps grew strongly (by 31% and 36%, respectively). Turnover in the large foreign exchange swaps segment was flat relative to the previous survey, while trading in currency options fell. 3. As regards counterparties, the higher global foreign exchange market turnover is associated with the increased trading activity of ―other financial institutions‖ – a category that includes non-reporting banks, hedge funds, pension funds, mutual funds, insurance companies and central banks. Turnover by this category grew by 42%, rising to $1.9 trillion in April 2010 from $1.3 trillion in April 2007. At 13%, the share of trading with non-financial customers was the lowest since 2001. 4. Foreign exchange market activity became more global, with cross-border transactions representing 65% of trading activity in April 2010, while local transactions accounted for 35%, the lowest share ever. 54
  • 55. 5. The relative ranking of foreign exchange trading centres has changed slightly from the previous survey. Banks located in the United Kingdom accounted for 37% of all foreign exchange market turnover, against 35% in 2007, followed by the United States (18%), Japan (6%), Singapore (5%), Switzerland (5%), Hong Kong SAR (5%) and Australia (4%). 1. Growth of global foreign exchange turnover The 2010 triennial survey shows another substantial increase in global foreign exchange market activity (spot transactions, outright forwards, foreign exchange swaps, currency swaps, currency options and other foreign exchange products) since the last survey in 2007, following the unprecedented 72% rise in activity between 2004 and 2007.2 In the wake of the financial crisis, global foreign exchange market turnover was 20% higher in April 2010 than in April 2007 (Table B.1). This increase brought average daily turnover to $4.0 trillion (from $3.3 trillion) at current exchange rates. Because euro/dollar exchange rates were almost unchanged in April 2007 and 2010, growth calculated at constant exchange rates was similar at 18% 55
  • 56. The currency composition of turnover has changed only slightly over the past three years, with the relative share of the main currencies diverging somewhat (Table B.4).9 The market share of the top three currencies (the US dollar, euro and Japanese yen) increased by 3 percentage points, with the market share of the top 10 increasing by only 1.4 percentage points. The biggest increases were seen for the euro and yen, and the biggest decline for sterling. The most significant increases in emerging market currencies were seen for the Turkish lira, Chinese renminbi and Korean won, followed by the Brazilian real and Singapore dollar10. The renminbi now accounts for almost 1% of global turnover, on a par with the Indian rupee and the Russian rouble. 56
  • 57. Growth in the positions of OTC foreign exchange instruments was moderate at 9%, compared with an increase of 83% in notional amounts outstanding of currency instruments in the 2004–07period. The 2007 and 2010 BIS triennial surveys bracket a period of strong growth in amounts outstanding, as shown by comparison with the semiannual data in Graph C.1. Notional amounts outstanding in all instruments peaked in June 2008, declined thereafter and recovered somewhat by June 2010. 57
  • 58. ‗ Forwards: A forward contract is a customized contract between two parties, where settlement takes place on a specific date in the future at today's pre-agreed price. Suppose that Bob wants to buy a house a year from now. At the same time, suppose that Andy currently owns a $100,000 house that he wishes to sell a year from now. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of $104,000 (more below on why the sale price should be this amount). Andy and Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Andy will have the short forward contract. At the end of one year, suppose that the current market valuation of Andy's house is $110,000. Then, because Andy is obliged to sell to Bob for only $104,000, Bob will make a profit of $6,000. To see why this is so, one need only to recognize that Bob can buy from Andy for $104,000 and immediately sells to the market for $110,000. Bob has made the difference in profit. In contrast, Andy has made a potential loss of $6,000, and an actual profit of $4,000. The similar situation works among currency forwards, where one party opens a forward contract to buy or sell a currency (ex. a contract to buy Canadian dollars) to expire/settle at a future date, as they do not wish to be exposed to exchange rate/currency risk over a period of time. As the exchange rate between U.S. dollars and Canadian dollars fluctuates between the trade date and the earlier of the date at which the contract is closed or the expiration date, one party gains and the counterparty loses as one currency strengthens against the other. Sometimes, the buy forward is opened because the investor will actually 58
  • 59. need Canadian dollars at a future date such as to pay a debt owed that is denominated in Canadian dollars. Other times, the party opening a forward does so, not because they need Canadian dollars nor because they are hedging currency risk, but because they are speculating on the currency, expecting the exchange rate to move favorably to generate a gain on closing the contract. In a currency forward, the national amounts of currencies are specified (ex: a contract to buy $100 million Canadian dollars equivalent to, say $114.4 million USD at the current rate—these two amounts are called the notional amount(s)). While the notional amount or reference amount may be a large number, the cost or margin requirement to command or open such a contract is considerably less than that amount, which refers to the leverage created, which is typical in derivative contracts. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that they are standardized and are generally traded on an exchange. A futures contract is a standardized contract, traded on an exchange, to buy or sell a certain underlying asset or an instrument at a certain date in the future, at a specified price. When the underlying is an exchange rate, the contract is termed a ―currency futures contract‖. In other words, it is a contract to exchange one currency for another currency at a specified date and a specified rate in the future. Therefore, the buyer and the seller lock themselves into an exchange rate for a specific value and delivery date. Both parties of the futures contract must fulfill their obligations on the settlement date. Internationally, currency futures can be cash settled or settled by delivering the respective obligation of the seller and buyer. All settlements, however, unlike in the case of OTC markets, go through the exchange. Currency futures are a linear product, and calculating profits or losses on Currency Futures will be similar to calculating profits or losses on Index futures. In 59
  • 60. determining profits and losses in futures trading, it is essential to know both the contract size (the number of currency units being traded) and also what the ―tick‖ value is. A tick is the minimum trading increment or price differential at which traders are able to enter bids and offers. Tick values differ for different currency pairs and different underlings‘. For e.g. in the case of the USD-INR currency futures contract the tick size shall be 0.25 paise or 0.0025 Rupee. To demonstrate how a move of one tick affects the price, imagine a trader buys a contract (USD 1000 being the value of each contract) at Rs. 42.2500. One tick move on this contract will translate to Rs.42.2475 or Rs.42.2525 depending on the direction of market movement. Purchase price: Rs.42.2500 Price increases by one tick: +Rs.00.0025 New price: Rs.42.2525 Purchase price: Rs.42.2500 Price decreases by one tick: –Rs.00.0025 New price: Rs.42.2475 The value of one tick on each contract is Rupees 2.50 (1000X 0.0025). So if a trader buys 5 contracts and the price moves up by 4 ticks, he makes Rupees 50.00 Step 1: 42.2600 – 42.2500 Step 2: 4 ticks * 5 contracts = 20 points Step 3: 20 points * Rupees 2.5 per tick = Rupees 50.00 RATIONALE BEHIND CURRENCY FUTURES Futures markets were designed to address certain problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. A futures contract is standardized contract with standard underlying instrument, a standard quantity of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be 60
  • 61. offset prior to maturity by entering into an equal and opposite transaction. The standardized items in a futures contract are: • Quantity of the underlying • The date and the month of delivery • The units of price quotation and minimum price change • Location of settlement THE ORIGIN FOREX FUTURES The Chicago Mercantile Exchange (CME) created FX futures, the first ever financial futures contracts, in 1972. The contracts were created under the guidance and leadership of Leo Melamed, CME Chairman Emeritus. The FX contract capitalized on the U.S. abandonment of the Bretton Woods agreement, which had fixed world exchange rates to a gold standard after World War II. The abandonment of the Bretton Woods agreement resulted in currency values being allowed to float, increasing the risk of doing business. By creating another type of market in which futures could be traded, CME currency futures extended the reach of risk management beyond commodities, which were the main derivative contracts traded at CME until then. The concept of currency futures at CME was revolutionary, and gained credibility through endorsement of Nobel-prize-winning economist Milton Friedman. Today, CME offers 41 individual FX futures and 31 options contracts on 19 currencies, all of which trade electronically on the exchange‘s CME Globex platform. It is the largest regulated marketplace for FX trading. Traders of CME FX futures are a diverse group that includes multinational corporations, hedge funds, commercial banks, investment banks, financial managers, commodity trading advisors (CTAs), proprietary trading firms, currency overlay managers and individual investors. They trade in order to transact business, hedge against unfavourable changes in currency rates, or to speculate on rate fluctuations. 61
  • 63. INTEREST RATE PARITY AND PRICING OF CURRENCY FUTURES: For currencies which are fully convertible, the rate of exchange for any date other than spot, is a function of spot and the relative interest rates in each currency. The assumption is that, any funds held will be invested in a time deposit of that currency. Hence, the forward rate is the rate which neutralizes the effect of differences in the interest rates in both the currencies. In the context of currencies, like USD/INR which are not fully convertible, forwards and futures prices can be influenced by several factors including regulations that are in place at any given point in time. The forward rate is a function of the spot rate and the interest rate differential between the two currencies, adjusted for time. A futures contract is a standardized forward contract traded through an exchange to eliminate counterparty risk. In order to derive the forward rate from the spot rate, there are three commonly used formulae which give similar results, viz. a. Term : Base Formula b. Spot-Forward r& p Formula c. Continuous Compounding Formula a. Term : Base Formula Forward Rate = Spot + Points Points = Spot 1 + terms i * days basis _ 1 1 + base i * days basis Where : i = rate of interest basis = day count basis (Most currencies use a 360-day basis, except the pound sterling and a few others, which use a 365-day year.) 63
  • 64. b. Spot-Forward r& p Formula The spot exchange rate is S0. This quote is in USD per INR. The US risk-free interest rate is p, and the holding period is T. You take S0 (1+ p)-T INR and buy (1+ p)-T dollars. Simultaneously, you sell one future contract expiring at time T. The future exchange rate is F0, which is also in INR per dollar. You take your (1+ p)-T dollars and invest them in US T-bills that have a return of p. When the forward contract expires, you will have 1 dollar. This is because your (1+ ρ)-T dollars will have grown by the factor (1+ p) T therefore (1+ p)-T (1+ p)T = 1. Your forward contract obligates you to deliver the dollar, for transaction is riskless, your return should be the INR rate, r; therefore: F (0, T) = S0 (1+ r) T/ (1+p) T C. Continuous Compounding Formula F (0, T) = S0e(r-p) T Illustration: Consider the following example from an Indian perspective. On January 31 of a particular year, the spot USD/INR rate w as 43.50. The US interest rate was 3 percent, while the Indian interest rate was 6 percent. The time to expiration was 90/360 = 0.25. This can be solved using three different formulae as illustrated below: 64
  • 65. As can be noticed from the above table, the three formulae give results which are similar but not identical. Any of these formulae can be used for decision making. However, from a trading perspective, greater levels of accuracy may be desired. Hence, traders prefer the Continuous Compounding formula. SPECULATION IN FUTURES MARKETS Speculators play a vital role in the futures markets. Futures are designed primarily to assist hedgers in managing their exposure to price risk; however, this would not be possible without the participation of speculators. Speculators, or traders, assume the price risk that hedgers attempt to lay off in the markets. In other words, hedgers often depend on speculators to take the other side of their trades (i.e. act as counter party) and to add depth and liquidity to the markets that are vital for the functioning of a futures market. The speculators therefore have a big hand in making the market. Speculation is not similar to manipulation. A manipulator tries to push prices in the reverse direction of the market equilibrium while the speculator forecasts the movement in prices and this effort eventually brings the prices closer to the market equilibrium. If the speculators do not adhere to the relevant fundamental factors of the spot market, they would not survive since their correlation with the underlying spot market would be nonexistent. 4.2 LONG POSITION IN FUTURES Long position in a currency futures contract without any exposure in the cash market is called a speculative position. Long position in futures for speculative purpose means buying futures contract in anticipation of strengthening of the exchange rate (which actually means buy the base currency (USD) and sell the terms currency (INR) and you want the base currency to rise in value and then you would sell it back at a higher price). If the exchange rate strengthens before the expiry of the contract then the trader makes a profit on squaring off the position, and if the exchange rate weakens then the trader makes a loss. 65
  • 66. The graph above depicts the pay-off of a long position in a future contract, which does demonstrate that the pay-off of a trader is a linear derivative, that is, he makes unlimited profit if the market moves as per his directional view, and if the market goes against, he has equal risk of making unlimited losses if he doesn‘t choose to exit out his position. Hypothetical Example – Long positions in futures On May 1, 2008, an active trader in the currency futures market expects INR will depreciate against USD caused by India‘s sharply rising import bill and poor FII equity flows. On the basis of his view about the USD/INR movement, he buys 1 USD/INR August contract at the prevailing rate of Rs. 40.5800. He decides to hold the contract till expiry and during the holding period USD/INR futures actually moves as per his anticipation and the RBI Reference rate increases to USD/INR 42.46 on May 30, 2008. He squares off his position and books a profit of Rs. 1880 (42.4600x1000 - 40.5800x1000) on 1 contract of USD/INR futures contract. 66
  • 67. Observation: The trader has effectively analysed the market conditions and has taken a right call by going long on futures and thus has made a gain of Rs. 1,880. SHORT POSITION IN FUTURES Short position in a currency futures contract without any exposure in the cash market is called a speculative transaction. Short position in futures for speculative purposes means selling a futures contract in anticipation of decline in the exchange rate (which actually means sell the base currency (USD) and buy the terms currency (INR) and you want the base currency to fall in value and then you would buy it back at a lower price). If the exchange rate weakens before the expiry of the contract, then the trader makes a profit on squaring off the position, and if the exchange rate strengthens then the trader makes loss. The graph above depicts the pay-off of a short position in a future contract which does exhibit that the pay-off of a short trader is a linear derivative, that is, he makes unlimited profit if the market moves as per his directional view and if the market goes against his view he has equal risk of making unlimited loss if he doesn‘t choose to exit out his position. 67
  • 68. Example – Short positions in futures On August 1, 2008, an active trader in the currency futures market expects INR will appreciate against USD, caused by softening of crude oil prices in the international market and hence improving India‘s trade balance. On the basis of his view about the USD/INR movement, he sells 1 USD/INR August contract at the prevailing rate of Rs. 42.3600. On August 6, 2008, USD/INR August futures contract actually moves as per his anticipation and declines to 41.9975. He decides to square off his position and earns a profit of Rs. 362.50 (42.3600x1000 – 41.9975x1000) on squaring off the short position of 1 USD/INR August futures contract. Observation: The trader has effectively analysed the market conditions and has taken a right call by going short on futures and thus has made a gain of Rs. 362.50 per contract with small investment (a margin of 3%, which comes to Rs. 1270.80) in a span of 6 days. 68
  • 69. HEDGING USING CURRENCY FUTURES Hedging: Hedging means taking a position in the future market that is opposite to a position in the physical market with a view to reduce or limit risk associated with unpredictable changes in exchange rate. A hedger has an Overall Portfolio (OP) composed of (at least) 2 positions: 1. Underlying position 2. Hedging position with negative correlation with underlying position Value of OP = Underlying position + Hedging position; and in case of a Perfect hedge, the Value of the OP is insensitive to exchange rate (FX) changes. Types of FX Hedgers using Futures Long hedge: • Underlying position: short in the foreign currency • Hedging position: long in currency futures Short hedge: • Underlying position: long in the foreign currency • Hedging position: short in currency futures The proper size of the Hedging position • Basic Approach: Equal hedge • Modern Approach: Optimal hedge Equal hedge: In an Equal Hedge, the total value of the futures contracts involved is the same as the value of the spot market position. As an example, a US importer who has an exposure of £ 1 million will go long on 16 contracts assuming a face value of £62,500 per contract. Therefore in an equal hedge: Size of Underlying position = Size of Hedging position. 69
  • 70. Optimal Hedge: An optimal hedge is one where the changes in the spot prices are negatively correlated with the changes in the futures prices and perfectly offset each other. This can generally be described as an equal hedge, except when the spot-future basis relationship changes. An Optimal Hedge is a hedging strategy which yields the highest level of utility to the hedger. Corporate Hedging: - Before the introduction of currency futures, a corporate hedger had only Over-the-Counter (OTC) market as a platform to hedge his currency exposure; however now he has an additional platform where he can compare between the two platforms and accordingly decide whether he will hedge his exposure in the OTC market or on an exchange or he will like to hedge his exposures partially on both the platforms. Example 1: Long Futures Hedge Exposed to the Risk of Strengthening USD Unhedged Exposure: Let‘s say on January 1, 2008, an Indian importer enters into a contract to import 1,000 barrels of oil with payment to be made in US Dollar (USD) on July 1, 2008. The price of each barrel of oil has been fixed at USD 110/barrel at the prevailing exchange rate of 1 USD = INR 39.41; the cost of one barrel of oil in INR works out to be Rs. 4335.10 (110 x 39.41). The importer has a risk that the USD may strengthen over the next six months causing the oil to cost more in INR; however, he decides not to hedge his position. On July 1, 2008, the INR actually depreciates and now the exchange rate stands at 1 USD = INR 43.23. In dollar terms he has fixed his price, that is USD 110/barrel, however, to make payment in USD he has to convert the INR into USD on the given date and now the exchange rate stands at 1USD = INR43.23. Therefore, to make payment for one dollar, he has to shell out Rs. 43.23. Hence the same barrel of oil which was costing Rs. 4335.10 on January 1, 2008 will now cost him Rs. 4755.30, which means 1 barrel of oil ended up costing 70
  • 71. Rs. 4755.30 - Rs. 4335.10 = Rs. 420.20 more and hence the 1000 barrels of oil has become dearer by INR 4,20,200. When INR weakens, he makes a loss, and when INR strengthens, he makes a profit. As the importer cannot be sure of future exchange rate developments, he has an entirely speculative position in the cash market, which can affect the value of his operating cash flows, income statement, and competitive position, hence market share and stock price. Hedged: Let‘s presume the same Indian Importer pre-empted that there is good probability that INR will weaken against the USD given the current macroeconomic fundamentals of increasing Current Account deficit and FII outflows and decides to hedge his exposure on an exchange platform using currency futures. Since he is concerned that the value of USD will rise he decides go long on currency futures, it means he purchases a USD/INR futures contract. This protects the importer because strengthening of USD would lead to 31 profit in the long futures position, which would effectively ensure that his loss in the 71
  • 72. physical market would be mitigated. The following figure and Exhibit explain the mechanics of hedging using currency futures. Example 2: Short Futures Hedge Exposed to the Risk of Weakening USD Unhedged Exposure: Let‘s say on March 1, 2008, an Indian refiner enters into a contract to export 1000 barrels of oil with payment to be received in US Dollar (USD) on June 1, 2008. The price of each barrel of oil has been fixed at USD 80/barrel at the prevailing exchange rate of 1 USD = INR 44.05; the price of one barrel of oil in INR works out to be is Rs. 3524 (80 x 44.05). The refiner has a risk that the INR may strengthen over the next three months causing the oil to cost less in INR; however he decides not to hedge his position. On June 1, 2008, the INR actually appreciates against the USD and now the exchange rate stands at 1 USD = INR 40.30. In dollar terms he has fixed his price, that is USD 80/barrel; however, the dollar that he receives has to be converted in INR on the given date and the exchange rate stands at 1USD = INR40.30. Therefore, every dollar that he receives is worth Rs. 40.30 as against Rs. 44.05. Hence the same barrel of oil that initially would have garnered him Rs. 3524 (80 x 44.05) will now realize Rs. 3224, which means 1 barrel of oil ended up selling Rs. 3524 – Rs. 3224 = Rs. 300 less and hence the 1000 barrels of oil has become cheaper by INR 3,00,000. 72
  • 73. Following a 9.7% rise in the spot price for USD, the US dollars are purchased at the new, higher spot price, but profits on the hedge foster an effective exchange rate equal to the original hedge price. Example 2: Short Futures Hedge Exposed to the Risk of Weakening USD Unhedged Exposure: Let‘s say on March 1, 2008, an Indian refiner enters into a contract to export 1000 barrels of oil with payment to be received in US Dollar (USD) on June 1, 2008. The price of each barrel of oil has been fixed at USD 80/barrel at the prevailing exchange rate of 1 USD = INR 44.05; the price of one barrel of oil in INR works out to be is Rs. 3524 (80 x 44.05). The refiner 73
  • 74. has a risk that the INR may strengthen over the next three months causing the oil to cost less in INR; however he decides not to hedge his position. On June 1, 2008, the INR actually appreciates against the USD and now the exchange rate stands at 1 USD = INR 40.30. In dollar terms he has fixed his price, that is USD 80/barrel; however, the dollar that he receives has to be converted in INR on the given date and the exchange rate stands at 1USD = INR40.30. Therefore, every dollar that he receives is worth Rs. 40.30 as against Rs. 44.05. Hence the same barrel of oil that initially would have garnered him Rs. 3524 (80 x 44.05) will now realize Rs. 3224, which means 1 barrel of oil ended up selling Rs. 3524 – Rs. 3224 = Rs. 300 less and hence the 1000 barrels of oil has become cheaper by INR 3,00,000. When INR strengthens, he makes a loss and when INR weakens, he makes a profit. As the refiner cannot be sure of future exchange rate developments, he has an entirely speculative position in the cash market, which can affect the value of his operating cash flows, income statement, and competitive position, hence market share and stock price. Hedged: Let‘s presume the same Indian refiner pre-empted that there is good probability that INR will strengthen against the USD given the current macroeconomic fundamentals of reducing fiscal deficit, stable current account 74
  • 75. deficit and strong FII inflows and decides to hedge his exposure on an exchange platform using currency futures. Since he is concerned that the value of USD will fall he decides go short on currency futures, it means he sells a USD/INR future contract. This protects the importer because weakening of USD would lead to profit in the short futures position, which would effectively ensure that his loss in the physical market would be mitigated. The following figure and exhibit explain the mechanics of hedging using currency futures. 75
  • 76. Observation: Following an 8.51% fall in the spot price for USD, the US dollars are sold at the new, lower spot price; but profits on the hedge foster an effective exchange rate equal to the original hedge price. Example 3: Retail Hedging – Long Futures Hedge Exposed to the Risk of a stronger USD On 1st March 2008, a student decides to enroll for CMT-USA October 2008 exam for which he needs to make a payment of USD 1,000 on 15th September, 2008. On 1st March, 2008 USD/INR rate of 40.26, the price of enrolment in INR works out to be Rs. 40,260. The student has the risk that the USD may strengthen over the next six months causing the enrolment to cost more in INR hence decides to hedge his exposure on an exchange platform using currency futures. Since he is concerned that the value of USD will rise, he decides go long on currency futures; it means he purchases a USD/INR futures contract. This protects the student because strengthening of USD would lead to profit in the long futures position, which would effectively ensure that his loss in the physical 76
  • 77. market would be mitigated. The following figure and Exhibit explain the mechanics of hedging using currency futures. Observation: Following a 14.25% rise in the spot price for USD (against INR), the US dollars are bought at the new, higher spot price; but profits on the hedge foster an effective exchange rate equal to the original hedge price. Example 4: Retail Hedging – Remove Forex Risk while Investing Abroad Let‘s say when USD/INR at 44.20, an active stock market investor decides to invest USD 200,000 for a period of six months in the S&P 500 Index with a perspective that the market will grow and his investment will fetch him a decent return. In Indian terms, the investment is about Rs. 8,840,000. Let‘s say that 77
  • 78. after six months, as per his anticipation, the market wherein he has invested has appreciated by 10% and now his investment of USD 200,000 stands at USD 220,000. Having earned a decent return the investor decides to square off all his positions and bring back his proceeds to India. The current USD/INR exchange rate stands at 40.75 and his investment of USD 220,000 in Indian term stands at Rs. 8,965,000. Thus fetching him a meager return of 1.41% as compared to return of 10% in USD, this is because during the same period USD has depreciated by 7.81% against the INR and therefore the poor return. Consequently, even after gauging the overseas stock market movement correctly he is not able to earn the desired overseas return because he was not able to capture and manage his currency exposure. Let‘s presume the same Indian investor pre-empted that there is good probability that the USD will weaken given the then market fundamentals and has decided to hedge his exposure on an exchange platform using currency futures. Since he was concerned that the value of USD will fall he decides go short on currency futures, it means he sells a USD/INR futures contract. This protects the investor because weakening of USD would lead to profit in the short futures position, which would effectively ensure that his loss in the investment abroad would bemitigated. The following figure and Exhibit explain the mechanics of hedging using currency futures. 78
  • 79. Observation – Had the exchange rate been stagnant at 44.20 during the sixmonth investment period the investment in Rupee terms would have grown from INR 884,00,000 to INR 9,724,000 fetching him a return of INR 8,84,000 in absolute terms. However, during the investment period, the USD has depreciated by 7.81% and hence his investment has earned him a return of only INR 125,000. Had he hedged his exposure using currency futures, he could have mitigated a major portion of his risk as explained in the above example; he is not able to mitigate his risk completely even with the basis remaining the same because during the holding period his investment has grown from USD 2,00,000 to USD 2,20,000. The exhibit below gives the tabular representation of the portfolio with and without currency hedging: 79
  • 80. Hence a hedging using currency future has provided him better return as compared to the one without hedging. Also, it is not possible for every investor to gauge both the markets correctly, as in this case the investor may be an intelligent and well informed stock investor, but he may not be equally good when it comes to currency market; also it is not necessary that both markets move in the direction of the investor‘s advantage. So it‘s advisable that if an investor is taking a bet in one market, he will be better off if he can mitigate the risk related to other markets. TRADING SPREADS USING CURRENCY FUTURES . Spread refers to difference in prices of two futures contracts. A good understanding of spread relation in terms of pair spread is essential to earn profit. Considerable knowledge of a particular currency pair is also necessary to enable the trader to use spread trading strategy. Spread movement is based on following factors: o Interest Rate Differentials o Liquidity in Banking System o Monetary Policy Decisions (Repo, Reverse Repo and CRR) o Inflation 80
  • 81. Intra-Currency Pair Spread: An intra-currency pair spread consists of one long futures and one short futures contract. Both have the same underlying but different maturities. Inter-Currency Pair Spread: An inter–currency pair spread is a long-short position in futures on different underlying currency pairs. Both typically have the same maturity. Example: A person is an active trader in the currency futures market. In September 2008, he gets an opportunity for spread trading in currency futures. He is of the view that in the current environment of high inflation and high interest rate the premium will move higher and hence USD will appreciate far more than the indication in the current quotes, i.e. spread will widen. On the basis of his views, he decides to buy December currency futures at 47.00 and at the same time sell October futures contract at 46.80; the spread between the two contracts is 0.20. Let‘s say after 30 days the spread widens as per his expectation and now the October futures contract is trading at 46.90 and December futures contract is trading at 47.25, the spread now stands at 0.35. He decides to square off his position making a gain of Rs. 150 (0.35 – 0.20 = 0.15 x $1000) per contract. ARBITRAGE Arbitrage means locking in a profit by simultaneously entering into transactions in two or more markets. If the relation between forward prices and futures prices differs, it gives rise to arbitrage opportunities. Difference in the equilibrium prices determined by the demand and supply at two different markets also gives opportunities to arbitrage. Example – Let‘s say the spot rate for USD/INR is quoted @ Rs. 44.325 and one month forward is quoted at 3 paisa premium to spot @ 44.3550 while at the same time one month currency futures is trading @ Rs. 44.4625. An active arbitrager realizes that there is an arbitrage opportunity as the one month futures price is more than the one month forward price. He implements the arbitrage trade where he; o Sells in futures @ 44.4625 levels (1 month) Buys in forward @ 44.3250 + 3 paisa premium = 44.3550 (1 month) with the same term period 81
  • 82. o On the date of future expiry he buys in forward and delivers the same on exchange platform o In a process, he makes a Net Gain of 44.4625-44.3550 = 0.1075 o i.e. Approx 11 Paisa arbitrage o Profit per contract = 107.50 (0.1075x1000) Observation – The discrepancies in the prices between the two markets have given an opportunity to implement a lower risk arbitrage. As more and more market players will realize this opportunity, they may also implement the arbitrage strategy and in the process will enable market to come to a level of equilibrium. Conclusion It must be noted that though the above examples illustrate how a hedger can successfully avoid negative outcomes by taking an opposite position in FX futures, it is also possible, that on occasion the FX fluctuations may have been beneficial to the hedger had he not hedged his position and taking a hedge may have reduced his windfall gains from these FX fluctuations. FX hedging may not always make the hedger better-off but it helps him to avoid the risk (uncertainty) and lets him focus on his core competencies instead. Many people are attracted toward futures market speculation after hearing stories about the amount of money that can be made by trading futures. While there are success stories, and many people have achieved a more modest level of success in futures trading, the keys to their success are typically hard work, a disciplined approach, and a dedication to master their trade. An investor should always remember the trade that he has initiated has the equal probability of going wrong and must therefore apply meticulous risk management practices to ensure the safety of his hard-earned capital. If you intend to follow this path, this market is the place to be. 82
  • 83. ROAD AHEAD FOR CURRENCY FUTURES MARKETS IN INDIA Market statistics of the first seven months of the launch of exchange traded currency futures reveal growing interest in the markets. However, these markets have not been able to evince the kind of activity that OTC markets are witnessing. Many corporate using currency derivatives for hedging their foreign currency exposure find requirement of margin and settlement of daily mark - to – market differences cumbersome especially since there is no such requirement for OTC trades. It would perhaps take some time for them to realize the concomitant benefits of these risk containment measures. There is a perceive resistance to change or switch over from OTC to Exchange traded framework with the grip and comfort ability level in the OTC markets. Further, presently the markets are restricted in a number of ways. The following are some of the possible measures that could enhance the liquidity and deepen these markets: a. Presently only INR-USD futures contracts have been permitted. There is scope and demand for increase in array of contracts with other major currencies such as GBP, Yen and Euro. Also introduction of exchange traded options could be the next possible step towards further development of exchange traded markets. b. The positions limits for clients trading in this segment are USD 10 mn or 6% of open interest whichever is higher and for trading members it is USD 50 mn or 15% of open interest, whichever is higher, with the limit being USD 100 million or 15% of open interest for trading members who are banks. Consider this, the highest open interest achieved so for has been USD 363 mn on 17th February 2009. With this, the limit for client level of USD 22 mn and USD 54 mn for trading members has already been reached. There is thus a felt need to enhance these limits in terms of percentage of open interest. For larger exporters and importers these limits may be restrictive and chances are that they might continue to deal in the OTC market, where there is no limit on the hedges. 83
  • 84. c. To start with (FIIs) have not been permitted to participate in the exchange traded currency markets. This has in effect restricted the liquidity that FIIs could have otherwise created. FIIs are already active in Dubai Gold and Commodity Exchange (DGCX). There is opportunity for business for domestic exchanges and intermediaries to be created in bringing this market onshore. According to latest release from DGCX, in the year 2009, till mid-April 2009, the volume for the DGCX Indian Rupee-Dollar futures was 6,015 contracts, valued at US $241 million, an increase of 34% compared with volume during the same period last year, indicating growing interest in the DGCX Indian Rupee futures contract. Though small in comparison to volumes being traded on Indian exchanges, there is still merit in getting this market onshore. d. The offshore Non Deliverable Forward (NDF) market in the Indian Rupee has been witnessing increasing volumes. As reported by Misra and Behera (2006), the average daily volumes on the NDF rupee markets has increased from USD 38 mn in 2003 Q1 to USD 3736 mn during January to April, 2007. Deutsche Bank estimates average daily trading volume of USD 800 million during 2008-09 in the NDF markets for Indian rupee7. Most major foreign banks offer NDFs, but Indian banks are barred from doing so. These markets have evolved for the Indian Rupee, as for other emerging market currencies, following foreign exchange convertibility restrictions. It is serving as an avenue for non-domestic players, private companies and investors in India to hedge foreign currency exposure. This market also derives liquidity from nonresidents wishing to speculate in the Indian rupee without exposure to the currency and from arbitrageurs who try to exploit the differentials in the prices in the onshore and offshore markets. Though foreign investors can now transact in the onshore Indian forward markets with greater flexibility (following various measures listed earlier in the paper), allowing them access to the exchange traded currency futures platform would further help in getting the volumes in the NDF market onshore and enhance the liquidity on the domestic exchanges. In conclusion, considering the nascent stage of development of these markets in the country, the cautious approach of the regulators is understandable. One hopes to see further developments in exchange traded currency markets over time. There is no doubting that this is a market which will eventually establish its 84
  • 85. niche and would be an area of activity to watch and gain from for all market participants in the near future. 85
  • 86. Foreign Currency Rupee Swap: A person resident in India who has a long-term foreign currency or rupee liability is permitted to enter into such a swap transaction with ADs (CategoryI) to hedge or transform exposure in foreign currency/foreign interest rate to rupee/rupee interest rate. Swap Market in India: In India, the Reserve Bank of India has permitted banks to arrange currency swaps with one currency leg being Indian Rupee. However, the USD/INR forward foreign exchange markets are illiquid beyond one year. Since currency swaps involve the forward foreign exchange markets also, there are limitations to entering the Indian Rupee currency swaps beyond twelve months. Moreover, banks are also not allowed to take risk /run open swap books i.e., they have to locate counter parties with matching requirements; e.g. one desiring to swap a dollar liabilities into rupee liabilities and the other wishing to exchange rupee debt servicing obligation for dollar obligations. However, some aggressive banks do provide quotes for currency swaps for three to five years out for reasonable size transactions. Corporates who have huge rupee liabilities and want have foreign currency loans in their books, both as a diversification as well as a cost reduction exercise could achieve their objective by swapping their rupee loans into foreign currency loans through the dollar/rupee swap route. However, the company is assuming currency risk in the process and unless carefully managed, might end up increasing the cost of the loan instead of reducing it. In India, it is more the norm for corporates to swap their foreign currency loans into rupee liabilities rather than the other way round. Example: A corporate has a loan of USD 10 million outstanding with remaining maturity of 2 years, interest on which is payable every six months linked to 6month Libor + 150 basis points. This dollar loan can be effectively converted into a fixed rate rupee loan through a currency swap. If the corporate wants to enter into a currency swap to convert his loan interest payments and principal into INR, he can find a banker with whom he can exchange the USD interest 86
  • 87. payments for INR interest payments and a notional amount of principal at the end of the swap period. The banker quotes a rate of say 10.75% for a USD/INR swap. The total cost for the corporate would now work out to 12.25%. If the spot rate on the date of transaction is 44.65, the rupee liability gets fixed at Rs. 446.50 mio. At the end of the swap, the bank delivers USD 10 million to the corporate for an exchange of INR 446.50 mio, which is used by the corporate to repay his USD loan. The corporate is able to switch from foreign currency. 87
  • 88. Foreign Currency Rupee Options: ADs (Category-I) approved by the Reserve Bank and Ads (Category-I) who are not market makers are allowed to sell foreign currency rupee options to their customers on a back-to-back basis, provided they have a capital to risk weighted assets ratio (CRAR) of 9 per cent or above. These options are used by customers who have genuine foreign currency exposures, as permitted by the Reserve Bank and by ADs (Category-I) for the purpose of hedging trading books and balance sheet exposures. Cross-Currency Options: ADs (Category-I) are permitted to issue cross-currency options to a person resident in India with crystallised foreign currency exposure, as permitted by the Reserve Bank. The clients use this instrument to hedge or transform foreign currency exposure arising out of current account transactions. ADs use this instrument to cover the risks arising out of market-making in foreign currency rupee options as well as cross currency options, as permitted by the Reserve Bank. The Reserve Bank of India has permitted authorized dealers to offer cross currency options to the corporate clients and other interbank counter parties to hedge their foreign currency exposures. Before the introduction of these options the corporates were permitted to hedge their foreign currency exposures only through forwards and swaps route. Forwards and swaps do remove the uncertainty by hedging the exposure but they also result in the elimination of potential extraordinary gains from the currency position. Currency options provide a way of availing of the upside from any currency exposure while being protected from the downside for the payment of an upfront premium. 88
  • 89. RBI Regulations These contracts were allowed with the following conditions: a) These currency options can be used as a hedge for foreign currency loans provided that the option does not involve rupee and the face value does not exceed the outstanding amount of the loan, and the maturity of the contract does not exceed the un-expired maturity of the underlying loan. b) Such contracts are allowed to be freely re-booked and cancelled. Any premia payable on account of such transactions does not require RBI approval c) Cost reduction strategies like range forwards can be used as long as there is no net inflow of premia to the customer. d) Banks can also purchase call or put options to hedge their cross currency proprietary trading positions. But banks are also required to fulfill the condition that no ‗stand alone‘ transactions are initiated. e) If a hedge becomes naked in part or full owing to shrinking of the portfolio, it may be allowed to continue till the original maturity and should be marked to market at regular intervals. There is still restricted activity in this market but we may witness increasing activity in cross currency options as the corporates start understanding this product better. 89
  • 90. 90
  • 91. Question 1. How many clients do you have?  0-25 10 11.11% 26-50 16 17.78% 51-75 16 17.78% 76-above 48 53.33% No. of Clients 11% 18% 53% 0-25 26-50 18% 51-75 76-above Analysis: From the survey of 90 brokers which we conducted in Ahmedabad, we came to know that 11.11% of the brokers have less than 25 clients, 17.78% brokers have clients between26-50, 17.78% of brokers have clients between 5175 and 53.33% of brokers have more than 76 clients. Thus, more than 50% of brokers have more than 76 clients in number. Hence, even though the forex derivative market is comparatively new to our economy, it has grown quickly in Ahmedabad. 91
  • 92. Question 2: From the total clientele, how many are active clients?  <25% 19 21.11% 26%-50% 30 33.33% 51%-75% 22 24.44% 76%-100% 19 21.11% No. of Clients 21% 21% <25% 26%-50% 25% 33% 51%-75% 76%-100% Analysis: As seen from the statistics above it can be analyzed that 21.11% of brokers have clients which are less active, 33.33% of brokers have an active clientele which ranges from 26% -50%, 24.44% of brokers have their active clientele which ranges from 51% -75% and 21.11% of brokers have active clients from 76%-100%. It can be seen that most of the brokers have their active clientele which ranges from 26%-75%. Thus, most of the clients are active traders consisting of speculators & arbitrageurs while the others are long term hedgers which consist of export-import players. 92
  • 93. Question 3: In which derivatives do clients mostly trade? Intraday Positional Cash F &Os 42 G 46.66% r 29% 41 45.55% 28% 30 33.33% 21% 32 35.56% 22% (in accordance to 90 Brokers Actual % 100 (Base) Derivatives type 21% 29% Intraday Positional 22% 28% Cash F & Os Analysis: From the survey we came to know that in all the derivatives, clients trade equally i.e. the trading pattern is flat for all the derivatives. Clients mostly trade in intra-day i.e. 46.67% and clients trading in positional are 45.55%. 35.56% clients of brokers trade in cash, while 33.33% clients trade in F & O. It was also seen that many of the clients trade in multiple combination of derivatives. 93
  • 94. Question 4: What is the Rate of brokerage charged by your company?  0.01-0.05 0.05-0.10 0.10-0.15 >0.15 Sample Size 29 32.22% 37 41.11% 15 16.67% 90 Brokers ― 9 10% Brokerage Charged 10% 17% 32% <5% 5%-10% 10%-15% 41% >15% Analysis: Depending on the norms of SEBI & their pricing strategy, every company charges different brokerage for their services. A majority of 41.11% of the firms in our survey of Ahmedabad charged 0.05%-0.10% brokerage. Next to them are the companies who charges 0.01%-0.05% with 32.22%. 0.10%-0.30% brokerage is charged by few companies who form 16.67% of the total and very few companies charge higher than 0.3%; they form only 10% of total. 94
  • 95. Question 5 :How much is the margin taken from the clients?  <5% 5%-10% 10%-15% >15% Sample Size 19 21.11% 33 36.67% 16 17.87% 90 Brokers ― 20 22.22% Margin taken 23% 22% <5% 5%-10% 18% 37% 10%-15% >15% Analysis: All brokers charge a fixed amount of deposit money to all their clients. This is done in order to keep a safety, in case customer suffers loss. As per the survey conducted, we came to know that the margin taken by brokers from the clients are as under:<5% margin is charged by 21.11%, from 5%-10% it is 36.67%, from 10%-15% it is 17.8% and >15% margin is taken by 22.22% of the brokers. From survey it is clear that 5%-10% margin is most preferable by brokers. 95
  • 96. Question 6: What are measures taken for creating awareness? Analysis: Newspaper, mobiles and internet are the major mediums used by the companies to explore their markets. As per the analysis, we concluded that 32.22% brokers, create awareness among their clients through newspaper, 34.44% uses as mobile advertisement and 53.33% of broker opt for internet and 26.67% of brokers create awareness by other means like t.v. , personal advice etc. it is also seen that brokers have opted for multiple combination of mediums to create awareness. Question 7: Which is/are the other derivative services provided ? Analysis: In derivatives many products are covered like commodity, cash, stock, interest rates etc. On the basis of our survey it us analysed that 47.78% of brokers/companies provide commodity service, while 58.8% of brokers provide stock services and only 11.11% provides interest rate services, where as 15.56% provides other services like cash, metals etc. From the analysis, most of brokers/companies provided derivative services in commodity and stock while in other two service providers are low in our Ahmedabad. 96
  • 97. 97
  • 98. Question : 1 Do you deal in derivative instruments? . Customer Response No. %age Yes 92 84% No 18 16% Deals in Derivative Instrument 16% Yes 84% No  Analysis: In our survey of customers dealing in derivatives, we found that 84% of our total customers do deal in such instruments & 16% do not deal. Though all the major persons whom we met had knowledge of derivatives, but very few among them were able to guide and help us in our topic. Thus, it can be inferred that people in Ahmedabad are quite active in the equity & commodity derivatives but they lack knowledge with respect to forex derivatives. 98
  • 99. Question 2: If yes, then how do you trade?  Trading Platform Intraday Long term (positional) Both No. 29 67 14 %age 26% 61% 13% in accordance with 110 customers ― ― Trading Method 13% 26% Intraday Long Term (Positional) 61% Both  Analysis: In derivative market Intraday and Long term (positional) are two major ways of trading of which in our survey of 110 customers only 26% customers followed intraday and other 61% opt for long term trade. However 13% clients opt for both options. They trade in derivatives using both options. Thus most of the investors seem to consist of importers & exporters who hedge their positions in order to reduce their risk factor. 99
  • 100. Question 3: Which derivative market do you prefer ?  OTC (over the counter) Exchange Traded Both Sample Size 21 76 13 110 customers 19% 69% 12% 100 percent Derivative Market Preferance 12% 19% OTC Exchange Traded 69% Both  Analysis: Generally, customers like to reduce the risk and go for the exchange traded system. Thus 69% of customers go for exchange traded, while OTC is opted by 19% of the customers. The proportion of clients using both systems is 12%. This shows the increasing popularity & convenience of the exchange traded system. 100
  • 101. Question 4: Whose advice do you take before investing in derivatives markets? Advisers Brokerage House Research Analyst Websites News Networks  No. 68 42 25 40 %age 61.82% 38.18% 22.72% 36.36% Advisors Followed 70.00% 61.82% Percentage (%) 60.00% 50.00% 38.18% 36.36% 40.00% 22.72% 30.00% %age 20.00% 10.00% 0.00% Brokerage House Research Analyst Websites News Networks Advisors  Analysis: In the derivative markets the risk level is too much, so clients always follow forecasts which help them to eliminate or like to narrow down risk. In our research study from Ahmedabad we concluded that brokerage houses are followed by a majority 61.82%, followed by research analysts 38.18%, followed by news network 36.36% and lastly websites with 22.72%. It has been analyzed in the study that clients follow more than one advisor simultaneously. 101
  • 102. Question 5: Who is your participant in Derivative market?  Investor Speculator Broker /Dealer Hedger Sample Size 60 54.54% 13 11.81% 39 35.46% 11 10% 110 customers 100 Participants in Derivatives Percentage (%) 40.00% 34.23% 32.43% 30.00% 20.00% 17.11% 16.22% Series1 10.00% 0.00% Participants  Analysis: Investor, speculator, broker and hedger are major types of participants of derivative market. Major numbers of participants are investors who constituted 54.54% of total. After them comes broker/dealers who form 35.5% and than speculator and hedger with 11.81% and 10% respectively. Investor is the major participant who is affected the most by market changing trends. 102
  • 103. Ques.Which currencies do you trade?  INR US$ JPY 79 56 10 71.82% 50.91% 9.1% Graphical presentation is as under: Dinnar Dirham Others 6 8 12 5.5% 7.27% 10.91% Currencies traded Percentage (%) 40.00% 34.23% 32.43% 30.00% 20.00% 17.11% 16.22% Series1 10.00% 0.00% <8% 8%-10% 10%15% >15% Currencies  Analysis: There are 192 countries in the world all have their own currencies which is identified in international market. Among them we surveyed for major currencies in our local areas, Ahmadabad, where currency traders mostly i.e.; 71.82% traded INR, US$ and JPY with 50.91% and 9.91% respectively. DINNAR and DIRHAM are also traded by amdavadis only 5.51% and 7.27% scales. Other currencies like CAD$, EURO, POUND etc. form 10.91% of trading. 103
  • 104. Ques.How much Margin you allow/pay to your broker?  <5% 5%-10% 10%>5% 15% 53 30 15 19 49.53% 28.03% 10.28% 12.15% Graphical presentation is as under: Margin Paid Percentage (%) 40.00% 34.23% 32.43% 30.00% 20.00% 17.11% 16.22% Series1 10.00% 0.00% <8% 8%-10% 10%-15% >15% Margin  Analysis: Margin is the Companies take some margin from customers. Most of companies have kept margin of <5% and they constituted 49.53% and then are some companies who take a little higher margin of 5%-10% are 28.03% followed by 10%-15% and lastly by >15% with 13.7% and 8.18% 104
  • 105. Ques.How much Brokerage do you pay?  0.01%0.05% 54 48.65% 0.05%0.10% 33 29.73% 0.10%- >0.30% 0.30% 21 3 18.92% 2.7% Graphical presentation is as under: Brokerage Paid Percentage (%) 40.00% 34.23% 32.43% 30.00% 20.00% 17.11% 16.22% Series1 10.00% 0.00% <8% 8%-10% 10%-15% >15% Brokerage  Analysis: Though the customers we surveyed were using different advisors for guidance and safety measures, they were all joined or had an account with recognized dealers who allow them to trade in it under SEBI guidelines. So these brokers are paid some brokerage by customers. The sections of brokers paid 0.01%-0.055 are 48.65% followed by 0.05%-0.10% with 29.73%, then comes 0.10%-0.30% with 18.92% and very few people who deal in high market pays nearly 2.7% of brokerage. 105
  • 106. Ques.How much risk do you trade?  Low 43 39.09% Moderate 56 50.91% High 11 10% Graphical presentation is as under: Risk Undertaken Percentage (%) 60.00% 50.00% 50.91% 39.09% 40.00% 30.00% Series1 20.00% 10% 10.00% 0.00% Low Moderate Risk Level High  Analysis: Risk is the main factor of derivative market. Risk will either earn you or will make you losses. In our survey of Ahmedabad, mainly participants go for Moderate risk i.e. 50.91%, half of participants; low risk is covered and faced by 39.09% and only 10% of participants like to play a risky and big deal. 106
  • 107. Ques.How much return do you expect?  <8% 18 16.22% 8%-10% 38 34.23% 10%-15% >15% 36 19 32.43% 17.11% Graphical presentation is as under: Return Expected Percentage (%) 40.00% 34.23% 32.43% 30.00% 20.00% 17.11% 16.22% Series1 10.00% 0.00% <8% 8%-10% 10%-15% >15% Expected return  Analysis: In our survey, it is readily accepted that customers take risks to earn, it is obvious. Mainly they expect a return of 8%-10% i.e. nearly 35% expect it. And others 32.43% expect 10%-15% return on trading. Generally, 8%-15%. 107
  • 108. Ques.What is your Leverage level?  Low 43 38.74% Medium 55 49.55% High 13 11.71% Graphical presentation is as under: Leverage Level 49.55% Percentage (%) 60.00% 38.74% 40.00% 11.71% Series1 20.00% 0.00% Low Medium High Level  Analysis: Leverage is the level of risk taken for expected return. Medium leverage level is opted by 49.55% of our research work customers of companies, followed by low leverage level of 38.74% and few risk takers i.e. 11.71% are the only opting for highly leveraged level. 108
  • 109. Ques.Is early exit in Foreign Exchange control possible? . Options Yes No No. 45 56 %age 40.91% 50.91% Graphical presentation is as under: Early exit in Forex 45% Yes 55% No (in fig. percent are in proportionate to 100).  Analysis: Early exit in foreign exchange is thought possible but, looking at the market trends sometimes fear, sometimes greed and sometimes huge amount do not allow the participants to easily exit the market without recovering or gaining the amount. From our survey in Ahmedabad, 40.91% (45%) of participants accepted that early exit is possible but 50.91% (55%) responded negatively. 109
  • 110. FINDINGS New concept of Exchange traded currency future trading is regulated by higher authority and regulatory. The whole function of Exchange traded currency future is regulated by SEBI, and they established rules and regulation so there is very safe trading is emerged and counter party risk is minimized in currency Future trading. And also time reduced in Clearing and Settlement process up to T+1 day‘s basis. Larger exporter and importer has continued to deal in the OTC counter even exchange traded currency future is available in markets because, there is a limit of USD 100 million on open interest applicable to trading member who are banks. And the USD 25 million limit for other trading members so larger exporter and importer might continue to deal in the OTC market where there is no limit on hedges. In India RBI and SEBI has restricted other currency derivatives except Currency future, at this time if any person wants to use other instrument of currency derivatives in this case he has to use OTC. In INDIA the highest chunk of forex activity is from GUJARAT, Northern India & Mumbai and moderate level from Southern INDIA. EURO is the highest traded currency. More than 60% of interest volumes counts from it. And American $ is the base currency or can be called vehicle for all the currencies. Liquidity in exchange traded is for 3 to 4 months whereas it is only for couple of months in OTC. 110
  • 111. LIMITATIONS  The main limitation for the project is platform taken by us is limited up to Ahmedabad for the survey of customers & brokers.  The limitations of the study were the analysis was mostly based on secondary data. So any error in the secondary data might also affect the study undertaken.  The study of forex and derivatives is new concept in a developing stage not widely known by all. Currency derivatives have been approved by SEBI in August 2008 for future trading and for options have got approval in July 2010.  The product involves only 4 currencies i) Australian $ ii) US$ iii) Euro iv) Pound in exchange trading which is mainly done by the clienteles.  The public at large is still not aware of the currency Derivative products in INDIA, so it hampered a lot in the process of data collection and thereafter also.  The response from Brokers during the survey was average and public at large is still having very low awareness about FOREX. Only the corporates and the entrepreneurs belonging to import export trading are users of the foreign currency.  Marginal and small brokers do not provide FoREX services. 111
  • 112. SUGGESTIONS  Currency Future need to change some restriction it imposed such as cut off limit of 5 million USD, Ban on NRI‘s and FII‘s and Mutual Funds from participating.  Now in exchange traded currency future segment only one pair USDINR is available to trade so there is also one more demand by the exporters and importers to introduce another pair in currency trading. Like POUND-INR, CAD-INR etc.  In OTC there is no limit for trader to buy or short Currency futures so there demand arises that in Exchange traded currency future should have increase limit for Trading Members and also at client level, in result OTC users will divert to Exchange traded currency Futures.  In India the regulatory of Financial and Securities market (SEBI) has Ban on other Currency Derivatives except Currency Futures, so this restriction seem unreasonable to exporters and importers.  According to Indian financial growth now it‘s become necessary to introduce other currency derivatives in Exchange traded currency derivative segment.  Media for awareness should be improvised and broaden. Marginal brokers and clients or potential customers should be made aware of this services. 112
  • 113. OBSERVATIONS  The global ranking for the derivatives traded on the basis of their turnover is Currency, commodities and equity. Currency counts for 38,000 crore US $, 1,2000 crore rupees. Commodities form a part of 60% - 70% of toal market.  In INDIA ranking is reversly ordered i.e. equity, commodity and currency.  Forex is a new initiative so very less number of customers are trading in it (exchange trading). This is mainly used for hedging purpose and most of the time it is 12 months contract. There are no exchange charges, no security transaction tax levied on it.  OTC is mainly done by corporate by which they contribute 40% -50%. Exchange trading is compromising of retail clients, money changers which compromises of 20%- 30%. In OTC banks participates for 30% - 40% of total volume and properiotry trading (pro trading) held for another 30% -40%. Maximum amount of pro tading is done in GUJARAT. Clientele trading is very less about 20%. 113
  • 114. CONCLUSIONS  By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives These instruments enhances the ability to differentiate risk and allocate it to those investors most able and willing to take it- a process that has undoubtedly improved national productivity growth and standards of livings.  The currency future gives the safe and standardized contract to its investors and individuals who are aware about the forex market or predict the movement of exchange rate so they will get the right platform for the trading in currency future. Because of exchange traded future contract and its standardized nature give counter party risk minimized.  Initially only NSE had the permission but now BSE and MCX has also started currency future. It is shows that how currency future covers ground in the compare of other available derivatives instruments Not only big businessmen and exporter and importers use this but individual who are interested and having knowledge about forex market they can also invest in currency future.  Exchange between USD-INR markets in india is very big and these exchange traded contract will give more awareness in market and attract the investors.  In INDIAN market, FOREX is still only 2.5 year old baby in future and option is only 6 months old baby, i.e. it is still in its developing phase. It has really a huge potential scope and probably a wide market can be availed by it in future. 114
  • 115. PROBLEMS FACED DURING THE RESEARCH 1. The main problem lied in the factor that survey is limited up to AHMEDABAD only. The trend of foreign currency market may differ at national level and domestic level. 2. The lack of information among the people was seen during the stage of Questionnaire survey. The people were not able to provide information & guide about the topic, the main reason was the Foreign Currency trading is still in developing phase. The responsiveness among the public at large is very less. 3. The marginal and small brokers are not providing this facility. 4. The corporate customers are mainly involved in this, so their cooperation for the guidelines and information was negligible. 5. The retail customers have very less ken about the rates of Forex due to less number of customers spread in hands of wide range of brokers. 6. The customers handle over their accounts and terminals to the respective brokers as such increase difficulty in gaining the practical knowledge of the subject. 7. The wide range of brokers made it difficult to get the range of brokerage and margin, which varies from broker to broker. 8. The equity and commodity market rules the market respectively in the India. And also due to new concept, the Forex is still not widely known. This created a setback for the process of collecting information and the process thereafter. 115
  • 116. BIBLOGRAPHY Books 1.Options Futures and other Derivatives by John C Hull 2. Derivatives FAQ by Ajay Shah 3.NSE‘s Certification in Financial Markets: - Derivatives Core module 4. All about Foreign exchange by Mark Mobius Websites: www.moneycontrol.com www.nseindia.com www.businesstoday.com Personal interview: 1. Mr Ashish Buch Head currency derivative, Anagram Capital Limited. 2. Mr. Darpan Shah Broker - Angel Broking 116
  • 117. DECLARATION We hereby declare that the project titled “Foreign Exchange & The Implications Of Derivatives On Forex” is true to the best of our knowledge and has not been published elsewhere .This project is prepared for the purpose of partial fulfillments for the award of the degree of BBA. PRATIK BAJAJ MUNIRA CHHAYANWAL A ADITYA KAPOOR NAMAN SHAH SHIKHA KOTHARI BINAL PATEL 117 AADIL PATHAN AMI KHANDEDIYA RISHITA KAYASTH NIRALI CHOVATIA