Project report on currency derivatives2


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Project report on currency derivatives2

  1. 1. INTRODUCTION TO THE TOPIC Page | 1 Institute of Management Education, Sahibabad
  2. 2. INTRODUCTION TO FINANCIAL DERIVATIVES “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.” Alan Greenspan, Former Chairman. US Federal Reserve Bank The past decades has witnessed the multiple growths in the volume of international trade and business due to the wave of globalization and liberalization all over the world. As a result, the demand for the international money and financial instruments increased significantly at the global level. In this respect, changes in the interest rates, exchange rate and stock market prices at the different financial market have increased the financial risks to the corporate world. It is therefore, to manage such risks; the new financial instruments have been developed in the financial markets, which are also popularly known as financial derivatives. **DEFINITION OF FINANCIALDERIVATIVES**  A word formed by derivation. It means, this word has been arisen by derivation.  Something derived; it means that some things have to be derived or arisen out of the underlying variables. A financial derivative is an indeed derived from the financial market.  Derivatives are financial contracts whose value/price is independent on the behavior of the price of one or more basic underlying assets. These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future. These assets can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil, soybeans, cotton, coffee and what you have.  A very simple example of derivatives is curd, which is derivative of milk. The price of curd depends upon the price of milk which in turn depends upon the demand and supply of milk. Page | 2 Institute of Management Education, Sahibabad
  3. 3.  The Underlying Securities for Derivatives are :  Commodities: Castor seed, Grain, Pepper, Potatoes, etc.  Precious Metal : Gold, Silver  Short Term Debt Securities : Treasury Bills  Interest Rates  Common shares/stock  Stock Index Value : NSE Nifty  Currency : Exchange Rate TYPES OF FINANCIAL DERIVATIVES Financial derivatives are those assets whose values are determined by the value of some other assets, called as the underlying. Presently there are Complex varieties of derivatives already in existence and the markets are innovating newer and newer ones continuously. For example, various types of financial derivatives based on their different properties like, plain, simple or straightforward, composite, joint or hybrid, synthetic, leveraged, mildly leveraged, OTC traded, standardized or organized exchange traded, etc. are available in the market. Due to complexity in nature, it is very difficult to classify the financial derivatives, so in the present context, the basic financial derivatives which are popularly in the market have been described. In the simple form, the derivatives can be classified into different categories which are shown below : DERIVATIVES Financials Commodities Basics Complex 1. Forwards 1. Swaps 2. Futures 2.Exotics (Non STD) 3. Options Page | 3 Institute of Management Education, Sahibabad
  4. 4. 4. Warrants and Convertibles One form of classification of derivative instruments is between commodity derivatives and financial derivatives. The basic difference between these is the nature of the underlying instrument or assets. In commodity derivatives, the underlying instrument is commodity which may be wheat, cotton, pepper, sugar, jute, turmeric, corn, crude oil, natural gas, gold, silver and so on. In financial derivative, the underlying instrument may be treasury bills, stocks, bonds, foreign exchange, stock index, cost of living index etc. It is to be noted that financial derivative is fairly standard and there are no quality issues whereas in commodity derivative, the quality may be the underlying matters. Another way of classifying the financial derivatives is into basic and complex. In this, forward contracts, futures contracts and option contracts have been included in the basic derivatives whereas swaps and other complex derivatives are taken into complex category because they are built up from either forwards/futures or options contracts, or both. In fact, such derivatives are effectively derivatives of derivatives.  Derivatives are traded at organized exchanges and in the Over The Counter ( OTC ) market : Derivatives Trading Forum Organized Exchanges Over The Counter Commodity Futures Forward Contracts Financial Futures Swaps Options (stock and index) Stock Index Future Derivatives traded at exchanges are standardized contracts having standard delivery dates and trading units. OTC derivatives are customized contracts that enable the parties to select the trading units and delivery dates to suit their requirements. Page | 4 Institute of Management Education, Sahibabad
  5. 5. A major difference between the two is that of counterparty risk—the risk of default by either party. With the exchange traded derivatives, the risk is controlled by exchanges through clearing house which act as a contractual intermediary and impose margin requirement. In contrast, OTC derivatives signify greater vulnerability. DERIVATIVES INTRODUCTION IN INDIA The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. SEBI set up a 24 – member committee under the chairmanship of Dr. L.C. Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India, submitted its report on March 17, 1998. The committee recommended that the derivatives should be declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’ could also govern trading of derivatives. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE-30 (Sensex) index. The trading in index options commenced in June 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. HISTORY OF CURRENCY DERIVATIVES Currency futures were first created at the Chicago Mercantile Exchange (CME) 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 Page | 5 Institute of Management Education, Sahibabad
  6. 6. 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 unfavorable changes in currency rates, or to speculate on rate fluctuations. UTILITY OF CURRENCY DERIVATIVES Currency-based derivatives are used by exporters invoicing receivables in foreign currency, willing to protect their earnings from the foreign currency depreciation by locking the currency conversion rate at a high level. Their use by importers hedging foreign currency payables is effective when the payment currency is expected to appreciate and the importers would like to guarantee a lower conversion rate. Investors in foreign currency denominated securities would like to secure strong foreign earnings by obtaining the right to sell foreign currency at a high conversion rate, thus defending their revenue from the foreign currency depreciation. Multinational companies use currency derivatives being engaged in direct investment overseas. They want to guarantee the rate of purchasing foreign currency for various payments related to the installation of a foreign branch or subsidiary, or to a joint venture with a foreign partner. A high degree of volatility of exchange rates creates a fertile ground for foreign exchange speculators. Their objective is to guarantee a high selling rate of a foreign currency by obtaining a derivative contract while hoping to buy the currency at a low rate in the future. Alternatively, they may wish to obtain a foreign currency forward buying contract, expecting to sell the appreciating currency at a high future rate. In either case, they are exposed to the risk of currency fluctuations in the future betting on the pattern of the spot exchange rate adjustment consistent with their initial expectations. Page | 6 Institute of Management Education, Sahibabad
  7. 7. The most commonly used instrument among the currency derivatives are currency forward contracts. These are large notional value selling or buying contracts obtained by exporters, importers, investors and speculators from banks with denomination normally exceeding 2 million USD. The contracts guarantee the future conversion rate between two currencies and can be obtained for any customized amount and any date in the future. They normally do not require a security deposit since their purchasers are mostly large business firms and investment institutions, although the banks may require compensating deposit balances or lines of credit. Their transaction costs are set by spread between bank's buy and sell prices. Exporters invoicing receivables in foreign currency are the most frequent users of these contracts. They are willing to protect themselves from the currency depreciation by locking in the future currency conversion rate at a high level. A similar foreign currency forward selling contract is obtained by investors in foreign currency denominated bonds (or other securities) who want to take advantage of higher foreign that domestic interest rates on government or corporate bonds and the foreign currency forward premium. They hedge against the foreign currency depreciation below the forward selling rate which would ruin their return from foreign financial investment. Investment in foreign securities induced by higher foreign interest rates and accompanied by the forward selling of the foreign currency income is called a covered interest arbitrage. INTRODUCTION TO CURRENCY DERIVATIVES Each country has its own currency through which both national and international transactions are performed. All the international business transactions involve an exchange of one currency for another. For example, If any Indian firm borrows funds from international financial market in US dollars for short or long term then at maturity the same would be refunded in particular agreed currency along with accrued interest on borrowed money. It means that the borrowed foreign currency brought in the country will be converted into Indian currency, and when borrowed fund are paid to the lender then the home currency will be converted into foreign lender’s currency. Thus, the currency units of a country involve an exchange of one currency for another. Page | 7 Institute of Management Education, Sahibabad
  8. 8. The price of one currency in terms of other currency is known as exchange rate. The foreign exchange markets of a country provide the mechanism of exchanging different currencies with one and another, and thus, facilitating transfer of purchasing power from one country to another. With the multiple growths of international trade and finance all over the world, trading in foreign currencies has grown tremendously over the past several decades. Since the exchange rates are continuously changing, so the firms are exposed to the risk of exchange rate movements. As a result the assets or liability or cash flows of a firm which are denominated in foreign currencies undergo a change in value over a period of time due to variation in exchange rates. This variability in the value of assets or liabilities or cash flows is referred to exchange rate risk. Since the fixed exchange rate system has been fallen in the early 1970s, specifically in developed countries, the currency risk has become substantial for many business firms. As a result, these firms are increasingly turning to various risk hedging products like foreign currency futures, foreign currency forwards, foreign currency options, and foreign currency swaps. INTRODUCTION TO CURRENCY FUTURE 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 asset is a commodity, e.g. Oil or Wheat, the contract is termed a “commodity futures contract”. 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 or delivery date. Both parties of the futures contract must fulfill their obligations on the settlement date. Page | 8 Institute of Management Education, Sahibabad
  9. 9. 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 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 underlying. For e.g. in the case of the USD-INR currency futures contract the tick size shall be 0.25 paise or 0.0025 Rupees. 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. So if a trader buys 5 contracts and the price moves up by 4 tick, she makes Rupees 50. 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 Page | 9 Institute of Management Education, Sahibabad
  10. 10. COMPANY PROFILE Page | 10 Institute of Management Education, Sahibabad
  11. 11. AnandRathi Securities Limited AnandRathi (AR) is a leading full service securities firm providing the entire gamut of financial services. The firm, founded in 1994 by Mr. AnandRathi, today has a pan India presence as well as an international presence through offices in Dubai and Bangkok. AR provides a breadth of financial and advisory services including wealth management, investment banking, corporate advisory, brokerage & distribution of equities, commodities, mutual funds and insurance, structured products - all of which are supported by powerful research teams. The firm's philosophy is entirely client centric, with a clear focus on providing long term value addition to clients, while maintaining the highest standards of excellence, ethics and professionalism. The entire firm activities are divided across distinct client groups: Individuals, Private Clients, Corporate and Institutions and was recently ranked by Asia Money 2006 poll amongst South Asia's top 5 wealth managers for the ultra-rich. The offices of AnandRathi are located in 197 cities across 28 cities and it also has branches in Dubai and Bangkok with more than 44000 employees. It has a daily turnover in excess of Rs. 4billion. It has 1,00,000+ clients nationwide. It is also a leading Distributor of IPO's In the year 2007 Citigroup Venture Capital International joined the group as a financial partner. In India AnandRathi is present in 21 States: Andhra Pradesh , Assam, Bihar , Chhattisgarh, Delhi , Goa, Gujarat, Haryana Jammu & Kashmir, Jharkhand, Karnataka, Kerala, Madhya Pradesh, Maharashtra, Orissa, Punjab, Rajasthan, Tamil Nadu, Uttar Pradesh, Uttaranchal, West Bengal. Mission To be India's first multinational providing complete financial services solution across the globe. Page | 11 Institute of Management Education, Sahibabad
  12. 12. Vision "To be a shining example as leader in innovation and the first choice for clients & employees" Milestones • 1994: Started activities in consulting and Institutional equity sales with staff of 15 • 1995: Set up a research desk and empanelled with major institutional investors • 1997: Introduced investment banking businesses Retail brokerage services launched • 1999: Lead managed first IPO and executed first M & A deal • 2001: Initiated Wealth Management Services • 2002: Retail business expansion recommences with ownership model • 2003: Wealth Management assets cross Rs1500 crores Insurance broking launched Launch of Wealth Management services in Dubai Retail Branch network exceeds 50 • 2009: Anand Rathi has been Ranked as the #1 Private Bank - Domestic in India by Asiamoney Polls 2009 and Ranked as the #2 Private Bank - Overall in India by Asiamoney Polls 2009 • 2010: Anand Rathi Private Wealth adjudged Best Domestic Private Bank (India) by Asia Money Polls 2010 for the second consecutive year. Page | 12 Institute of Management Education, Sahibabad
  13. 13. Products • Equities I Bonds I Mutual Funds I Derivatives • Managed Investment Services / PMS • Commodities • FX Trading • Life Insurance • General Insurance • Alternative Assets • - Private Equity Funds • - Structured Products • - Real Estate Oppurtunities Fund • Special Situation Oppurtunities • Offshore Structures & Global Investments Services • Creation of a customized financial strategy • Diversification of assets based on a formal process of asset allocation • Active tracking, monitoring and review of portfolios • Creation of private trusts • Tax planning • Estate planning • Structuring of family wealth Equity & derivatives brokerage AnandRathi provides end-to-end equity solutions to institutional and individual investors. Consistent delivery of high quality advice on individual stocks, sector trends and investment strategy has established us a competent and reliable research unit across the country. Page | 13 Institute of Management Education, Sahibabad
  14. 14. Clients can trade through us online on BSE and NSE for both equities and derivatives. They are supported by dedicated sales & trading teams in our trading desks across the country. Research and investment ideas can be accessed by clients either through their designated dealers, email, web or SMS. Mutual funds AR is one of India's top mutual fund distribution houses. Our success lies in our philosophy of providing consistently superior, independent and unbiased advice to our clients backed by in-depth research. We firmly believe in the importance of selecting appropriate asset allocations based on the client's risk profile. We have a dedicated mutual fund research cell for mutual funds that consistently churns out superior investment ideas, picking best performing funds across asset classes and providing insights into performances of select funds. Depository services AR Depository Services provides you with a secure and convenient way for holding your securities on both CDSL and NSDL. Our depository services include settlement, clearing and custody of securities, registration of shares and dematerialization. We offer you daily updated internet access to your holding statement and transaction summary. Commodities Commodities broking - A whole new opportunity to hedge business risk and an attractive investment opportunity to deliver superior returns for investors. Our commodities broking services include online futures trading through NCDEX and MCX and depository services through CDSL. Commodities broking is supported by a dedicated research cell that provides both technical as well as fundamental research. Our research covers a broad range of traded commodities including precious and base metals, Oils and Oilseeds, agri-commodities such as Page | 14 Institute of Management Education, Sahibabad
  15. 15. wheat, chana, guar, guar gum and spices such as sugar, jeera and cotton. In addition to transaction execution, we provide our clients customized advice on hedging strategies, investment ideas and arbitrage opportunities. Insurance broking As an insurance broker, we provide to our clients comprehensive risk management techniques, both within the business as well as on the personal front. Risk management includes identification, measurement and assessment of the risk and handling of the risk, of which insurance is an integral part. The firm deals with both life insurance and general insurance products across all insurance companies. Our guiding philosophy is to manage the clients' entire risk set by providing the optimal level of cover at the least possible cost. The entire sales process and product selection is research oriented and customized to the client's needs. We lay strong emphasis on timely claim settlement and post sales services. IPO AnandRathi Securities Ltd. is a leading primary market distributor across the country. Their strong performance in IPOs has been a result of their vast experience in the Primary Market, a wide network of branches across India, strong distribution capabilities and a dedicated research team. They have been consistently ranked among the top 10 distributors of IPOs on all major offerings. Our IPO research team provides clients with in-depth overviews of forthcoming IPOs as well as investment recommendations. Online filling of forms is also available. Global Products • Structuring of trusts / investment companies • Offshore Mutual Funds • Structured Products / Deposits including capital-guaranteed notes on • Trading in global markets (Equities, Bonds, Commodities) • Real Estate investments • Alternative investments (including hedge funds and fund-of-hedge funds) Our services Page | 15 Institute of Management Education, Sahibabad
  16. 16. • Risk Management • Due diligence and research on policies available • Recommendation on a comprehensive insurance cover based on clients needs • Maintain proper records of client policies • Assist client in paying premiums • Continuous monitoring of client account • Assist client in claim negotiation and settlement. Management Team AR brings together a highly professional core management team that comprises of individuals with extensive business as well as industry experience. Our senior Management comprises a diverse talent pool that brings together rich experience from across industry as well as financial services. Mr. Anand Rathi - Group Chairman Chartered Accountant Past President, BSE Held several Senior Management positions with one of India's largest industrial groups Mr. Pradeep Gupta - Vice Chairman plus 17 years of experience in Financial Services Mr. Amit Rathi - Managing Director Chartered Accountant & MBA plus 11 years of experience in Financial Services Why choose AR? • Superior understanding of the Indian economy & markets • Ability to structure and manage your tax and regulatory compliances • Dedicated relationship team • Unparalleled product range - Indian and Global Page | 16 Institute of Management Education, Sahibabad
  17. 17. RESEARCH METHODOLOGY Page | 17 Institute of Management Education, Sahibabad
  18. 18. RESEARCH METHODOLOGY  TYPE OF RESEARCH In this project Descriptive research methodologies were used. The research methodology adopted for carrying out the study was at the first stage theoretical study is attempted and at the second stage observed online trading on NSE/BSE.  SOURCE OF DATA COLLECTION Secondary data were used such as various books, report submitted by RBI/SEBI committee and NCFM/BCFM modules.  OBJECTIVES OF THE STUDY The basic idea behind undertaking Currency Derivatives project is to gain knowledge about currency future market. To study the basic concept of Currency future To study the exchange traded currency future To understand the ways of considering currency future price. To analyze different currency derivatives products.  LIMITATION OF THE STUDY The limitations of the study were:- The analysis was purely based on the secondary data. So, any error in the secondary data might also affect the study undertaken. The currency future is new concept and topic related book was not available in library and market. Page | 18 Institute of Management Education, Sahibabad
  19. 19. BRIEF OVERVIEW OF FOREIGN EXCHANGE MARKET Page | 19 Institute of Management Education, Sahibabad
  20. 20. OVERVIEW OF THE FOREIGN EXCHANGE MARKET IN INDIA During the early 1990s, India embarked on a series of structural reforms in the foreign exchange market. The exchange rate regime, that was earlier pegged, was partially floated in March 1992 and fully floated in March 1993. The unification of the exchange rate was instrumental in developing a market-determined exchange rate of the rupee and was an important step in the progress towards total current account convertibility, which was achieved in August 1994. Although liberalization helped the Indian Forex market in various ways, it led to extensive fluctuations of exchange rate. This issue has attracted a great deal of concern from policy-makers and investors. While some flexibility in foreign exchange markets and exchange rate determination is desirable, excessive volatility can have an adverse impact on price discovery, export performance, sustainability of current account balance, and balance sheets. In the context of upgrading Indian foreign exchange market to international standards, a well- developed foreign exchange derivative market (both OTC as well as Exchange-traded) is imperative. With a view to enable entities to manage volatility in the currency market, RBI on April 20, 2007 issued comprehensive guidelines on the usage of foreign currency forwards, swaps and options in the OTC market. At the same time, RBI also set up an Internal Working Group to explore the advantages of introducing currency futures. The Report of the Internal Working Group of RBI submitted in April 2008, recommended the introduction of Exchange Traded Currency Futures. Subsequently, RBI and SEBI jointly constituted a Standing Technical Committee to analyze the Currency Forward and Future market around the world and lay down the guidelines to introduce Exchange Traded Currency Futures in the Indian market. The Committee submitted its report on May 29, 2008. Further RBI and SEBI also issued circulars in this regard on August 06, 2008. Currently, India is a USD 34 billion OTC market, where all the major currencies like USD, EURO, YEN, Pound, Swiss Franc etc. are traded. With the help of electronic trading and efficient risk management systems, Exchange Traded Currency Futures will bring in more transparency and efficiency in price discovery, eliminate counterparty credit risk, provide access to all types of market Page | 20 Institute of Management Education, Sahibabad
  21. 21. participants, offer standardized products and provide transparent trading platform. Banks are also allowed to become members of this segment on the Exchange, thereby providing them with a new opportunity. CURRENCY DERIVATIVE PRODUCTS 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.  FORWARD : The basic objective of a forward market in any underlying asset is to fix a price for a contract to be carried through on the future agreed date and is intended to free both the purchaser and the seller from any risk of loss which might incur due to fluctuations in the price of underlying asset. A forward contract is customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price. The exchange rate is fixed at the time the contract is entered into. This is known as forward exchange rate or simply forward rate.  FUTURE : A currency futures contract provides a simultaneous right and obligation to buy and sell a particular currency at a specified future date, a specified price and a standard quantity. In another word, a future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Future contracts are special types of forward contracts in the sense that they are standardized exchange-traded contracts.  SWAP : Swap is private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolio of forward contracts. The Page | 21 Institute of Management Education, Sahibabad
  22. 22. currency swap entails 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. There are a various types of currency swaps like as fixed-to-fixed currency swap, floating to floating swap, fixed to floating currency swap. In a swap normally three basic steps are involve___ (1) Initial exchange of principal amount (2) Ongoing exchange of interest (3) Re - exchange of principal amount on maturity.  OPTIONS : Currency option is a financial instrument that give the option holder a right and not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period ( until the expiration date ). In other words, a foreign currency option is a contract for future delivery of a specified currency in exchange for another in which buyer of the option has to right to buy (call) or sell (put) a particular currency at an agreed price for or within specified period. The seller of the option gets the premium from the buyer of the option for the obligation undertaken in the contract. Options generally have lives of up to 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 OTC. FOREIGN EXCHANGE SPOT (CASH) MARKET The foreign exchange spot market trades in different currencies for both spot and forward delivery. Generally they do not have specific location, and mostly take place primarily by means of telecommunications both within and between countries. It consists of a network of foreign dealers which are oftenly banks, financial institutions, large concerns, etc. The large banks usually make markets in different currencies. Page | 22 Institute of Management Education, Sahibabad
  23. 23. In the spot exchange market, the business is transacted throughout the world on a continual basis. So it is possible to transaction in foreign exchange markets 24 hours a day. The standard settlement period in this market is 48 hours, i.e., 2 days after the execution of the transaction. The spot foreign exchange market is similar to the OTC market for securities. There is no centralized meeting place and no fixed opening and closing time. Since most of the business in this market is done by banks, hence, transaction usually do not involve a physical transfer of currency, rather simply book keeping transfer entry among banks. Exchange rates are generally determined by demand and supply force in this market. The purchase and sale of currencies stem partly from the need to finance trade in goods and services. Another important source of demand and supply arises from the participation of the central banks which would emanate from a desire to influence the direction, extent or speed of exchange rate movements. FOREIGN EXCHANGE QUOTATIONS Foreign exchange quotations can be confusing because currencies are quoted in terms of other currencies. It means exchange rate is relative price. For example, If one US dollar is worth of Rs. 45 in Indian rupees then it implies that 45 Indian rupees will buy one dollar of USA, or that one rupee is worth of 0.022 US dollar which is simply reciprocal of the former dollar exchange rate. EXCHANGE RATE Direct Indirect The number of units of domestic The number of unit of foreign Currency stated against one unit currency per unit of domestic Page | 23 Institute of Management Education, Sahibabad
  24. 24. of foreign currency. currency. Re/$ = 45.7250 ( or ) Re 1 = $ 0.02187 $1 = Rs. 45.7250 There are two ways of quoting exchange rates: the direct and indirect. Most countries use the direct method. In global foreign exchange market, two rates are quoted by the dealer: one rate for buying (bid rate), and another for selling (ask or offered rate) for a currency. This is a unique feature of this market. It should be noted that where the bank sells dollars against rupees, one can say that rupees against dollar. In order to separate buying and selling rate, a small dash or oblique line is drawn after the dash. For example, If US dollar is quoted in the market as Rs 46.3500/3550, it means that the forex dealer is ready to purchase the dollar at Rs 46.3500 and ready to sell at Rs 46.3550. The difference between the buying and selling rates is called spread. It is important to note that selling rate is always higher than the buying rate. Traders, usually large banks, deal in two way prices, both buying and selling, are called market makers. Base Currency/ Terms Currency: In foreign exchange markets, the base currency is the first currency in a currency pair. The second currency is called as the terms currency. Exchange rates are quoted in per unit of the base currency. That is the expression Dollar-Rupee, tells you that the Dollar is being quoted in terms of the Rupee. The Dollar is the base currency and the Rupee is the terms currency. Exchange rates are constantly changing, which means that the value of one currency in terms of the other is constantly in flux. Changes in rates are expressed as strengthening or weakening of one currency vis-à-vis the second currency. Page | 24 Institute of Management Education, Sahibabad
  25. 25. Changes are also expressed as appreciation or depreciation of one currency in terms of the second currency. Whenever the base currency buys more of the terms currency, the base currency has strengthened / appreciated and the terms currency has weakened / depreciated. For example, If Dollar – Rupee moved from 43.00 to 43.25. The Dollar has appreciated and the Rupee has depreciated. And if it moved from 43.0000 to 42.7525 the Dollar has depreciated and Rupee has appreciated. NEED FOR EXCHANGE TRADED CURRENCY FUTURES With a view to enable entities to manage volatility in the currency market, RBI on April 20, 2007 issued comprehensive guidelines on the usage of foreign currency forwards, swaps and options in the OTC market. At the same time, RBI also set up an Internal Working Group to explore the advantages of introducing currency futures. The Report of the Internal Working Group of RBI submitted in April 2008, recommended the introduction of exchange traded currency futures. Exchange traded futures as compared to OTC forwards serve the same economic purpose, yet differ in fundamental ways. An individual entering into a forward contract agrees to transact at a forward price on a future date. On the maturity date, the obligation of the individual equals the forward price at which the contract was executed. Except on the maturity date, no money changes hands. On the other hand, in the case of an exchange traded futures contract, mark to market obligations is settled on a daily basis. Since the profits or losses in the futures market are collected / paid on a daily basis, the scope for building up of mark to market losses in the books of various participants gets limited. The counterparty risk in a futures contract is further eliminated by the presence of a clearing corporation, which by assuming counterparty guarantee eliminates credit risk. Further, in an Exchange traded scenario where the market lot is fixed at a much lesser size than the OTC market, equitable opportunity is provided to all classes of investors whether large or small to Page | 25 Institute of Management Education, Sahibabad
  26. 26. participate in the futures market. The transactions on an Exchange are executed on a price time priority ensuring that the best price is available to all categories of market participants irrespective of their size. Other advantages of an Exchange traded market would be greater transparency, efficiency and accessibility. RATIONALE FOR INTRODUCING CURRENCY FUTURE Futures markets were designed to solve the 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 and quality 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 offset prior to maturity by entering into an equal and opposite transaction. The standardized items in a futures contract are: •Quantity of the underlying •Quality of the underlying •The date and the month of delivery •The units of price quotation and minimum price change •Location of settlement The rationale for introducing currency futures in the Indian context has been outlined in the Report of the Internal Working Group on Currency Futures (Reserve Bank of India, April 2008) as follows; The rationale for establishing the currency futures market is manifold. Both residents and non- residents purchase domestic currency assets. If the exchange rate remains unchanged from the time of purchase of the asset to its sale, no gains and losses are made out of currency exposures. But if domestic currency depreciates (appreciates) against the foreign currency, the exposure would result Page | 26 Institute of Management Education, Sahibabad
  27. 27. in gain (loss) for residents purchasing foreign assets and loss (gain) for non residents purchasing domestic assets. In this backdrop, unpredicted movements in exchange rates expose investors to currency risks. Currency futures enable them to hedge these risks. Nominal exchange rates are often random walks with or without drift, while real exchange rates over long run are mean reverting. As such, it is possible that over a long – run, the incentive to hedge currency risk may not be large. However, financial planning horizon is much smaller than the long-run, which is typically inter- generational in the context of exchange rates. As such, there is a strong need to hedge currency risk and this need has grown manifold with fast growth in cross-border trade and investments flows. The argument for hedging currency risks appear to be natural in case of assets, and applies equally to trade in goods and services, which results in income flows with leads and lags and get converted into different currencies at the market rates. Empirically, changes in exchange rate are found to have very low correlations with foreign equity and bond returns. This in theory should lower portfolio risk. Therefore, sometimes argument is advanced against the need for hedging currency risks. But there is strong empirical evidence to suggest that hedging reduces the volatility of returns and indeed considering the episodic nature of currency returns, there are strong arguments to use instruments to hedge currency risks. FUTURE TERMINOLOGY  SPOT PRICE : The price at which an asset trades in the spot market. The transaction in which securities and foreign exchange get traded for immediate delivery. Since the exchange of securities and cash is virtually immediate, the term, cash market, has also been used to refer to spot dealing. In the case of USDINR, spot value is T + 2.  FUTURE PRICE : The price at which the future contract is traded in the future market.  CONTRACT CYCLE : Page | 27 Institute of Management Education, Sahibabad
  28. 28. The period over which a contract trades. The currency future contracts in Indian market have one month, two month, three month up to twelve month expiry cycles. In NSE/BSE will have 12 contracts outstanding at any given point in time.  VALUE DATE / FINAL SETTELMENT DATE : The last business day of the month will be termed the value date /final settlement date of each contract. The last business day would be taken to the same as that for inter bank settlements in Mumbai. The rules for inter bank settlements, including those for ‘known holidays’ and would be those as laid down by Foreign Exchange Dealers Association of India (FEDAI).  EXPIRY DATE : It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. The last trading day will be two business days prior to the value date / final settlement date.  CONTRACT SIZE : The amount of asset that has to be delivered under one contract. Also called as lot size. In case of USDINR it is USD 1000  BASIS : In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.  COST OF CARRY : The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance or ‘carry’ the asset till delivery less the income earned on the asset. For equity derivatives carry cost is the rate of interest.  INITIAL MARGIN : Page | 28 Institute of Management Education, Sahibabad
  29. 29. When the position is opened, the member has to deposit the margin with the clearing house as per the rate fixed by the exchange which may vary asset to asset. Or in another words, the amount that must be deposited in the margin account at the time a future contract is first entered into is known as initial margin.  MARKING TO MARKET : At the end of trading session, all the outstanding contracts are reprised at the settlement price of that session. It means that all the futures contracts are daily settled, and profit and loss is determined on each transaction. This procedure, called marking to market, requires that funds charge every day. The funds are added or subtracted from a mandatory margin (initial margin) that traders are required to maintain the balance in the account. Due to this adjustment, futures contract is also called as daily reconnected forwards.  MAINTENANCE MARGIN : Member’s account are debited or credited on a daily basis. In turn customers’ account are also required to be maintained at a certain level, usually about 75 percent of the initial margin, is called the maintenance margin. This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day. USES OF CURRENCY FUTURES  Hedging: Presume Entity A is expecting a remittance for USD 1000 on 27 August ‘08 wants to lock in the foreign exchange rate today so that the value of inflow in Indian rupee terms is Page | 29 Institute of Management Education, Sahibabad
  30. 30. safeguarded. The entity can do so by selling one contract of USDINR futures since one contract is for USD 1000. Presume that the current spot rate is Rs.43 and ‘USDINR 27 Aug 08’ contract is trading at Rs.44.2500. Entity A shall do the following: Sell one August contract today. The value of the contract is Rs.44,250. Let us assume the RBI reference rate on August 27, 2008 is Rs.44.0000. The entity shall sell on August 27, 2008, USD 1000 in the spot market and get Rs. 44,000. The futures contract will settle at Rs.44.0000 (final settlement price = RBI reference rate). The return from the futures transaction would be Rs. 250, i.e. (Rs. 44,250 – Rs. 44,000). As may be observed, the effective rate for the remittance received by the entity A is Rs.44. 2500 (Rs.44,000 + Rs.250)/1000, while spot rate on that date was Rs.44.0000. The entity was able to hedge its exposure.  Speculation: Bullish, buy futures Take the case of a speculator who has a view on the direction of the market. He would like to trade based on this view. He expects that the USD-INR rate presently at Rs.42, is to go up in the next two-three months. How can he trade based on this belief? In case he can buy dollars and hold it, by investing the necessary capital, he can profit if say the Rupee depreciates to Rs.42.50. Assuming he buys USD 10000, it would require an investment of Rs.4,20,000. If the exchange rate moves as he expected in the next three months, then he shall make a profit of around Rs.10000. This works out to an annual return of around 4.76%. It may please be noted that the cost of funds invested is not considered in computing this return. A speculator can take exactly the same position on the exchange rate by using futures contracts. Let us see how this works. If the INR- USD is Rs.42 and the three month futures trade at Rs.42.40. The minimum contract size is USD 1000. Therefore the speculator may buy 10 contracts. The exposure shall be the same as above USD 10000. Presumably, the margin may be around Rs.21, 000. Three months later if the Rupee depreciates to Rs. 42.50 against USD, (on the day of expiration of the contract), the futures price shall converge to the spot price (Rs. 42.50) Page | 30 Institute of Management Education, Sahibabad
  31. 31. and he makes a profit of Rs.1000 on an investment of Rs.21, 000. This works out to an annual return of 19 percent. Because of the leverage they provide, futures form an attractive option for speculators.  Speculation: Bearish, sell futures Futures can be used by a speculator who believes that an underlying is over-valued and is likely to see a fall in price. How can he trade based on his opinion? In the absence of a deferral product, there wasn't much he could do to profit from his opinion. Today all he needs to do is sell the futures. Let us understand how this works. Typically futures move correspondingly with the underlying, as long as there is sufficient liquidity in the market. If the underlying price rises, so will the futures price. If the underlying price falls, so will the futures price. Now take the case of the trader who expects to see a fall in the price of USD-INR. He sells one two-month contract of futures on USD say at Rs. 42.20 (each contact for USD 1000). He pays a small margin on the same. Two months later, when the futures contract expires, USD-INR rate let us say is Rs.42. On the day of expiration, the spot and the futures price converges. He has made a clean profit of 20 paise per dollar. For the one contract that he sold, this works out to be Rs.2000.  Arbitrage: Arbitrage is the strategy of taking advantage of difference in price of the same or similar product between two or more markets. That is, arbitrage is striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. If the same or similar product is traded in say two different markets, any entity which has access to both the markets will be able to identify price differentials, if any. If in one of the markets the product is trading at higher price, then the entity shall buy the product in the Page | 31 Institute of Management Education, Sahibabad
  32. 32. cheaper market and sell in the costlier market and thus benefit from the price differential without any additional risk. One of the methods of arbitrage with regard to USD-INR could be a trading strategy between forwards and futures market. As we discussed earlier, the futures price and forward prices are arrived at using the principle of cost of carry. Such of those entities who can trade both forwards and futures shall be able to identify any mis-pricing between forwards and futures. If one of them is priced higher, the same shall be sold while simultaneously buying the other which is priced lower. If the tenor of both the contracts is same, since both forwards and futures shall be settled at the same RBI reference rate, the transaction shall result in a risk less profit. TRADING PROCESS AND SETTLEMENT PROCESS Like other future trading, the future currencies are also traded at organized exchanges. The following diagram shows how operation take place on currency future market: Page | 32 Institute of Management Education, Sahibabad
  33. 33. TRADER TRADER ( BUYER ) ( SELLER ) Purchase order Sales order Transaction on the floor (Exchange) MEMBER MEMBER ( BROKER ) ( BROKER ) Informs CLEARING HOUSE It has been observed that in most futures markets, actual physical delivery of the underlying assets is very rare and it hardly ranges from 1 percent to 5 percent. Most often buyers and sellers offset their original position prior to delivery date by taking an opposite positions. This is because most of futures contracts in different products are predominantly speculative instruments. For example, X purchases American Dollar futures and Y sells it. It leads to two contracts, first, X party and clearing house and second Y party and clearing house. Assume next day X sells same contract to Z, then X is out of the picture and the clearing house is seller to Z and buyer from Y, and hence, this process is goes on. REGULATORY FRAMEWORK FOR CURRENCY FUTURES With a view to enable entities to manage volatility in the currency market, RBI on April 20, 2007 issued comprehensive guidelines on the usage of foreign currency forwards, Page | 33 Institute of Management Education, Sahibabad
  34. 34. swaps and options in the OTC market. At the same time, RBI also set up an Internal Working Group to explore the advantages of introducing currency futures. The Report of the Internal Working Group of RBI submitted in April 2008, recommended the introduction of exchange traded currency futures. With the expected benefits of exchange traded currency futures, it was decided in a joint meeting of RBI and SEBI on February 28, 2008, that an RBI-SEBI Standing Technical Committee on Exchange Traded Currency and Interest Rate Derivatives would be constituted. To begin with, the Committee would evolve norms and oversee the implementation of Exchange traded currency futures. The Terms of Reference to the Committee was as under: 1. To coordinate the regulatory roles of RBI and SEBI in regard to trading of Currency and Interest Rate Futures on the Exchanges. 2. To suggest the eligibility norms for existing and new Exchanges for Currency and Interest Rate Futures trading. 3. To suggest eligibility criteria for the members of such exchanges. 4. To review product design, margin requirements and other risk mitigation measures on an ongoing basis. 5. To suggest surveillance mechanism and dissemination of market information. 6. To consider microstructure issues, in the overall interest of financial stability. COMPARISION OF FORWARD AND FUTURES CURRENCY CONTRACT BASIS FORWARD FUTURES Size Structured as per requirement Standardized of the parties Delivery Tailored on individual needs Standardized Page | 34 Institute of Management Education, Sahibabad
  35. 35. date Method of Established by the bank or Open auction among buyers and seller on the transaction broker through electronic floor of recognized exchange. media Participants Banks, brokers, forex dealers, Banks, brokers, multinational companies, multinational companies, institutional investors, small traders, institutional investors, speculators, arbitrageurs, etc. arbitrageurs, traders, etc. Margins None as such, but Margin deposit required compensating bank balanced may be required Maturity Tailored to needs: from one Standardized week to 10 years Settlement Actual delivery or offset with Daily settlement to the market and variation cash settlement. No separate margin requirements clearing house Market Over the telephone worldwide At recognized exchange floor with worldwide place and computer networks communications Accessibility Limited to large customers Open to any one who is in need of hedging banks, institutions, etc. facilities or has risk capital to speculate Delivery More than 90 percent settled Actual delivery has very less even below one by actual delivery percent Secured Risk is high being less secured Highly secured through margin deposit. Page | 35 Institute of Management Education, Sahibabad
  36. 36. ANALYSIS INTEREST RATE PARITY PRINCIPLE 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. The forward rate is a function of the spot rate and the interest rate differential between the two currencies, adjusted for time. In the case of fully convertible currencies, having no restrictions on borrowing or lending of either currency the forward rate can be calculated as follows; Page | 36 Institute of Management Education, Sahibabad
  37. 37. Future Rate = (spot rate) {1 + interest rate on home currency * period} / {1 + interest rate on foreign currency * period} For example, Assume that on January 10, 2002, six month annual interest rate was 7 percent p.a. on Indian rupee and US dollar six month rate was 6 percent p.a. and spot ( Re/$ ) exchange rate was 46.3500. Using the above equation the theoretical future price on January 10, 2002, expiring on June 9, 2002 is: the answer will be Rs.46.7908 per dollar. Then, this theoretical price is compared with the quoted futures price on January 10, 2002 and the relationship is observed. Page | 37 Institute of Management Education, Sahibabad
  38. 38. PRODUCT DEFINITIONS OF CURRENCY FUTURE ON NSE/BSE Underlying Initially, currency futures contracts on US Dollar – Indian Rupee (US$-INR) would be permitted. Trading Hours The trading on currency futures would be available from 9 a.m. to 5 p.m. Size of the contract The minimum contract size of the currency futures contract at the time of introduction would be US$ 1000. The contract size would be periodically aligned to ensure that the size of the contract remains close to the minimum size. Quotation The currency futures contract would be quoted in rupee terms. However, the outstanding positions would be in dollar terms. Tenor of the contract The currency futures contract shall have a maximum maturity of 12 months. Available contracts All monthly maturities from 1 to 12 months would be made available. Page | 38 Institute of Management Education, Sahibabad
  39. 39. Settlement mechanism The currency futures contract shall be settled in cash in Indian Rupee. Settlement price The settlement price would be the Reserve Bank Reference Rate on the date of expiry. The methodology of computation and dissemination of the Reference Rate may be publicly disclosed by RBI. Final settlement day The currency futures contract would expire on the last working day (excluding Saturdays) of the month. The last working day would be taken to be the same as that for Interbank Settlements in Mumbai. The rules for Interbank Settlements, including those for ‘known holidays’ and ‘subsequently declared holiday’ would be those as laid down by FEDAI. The contract specification in a tabular form is as under: Underlying Rate of exchange between one USD and INR Trading Hours 09:00 a.m. to 05:00 p.m. (Monday to Friday) Contract Size USD 1000 Tick Size 0.25 paisa or INR 0.0025 Trading Period Maximum expiration period of 12 months Contract Months 12 near calendar months Final Settlement date/ Last working day of the month (subject to Value date holiday calendars) Last Trading Day Two working days prior to Final Settlement Date Settlement Cash settled Page | 39 Institute of Management Education, Sahibabad
  40. 40. Final Settlement Price The reference rate fixed by RBI two working days prior to the final settlement date will be used for final settlement CURRENCY FUTURES PAYOFFS A payoff is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on the X-axis and the profits/losses on the Y-axis. Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. Options do not have linear payoffs. Their pay offs are non-linear. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. However, currently only payoffs of futures are discussed as exchange traded foreign currency options are not permitted in India. Payoff for buyer of futures: Long futures The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who buys a two-month currency futures contract when the USD stands at say Rs.43.19. The underlying asset in this case is the currency, USD. When the value of dollar moves up, i.e. when Rupee depreciates, the long futures position starts making profits, and when the dollar depreciates, i.e. when rupee appreciates, it start making losses. Figure 4.1 shows the payoff diagram for the buyer of a futures contract. Payoff for buyer of future: The figure shows the profits/losses for a long futures position. The investor bought futures when the USD was at Rs.43.19. If the price goes up, his futures position starts making profit. If the price falls, his futures position starts showing losses. Page | 40 Institute of Management Education, Sahibabad
  41. 41. P R O F I T 43.19 0 USD L O S S Payoff for seller of futures: Short futures The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells a two month currency futures contract when the USD stands at say Rs.43.19. The underlying asset in this case is the currency, USD. When the value of dollar moves down, i.e. when rupee appreciates, the short futures position starts 25 making profits, and when the dollar appreciates, i.e. when rupee depreciates, it starts making losses. The Figure below shows the payoff diagram for the seller of a futures contract. Payoff for seller of future: The figure shows the profits/losses for a short futures position. The investor sold futures when the USD was at 43.19. If the price goes down, his futures position starts making profit. If the price rises, his futures position starts showing losses Page | 41 Institute of Management Education, Sahibabad
  42. 42. P R O F I T 43.19 0 USD L O S S PRICING FUTURES – COST OF CARRY MODEL Pricing of futures contract is very simple. Using the cost-of-carry logic, we calculate the fair value of a futures contract. Every time the observed price deviates from the fair value, arbitragers would enter into trades to capture the arbitrage profit. This in turn would push the futures price back to its fair value. The cost of carry model used for pricing futures is given below: F=Se^(r-rf)T where: r=Cost of financing (using continuously compounded interest rate) rf= one year interest rate in foreign T=Time till expiration in years E=2.71828 Page | 42 Institute of Management Education, Sahibabad
  43. 43. The relationship between F and S then could be given as F Se^(r rf )T - = This relationship is known as interest rate parity relationship and is used in international finance. To explain this, let us assume that one year interest rates in US and India are say 7% and 10% respectively and the spot rate of USD in India is Rs. 44. From the equation above the one year forward exchange rate should be F = 44 * e^(0.10-0.07 )*1=45.34 It may be noted from the above equation, if foreign interest rate is greater than the domestic rate i.e. rf > r, then F shall be less than S. The value of F shall decrease further as time T increase. If the foreign interest is lower than the domestic rate, i.e. rf < r, then value of F shall be greater than S. The value of F shall increase further as time T increases. HEDGING WITH CURENCY FUTURES Exchange rates are quite volatile and unpredictable, it is possible that anticipated profit in foreign investment may be eliminated, rather even may incur loss. Thus, in order to hedge this foreign currency risk, the traders’ oftenly use the currency futures. For example, a long hedge (I.e.., buying currency futures contracts) will protect against a rise in a foreign currency value whereas a short hedge (i.e., selling currency futures contracts) will protect against a decline in a foreign currency’s value. It is noted that corporate profits are exposed to exchange rate risk in many situation. For example, if a trader is exporting or importing any particular product from other countries then he is exposed to foreign exchange risk. Page | 43 Institute of Management Education, Sahibabad
  44. 44. Similarly, if the firm is borrowing or lending or investing for short or long period from foreign countries, in all these situations, the firm’s profit will be affected by change in foreign exchange rates. In all these situations, the firm can take long or short position in futures currency market as per requirement. The general rule for determining whether a long or short futures position will hedge a potential foreign exchange loss is: Loss from appreciating in Indian rupee= Short hedge Loss form depreciating in Indian rupee= Long hedge The choice of underlying currency The first important decision in this respect is deciding the currency in which futures contracts are to be initiated. For example, an Indian manufacturer wants to purchase some raw materials from Germany then he would like future in German mark since his exposure in straight forward in mark against home currency (Indian rupee). Assume that there is no such future (between rupee and mark) available in the market then the trader would choose among other currencies for the hedging in futures. Which contract should he choose? Probably he has only one option rupee with dollar. This is called cross hedge. Choice of the maturity of the contract The second important decision in hedging through currency futures is selecting the currency which matures nearest to the need of that currency. For example, suppose Indian importer import raw material of 100000 USD on 1st November 2008. And he will have to pay 100000 USD on 1st February 2009. And he predicts that the value of USD will increase against Indian rupees nearest to due date of that payment. Importer predicts that the value of USD will increase more than 51.0000. Page | 44 Institute of Management Education, Sahibabad
  45. 45. So what he will do to protect against depreciating in Indian rupee? Suppose spots value of 1 USD is 49.8500. Future Value of the 1USD on NSE as below: Price Watch Page | 45 Institute of Management Education, Sahibabad
  46. 46. Order Book Contract Best Buy Qty Best Buy Price Best Sell Price Best Sell Qty LTP Volume Open Interest USDINR 261108 464 49.8550 49.8575 712 49.8550 58506 43785 USDINR 291208 189 49.6925 49.7000 612 49.7300 176453 111830 USDINR Page | 46 Institute of Management Education, Sahibabad
  47. 47. Solution: He should buy ten contract of USDINR 28012009 at the rate of 49.8850. Value of the contract is (49.8850*1000*100) =4988500. (Value of currency future per USD*contract size*No of contract). For that he has to pay 5% margin on 5988500. Means he will have to pay Rs.299425 at present. And suppose on settlement day the spot price of USD is 51.0000. On settlement date payoff of importer will be (51.0000-59.8850) =1.115 per USD. And (1.115*100000) =Rs. 111500. Choice of the number of contracts (hedging ratio) Another important decision in this respect is to decide hedging ratio HR. The value of the futures position should be taken to match as closely as possible the value of the cash market position. As we know that in the futures markets due to their standardization, exact match will generally not be possible but hedge ratio should be as close to unity as possible. We may define the hedge ratio HR as follows: HR= VF / Vc Where, VF is the value of the futures position and Vc is the value of the cash position. Suppose value of contract dated 28th January 2009 is 49.8850. And spot value is 49.8500. HR=49.8850/49.8500=1.001. FINDINGS Page | 47 Institute of Management Education, Sahibabad
  48. 48.  Cost of carry model and Interest rate parity model are useful tools to find out standard future price and also useful for comparing standard with actual future price. And it’s also a very help full in Arbitraging.  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/RBI, 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.  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. SUGGESTIONS Page | 48 Institute of Management Education, Sahibabad
  49. 49.  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 USD-INR 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. And according to Indian financial growth now it’s become necessary to introducing other currency derivatives in Exchange traded currency derivative segment. CONCLUSIONS Page | 49 Institute of Management Education, Sahibabad
  50. 50. 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 gives 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. BIBLIOGRAPHY Page | 50 Institute of Management Education, Sahibabad
  51. 51. Financial Derivatives (theory, concepts and problems) By: S.L. Gupta. NCFM: Currency future Module. BCFM: Currency Future Module. Center for social and economic research) Poland Recent Development in International Currency Derivative Market by: Lucjan T. Orlowski) Report of the RBI-SEBI standing technical committee on exchange traded currency futures) 2008 Report of the Internal Working Group on Currency Futures (Reserve Bank of India, April 2008) Websites: Page | 51 Institute of Management Education, Sahibabad