Currency Futures - A New Leap Ahead


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With the availability of abundant off-shore investment opportunities, investors may get
tempted to diversify their investments. However, Financial Planners may help them in
hedging the exchange risks through the effective use of Currency Futures.

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Currency Futures - A New Leap Ahead

  1. 1. CUrreNCY MANAGeMeNt currency Futures – a new Leap aheaD JUNE 2010 | FINANCIAL PLANNING JOURNAL | 46
  2. 2. CUrreNCY MANAGeMeNt with the availability of abundant off-shore investment opportunities, investors may get tempted to diversify their investments. however, Financial planners may help them in hedging the exchange risks through the effective use of currency Futures. Amar Ranu Senior Manager, Mutual Fund Research Motilal Oswal Securities Limited T Need for Exchange Traded Currency he Indian market has been witnessing an increased participation in other financial products, moving Futures away from the obsession with equities. The interests Before introduction of Currency Futures pairs, the Indian for other financial products provide an alternate avenue to foreign exchange market was dominated by OTC (Over expand the basket of assets; it also provides hedging avenues the Counter) products which were predominantly for large for the domestic investors. In 1990s, India got on to a series corporate houses. Although liberalization helped India’s forex of structural reforms in the foreign exchange market. The market in various ways, there were excessive fluctuations of exchange rate being pegged earlier was floated fully in March exchange rates in Indian forex market, leading to excessive 1993. The integration of the exchange rate was instrumental volatility. So, in context to upgrade Indian foreign exchange in developing a market-determined exchange rate of the market to international standards, a well-developed foreign rupee and an important step in the progress towards current exchange derivative market was required. The Reserve Bank account convertibility, which was achieved in August 1994. of India (RBI), India’s Central Bank, set up an Internal The RBI increased the ceiling for remittances for resident Working Group to explore the advantages of introducing individuals under the Liberalized Remittance Scheme for currency futures. The group recommended the introduction Resident Individuals to US $ 2,00,000 in a phased manner. of Currency Futures in April 2008. Increased overseas investments have also been allowed for Exchange Traded Futures as compared to OTC forwards corporate houses to facilitate overseas acquisitions and fund serve the same economic purpose, although it differs in internal requirements. The prepayment limits have also been fundamental ways (Kindly see Table 1). raised to liberalize the guidelines on External Commercial Borrowings (ECBs). Hence, the globalization and table 1: comparision of Forward and Futures contract amalgamation of financial markets, coupled with increased Desription Forward Contract Futures Contract foreign exchange flows have led to the need of dynamic currency risk management. The free trade flows with other Nature of Non-standardized/ Standardized contract Contract Customized contract countries, increased participation in international markets Trading Over-the-counter Traded on Exchange and strong economic environment have led to increased market; Private inflows in the form of FDIs and FIIs’ investments. Moreover, contract between the foreign exchange market has achieved a new feat in terms parties of deeper participation, wide range of products, turnover and Risk Counter Party Risk; no Exchange provides the guarantee is provided guarantee of settlement and liquidity. The average daily turnover in the foreign exchange hence no counter party risk. market increased from US $ 23.7 billion in March 2006 to Settlement Single - Precified Daily settlement, known as US $ 33.0 billion in March 2007 in consonance with the Daily market settlement and increase in foreign exchange transactions. Final settlement JUNE 2010 | FINANCIAL PLANNING JOURNAL | 47
  3. 3. CUrreNCY MANAGeMeNt In case of forward contract, the money exchange takes • Settlement Mechanism: It is cash settled in Indian Rupees place only on maturity date while in the case of exchange at RBI Reference Rate on date of expiry. traded future contract, mark to market obligations are settled • Tenor of the contract: The maximum maturity is of 12 on a daily basis. Since the profits or losses in the futures market months. are collected / paid on daily basis, the scope for building up • Tick Size: 0.25 paise or INR 0.0025. of mark to market losses in the books of various participants • Price Operating Range: +/- 3% of base price for tenure gets reduced. The presence of a Clearing Corporation which up to 6 months and +/- 5% of base price for tenure provides Counterparty Guarantee reduces the counterparty greater than 6 months. risk in a future contract, thus, eliminates credit risk. Further, • Settlement: Daily Settlement at T+1 and Final Settlement at T+2. Initially, forex markets were beyond the reach of small investors, speculators and arbitragers but the presence of a clearing corporation which with the introduction of currency futures trading in provides counterparty Guarantee reduces India, apart from exporters, importers, companies the counterparty risk in a future contract, and banks, many retail traders and investors can also now take their positions in Foreign Exchange thus, eliminates credit risk. trading. The following are the benefits for different groups: in an exchange driven product, the market lot size is much • Hedgers: Currency Futures provide a high-liquidity smaller as compared to OTC market. It, thus, provides an platform for hedging against the effects of unfavorable equal opportunity to all classes of investors whether large or fluctuations in the foreign exchange markets. Exporters, small to participate in the futures market. Other advantages Importers, Corporate and Banks can hedge with of an Exchange traded market would be greater transparency, Currency Futures at low entry and exit costs. efficiency and accessibility. • Investors: All those who are interested in taking a view on the direction of the market i.e. appreciation or depreciation of exchange rate in the long and short term Currency Futures Market – A Perspective can participate in Currency Futures. For example, if a Initially the RBI and Securities and Exchange Board of person expects an appreciation in Indian Rupee against India (SEBI) allowed trading in currency futures in India, USD, he can sell the USD-INR contract. However, if based on the USD-INR exchange rate. This provided Indian one expects depreciation of the Indian Rupee against corporate another tool for hedging their foreign exchange risk the US dollar, he can take long (buy) position in USD- effectively and flexibly at transparent rates on an electronic INR contract. trading platform. The contract specifications of the futures • Arbitrageurs: Arbitrageurs get opportunity to trade in are as given below: interest rate differentials of respective countries implied from currency futures. • Underlying: Initially, currency futures contracts on US Dollar – Indian Rupee (USD-INR) have been permitted; Currency Futures for Forex players and its in April 2010. It has now been extended to Euro – Indian benefits Rupee (EUR-INR), British Pound Sterling – Indian After the RBI increased the ceiling for remittances for Rupee (GBP-INR) and Japanese Yen – Indian Rupee resident individuals under the Liberalized Remittance Scheme (JPY-INR). for Resident Individual to US $ 2,00,000, the Currency Futures • Size of the Contract: The minimum contract size of have attained a more important place due to increased forex the currency futures market is 1,000 USD, 1,000 Euro, volatility. Moreover, Indian corporate houses, including small 1,000 Pound Sterling and 1,00,000 YEN for USD-INR, and medium scale, have seen increased participation in terms EURO-INR, GBP-INR and JPY-INR respectively. of foreign currency borrowings as evident from the figures • Quotation: The currency futures contracts are quoted in of External Commercial Borrowings (ECBs) and Foreign Rupee terms, however, the outstanding positions are in Currency Convertible Bonds (FCCBs). So, the currency respective currency terms. futures have occupied an important place in terms of reducing • Trading Hours: The trading is available from 09:00 a.m. foreign exchange volatility. Also, High Networth Individuals to 5 p.m. from Monday to Friday. (HNIs) have started dabbling in currency futures in search • Available Contracts: All monthly maturities from 1 to 12 of alternate investment opportunity. There is no data on the months are available. participation of retail investors in currency trade, but the JUNE 2010 | FINANCIAL PLANNING JOURNAL | 48
  4. 4. CUrreNCY MANAGeMeNt evidence suggests that the trend has started. The reasons are In Indian Rupee, the investment is worth Rs. 45,63,000, many: one being the equity market is overvalued. Moreover, considering USD/INR is currently quoting at Rs. 45.63. after the addition of the other currency pairs, there has been After six months, his call goes right and his investments considerable interest in futures. The combined volume has grew by 10%; hence his investments would be worth US $ almost doubled. 1,10,000. Considering the current USD-INR rate at Rs. 41.20 and his investment of US $ 1,10,000, his portfolio would be Let us understand how a currency future works in benefits worth of Rs. 45,32,000. This is a loss making proposition for of different stakeholders including individuals: him, giving a loss of 0.68%, against actual returns of 10% on his investments. During this period, the USD has depreciated Consider an exporter XYZ exporting garments worth against the INR and therefore the returns are poor. Though US $ 1,00,000 wants to protect himself from the possible he was successful in gauging the stock market movement in appreciation in Indian Rupee in Nov 2010 i.e. when he US NASDAQ but he fails to capture and manage his currency expects to receive the payment. He will lock-in the exchange exposure. rate for the above transaction in the manner given below Let us now see how he can safeguard himself against his (Kindly see Table 2): exposures in USD. If he perceives that USD will depreciate, he can go short on currency futures i.e. he sells a USD/INR table 2: cashflows of exporter XYZ contract. The table 3 explains the mechanics of hedging One USD-INR Contract Size US $ 1,000 through Currency Futures. Sell 100 USD-INR Nov 10 Contracts (May Rs. 44.75 15, 2010) table 3: mechanics of hedging through currency Futures Buy 100 USD-INR Nov 10 Contracts in Rs. 44.40 particulars spot Market Futures Market Nov 2010 Leg 1 The current exchange rate is INR USD-INR contract is at Rs. 45.95; Strategy 45.63 per USD, therefore, the hence, the price per contract is current investment of USD 1,00,000 INR 45,950. The approximate Sell USD 1,00,000 in spot market @ Rs. is Rs. 45,63,000. number of contract he would sell is 4563000/45950 = 99.30 44.40 in Nov 2010 ≈ 99. Sell 99 contracts for Rs. 45,49,050. Assume that his predictions went right and the rupee appreciated to Rs. 44.40 Leg 2 The spot rate is INR 41.20. Receive Buy back 99 contracts at the USD 1,10,000 from his investments. prevailing rate of USD-INR 41.52. per USD as predicted by the exporter by His revenue in INR: 1,10,000 × 41.2 Price per contract is 41,520. end of Nov 2010 = INR 45,32,000 Hence, the value of 99 contract is Rs. 41,10,480. profit on Futures transaction is: Profit/Loss from Futures (Nov 2010 = 100× 1000 × (44.75-44.40) INR 45,49,050 Sale Price of Futures Contracts) = INR 35,000 (INR 41,10,480) (Buy Price of Futures) INR 4,38,750 Profit on Futures Analysis The net receipt in INR for the hedged transaction would mitigating Forex Risk and calculating stock market Return be: INR 45,32,000 Stock Proceedings Rs. (1,00,000 × 44.40 + 35,000) = Rs. 44,75,000. Had he INR 4,38,750 Future Gains not taken exposures in Currency Futures market, he would INR 49,70,750 Returns have got only Rs. 44,40,000. Here, we have considered ‘nil’ margin for taking positions in Currency Futures. It is to be Observation: Had the exchange rate been dormant at noted that the above examples do not include transaction fees Rs. 45.63 during the six-month period, the investment in and any other fees, which are essential for calculating final Indian currency would have grown from Rs. 45,63,000 to profit and loss. Rs. 50,19,300 fetching him an absolute return of 4,56,300. Similarly, the opposite of the above mentioned strategy can be taken if one anticipates depreciation in Indian Rupee. table 4: portfolio Return Thus, we see that Currency Future is proved to be a boon for without hedging hedging with currency Futures the market participants if it is used properly. Invest USD 1,00,000 (USD = Rs. Invests and sells 99 future contracts 45.63) at Rs. 45.95 How a retail investor can benefit from Investment grows to USD 1,10,000 After 6 months, square-off futures Currency Futures? after 6 months position at Rs. 41.52. Similarly, the currency futures can be used for Retail Sells his investment when the exchange rate is Rs. 41.2 Hedging particularly to remove forex risk while investing Return (In $) = 10% Return in Rs. Terms: abroad. Let us say an investor invests USD 1,00,000 for a Loss (In Rs.) = 0.68% Loss on Investment (In Rs.)= Rs. period of six months in the NASDAQ with a perspective 31,000 that the market will grow and he will earn a decent return. (1,10,000 × 41.2 - 1,00,000 × 45.63)/ On Futures = Rs. 4,38,750 (1,10,000 × 41.2) Net Return = 8.93% JUNE 2010 | FINANCIAL PLANNING JOURNAL | 49
  5. 5. CUrreNCY MANAGeMeNt However, during this period, the USD has depreciated by It is the writer who might catch 9.71% and hence, this investment made a loss. The table 4 the imagination of young people, gives a detailed presentation how he would benefit with and and plant a seed that will flower and without currency hedging. come to fruition Thus, he could post a better return by hedging his overseas portfolio using Currency Futures as compared to the - Issac asimov one without hedging. Indian Journey of Currency Futures Indian Currency Futures market has surpassed all past records in terms of volume in comparison to other assets classes, including equity. The total monthly turnover in the Currency Futures increased considerably, from Rs. 2.20 lakh crore in Dec 2009 (NSE and MCX Data) to Rs. 7.19 lakh crore in April 2009. Initially, when the USD-INR currency pair was launched, the average daily volume of currency wanted writers/ futures was Rs. 2,179.83 crore in Dec 2008 which increased Contributors for Financial Planning Journal to Rs. 18,929.05 crore in April 2010, a whooping increase of 359.85 per cent CAGR or an absolute increase of 768 per cent. Even a report of SEBI has noted that the currency futures market is slowly chipping away the market share from the OTC market. This has resulted in reduction of bid-ask what we are looking for? spreads (difference between the highest buying and lowest selling price) in currency futures. The report also says that • Passion to take the Financial Planning the participation of merchants (importers and exporters) in movement forward the OTC market has declined from 62 per cent in November • Original and Thought Provoking Ideas 2008 to 20 per cent in August 2009. The main reason for currency futures being tradable in large quantity is due to • Ability to challenge the Paradigms less initial money margin which ranges from Rs. 1,300 to Rs. • Research Orientation 3,500 per lot, depending upon the volatility and the liquidity for the respective currency pair. Due to an affordable margin requirement and a considerably small lot, these instruments what you get? have become a favorite for traders as well as emerging • Recognition companies including individuals that have a significant • Continuous Education points for CFPCM business exposure to the countries of the respective currency certificants in terms of revenue earnings. • Feedback from the readers Conclusion The exchange traded currency pairs is an extension of a deeply penetrated OTC market but with added benefits If you have it within you, then do contact in terms of liquidity, price transparency, standardized Prashant Kapoor, assistant editor, Financial Planning Journal at and contracts, counterparty risk management through Clearing be a part of the Financial Planning movement. Corporation and no requirement of underlying exposure in the currency. However, it would be too early to predict a major shift in trading activity to exchange based Currency Futures, compared to the OTC Market as OTC Market has created a niche for itself and perhaps it would take some time Financial Planning Journal, FPSB India, for the currency futures market to create one for itself. 702, 7th Floor, Leela Business Park, Andheri Kurla Road Andheri (East), Mumbai - 400059 Phone : 91 22 61712424 Fax: 91 22 61712444 Website: CFPCM, CERTIFIED FInanCIal PlannERCM and are certification marks owned outside the U.S. by Financial Planning Standards Board Ltd. Financial Planning Standards Board India is the marks licensing authority for the CFPCM marks in India, through agreement with FPSB Ltd. JUNE 2010 | FINANCIAL PLANNING JOURNAL | 50