This document provides a summary of the evolution of money from ancient barter systems to modern currencies. It describes how barter systems using commodities like livestock, grain, and salt evolved to using precious metals like gold and silver as commodity money. It then discusses the development of coinage using gold, silver, and other metals in ancient China, Greece, Rome, and other empires. Paper money and representative currencies backed by gold and silver emerged in China in the Song Dynasty before spreading to Europe. The document concludes with a brief discussion of the evolution of plastic money in the 20th century.

1. 1

2. THE GROUP OF INTEGRITY PRESENTS
A PROJECT REPORT ON
(A project report submitted in partial fulfillment of the award of BBA degree for the year 2010-11.)
Submitted to:
L.J. INSTITUTE OF BUSINESS ADMINISTRATION
Submitted by:
SHIKHA KOTHARI [36 A]
BINAL PATEL [57 A]
RISHITA KAYASTH [30 A]
AMI KHANDHEDIYA [32 A]
MUNIRA CHHAYANWALA [13 A]
NIRALI CHOVATIA [15 A]
Project Guides:
AADIL PATHAN [70 A]
PROF. NIHAR NANAVATI
ADITYA KAPOOR [29 A]
PROF. SAURIN SHAH
NAMAN SHAH [94 A]
PROF. CHINTAN DEVALIA
PRATIK BAJAJ [4 A]
2

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

62. TRADING IN INDIA

CURRENCY FUTURES CONTRACT SPECIFICATIONS:
62

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.
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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