Project Report On Currency Derivative

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ACKNOWLEDGEMENT
I wish to express my deep sense of gratitude to all the people who helped and supported me in preparing this project. I am highly indebted to RiddiSiddhi Bullions Ltd. for their guidance and constant supervision as well as for providing necessary information regarding the project & also for their support in completing the project. I would like to express my heartfelt thanks to Mr. Mahendra Bafna (VP RSBL), for giving an opportunity to work in this company. My thanks and appreciations also go to all the staff members of RSBL in developing the project and people who have willingly helped me out with their abilities.

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Contents
1. Company Profile 2. Introduction 3. Utility of Currency Derivative 4. Launch Of currency Derivative in India 5. Derivative Market 6. Exchanges Where Currency is traded 7. History of Currency Derivative 8. Need for the exchange traded currency futures 9. Derivative Market of Forex Currencies 10. Currency Forward Market 11. Foreign Exchange Quotation 12. Product Definitions of Currency Future on NSE Pg. 4 Pg. 5 Pg. 6 Pg. 8 Pg. 9 Pg. 11 Pg. 15 Pg. 16 Pg. 22 Pg. 25 Pg. 31 Pg. 34 Pg. 38 Pg. 43 Pg. 44

13. Regulatory Framework for Currency Future

14. Conclusion 15. Bibliography

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RiddiSiddhi Bullions Limited

RiddiSiddhi Bullions Limited (RSBL) is amongst the largest bullion dealers in India. Established in the year 1994 and started its operations in the financial year 1997-1998, it has achieved some very important feats in a short time. RSBL is one of the largest bullion dealers in India with turnover of over Rs. 17000 crores in financial year 2009-2010. RSBL offer one-of-its-kind online trading platform called RSBL SPOT, launched in March 2008 for spot delivery of Bullions. RSBL SPOT is fast & efficient for Bullion execution at industrys lowest margin requirements. Furthermore, they made a record delivery of more than 27 Tonnnes of gold, within one year of inception. RSBL SPOT Trading is the only trading platform available on mobile phone to trade Bullion Contracts on the go! Add to that, they have a presence in 10 major cities in India centers including Ahmedabad, Hyderabad, Chennai, Coimbatore, Banglore, Cochin, Indore, Pune, Vijaywada, and Kolkata with their head office located in Mumbai. At present there are 100 employees. RSBL are dedicated to guide and direct investors into the precious metal that best fits their investment goals, while offering the lowest prices available.

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INTRODUCTION OF CURRENCY DERIVATIVES

Each country has its own currency through which both national and international transactions are performed. All the international business transactions involve an exchange of one currency for another.

For example:

If any Indian firm borrows funds from international financial market in US dollars for short or long term then at maturity the same would be refunded in particular agreed currency along with accrued interest on borrowed money. It means that the borrowed foreign currency brought in the country will be converted into Indian currency, and when borrowed fund are paid to the lender then the home currency will be converted into foreign lenders currency.

Thus, the currency units of a country involve an exchange of one currency for another. The price of one currency in terms of other currency is known as exchange rate. The foreign exchange markets of a country provide the mechanism of exchanging different currencies with one and another, and thus, facilitating transfer of purchasing power from one country to another.

With the multiple growths of international trade and finance all over the world, trading in foreign currencies has grown tremendously over the past several decades. Since the exchange rates are continuously changing, so the firms are exposed to the risk of exchange rate movements. As a result the assets or liability or cash flows of a firm which are denominated in foreign currencies undergo a change in value over a period of time due to variation in exchange rates.

This variability in the value of assets or liabilities or cash flows is referred to exchange rate risk. Since the fixed exchange rate system has been fallen in the early 1970s, specifically in developed Currency Derivative: Business Perspective Page 5

countries, the currency risk has become substantial for many business firms. As a result, these firms are increasingly turning to various risk hedging products like foreign currency futures, foreign currency forwards, foreign currency options, foreign currency swaps.

UTILITY OF CURRENCY DERIVATIVES

Currency-based derivatives are used by exporters invoicing receivables in foreign currency, willing to protect their earnings from the foreign currency depreciation by locking the currency conversion rate at a high level. Their use by importers hedging foreign currency payables is effective when the payment currency is expected to appreciate and the importers would like to guarantee a lower conversion rate. Investors in foreign currency denominated securities would like to secure strong foreign earnings by obtaining the right to sell foreign currency at a high conversion rate, thus defending their revenue from the foreign currency depreciation. Multinational companies use currency derivatives being engaged in direct investment overseas. They want to guarantee the rate of purchasing foreign currency for various payments related to the installation of a foreign branch or subsidiary, or to a joint venture with a foreign partner. A high degree of volatility of exchange rates creates a fertile ground for foreign exchange speculators. Their objective is to guarantee a high selling rate of a foreign currency by obtaining a derivative contract while hoping to buy the currency at a low rate in the future. Alternatively, they may wish to obtain a foreign currency forward buying contract, expecting to sell the appreciating currency at a high future rate. In either case, they are exposed to the risk of currency fluctuations in the future betting on the pattern of the spot exchange rate adjustment consistent with their initial expectations.

The most commonly used instrument among the currency derivatives are currency forward contracts. These are large notional value selling or buying contracts obtained by exporters, importers, investors and speculators from banks with denomination normally exceeding 2million USD. The contracts guarantee the future conversion rate between two currencies and can be obtained for any customized amount and any date in the future. They normally do not require a security deposit since their purchasers are mostly large business firms and investment

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institutions, although the banks may require compensating deposit balances or lines of credit. Their transaction costs are set by spread between bank's buy and sell prices.

Exporters invoicing receivables in foreign currency are the most frequent users of these contracts. They are willing to protect themselves from the currency depreciation by locking in the future currency conversion rate at a high level. A similar foreign currency forward selling contract is obtained by investors in foreign currency denominated bonds (or other securities) who want to take advantage of higher foreign that domestic interest rates on government or corporate bonds and the foreign currency forward premium. They hedge against the foreign currency depreciation below the forward selling rate which would ruin their return from foreign financial investment. Investment in foreign securities induced by higher foreign interest rates and accompanied by the forward selling of the foreign currency income is called a covered interest arbitrage

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LAUNCH OF CURRENCY FUTURES CONTRACTS ON 29th AUGUST, 2008

Indias financial market has been increasingly integrating with rest of the world through increased trade and finance activity, as noted above, giving rise to a need to permit further hedging instruments, other that OTC products, to manage exchange risk like currency futures. With electronic trading and efficient risk management systems, exchange traded currency futures were expected to benefit the universe of participants including corporate and individual investors. The RBI Committee on Fuller Capital Account Convertibility recommended that currency futures may be introduced subject to risks being contained through proper trading mechanism, structure of contracts and regulatory environment.

Accordingly, Reserve Bank of India in the Annual Policy Statement for the Year 2007-08 proposed to set up a Working Group on Currency Futures to study the international experience and suggest a suitable framework to operationally the proposal, in line with the current legal and regulatory framework. This Group submitted its report in April 2008. Following this, RBI and Securities and Exchange Board of India (SEBI) jointly constituted a Standing Technical Committee to interalia evolve norms and oversee implementation of Exchange Traded Currency Derivatives.

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DERIVATIVES MARKET
This report laid down the framework for the launch of Exchange Traded Currency Futures in terms of the eligibility norms for existing and new Exchanges and their Clearing Corporations/Houses, eligibility criteria for members of such Exchanges/Clearing Corporations/Houses, product design, risk management measures, surveillance mechanism and other related issues.

The Regulatory framework for currency futures trading in the country, as laid down by the regulators, provide that persons resident in India are permitted to participate in the currency futures market in India subject to directions contained in the Currency Futures (Reserve Bank) Directions, 2008, which have come into force with effect from August 6, 2008. Standardized currency futures have the following features:

a. USD INR, EUR INR, JPY INR and GDP INR contracts are allowed to be traded. b. The size of each contract is - USD 1000, EUR 1000, GDP 1000 and JPY 1, 00,000. c. The contracts shall be quoted and settled in Indian Rupees. d. The maturity of the contracts shall not exceed 12 months. e. The settlement price shall be the Reserve Banks Reference Rate on the last trading day.

The membership of the currency futures market of a recognised stock exchange has been mandated to be separate from the membership of the equity derivative segment or the cash segment. Banks authorized by the Reserve Bank of India under section 10 of the Foreign Exchange Management Act, 1999 as AD Category - I bank are permitted to become trading and clearing members of the currency futures market of the recognized stock exchanges, on their own account and on behalf of their clients, subject to fulfilling certain minimum prudential requirements pertaining to net worth, non-performing assets etc. Currency Derivative: Business Perspective Page 9

NSE was the first exchange to have received an in-principle approval from SEBI for setting up currency derivative segment. The exchange launched its currency futures trading platform on 29th August 2008. While BSE commenced trading in currency futures on 1st October 2008, Multi-Commodity Exchange of India (MCX) started trading in this product on 7th October 2008

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NSE (NATIONAL STOCK EXCHANGE)

NSE was incorporated in 1992 and was given recognition as a stock exchange in April 1993. It started operations in June 1994, with trading on the Wholesale Debt Market Segment. Subsequently it launched the Capital Market Segment in November 1994 as a trading platform for equities and the Futures and Options Segment in June 2000 for various derivative instruments.

NSE has been able to take the stock market to the doorsteps of the investors. The technology has been harnessed to deliver the services to the investors across the country at the cheapest possible cost. It provides a nation-wide, screen-based, automated trading system, with a high degree of transparency and equal access to investors irrespective of geographical location. The high level of information dissemination through on-line system has helped in integrating retail investors on a nation-wide basis. The standards set by the exchange in terms of market practices, Products, technology and service standards have become industry benchmarks and are being replicated by other market participants. Within a very short span of time, NSE has been able to achieve all the objectives for which it was set up. It has been playing a leading role as a change agent in transforming the Indian Capital Markets to its present form. The Indian Capital Markets are a far cry from what they used to be a decade ago in terms of market practices, infrastructure, technology, risk management, learning and settlement and investor service.

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Multi Commodity Exchange is popularly known as MCX. It deals with round about 100 commodities. MCX is an independent commodity exchange in India. It was established in 2003 in Mumbai. MCX of India Limited is a new order exchange with a mandate for setting up a nationwide, online multi-commodity, Market place, offering unlimited opportunities to commodities market participants. As a true neutral market, MCX has taken many initiatives for users.

Features: The exchange's competitor is National Commodity & Derivatives Exchange Ltd. popularly known as NCDEX With a growing share of 72%, MCX continues to be India's No. 1 commodity exchange Globally, MCX ranks no. 1 in silver, no. 2 in natural gas, no. 3 in crude oil and gold in futures trading The average daily turnover of MCX is about US$ 2.2 billion) MCX now reaches out to about 500 cities in India with the help of about 10,000 trading terminals

Key Shareholders:

Financial Technologies (I) Ltd., State Bank of India and it's associates, National Bank for Agriculture and Rural Development (NABARD), National Stock Exchange of India Ltd. (NSE), Fid Fund (Mauritius) Ltd. - an affiliate of Fidelity International, Corporation Bank, Union Bank of India, Canara Bank, Bank of India, Bank of Baroda , HDFC Bank and SBI Life Insurance Co. Ltd., ICICI ventures, IL&FS, Meryll Lynch

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Bombay Stock Exchange is the oldest stock exchange in Asia What is now popularly known as the BSE was established as "The Native Share & Stock Brokers' Association" in 1875. Over the past 135 years, BSE has facilitated the growth of the Indian corporate sector by providing it with an efficient capital raising platform. Today, BSE is the world's number 1 exchange in the world in terms of the number of listed companies (over 4900). It is the world's 5th most active in terms of number of transactions handled through its electronic trading system. And it is in the top ten of global exchanges in terms of the market capitalization of its listed companies (as of December 31, 2009). The companies listed on BSE command a total market capitalization of USD Trillion 1.28 as of Feb, 2010. BSE is the first exchange in India and the second in the world to obtain an ISO 9001:2000 certifications. It is also the first Exchange in the country and second in the world to receive Information Security Management System Standard BS 7799-2-2002 certification for its BSE On-Line trading System (BOLT). Presently, we are ISO 27001:2005 certified, which is a ISO version of BS 7799 for Information Security. The BSE Index, SENSEX, is India's first and most popular Stock Market benchmark index. Exchange traded funds (ETF) on SENSEX, are listed on BSE and in Hong Kong. Futures and options on the index are also traded at BSE.

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United Stock Exchange, Indias newest stock exchange marks the beginning of a new chapter in the development of Indian financial markets. USE represents the commitment of ALL 21 Indian public sector banks, respected private banks and corporate houses to build an institution that is on its way to becoming an enduring symbol of Indias modern financial markets. Sophisticated financial products such as currency and interest rate derivatives are exciting introductions to Indian markets and hold immense opportunities for businesses and trading institutions alike. Consequently, USEs strong bank promoter base allows a build-up of a highly liquid marketplace for these products. It also provides the necessary expertise to reach out to Indian businesses and individuals, educate them on the benefits of these markets and facilitate easy access to them. USE also boasts of Bombay Stock Exchange, as a strategic partner. As Asias oldest stock exchange, BSE lends decades of unparalleled expertise in exchange technology, clearing & settlement, regulatory structure and governance. Leveraging the collective experience of its founding partners, USE has developed a trustworthy and state of the art exchange platform that provides a truly world class trading experience. In the years to come, USE aims to become Indias most preferred stock exchange, providing a range of sophisticated financial instruments for diverse market participants to trade on and manage their risks efficiently.

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HISTORY OF CURRENCY DERIVATIVES

Currency futures were first created at the Chicago mercantile exchange in 1972. The contracts were created under the guidance and leadership of Leo Melamed. CME chairman Emerilus. The FX contract capitalized on the U.S. abandonment the Bretton woods agreement, which had fired 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 future 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 endorsement of Nobel-prize-winning economist Milton Friedman.

Today, CME offer 41 individual FX futures and 31-option contract on 19 currencies, all of which trade electronically on the exchanges 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 manger commodity trading advisors (CTAs) proprietary trading firms; currency overlay managers and individual investors. They trade in order to transact business hedge against unfavorable changes in currency rates or to speculate on rate fluctuations.

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NEED FOR THE EXCHANGE TRADED CURRENCY FUTURES

With a view to enable entities to manage volatility in the currency market, RBI on April 2007 issued comprehensive guidelines on the usage of foreign currency forwards, swaps and option in the OTC market. At the same time, RBI also set up internal working group to explore the advantages of introducing currency futures. The report of the internal working group of RBI submitted in April 2008 recommended the introduction of exchange traded currency futures. Exchange traded futures as compared to OTC forwards serves the same economic purpose, yet differ in fundamental ways. An individual entering into a forward contract agreed to transact at a forward price on a future date. On the maturity date, the obligation of the individual equals the forward price at which the contract was executed. Except on the maturity date, no money changes hands. On the other hand, a daily basis, since the profit or losses in the futures market are collected/paid on a daily basis, the scope for building up of mark to market losses in the books of various participants gets limited.

The counter party risk in a futures contract is further eliminated by the presence of a clearing corporation, which by assuming counter party guarantee eliminates credit risk. Further, in an exchange-traded scenario where the market lot is fixed at a much lesser size than the OTC market, equitable opportunity is provided to all classes of investors whether large or small to participate in the futures market. The transaction on an exchange are executed on the price time priority ensuring that the best price is available to all categories of market participants irrespective of their size. Other advantages of an exchange-traded market would be greater transparency efficiency and accessibility.

Futures markets were designed to solve the product that exists in forward market. A futures contract is an agreement between two parties to buy or sell asset at a certain time in the future at certain price. But unlike forward contract the futures contract are standardized and exchange traded. To facilitate liquidity in the futures contract the exchange specifies certain standard features of the contract. A futures contract is standardized contract with standard underlying Currency Derivative: Business Perspective Page 16

instrument a standard quantity and quality of the underlying instrument that can be delivered, and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction.

The standardized items in a futures contract are: Quantity of the underlying Quality of the underlying The date and the month of delivery The unit of price quotation and minimum price change Location of settlement

The rationale for introducing currency futures in the Indian context has been outlined in the report of the internal working group on currency futures as follows. The rationale for establishing the currency futures market is manifold, both resident and nonresident purchase domestic currency assets. If the exchange rate remains unchanged from the time of purchase of the asset to its sale, no gain and losses are made out of currency exposures. But if domestic currency depreciates against the foreign currency the exposure would result in gain for resident purchasing foreign assets and loss for nonresident purchasing domestic assets. In this backdrop, unpredicted movement in exchange rate exposes investors to currency risks.

Currency futures enable them to hedge this risk. Nominal exchange rates are often random walks with or without drift, while real exchange rates over long run are mean reverting. As such it is possible that over a long run the incentive to hedge currency risk may not be large. However financial planning horizon is much smaller than the long run which is typically inter-generational in the context of exchange rates. As such there is a strong need to hedge currency risk and this need has grown manifold with fast growth in cross border trade and investment flows. The argument for hedging currency risks appear to be natural in the case of assets and applies equally to trade in goods and service, which result in come flow with leads and lags and get converted into different currencies at the market rates. Empirically, changes in exchanges rate are found to have very low correlation with foreign equity and bond return. This in theory should lower Currency Derivative: Business Perspective Page 17

portfolio risk. Therefore sometimes argument is advanced against the need for hedging currency risk, but there is strong empirical evidence to suggest that hedging reduces the volatility of returns and indeed considering the episodic nature of currency returns there strong arguments to use instrument to hedge currency risks

Market Design for Currency Derivatives Currency derivatives have been launched on the NSE in August 2008. The market design, including the risk management framework for this new product is summarized below:

Eligibility criteria The following entities are eligible to apply for membership subject to the regulatory norms and provisions of SEBI and As provided in the Rules, Regulations, Byelaws and Circulars of the Exchange a. Individuals; b. Partnership Firms registered under the Indian Partnership Act, 1932; c. Corporations, Companies or Institutions or subsidiaries of such Corporations, Companies or Institutions set up for providing financial services; d. Such other person as may be permitted under the Securities Contracts (Regulation) Rules 1957

Professional Clearing Member (PCM) The following persons are eligible to become PCMs of NSCCL for Currency Futures Derivatives provided they fulfill the prescribed criteria:

a. SEBI Registered Custodians; and b. Banks recognized by NSEIL/NSCCL for issuance of bank guarantees Banks authorized by the Reserve Bank of India under section 10 of the Foreign Exchange Management Act, 1999 as

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AD Category - I bank are permitted to become trading and clearing members of the currency futures market of the recognized stock exchanges, on their own account and on behalf of their clients, subject to fulfilling the following minimum prudential requirements:

a. Minimum net worth of Rs. 500 crores. b. Minimum CRAR of 10 per cent. c. Net NPA should not exceed 3 per cent. d. Made net profit for last 3 years.

The AD Category - I banks which fulfill the prudential requirements are required to lay down detailed guidelines with the approval of their Boards for trading and clearing of currency futures contracts and management of risks.

AD Category - I banks which do not meet the above minimum prudential requirements and AD Category - I banks which are Urban Co-operative banks or State Co-operative banks can participate in the currency futures market only as clients, subject to approval therefore from the respective regulatory Departments of the Reserve Bank.

Other applicable eligibility criteria

a. Where the applicant is a partnership firm/corporate entity, the applicant shall identify a Dominant Promoter Group as per the norms of the Exchange at the time of making the application. Any change in the shareholding of the company including that of the said Dominant Promoter Group or their shareholding interest shall be effected only with the prior permission of NSEIL/SEBI.

b. The applicant has to ensure that at any point of time they would ensure that at least individual/one partner/one designated director/compliance officer would have a valid NCFM certification as per the requirements of the Exchange. The above norm would be a continued admittance norm for membership of the Exchange.

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c. An applicant must be in a position to pay the membership and other fees, deposits etc, as applicable at the time of admission within three months of intimation to him of admission as a Trading Member or as per the time schedule specified by the Exchange.

d. The trading members and sales persons in the currency futures market must have passed a certification program me, which is considered adequate by SEBI. The approved users and sales personnel of the trading member should have passed the certification program me.

e. To begin with, FIIs and NRIs would not be permitted to participate in currency futures market. f. Strict enforcement of Know your customer rule is required. Therefore every client shall be registered with the member. The members are also required to make their clients aware of the risks involved in derivatives trading by issuing to the client the Risk Disclosure Document and obtain a copy of the same duly signed by the client. The members shall enter into a member constituent agreement as stipulated.

g. The Exchange may specify such standards for investor service and infrastructure with regard to any category of applicants, as it may deem necessary, from time to time.

Position limits

Client Level Position Limit: The client level position limit as prescribed in the Report of the RBI-SEBI Standing Technical Committee shall be applicable where the gross open position of the client across all contracts exceeds 6% of the total open interest or 5 million USD, whichever is higher. The client level gross open position would be computed on the basis of PAN across all members. Trading Member Level Position Limit: The trading member position limit shall be higher of 15% of the total open interest or 25 million USD. However, the position limit for a Trading Member, which is a bank, shall be higher of 15% of the total open interest or 100 million USD.

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Margins

Initial Margins: Initial margin shall be payable on all open positions of Clearing Members, up to client level, and shall be payable upfront by Clearing Members in accordance with the margin computation mechanism and/ or system as may be adopted by the Clearing Corporation from time to time. Initial Margin shall include SPAN margins, futures final settlement margin and such other additional margins, that may be specified by the Clearing Corporation from time to time.

Calendar Spread Margins: A currency futures position in one expiry month, which is hedged, by an offsetting position in a different expiry month would be treated as a calendar spread. The calendar-spread margin shall be Rs. 250/- per contract for all months of spread. The benefit for a calendar spread would continue till expiry of the near month contract.

Minimum Margins: The minimum margin percentage shall be 1.75% on the first day of currency futures trading and 1 % thereafter which shall be scaled up by look ahead period as may be specified by the Clearing Corporation from time to time.

Futures Final Settlement Margin: Futures Final Settlement Margin shall be levied at the clearing member level in respect of the final settlement amount due. The final settlement margins shall be levied from the last trading day of the contract till the completion of pay-in towards the Final Settlement.

Extreme Loss margins: Clearing members shall be subject to extreme loss margins in addition to initial margins. The applicable extreme loss margin shall be 1% on the mark to market value of the gross open positions or the relevant authority may specify as from time to time.

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DERIVATIVE MARKET OF FOREX CURRENCIES

The following Forex types will be reviewed in this part:

Currency futures Currency forwards Currency swaps Currency options Derivatives play an important and useful role in the economy, but they also pose several

dangers to the stability of financial markets and the overall economy. Derivatives are often employed for the useful purpose of hedging and risk management, and this role becomes more important as financial markets grow more volatile. Derivatives are also used to commit fraud and to manipulate markets. Derivatives are powerful tools that can be used to hedge the risks normally associated with production, commerce and finance. Derivatives facilitate risk management by allowing a person to reduce his exposure to certain kinds of risk by transferring those risks to another person that is more willing and able to bear such risks. Today, derivatives are traded in most parts of the world, and the size of these markets is enormous. Data for 2002 by the Bank of International Settlements puts the amount of outstanding derivatives in excess of $151 trillion and the trading volume on organized derivatives exchanges at $694 trillion. By comparison, the IMFs figure for worldwide output, or GDP, is $32.1 trillion. A derivative is a financial contract whose value is linked to the price of an underlying commodity, asset, rate, index or the occurrence or magnitude of an event. The term derivative refers to how the price of these contracts is derived from the price the underlying item. Typical examples of derivatives include futures, forwards, swaps and options, and these can be combined with traditional securities and loans in order to create structured securities which are also known as hybrid instruments. Currency Derivative: Business Perspective Page 22

Warren Buffet says: Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal. Reasons why Companies are moving away from it: 1) They face pretty high trading costs to a build a replicating portfolio 2) To replicate a call option one has to shuffle the replicating portfolio that involves repeated trades in which the prices of underlying asset changes. 3) Difficulty in identifying the correct replicating strategy Risks involved in Derivatives Credit Risks Market Risks Operational Risks Entrepreneurial Risks Systematic Risks Forward deals are a form of insurance against the risk that exchange rates will change between now and the delivery date of the contract. A forward is a simple kind of a derivative - a financial instrument whose price is based on another underlying asset. The price in a forward contract is known as the delivery price and allows the investor to lock in the current exchange rate and thus avoid subsequent Forex fluctuations. Futures contracts are like forwards, except that they are highly standardized. The futures contracts traded on most organized exchanges are so standardized that they are fungible meaning that they are substitutable one for another. This fungibility facilitates trading and results in greater trading volume and greater market liquidity.

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While futures and forward contracts are both a contract to trade on a future date, key differences include:

Futures are always traded on an exchange, whereas forwards always trade over-thecounter

Futures are highly standardized, whereas each forward is unique The price at which the contract is finally settled is different: Futures are settled at the settlement price fixed on the last trading date of the contract (i.e. at the end)

Forwards are settled at the forward price agreed on the trade date (i.e. at the start) The credit risk of futures is much lower than that of forwards: The profit or loss on a futures position is exchanged in cash every day. After this the credit exposure is again zero.

The profit or loss on a forward contract is only realized at the time of settlement, so the credit exposure can keep increasing

In case of physical delivery, the forward contract specifies to whom to make the delivery. The counter party on a futures contract is chosen randomly by the exchange.

In a forward there are no cash flows until delivery, whereas in futures there are margin requirements and periodic margin calls.

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CURRENCY FORWARD MARKET: Forward (Cash) Contract is a cash contract in which a seller agrees to deliver a specific cash commodity to a buyer sometime in the future. Forward contracts, in contrast to futures contracts, are privately negotiated and are not standardized. Many market participants want to exchange currencies at a time other than two days in advance but would like to know the rate of exchange now. Forward foreign exchange contracts are generally used by importers, exporters and investors who seek to lock in exchange rates for a future date in order to hedge their foreign currency cash flows. For example, if a company had contracted to purchase equipment for the price of GBP 1 million payable in 3 months time but was concerned that the GBP would rise against the Australian dollar in the interim, the company could agree today to buy the USD for delivery in 3 months time. In other words, the company could negotiate a rate at which it could buy GBP at some time in the future, setting the amount of GBP needed; the date needed etc. and hence be sure of the Australian Dollar purchasing price now. There are two components to the price in forward transaction and they are the spot price and the forward rate adjustment. The spot rate is simply the current market rate as determined by supply and demand. The forward rate adjustment is a slightly more complicated calculation that involves the applicable interest rates of the currencies involved. Forward Exchange Contracts, both Buying and Selling, may be either fixed or optional term contracts. Fixed Term Contracts With a Fixed Term Contract the customer specifies the date on which delivery of the overseas currency is to take place. An earlier delivery can be arranged but it may involve a marginal adjustment to the Forward Contract Rate.

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Optional Term Contracts Optional Term Contracts can be entered into for a specific period and the customer states the period within which delivery is to be made (normally for periods not more than one month) eg. a contract may be entered into for a six month period with the customer having the option of delivery at anytime during the last week. In each case there is a firm contract to affect delivery by both the Bank and the customer. An optional delivery contract does not give the customer an option to not deliver the Forward Exchange Contract. It is only the period during which delivery may occur that is optional. Forward rates are quoted for transactions where settlement is to take place more than two business days after the transaction date. Forward Contract rates consist of the Spot rate for the currency concerned adjusted by the relative Forward Margin. Forward Margins are a reflection of the interest rate differentials between currencies, and not necessarily a forecast of what the spot rate will be at the future date. The Forward rate may be expressed as being at parity (par), or at a Premium (dearer) or at a Discount (cheaper), when related to the spot rate. It follows therefore that premiums are deducted from the spot rate and discounts are added to the spot rate. Forward Rates incorporating a 'Premium' are more favorable to exporters and less favorable to importers than the relative spot rates on which they are based. Similarly, Forward rates incorporating a 'Discount' are more favorable to importers and less favorable to exporters that the relative spot rates on which they are based. The general rule in determining whether a currency will be quoted at a premium or a discount is as follows:

The currency with the higher interest rate will be at a discount on a forward basis against the currency with the lower interest rate.

The currency with the lower interest rate will be at a premium on a forward basis against the currency with the high interest rate.

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As the interest differential between the currencies widens then the premium or discount margin increases (i.e. moves farther from parity) and similarly as the interest differential narrows then the premium or discount margin decreases (ie moves towards parity).

Comparison between currency Futures and Currency Forward Markets:-

Features Size of contract Quotation

Currency Futures Standardized

Currency Forwards Negotiated/Tailor made

Generally U.S. Dollar/Currency unit

US $/ Currency Unit

Maturity

Standardized , generally shorter than one year

Negotiated

Location of trading Price Settlement

Futures exchanges

Linkages by telephone or fax

Fixed on the market Generally no settlement but compensation through reverse operations

Quotation of rates Generally delivery of currencies

Counterparties Generally do not know each other Negotiation Hours Guarantee Marking to market Guarantee Deposit Gains or losses on positions settled every day During market sessions

Generally in contact with each other Round the clock

No guarantee deposit No marking to market

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CURRENCY OPTION MARKET: Forex option is a contract that conveys the right, but not the obligation, to buy or sell a particular item at a certain price for a limited time. Only the seller of the option is obligated to perform. Simply stated, a buyer of a currency option acquires the right - but not the obligation - to buy (a call) or sell (a put) a specific amount of one currency for another at a predetermined price and date in the future. The cost of the option is called a premium and is paid by the buyer to the seller. The seller determines the price of the premium at which they are willing to grant the option, based on current rates, nominated delivery and expiry dates, the nominated strike rate and option style. It is entirely up to the buyer whether or not to exercise that right; only the seller of the option is obligated to perform. Call option Call Option - an option to BUY an underlying asset (stock or currency) at an agreed upon price (Strike Price or Exercise Price) on or before the expiration date. Since this option has economic value, you have to pay a price, called the Premium.

Like futures trading, option trading is a zero-sum game. The buyer of the option purchases it from the seller or the person who "writes" the call. Options are traded in units of 100 shares.

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Put option Put Option - gives the owner the right, but not the obligation to sell an underlying asset at a stated price on or before the expiration date. The option extends only until the expiration date. The rate at which one currency can be purchased or sold is one of the terms of the option and is called the exercise price or strike price. The total description of a currency option includes the underlying currencies, the contract size, the expiration date, the exercise price and another important detail: that is whether the option is an option to purchase the underlying currency - a call - or an option to sell the underlying currency - a put. A Currency Option is a bilateral contract between two counterparties, and therefore each party is responsible for assessing the credit standing and capacity of the other party, before entering into a transaction. There are two types of option expirations - American-style and European-style. American-style options can be exercised on any business day prior to the expiration date. European-style options can be exercised at expiration only. Currency options give the holder the right, but not the obligation, to buy or sell a fixed amount of foreign currency at a specified price. 'American' options are exercisable at any time prior to the expiration date, while 'European' options are exercisable only on the expiration date. Most currency options have 'American' exercise features. Call options give the holder the right to buy foreign currency, while put options give the holder the right to sell foreign currency. Call options make money when the exchange rate rises above the exercise price (allowing the holder to buy foreign currency at a lower rate), while put options make money when the exchange rate falls below the exercise price (allowing the holder to sell foreign currency at a higher rate). If the exchange rate doesn't reach a level at which the option makes money prior to expiration, it expires worthless unlike forwards and futures, the holder of an option does not have an obligation to buy or sell if it is not advantageous to do so.

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Options allow investors even greater flexibility. Although more expensive than futures contracts, options are valued because they allow investors to choose whether to exercise a futures contract or not. The option-holder is under no obligation to buy or sell the underlying asset. Call options give an investor the right, but not the obligation, to purchase the indicated asset at a specified (strike) price by a certain date. Foreign currency swaps can be defined as a financial foreign currency contract whereby the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate. It is worth mentioning in this regard that the buyer and seller exchange fixed or floating rate interest payments in their respective swapped currencies over the term of the contract. According to experts upon the maturity, the principal amount is effectively re-swapped at a predetermined exchange rate so that the parties end up with their original currencies. Foreign currency swaps are more often than not been used by commercials as a foreign currency-hedging vehicle rather than by retail Forex traders.

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FOREIGN EXCHANGE QUOTATIONS

Foreign exchange quotations can be confusing because currencies are quoted in terms of other currencies. It means exchange rate is relative price.

For example:

If one US dollar is worth of Rs. 45 in Indian rupees then it implies that 45 Indian rupees will buy one dollar of USA, or that one rupee is worth of 0.022 US dollar which is simply reciprocal of the former dollar exchange rate.

EXCHANGE RATE

Direct The number of units of domestic Currency stated against one unit Of foreign currency. Re/$ = 45.7250 (or) $1 = Rs. 45.7250

Indirect the number of unit of foreign Currency per unit of domestic Currency. Re 1 = $ 0.02187

There are two ways of quoting exchange rates: the direct and indirect. Most countries use the direct method. In global foreign exchange market, two rates are quoted by the dealer: one rate for buying (bid rate), and another for selling (ask or offered rate) for a currency. This is a unique feature of this market. It should be noted that where the bank sells dollars against rupees, one can say that rupees against dollar. In order to separate buying and selling rate, a small dash or oblique line is drawn after the dash.

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For example:

If

US

dollar is quoted in the market as Rs 46.3500/3550, it means that the Forex dealer is

ready to purchase the dollar at Rs 46.3500 and ready to sell at Rs 46.3550. The difference between the buying and selling rates is called spread. It is important to note that selling rate is always higher than the buying rate. Traders, usually large banks, deal in two way prices, both buying and selling, are called market makers.

Base Currency/ Terms Currency:

In foreign exchange markets, the base currency is the first currency in a currency pair. The second currency is called as the terms currency. Exchange rates are quoted in per unit of the base currency. That is the expression Dollar-Rupee, tells you that the Dollar is being quoted in terms of the Rupee. The Dollar is the base currency and the Rupee is the terms currency. Exchange rates are constantly changing, which means that the value of one currency in terms of the other is constantly in flux. Changes in rates are expressed as strengthening or weakening of one currency vis--vis the second currency. Changes are also expressed as appreciation or depreciation of one currency in terms of the second currency. Whenever the base currency buys more of the terms currency, the base currency has strengthened / appreciated and the terms currency has weakened / depreciated.

For example: If Dollar Rupee moved from 43.00 to 43.25. The Dollar has appreciated and the Rupee has depreciated. And if it moved from 43.0000 to 42.7525 the Dollar has depreciated and Rupee has appreciated.

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TRADING PROCESS AND SETTLEMENT PROCESS

Like other future trading, the future currencies are also traded at organized exchanges. The following diagram shows how operation take place on currency future market: It has been observed that in most futures markets, actual physical delivery of the underlying assets is very rare and hardly has it ranged from 1 percent to 5 percent. Most often buyers and sellers offset their original position prior to delivery date by taking an opposite positions. This is because most of futures contracts in different products are predominantly speculative instruments. For example, X purchases American Dollar futures and Y sells it. It leads to two contracts, first, X party and clearing house and second Y party and clearing house. Assume next day X sells same contract to Z, then X is out of the picture and the clearing house is seller to Z and buyer from Y, and hence, this process is goes on.

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PRODUCT DEFINITIONS OF CURRENCY FUTURE ON NSE

The contract specification in a tabular form is as under: Contract Specifications for Euro-INR Symbol Instrument Type Unit of trading Underlying Quotation/Price Quote Tick size Trading hours Contract trading cycle Settlement price Last trading day Final settlement day Base price Price operating range EURINR FUTCUR 1 (1 unit denotes 1000 EURO) EURO Rs. per EUR 0.25 paisa or INR 0.0025 Monday to Friday 9:00 a.m. to 5:00 p.m. 12 month trading cycle. RBI Reference Rate on the date of expiry Two working days prior to the last business day of the expiry month at 12 noon. Last working day (excluding Saturdays) of the expiry month. The last working day will be the same as that for Interbank Settlements in Mumbai. Theoretical price on the 1st day of the contract. On all other days, DSP of the contract Tenure up to 6 months +/-3 % of base price Clients Higher of 6% of total open interest or EUR 5 million Tenure greater than 6 months +/- 5% of base price Banks Higher of 15% of the total open interest or EUR 50 million

Position limits

Trading Members Higher of 15% of the total open interest or EUR 25 million

Minimum initial margin Extreme loss margin Calendar spreads Settlement

2.8% on First day & 2% thereafter 0.3% of MTM value of gross open positions. Rs.700/- for a spread of 1 month, 1000/- for a spread of 2 months, Rs.1500/- for a spread of 3 months or more Daily settlement : T + 1 Page 34

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Final settlement : T + 2 Mode of settlement Cash settled in Indian Rupees Daily settlement price (DSP) Final settlement price (FSP) DSP shall be calculated on the basis of the last half an hour weighted average price of such contract or such other price as may be decided by the relevant authority from time to time. RBI reference rate

Contract Specifications for Pound Sterling-INR

Symbol Instrument Type Unit of trading Underlying Quotation/Price Quote Tick size Trading hours Contract trading cycle Settlement price Last trading day Final settlement day Base price Price operating range Position limits

GBPINR FUTCUR 1 (1 unit denotes 1000 POUND STERLING) POUND STERLING Rs. per GBP 0.25 paise or INR 0.0025 Monday to Friday 9:00 a.m. to 5:00 p.m. 12 month trading cycle. Exchange rate published by the Reserve Bank in its Press Release captioned RBI Reference Rate for US$ and Euro. Two working days prior to the last business day of the expiry month at 12 noon. Last working day (excluding Saturdays) of the expiry month. The last working day will be the same as that for Interbank Settlements in Mumbai. Theoretical price on the 1st day of the contract. On all other days, DSP of the contract Tenure up to 6 months +/-3 % of base price Tenure greater than 6 months +/- 5% of base price

Clients Trading Members Banks Higher of 6% of total Higher of 15% of the Higher of 15% of the open interest or GBP total open interest or GBP total open interest or Page 35

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5 million Minimum initial margin Extreme loss margin Calendar spreads Settlement

25 million

GBP 50 million

3.2% on first day & 2% thereafter 0.5% of MTM value of gross open positions. Rs.1500/- for a spread of 1 month, 1800/- for a spread of 2 months, Rs.2000/- for a spread of 3 months or more Daily settlement : T + 1 Final settlement : T + 2 DSP shall be calculated on the basis of the last half an hour weighted average price of such contract or such other price as may be decided by the relevant authority from time to time. Exchange rate published by the Reserve Bank in its Press Release captioned RBI Reference Rate for US$ and Euro.

Mode of settlement Cash settled in Indian Rupees Daily settlement price (DSP) Final settlement price (FSP)

Contract Specifications for Japanese Yen-INR Symbol Instrument Type Unit of trading Underlying Quotation/Price Quote Tick size Trading hours Contract trading cycle Settlement price Last trading day Final settlement day Base price JPYINR FUTCUR 1 (1 unit denotes 100000 YEN) JPY Rs per 100 YEN 0.25 paise or INR 0.0025 Monday to Friday 9:00 a.m. to 5:00 p.m. 12 month trading cycle. Exchange rate published by the Reserve Bank in its Press Release captioned RBI Reference Rate for US$ and Euro. Two working days prior to the last business day of the expiry month at 12 noon. Last working day (excluding Saturdays) of the expiry month. The last working day will be the same as that for Interbank Settlements in Mumbai. Theoretical price on the 1st day of the contract. On all other days, DSP of the contract Page 36

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Price operating range

Tenure up to 6 months +/-3 % of base price Clients Higher of 6% of total open interest or JPY 200 million

Tenure greater than 6 months +/- 5% of base price Banks Higher of 15% of the total open interest or JPY 2000 million

Position limits

Trading Members Higher of 15% of the total open interest or JPY 1000 million

Minimum initial margin Extreme loss margin Calendar spreads Settlement

4.50% on first day & 2.30% thereafter 0.7% of MTM value of gross open positions. Rs. 600 for a spread of 1 month; Rs 1000 for a spread of 2 months and Rs 1500 for a spread of 3 months or more Daily settlement : T + 1 Final settlement : T + 2 DSP shall be calculated on the basis of the last half an hour weighted average price of such contract or such other price as may be decided by the relevant authority from time to time. Exchange rate published by the Reserve Bank in its Press Release captioned RBI Reference Rate for US$ and Euro.

Mode of settlement Cash settled in Indian Rupees Daily settlement price (DSP) Final settlement price (FSP)

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REGULATORY FRAMEWORK FOR CURRENCY FUTURES

With a view to enable entities to manage volatility in the currency market, RBI on April 20, 2007 issued comprehensive guidelines on the usage of foreign currency forwards, swaps and options in the OTC market. At the same time, RBI also set up an Internal Working Group to explore the advantages of introducing currency futures. The Report of the Internal Working Group of RBI submitted in April 2008, recommended the introduction of exchange traded currency futures. With the expected benefits of exchange traded currency futures, it was decided in a joint meeting of RBI and SEBI on February 28, 2008, that an RBI-SEBI Standing Technical Committee on Exchange Traded Currency and Interest Rate Derivatives would be constituted. To begin with, the Committee would evolve norms and oversee the implementation of Exchange traded currency futures. The Terms of Reference to the Committee was as under: 1. To coordinate the regulatory roles of RBI and SEBI in regard to trading of Currency and Interest Rate Futures on the Exchanges. 2. To suggest the eligibility norms for existing and new Exchanges for Currency and Interest Rate Futures trading. 3. To suggest eligibility criteria for the members of such exchanges. 4. To review product design, margin requirements and other risk mitigation measures on an ongoing basis. 5. To suggest surveillance mechanism and dissemination of market information.

To consider microstructure issues, in the overall interest of financial stability.

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Foreign Exchange Derivatives Market in India Status and Prospects

The gradual liberalization of Indian economy has resulted in substantial inflow of foreign capital into India. Simultaneously dismantling of trade barriers has also facilitated the integration of domestic economy with world economy. With the globalization of trade and relatively free movement of financial assets, risk management through derivatives products has become a necessity in India also, like in other developed and developing countries. As Indian businesses become more global in their approach, evolution of a broad based, active and liquid Forex derivatives markets is required to provide them with a spectrum of hedging products for effectively managing their foreign exchange exposures.

The global market for derivatives has grown substantially in the recent past. The Foreign Exchange and Derivatives Market Activity survey conducted by Bank for International Settlements (BIS) points to this increased activity. The total estimated notional amount of outstanding OTC contracts increasing to $111 trillion at end December 2001 from $94trillion at end June 2000. This growth in the derivatives segment is even more substantial when viewed in the light of declining activity in the spot foreign exchange markets. The turnover in traditional foreign exchange markets declined substantially between 1998 and2001. In April 2001, average daily turnover was $1,200 billion, compared to $1,490 billion in April 1998, a 14% decline when volumes are measured at constant exchange rates. Whereas the global daily turnover during the same period in foreign exchange and interest rate derivative contracts, including what are considered to be "traditional" foreign exchange derivative instruments, increased by an estimated 10% to $1.4 trillion.

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Evolution of the Forex derivatives market in India

This tremendous growth in global derivative markets can be attributed to a number of factors. They reallocate risk among financial market participants, help to make financial markets more complete, and provide valuable information to investors about economic fundamentals. Derivatives also provide an important function of efficient price discovery and make unbundling of risk easier.

In India, the economic liberalization in the early nineties provided the economic rationale for the introduction of FX derivatives. Business houses started actively approaching foreign markets not only with their products but also as a source of capital and direct investment opportunities. With limited convertibility on the trade account being introduced in 1993, the environment became even more conducive for the introduction of these hedge products.

Hence, the development in the Indian Forex derivatives market should be seen along with the steps taken to gradually reform the Indian financial markets. As these steps were large instrumental in the integration of the Indian financial markets with the global markets.

Rupee Forwards

An important segment of the Forex derivatives market in India is the Rupee forward contracts market. This has been growing rapidly with increasing participation from corporate, exporters, importers, banks and FIIs. Till February 1992, forward contracts were permitted only against trade related exposures and these contracts could not be cancelled except where the underlying transactions failed to materialize. In March 1992, in order to provide operational freedom to corporate entities, unrestricted booking and cancellation of forward contracts for all genuine exposures, whether trade related or not, were permitted.

Although due to the Asian crisis, freedom to rebook cancelled contracts was suspended, which has been since relaxed for the exporters but the restriction still remains for the importers. Currency Derivative: Business Perspective Page 40

The forward contracts are also allowed to be booked for foreign currencies (other than Dollar) and Rupee subject to similar conditions as mentioned above. The banks are also allowed to enter into forward contracts to manage their assets liability portfolio.

The cancellation and rebooking of the forward contracts is permitted only for genuine exposures out of trade/business up-to 1 year for both exporters and importers, whereas in case of exposures of more than 1 year, only the exporters are permitted to cancel and rebook the contracts. Also another restriction on booking the forward contracts is that the maturity of the hedge should not exceed the maturity of the underlying transaction.

RBI Regulations: These contracts were allowed with the following conditions:

These currency options can be used as a hedge for foreign currency loans provided that the option does not involve rupee and the face value does not exceed the outstanding amount of the loan, and the maturity of the contract does not exceed the unexpired maturity of the underlying loan.

Such contracts are allowed to be freely rebooked and cancelled. Any premia Payable on account of such transactions does not require RBI approval

Cost reduction strategies like range forwards can be used as long as there is no net inflow of premia to the customer.

Banks can also purchase call or put options to hedge their cross currency Proprietary trading positions. But banks are also required to fulfill the condition That no stand alone transactions are initiated.

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If a hedge becomes naked in part or full owing to shrinking of the portfolio, it may be allowed to continue till the original maturity and should be marked to market at regular intervals.

There is still restricted activity in this market but we may witness increasing activity in cross currency options as the corporate start understanding this product better.

In short, The Indian Forex derivatives market is still in a nascent stage of development but offers tremendous growth potential. The development of a vibrant Forex derivatives market in India would critically depend on the growth in the underlying spot/forward markets, growth in the rupee derivative markets along with the evolution of a supporting regulatory structure. Factors such as market liquidity, investor behavior, and regulatory structure and tax laws will have a heavy bearing on the behavior of market variables in this market.

Increasing convertibility on the capital account would accelerate the process of integration of Indian financial markets with international markets. Some of the necessary preconditions to this as suggested by the Tara pore committee report are already being met. Increasing convertibility does carry the risk of removing the insularity of the Indian markets to external shocks like the South East Asian crisis, but a proper management of the transition should speed up the growth of the financial markets and the economy. Introduction of derivative products tailored to specific corporate requirements would enable corporate to completely focus on its core businesses, de-risking the currency and interest rate risks while allowing it to gain despite any upheavals in the financial markets.

Increasing convertibility on the rupee and regulatory impetus for new products should see a host of innovative products and structures, tailored to business needs. The possibilities are many and include INR options, currency futures, exotic options, rupee forward rate agreements, both rupee and cross currency swap options, as well as structures composed of the above to address business needs as well as create real options.

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Conclusion
Majority of the people know what currency derivative market is, how transaction take place in it etc. Traders generally take decision on their own but who do not have knowledge about the currency market depend, mostly on broker. Traders trade in future and option higher compare to only future or only options market. It has been observed that traders trading in currency F&O market are using such markets for hedging purpose mainly. Traders who do not invest in currency F&O market are of the opinion that such markets are highly risky and uncertain. Political factor is the most affected factor to the market movement in the stock broking industry. Along with derivatives, majority of the traders would like to invest in cash market for long term investment purpose. Lack of fund is the main cause, which hold respondent back to invest in cash market and trade in currency derivative market. There are very less people whose purpose to trade in currency derivative market is arbitrage compare to speculation. Risk is the most considerable factor by the respondent while trading in currency derivative compare to the price, return, volatility and status of the countries.

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Bibliography
Books
1)Foreign Currency Management Author: - Gary Shoup 2)Currency Market Derivatives Author: - GRK Murty

Website
www.goforex.net www.rbi.org.in www.sebi.com www.nseindia.com www.bseindia.org

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