Professional Documents
Culture Documents
ON
CURRENCY DERIVATIVES
PREPARED BY
KRUTARTH MANKAD
SUBMITTED TO
PROF.M. SHOWRY
IBS HYDERABAD
Introduction:
Globalization and amalgamation of financial markets along with continuous boost of cross
border flow of capital have transformed the dynamics of Indian financial markets. This has
increased the need for dynamic currency risk management. In today’s globalised and integrated
business environment, many entities irrespective of its business are impacted by currency risk
either directly or indirectly. The stable rise in India’s foreign trade along with liberalization in
foreign exchange regime has led to large inflow of foreign currency into the system. This has
been in the form of FDI and FIIs investments.
Currency Derivatives are primarily of 2 types: Currency Futures and Currency Options.
Currency Futures:
Currency Future is “A transferable futures contract that specifies the price at which a specified
currency can be bought or sold at a future date." We can explain currency futures as, "Currency
future contracts allow investors to hedge against foreign exchange risk. Since these contracts are
marked-to-market daily, investors can--by closing out their position--exit from their obligation to
buy or sell the currency prior to the contract's delivery date."
Characteristic of Futures:
For providing a liquid, crystal - clear and pulsating market for foreign exchange rate risk
management, Securities & Exchange Board of India (SEBI) and Reserve Bank of India (RBI)
have permitted trading in currency futures in India based on the USD-INR exchange rate. This
gave Indian corporate another tool for hedging their exchange risk effectively. The primary
purpose of exchange traded currency future derivatives is to provide a mechanism for price risk
management and consequently provide price curve of expected future prices to enable the
industry to protect its foreign currency exposure. In spite of it being in the nascent stage,
currency future is a better option for investment than other futures and options.
- Chicago Mercantile Exchange (CME) was the first exchange that came out with currency
futures in 1972
- The CME established the International Monetary Market and launched trading in 7
currency futures
- Today IMM is a division of CME
- Currency Futures was started trading in Mumbai from August 29, 2008
- On the first day itself there were nearly 70000 contracts being traded
- The first trader on NSE was made by East India Securities Ltd.
- Banks contributed around 40% of total gross volume of the contract with HDFC bank
being the first to carry out a trade
- The largest trade was made by Standard Chartered Bank constituting 15000 contracts
Terminologies Used:
- Spot Price – the price at which an asset trades in a spot market. This is the transaction
where securities and foreign exchange get traded for immediate delivery. In case of USD
INR the spot value is T+2
- Future Price – the price at which future contract is traded in future market
- Contract cycle – it is a period over which a contract trades. The currency future contracts
in Indian market have one month, two months, and three month up to twelve month
expiry cycles. Both NSE and BS E will have 12 contracts outstanding at any given point
in time
- Final Settlement date (Value date) – the last business day of the month is called final
settlement date of each contract.
- Expiry date – it is the date specified in futures contract. This is the last day on which
contract will be traded, at the end of which it will cease to exist. The last trading day will
be 2 days prior to the final settlement date.
- Contract size – the amount of asset that has to be delivered under one contract. As
mentioned before, in case of USDINR it is USD 1000.
- Basis – in the context of financial futures, basis can be defined as the futures price minus
the spot price. There will be a different basis for each delivery month for each contract. In
normal markets, basis will be positive. This reflects that future prices normally exceed
spot prices
- Cost of Carry - the relationship between futures price and spot price can be summarized
in terms of what is known as cost of carry. This measures the storage cost plus the
interest that is paid to finance or ‘carry’ the asset till delivery less the income earned on
the asset.
- Initial Margin – when the position is opened, the member has to deposit the margin with
the clearing house as per the rate fixed by the exchange which may vary asset to asset.
- Mark to Market - At the end of trading session, all the outstanding contracts are re-priced
at the settlement price of that session. It means all futures contracts are daily settled, and
profit and loss is determined on each transaction. This procedure, called mark to market
requires that funds charge everyday. The funds are added or subtracted form mandatory
margin that traders are required to maintain the balance in their account. Due to this
adjustment, futures contract is also called as daily reconnected forwards.
- Maintenance Margin- usually 75% of the initial margin is called maintenance margin.
This is set to ensure that balance in the margin account never becomes negative. If the
balance in the margin account falls below the maintenance margin, the investor receives a
margin call and is expected to top up the margin account to the initial margin level before
trading commences on the next day.
- Ease of Accessibility - Small investors get an easy access to currency futures trading on
the popular exchanges like NSE and BSE. It is as easy as trading in a blue chip stock on
any of the exchanges
- Easy Affordability - Margins are very low and the contract size is very small. As per the
specification of NSE, for USD-INR currency future contract the lot size is $1000. Margin
is 1.75%. Thus it was never so easy and affordable for any retail investor to take a call on
Indian Rupee by taking position in currency futures
- Transparency – One can verify the trade details on NSE if he/she has a doubt that the
broker has cheated him
- Low Transaction Costs - When one trade in INT currency futures on NSE in India, one
has to pay a small amount of brokerage fees and statutory duties and taxes. In overseas
Forex trading one has to pay commission to the banks or foreign exchange agents in the
form of spread. Spread is the difference in the buy/sell price over the reference rate,
which can be very high
- Efficient Price Discovery – It has been established that currency future is a better and
efficient mechanism for price discovery. This is primarily due to the fact that it is traded
on automated electronic trading system where the orders are executed on the basis of
price-time priority
- Counter Party Default Risks – Since all the trades are done on recognized exchanges,
they are guaranteed by clearing corporation and hence eliminate the risk associated with
counter party default. NSCCL (National Securities Clearing Corporation Limited) carries
out all the novation, clearing and settlement process of currency futures trading
- Standardized Contracts – They have a lot size of $1000 and maturity of 12 monthly
contracts. Hence it is immensely beneficial for the Retail investors who have limited
resources but can still invest and take position in futures contract
- Hedgers – An investor who takes step to reduce the risk of an investment by making an
offsetting investment is called a hedger. Hedgers in the futures market try to offset
potential price changes in the spot market by buying or selling a futures contract. Their
main aim is to minimize the risk doing so might reduce their profit as well. Banks,
importers, exporters and corporate who want to reduce their risk can hedge in currency
futures at a relatively low entry and exit cost.
- Traders – In finance, a trader is someone who buys and sells financials instruments like
stocks, commodities, bonds, derivatives, etc. Traders who are interested in taking short
term positions with a view on appreciation or deprec iation of the US Dollar against the
Indian Rupee can participate in currency futures trading. They provide liquidity to the
market thereby enabling hedgers to efficiently transfer risk
- Arbitrageurs – These are the types of investors who attempts to profit from price
inefficiencies in the market by making simultaneous trades that offset each other and
capturing risk- free profits. Market participants often get opportunities to exploit the price
differential of USD/INR between different markets (e.g. OTC forward market and futures
market). Arbitrage process removes any inefficient price differential across markets
- Speculators – Bearish – Sell Futures. Futures can be used by a speculator who believes
that an underlying is over-valued and is likely to see a fall in price. E.g. take the case of a
trader who expects to see a fall in the price of USD-INR. He sells one two- month
contract of futures on USD say at Rs. 42.20 (each contact for USD 1000). He pays a
small margin on the same. Two months later, when the futures contract expires, USD-
INR rate let us say is Rs.42. On the day of expiration, the spot and the futures price
converges. He has made a clean profit of 20 paisa per dollar. For the one contract that he
sold, this works out to be Rs.2000
- Speculators – Bullish – Buy futures. If the INR- USD is Rs.42 and the three month
futures trade at Rs.42.40. The minimum contract size is USD 1000. Therefore the
speculator may buy 10 contracts. The exposure shall be the same as above USD 10000.
Presumably, the margin may be around Rs.21, 000. Three months later if the Rupee
depreciates to Rs. 42.50 against USD, (on the day of expiration of the contract), the
futures price shall converge to the spot price (Rs. 42.50) and he makes a profit of Rs.1000
on an investment of Rs.21, 000. This works out to an annual return of 19 percent. Due to
the leverage they provide, futures form an attractive option for speculators.
Position Limits:
- Trading Member level – Gross positions across all contracts cannot exceed 15% of the
total open interest or USD 25 million whichever is higher. For banks the figure is USD
100 million instead of 25 million.
- Client level – gross open positions across all contracts cannot exceed 6% of the total open
interest or USD 5 million whichever is higher
- Clearing Member level – no separate position limit is prescribed at this level
Clearing House:
Mode of Settlement:
- Daily Settlement – T + 1 day. It is calculated on the basis of last half an hour weighted
average price. Here Mark to Market profit and loss is payable/receivable by the traders.
- Final Settlement – T + 2 days. Contracts can be settled in cash on the final settlement date
as per the reference rate of SBI. Final settlement day would be the last working day of the
month (except Saturday and holiday)
Trading Process and Settlement Process
It has been observed that in most futures markets, actua l physical delivery of the underlying
assets is very rare and it ranges from 1 percent to 5 percent. Most often buyers and sellers offset
their original position prior to delivery date by taking an opposite positions. This is because most
of futures contracts in different products are predominantly speculative instruments. For
example, X purchases American Dollar futures and Y sells it. It leads to two contracts, first, X
party and clearing house and second Y party and clearing house. Assume next day X sells same
contract to Z, then X is out of the picture and the clearing house is seller to Z and buyer from Y,
and hence, this process is goes on.
Trading Process:
- The currency trading system of NSE is called NEAT - CDS (National Exchange for
Automated Trading – Currency Derivative Segment)
- It provides a fully automated screen-based trading for currency futures on a nationwide
basis as well as an online monitoring and surveillance mechanism
- It supports an order driven market and provides complete transparency o f trading
operations
- The online trading system is similar to that of trading of equity derivatives in the Futures
& Options (F&O) segment of NSE.
Entities in the Trading System:
- Trading Members (TM) - Trading members are members of NSE. They can trade either
on their own account or on behalf of their clients including participants. The exchange
assigns a trading member ID to each trading member. Each trading member can have
more than one user. The number of users allowed for each trading member is notified by
the exchange from time to time. Each user of a trading member must be registered with
the exchange and is assigned an unique user ID. The unique trading member ID functions
as a reference for all orders/trades of different users. This ID is common for all users of a
particular trading member. It is the responsibility of the trading member to maintain
adequate control over persons having access to the firm’s User IDs.
- Clearing members (CM) - Clearing members are members of NSCCL. They carry out
risk management activities and confirmation/inquiry of participant trades through the
trading system.
- Professional clearing members (PCM) - A professional clearing members is a clearing
member who is not a trading member. Typically, banks and custodians become
professional clearing members and clear and settle for their trading members and
participants.
- Participants: A participant is a client of trading members like financial institutions.
These clients may trade through multiple trading members but settle through a single
clearing member.
Settlement Process:
Settlement Mechanis m
All futures contracts are cash settled, i.e. through exchange of cash in Indian Rupees. The
settlement amount for a CM is netted across all their TMs/clients, with respect to their
obligations on MTM settlement.
Currency futures contracts have two types of settlements, the MTM settlement which happens on
a continuous basis at the end of each day, and the final settlement which happens on the last
trading day of the futures contract.
Regulatory Frame work for 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:
- To coordinate the regulatory roles of RBI and SEBI in regard to trading of Currency and
Interest Rate Futures on the Exchanges.
- To suggest the eligibility norms for existing and new Exchanges for Currency and
Interest Rate Futures trading.
- To suggest eligibility criteria for the members of such exchanges.
- To review product design, margin requirements and other risk mitigation measures on an
ongoing basis.
- To suggest surveillance mechanism and dissemination of market information.
- To consider microstructure issues, in the overall interest of financial stability.
- At the time of the trade, one doesn’t actually getting anything or owning anything, since
it is based on a future price. Whereas in spot trading, we are actually purchasing the
currency right at the same time.
- One cannot trade 24 hours a day like one can doing spot trading for the currency. Since
the future trading takes place at various exchanges, it can only be done during the regular
trading hours. In India, currency market is open from 9.00 AM to 17.00 PM.
- We have to pay commission on futures trading. Since we are getting the benefit of
choosing the buy and sell price, we end up having to pay the extra commission.
Currency Options:
In finance, an option is a derivative financial instrument that establishes a contract between two
parties concerning the buying and selling of an asset at a reference price.
- The underlying for the currency option shall be US Dollar – Indian Rupee (USD – INR)
spot rate
- The options shall be premium styled European call and put options
- The size of each contract shall be USD 1000.
- The premium shall be quoted in rupee terms
- The outstanding position shall be in USD
- Maturity of the contracts shall not exceed 12 months
- Contracts shall be settled in cash in Indian Rupees
- The settlement price shall be the Reserve Bank’s Reference Rate on the date of expiry of
contracts
- The investor seem to have great amount of gains and very less risks
- Leverage – here the investor can gain leverage without committing to a trade
- Limited Risk – it is limited to the option premium
- One can use it to speculate or to hedge open positions.
- It is the only option trade that operates for 24 hours
- A trader dealing with currency options will know how unpredictable the market of the
foreign exchange is. He is aware that you can win or lose within the blink of an eyelid.
However, currency options have better predictive potential because the movements are
more constant due to their being in a stable and fixed time framework.
- Potential losses too, can be foreseen beforehand. You always have a second chance when
it comes to trading currency options - the chance to change your position before the
trading actually commences. However, it also means that you will not win every single
time just like any other trade - but you still have some knowledge of what will happen
before it actually does.
- Even with currency options trading and its degree of predictability, you are not exempt
from the constant tracking of market conditions. Since currencies change value from high
to low very randomly, a great deal of foresight is required from the trader in order to
attribute a particular value to your chosen currency.
Disadvantages of Currency Options:
Correlations:
Between exchange rate and inflation rate for the year 2009 and 2010
CURRENCY INFLATION
YEAR RATE X RATE Y XY X2 Y2
r= n∑xy-∑x∑y = 0.623
√[n∑x2-(∑x)2][n∑y2-(∑y)2]
Inte rpretation: The coefficient correlation (r = 0.623) shows that there is a positive correlation.
Though there is no strong correlation between two. Positive values indicate a relationship
between x and y variables such that as rate of inflation increases, values of USD/INR exchange
rate also increases.
Correlation between exchange rate and crude oil prices for the year 2009 and 2010
CURRENCY CRUDE OIL
RATE X PRICES Y XY X2 Y2
MAR-
2009 51.2 39.88 2041.856 2621.44 1590.414
MAY-
2009 48.55 51.02 2477.021 2357.103 2603.04
AUG-
2009 48.33 62.8 3035.124 2335.789 3943.84
NOV-
2009 46.56 69.43 3232.661 2167.834 4820.525
MAR-
2010 45.49 72.9 3316.221 2069.34 5314.41
MAY-
2010 45.87 66.25 3038.888 2104.057 4389.063
AUG-
2010 46.57 68.34 3182.594 2168.765 4670.356
NOV-
2010 44.99 76 3419.24 2024.1 5776
r= n∑xy-∑x∑y = -0.87
√[n∑x2-(∑x)2][n∑y2-(∑y)2]
Inte rpretation: The coefficient correlation (r = -0.87) shows that there is a negative correlation.
Though there is no strong correlation between two. Negative values indicate a relationship
between USD/INR EXHANGE Rate and Crude Oil Prices such that as Crude Oil Price
decreases, values for USD/INR EXHANGE Rate increases & vice- versa.
Correlation between exchange rates and nifty index for the year 2009 and 2010
CURRENCY
YEAR RATE X NIFTY NDEX Y XY X2 Y2
MAR-
2009 51.2 3020 154624 2621.44 9120400
MAY-
2009 48.55 4448 215950.4 2357.103 19784704
AUG-
2009 48.33 4662 225314.5 2335.789 21734244
NOV-
2009 46.56 5032 234289.9 2167.834 25321024
MAR-
2010 45.49 5249 238777 2069.34 27552001
MAY-
2010 45.87 5086 233294.8 2104.057 25867396
AUG-
2010 46.57 5402 251571.1 2168.765 29181604
NOV-
2010 44.99 5862 263731.4 2024.1 34363044
r= n∑xy-∑x∑y = -0.82
√ [n∑x2-(∑x) 2] [n∑y2-(∑y) 2]
Inte rpretation: The coefficient correlation (r = -0.82) shows that there is a negative correlation.
As x and y have a strong negative linear correlation, r is close to -1. .Negative values indicate a
relationship between USD/INR EXHANGE Rate and Nifty such that as values for x increase,
values for y decrease. One of the reasons for Nifty Index to go up is investment made by
Foreign Institutional Investors (FIIs).Thus FIIs have to sell Dollar to buy Indian rupee.
Correlation between exchange rates and GDP from the year 1999 to 2009
CURRENCY
YEAR RATE X GDP Y XY X2 Y2
r= n∑xy-∑x∑y = -0.02
√ [n∑x2-(∑x) 2] [n∑y2-(∑y) 2]
Inte rpretation:
The coefficient correlation (r = -0.02) shows that there is a negative correlation. Though
there is no strong correlation between two .Negative values indicate a relationship between
USD/INR EXHANGE Rate and GDP Growth Rate such that as values for USD/INR
EXHANGE Rate increases, GDP rate shows declining trend.
The gross domestic product (GDP) is a measure of a country's overall economic output.
It is the market value of all final goods and services made within the borders of a country
in a year.
Higher GDP means increasing export & decreasing import which results in positive trade
balance. Lower demand for foreign currency
Correlation between exchange rates and gold prices for the year 2009 and 2010
CURRENCY
YEAR RATE X GOLD PRICE Y XY X2 Y2
r= n∑xy-∑x∑y = -0.74
√ [n∑x2-(∑x) 2] [n∑y2-(∑y) 2]
Inte rpretation:
The coefficient correlation (r = -0.74) shows that there is a negative correlation. Though there is
no strong correlation between two. Negative values indicate a relationship between USD/INR
EXHANGE Rate and gold Prices such that as gold Price decreases, values for USD/INR
EXHANGE Rate increases & vice- versa.
Findings from above Correlations:
CONCLUSION
By far the most significant event in finance during the past decade has been the
extraordinary development and expansion of financial derivatives. These instruments enhances
the ability to differentiate risk and allocate it to those investors most able and willing to take it-
a process that has undoubtedly improved national productivity growth and standards of livings
The currency future as well as option gives the safe and standardized contract to its investors
and individuals who are aware about the forex market or predict the movement of exchange rate
so they will get the right platform for the trading in currency future and option. Because of
exchange traded future / options contract and its standardized nature, counter party risk
minimized.
Initially only NSE had the permission but now MCX has also started currency future and option.
It shows how currency future / option covers ground in the comparison with other available
derivatives instruments. Not only big businessmen and exporter and importers use these but
individuals who are interested and having knowledge about forex market they can also invest in
currency future as well as option.
Exchange between USD-INR markets in India is very big and these exchange traded contract
will give more awareness in market and attract the investors.
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