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By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivativesThese instruments enhances the ability to differentiate risk and allocate it to those investors most able and willing to take it- a process that has undoubtedly improved national productivity growth and standards of livings. Alan Greenspan, Former Chairman. US Federal Reserve Bank
The financial environment today has more risks than earlier. Successful business firms are those that are able to manage these risks effectively. Due to changes in the macroeconomic structures and increasing internationalization of businesses, there has been a dramatic increase in the volatility of economic variables such as interest rates, exchange rates, commodity prices etc. Firms that monitor their risks carefully and manage their risks with judicious policies enjoy a more stable business than those who are unable to identify and manage their risks. There are many risks which are influenced by factors external to the business and therefore suitable mechanisms to manage and reduce such risks need to be adopted. One of the modern day solutions to manage financial risks is hedging which can be done through derivatives.
In finance, a derivative is a financial instrument whose value depends on other, more basic, underlying variables. Such a variable is called an "underlying" and can be a traded asset, for example, a stock or commodity, but can also be something which is impossible to trade, such as the temperature (in the case of weather derivatives), unemployment rate, or any kind of (economical) index. A derivative is essentially a contract whose payoff depends on the behavior of some benchmark. The most common derivatives are futures, options, and swaps.
Derivatives are financial contracts whose value/price is independent on the behavior of the price of one or more basic underlying assets. These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future. These assets can be a share,
index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil, soybeans, cotton, coffee and what you have. A very simple example of derivatives is curd, which is derivative of milk. The price of curd depends upon the price of milk which in turn depends upon the demand and supply of milk.
The Underlying Securities for Derivatives are : y y y y y y y Commodities: Castor seed, Grain, Pepper, Potatoes, etc. Precious Metal : Gold, Silver Short Term Debt Securities : Treasury Bills Interest Rates Common shares/stock Stock Index Value : NSE Nifty Currency : Exchange Rate
CURRENCY DERIVATIVES
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 countries, the currency risk has become substantial for many business firms. As a result, these firms are increasingly turning to various risk hedging products like foreign currency futures, foreign currency forwards, foreign currency options, and foreign currency swaps.
The report laid down the framework for the launch of Exchange Traded Currency Future 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 Currency Future in India was first time traded at NSE on August 29, 2008. Thereafter BSE and MCX were subsequently allowed to deal in currency future from October 1, 2008 and October 31, 2008.
EXCHANGE RATE Foreign exchange rate is the value of a foreign currency relative to domestic currency. T he exchange of currencies is done in the foreign exchange market, which is one of the biggest financial markets. The participants of the market are banks, corporations, exporters, importers etc. A foreign
exchange contract typically states the currency pair, the amount of the contract, the agreed rate of exchange etc.
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. 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. A foreign exchange deal is always done in currency pairs, for example, US Dollar Indian Rupee contract (USD INR); British Pound INR (GBP - INR), Japanese Yen U.S. Dollar (JPYUSD), U.S. Dollar Swiss Franc (USD-CHF) etc. Some of the liquid currencies in the world are USD, JPY, EURO, GBP, and CHF and some of the liquid currency contracts are on USD-JPY, USDEURO, EURO-JPY, USD-GBP, and USD-CHF. The prevailing exchange rates are usually depicted in a currency table like the one given below:
Base Currency/ Terms Currency: In foreign exchange markets, the base currency is the first currency in a currency pair. The second currency is referred to as the counter/terms/quote currency. The exchange rate tells the worth of the base currency in terms of the terms currency, i.e. for a buyer, how much of the terms currency must be paid to obtain one unit of the base 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, a USD-INR rate of Rs. 48.0530 implies that Rs. 48.0530 must be paid to obtain one US Dollar. Foreign exchange prices are highly volatile and fluctuate on a real time basis. In foreign exchange contracts, the price fluctuation is expressed as appreciation/depreciation or the strengthening/weakening of a currency relative to the other. A change of USD-INR rate from Rs. 48 to Rs. 48.50 implies that USD has strengthened/ appreciated and the INR has weakened/depreciated, since a buyer of USD will now have to pay more INR to buy 1 USD than before. Fixed Exchange Rate Regime and Floating Exchange Rate Regime There are mainly two methods employed by governments to determine the value of domestic currency vis--vis other currencies : fixed and floating exchange rate.
Fixed exchange rate regime: Fixed exchange rate, also known as a pegged exchange rate, is when a currency's value is maintained at a fixed ratio to the value of another currency or to a basket of currencies or to any other measure of value e.g. gold. In order to maintain a fixed exchange rate, a government participates in the open currency market. When the value of currency rises beyond the permissible limits, the government sells the currency in the open market, thereby increasing its supply and reducing value. Similarly, when the currency value falls beyond certain limit, the government buys it from the open market, resulting in an increase in its demand and value. Another method of maintaining a fixed exchange rate is by making it illegal to trade currency at any other rate. However, this is difficult to enforce and often leads to a black market in foreign currency. Floating exchange rate regime: Unlike the fixed rate, a floating exchange rate is determined by a market mechanism through supply and demand for the currency. A floating rate is often termed "self-correcting", as any fluctuation in the value caused by differences in supply and demand will automatically be corrected by the market. For example, if demand for a currency is low, its value will decrease, thus making imported goods more expensive and exports relatively cheaper. The countries buying these export goods will demand the domestic currency in order to make payments, and the demand for domestic currency will increase. This will again lead to appreciation in the value of the currency. Therefore, floating exchange rate is self correcting, requiring no government intervention. However, usually in cases of extreme appreciation or depreciation of the currency, the countrys Central Bank intervenes to stabilize the currency. Thus, the exchange rate regimes of floating currencies are more technically called a managed float.
Factors Affecting Exchange Rates There are various factors affecting the exchange rate of a currency. They can be classified as fundamental factors, technical factors, political factors and speculative factors. A countrys currency exchange rate is typically affected by the supply and demand for the countrys currency in the international foreign exchange market. The demand and supply dynamics is principally influenced by factors like interest rates, inflation, and trade balance and economic & political scenarios in the country. The level of confidence in the economy of a particular country also influences the currency of that country
Fundamental factors: The fundamental factors are basic economic policies followed by the government in relation to inflation, balance of payment position, unemployment, capacity utilization, trends in import and export, etc. Normally, other things remaining constant the currencies of the countries that follow sound economic policies will always be stronger. Similarly, countries having balance of payment surplus will enjoy a favorable exchange rate. Conversely, for countries facing balance of payment deficit, the exchange rate will be adverse.
Technical factors: y Interest rates: Rising interest rates in a country may lead to inflow of hot money in the
country, thereby raising demand for the domestic currency. This in turn causes appreciation in the value of the domestic currency. y Inflation rate: High inflation rate in a country reduces the relative competitiveness of the
export sector of that country. Lower exports result in a reduction in demand of the domestic currency and therefore the currency depreciates. Exchange rate policy and Central Bank interventions: Exchange rate policy of the country is the most important factor influencing determination of exchange rates. For example, a country may decide to follow a fixed or flexible exchange rate regime, and based on this, exchange rate movements may be less/more frequent. Further, governments sometimes participate in foreign exchange market through its Central bank in order to control the demand or supply of domestic currency.
Political factors: Political stability also influences the exchange rates. Exchange rates are susceptible to political instability and can be very volatile during times of political crises.
Speculation: Speculative activities by traders worldwide also affect exchange rate movements. For example, if speculators think that the currency of a country is over valued and will devalue in near future, they
will pull out their money from that country resulting in reduced demand for that currency and depreciating its value.
The Rupee depreciated against the Dollar, with the close price of USDINR for May 2011 moving from `44.5450 to `45.2425 during the period, experiencing an intraday high of `45.4875 and a low of `44.4750.
The Rupee appreciated against the EURO, with the close price of EURINR for May 2011 moving from `66.0825 to `65.0725 during the period, experiencing an intraday high of `66.7075 and a low of `63.3625.
QUOTES In currency markets, the rates are generally quoted in terms of USD. The price of a currency in terms of another currency is called quote. A quote where USD is the base currency is referred to as a direct quote (e.g. 1 USD INR 48.5000) while a quote where USD is referred to as the terms currency is an indirect quote (e.g. 1 INR = 0.021 USD).
USD is the most widely traded currency and is often used as the vehicle currency. Use of vehicle currency helps the market in reduction in number of quotes at any point of time, since exchange rate
between any two currencies can be determined through the USD quote for those currencies. This is possible since a quote for any currency against the USD is readily available. Any quote not against the USD is referred to as cross since the rate is calculated via the USD.
For example, the cross quote for EUR-GBP can be arrived through EUR-USD quote * USD-GBP quote (i.e. 1.406 * 0.606 = 0.852). Therefore, availability of USD quote for all currencies can help in determining the exchange rate for any pair of currency by using the cross-rate.
TICK-SIZE Tick size refers to the minimum price differential at which traders can enter bids and offers. For example, the Currency Futures contracts traded at the NSE have a tick size of Rs. 0.0025. So, if the prevailing futures price is Rs. 48.5000, the minimum permissible price movement can cause the new price to be either Rs. 48.4975 or Rs. 48.5025. Tick value refers to the amount of money that is made or lost in a contract with each price movement. 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. 52.2500. One tick move on this contract will translate to Rs. 52.2475 or Rs. 52.2525 depending on the direction of market movement.
Purchase price: Rs. 52.2500 Price increases by one tick: + Rs. 00.0025 New price: Rs. 52.2525 Purchase price: Rs. 52.2500 Price decreases by one tick: Rs. 00.0025 New price: Rs. 52.2475 The value of one tick on each contract is Rupees 2.50. So if a trader buys 5 contracts and the price moves up by 4 ticks, she makes Rupees 50. Step 1: 52.2600 52.2500 Step 2: 4 ticks * 5 contracts = 20 points Step 3: 20 points * Rs. 2.5 per tick = Rs. 50
(Note: please note the above examples do not include transaction fees and any other fees, which are essential for calculating final profit and loss)
SPREADS Spreads or the dealers margin is the difference between bid price (the price at which a dealer is willing to buy a foreign currency) and ask price (the price at which a dealer is willing to sell a foreign currency). the quote for bid will be lower than ask, which means the amount to be paid in counter currency to acquire a base currency will be higher than the amount of counter currency that one can receive by selling a base currency. For example, a bid-ask quote for USDINR of Rs. 47.5000 Rs. 47.8000 means that the dealer is willing to buy USD by paying Rs. 47.5000 and sell USD at a price of Rs. 47.8000. The spread or the profit of the dealer in this case is Rs. 0.30.
SPOT TRANSACTION AND FORWARD TRANSACTION The spot market transaction does not imply immediate exchange of currency, rather the settlement (exchange of currency) takes place on a value date, which is usually two business days after the trade date. The price at which the deal takes place is known as the spot rate (also known as benchmark price). The two-day settlement period allows the parties to confirm the transaction and arrange payment to each other. A forward transaction is a currency transaction wherein the actual settlement date is at a specified future date, which is more than two working days after the deal date. The date of settlement and the rate of exchange (called forward rate) is specified in the contract. The difference between spot rate and forward rate is called forward margin.
regulated stock exchange and suffer from counter -party risks and liquidity risks. Counter Party risk means that one party in the contract may default on fulfilling its obligations thereby causing loss to the other party.
Futures Contracts Futures contracts are also agreements to buy or sell an asset for a certain price at a future time. Unlike forward contracts, which are traded in the over -the-counter market with no standard contract size or standard delivery arrangements, futures contracts are exchange traded and are more standardized. They are standardized in terms of contract sizes, trading parameters, settlement procedures and are traded on a regulated exchange. The contract size is fixed and is referred to as lot size. Since futures contracts are traded through exchanges, the settlement of the contract is guaranteed by the exchange or a clearing corporation and hence there is no counter party risk. Exchanges guarantee the execution by holding an amount as security from both the parties. This amount is called as Margin money. Futures contracts provide the flexibility of closing out the contract prior to the maturity by squaring off the transaction in the market. Table 3.1 draws a comparison between a forward contract and a futures contract.
Established by the bank or Open auction among buyers broker through electronic media and seller on the floor of recognized exchange.
Participants
Banks, brokers, forex dealers, multinational companies, institutional investors, arbitrageurs, traders, etc.
Banks, brokers, multinational companies, institutional investors, small traders, speculators, arbitrageurs, etc. Margin deposit required
Margins
compensating bank balanced may be required Maturity Tailored to needs: from one week to 10 years Settlement Actual delivery or offset with cash settlement. No separate clearing house Daily settlement to the market and variation margin requirements Standardized
Market place
Accessibility
Open to any one who is in need of hedging facilities or has risk capital to speculate
Delivery
Actual delivery has very less even below one percent Exchange provides the guarantee of settlement and hence no counter party risk.
Risk
Trading
Traded on an exchange
Secured
Swap : Swap is private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolio of forward contracts. The currency swap entails swapping both principal and interest between the parties, with the cash flows in one direction
being in a different currency than those in the opposite direction. There are a various types of currency swaps like as fixed-to-fixed currency swap, floating to floating swap, fixed to floating currency swap. In a swap normally three basic steps are involve___ (1) Initial exchange of principal amount (2) Ongoing exchange of interest (3) Re - exchange of principal amount on maturity.
Option: Currency option is a financial instrument that give the option holder a right and not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period ( until the expiration date ). In other words, a foreign currency option is a contract for future delivery of a specified currency in exchange for another in which buyer of the option has to right to buy (call) or sell (put) a particular currency at an agreed price for or within specified period. The seller of the option gets the premium from the buyer of the option for the obligation undertaken in the contract. Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer dated options are called warrants and are generally traded OTC.
The spot foreign exchange market is similar to the OTC market for securities. There is no centralized meeting place and no fixed opening and closing time. Since most of the business in this market is done by banks, hence, transaction usually do not involve a physical transfer of currency, rather simply book keeping transfer entry among banks.
Exchange rates are generally determined by demand and supply force in this market. The purchase and sale of currencies stem partly from the need to finance trade in goods and services. Another important source of demand and supply arises from the participation of the central banks which would emanate from a desire to influence the direction, extent or speed of exchange rate movements.
and can be obtained for any customized amount and any date in the 0future. They normally do not require a security deposit since their purchasers are mostly large business firms and investment institutions, although the banks may require compensating deposit balances or lines of credit. Their transaction costs are set by spread between bank's buy and sell prices. Exporters invoicing receivables in foreign currency are the most frequent users of these contracts. They are willing to protect themselves from the currency depreciation by locking in the future currency conversion rate at a high level. A similar foreign currency forward selling contract is obtained by investors in foreign currency denominated bonds (or other securities) who want to take advantage of higher foreign that domestic interest rates on government or corporate bonds and the foreign currency forward premium. They hedge against the foreign currency depreciation below the forward selling rate which would ruin their return from foreign financial investment. Investment in foreign securities induced by higher foreign interest rates and accompanied by the forward selling of the foreign currency income is called a covered interest arbitrage.
underlying. For e.g. in the case of the USD-INR currency futures contract the tick size shall be 0.25 paise or 0.0025 Rupees. To demonstrate how a move of one tick affects the price, imagine a trader buys a contract (USD 1000 being the value of each contract) at Rs.42.2500. One tick move on this contract will translate to Rs.42.2475 or Rs.42.2525 depending on the direction of market movement.
The value of one tick on each contract is Rupees 2.50. So if a trader buys 5 contracts and the price moves up by 4 tick, she makes Rupees 50. Step 1: 42.2600 42.2500 Step 2: 4 ticks * 5 contracts = 20 points Step 3: 20 points * Rupees 2.5 per tick = Rupees 50
PRICING FUTURES
INTEREST RATE PARITY PRINCIPLE
For currencies which are fully convertible, the rate of exchange for any date other than spot is a function of spot and the relative interest rates in each currency. The assumption is that, any funds held will be invested in a time deposit of that currency. Hence, the forward rate is the rate which neutralizes the effect of differences in the interest rates in both the currencies. The forward rate is a function of the spot rate and the interest rate differential between the two currencies, adjusted for time. In the case of fully convertible currencies, having no restrictions on borrowing or lending of either currency the forward rate can be calculated as follows;
Future Rate = (spot rate) {1 + interest rate on home currency * period} / {1 + interest rate on foreign currency * period} For example, Assume that on January 10, 2011, six month annual interest rate was 7 percent p.a. on Indian rupee and US dollar six month rate was 6 percent p.a. and spot ( Re/$ ) exchange rate was 46.3500. Using the above equation the theoretical future price on January 10, 2011, expiring on June 9, 2011 is : the answer will be Rs.46.7908 per dollar. Then, this theoretical price is compared with the quoted futures price on January 10, 2011 and the relationship is observed.
rf= one year interest rate in foreign T=Time till expiration in years E=2.71828 The relationship between F and S then could be given as F Se^(r rf )T - = This relationship is known as interest rate parity relationship and is used in international finance. To explain this, let us assume that one year interest rates in US and India are say 7% and 10% respectively and the spot rate of USD in India is Rs. 44. From the equation above the one year forward exchange rate should be F = 44 * e^(0.10-0.07 )*1=45.34 It may be noted from the above equation, if foreign interest rate is greater than the domestic rate i.e. rf > r, then F shall be less than S. The value of F shall decrease further as time T increase. If the foreign interest is lower than the domestic rate, i.e. rf < r, then value of F shall be greater than S. The value of F shall increase further as time T increases.
spot market price after three months the companys liability is locked in at INR 45,00,000. In other words, the company is protected against adverse movement in the exchange rates. This is known as hedging and currency futures contracts are generally used by hedgers to reduce any known risks relating to the exchange rate. In a currency futures contract, the party taking a long (buy) position agrees to buy the base currency at the future rate by paying the terms currency. The party with a short (sell) position agrees to sell the base currency and receive the terms currency at the pre-specified exchange rate. When the base currency appreciates and the spot rate at maturity date (S) becomes more than the strike rate in the futures contract (K), the long party who is going to buy the base currency at the strike rate makes a profit. The party with the long position can buy the USD at a lower rate and sell in the market where the exchange rate is higher thereby making a profit. The party with a short position loses since it has to sell the base currency at a price lower than the prevailing spot rate. When the base currency depreciates and falls below the strike rate (K), the long party loses and a short position gains. This is depicted in Figure 4-1 as a pay-off diagram. In the pay-off diagram the profits are illustrative above the horizontal line and the losses below. The movement in the exchange rate is given on the horizontal line. The straight line (diagonal) indicates the pay-off for a buyer of USDINR contract. This pay-off is also called as a linear pay-off. An exposure in the currency futures market without any exposure (actual or expected) in the spot market becomes a speculative transaction. However, the role of speculators cannot be undermined in the futures market. They play an active role in the derivatives market and help in providing liquidity to the market. In this chapter, we will discuss the various positions that can be taken in a futures market. We will also discuss the relevance of each position to different market players.
Hedging in currency market can be done through two positions, viz. Short Hedge and Long
Hedge. They are explained as under: Short-Hedge A short hedge involves taking a short position in the futures market. In a currency market, short hedge is taken by someone who already owns the base currency or is expecting a future receipt of the base currency. An example where this strategy can be used: An exporter, who is expecting a receipt of USD in the future, will try to fix the conversion rate by holding a short position in the USD-INR contract. Box 4.1 explains the pay-off from a short hedge strategy through an example.
Long Hedge A long hedge involves holding a long position in the futures market. A Long position holder agrees to buy the base currency at the expiry date by paying the agreed exchange rate. This strategy is used by those who will need to acquire base currency in the future to pay any liability in the future. An example where this strategy can be used: An importer who has to make payment for his imports in USD will take a long position in USDINR contracts and fix the rate at which he can buy USD in future by paying INR. Box 4.2 explains the pay-off from a long hedge strategy in currency market.
the trader would choose among other currencies for the hedging in futures. Which contract should he choose? Probably he has only one option rupee with dollar. This is called cross hedge.
Speculation: Bullish, buy futures Take the case of a speculator who has a view on the direction of the market. He would like to
trade based on this view. He expects that the USD-INR rate presently at Rs.42, is to go up in the next two-three months. How can he trade based on this belief? In case he can buy dollars and hold it, by investing the necessary capital, he can profit if say the Rupee depreciates to Rs.42.50. Assuming he buys USD 10000, it would require an investment of Rs.4,20,000. If the exchange rate moves as he expected in the next three months, then he shall make a profit of around Rs.10000. This works out to an annual return of around 4.76%. It may please be noted that the cost of funds invested is not considered in computing this return. A speculator can take exactly the same position on the exchange rate by using futures contracts. Let us see how this works. If the INR- USD is Rs.42 and the three month futures trade at Rs.42.40. The minimum contract size is USD 1000. Therefore the speculator may buy 10 contracts. The exposure shall be the same as above USD 10000. Presumably, the margin may be around Rs.21, 000. Three months later if the Rupee depreciates to Rs. 42.50 against USD, (on the day of expiration of the contract), the futures price shall converge to the spot price (Rs. 42.50) and he makes a profit of Rs.1000 on an investment of Rs.21, 000. This works out to an annual return of 19 percent. Because of the leverage they provide, futures form an attractive option for speculators. y Speculation: Bearish, sell futures Futures can be used by a speculator who believes that an underlying is over-valued and is likely to see a fall in price. How can he trade based on his opinion? In the absence of a deferral product, there wasn't much he could do to profit from his opinion. Today all he needs to do is sell the futures. Let us understand how this works. Typically futures move correspondingly with the underlying, as long as there is sufficient liquidity in the market. If the underlying price rises, so will the futures price. If the underlying price falls, so will the futures price. Now take the case of the trader who expects to see a fall in the price of USD-INR. He sells one two-month contract of futures on USD say at Rs. 42.20 (each contact for USD 1000). He pays a small margin on the same. Two months later, when the futures contract expires, USD-INR rate let us say is Rs.42. On the day of expiration, the spot and the futures price converges. He has made a clean profit of 20 paise per dollar. For the one contract that he sold, this works out to be Rs.2000.
Arbitrage:
Arbitrage is the strategy of taking advantage of difference in price of the same or similar product between two or more markets. That is, arbitrage is striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. If the same or similar product is traded in say two different markets, any entity which has access to both the markets will be able to identify price differentials, if any. If in one of the markets the product is trading at higher price, then the entity shall buy the product in the cheaper market and sell in the costlier market and thus benefit from the price differential without any additional risk. One of the methods of arbitrage with regard to USD-INR could be a trading strategy between forwards and futures market. As we discussed earlier, the futures price and forward prices are arrived at using the principle of cost of carry. Such of those entities who can trade both forwards and futures shall be able to identify any mispricing between forwards and futures. If one of them is priced higher, the same shall be sold while simultaneously buying the other which is priced lower. If the tenor of both the contracts is same, since both forwards and futures shall be settled at the same RBI reference rate, the transaction shall result in a risk less profit.
y y
The counter-party risk is eliminated as the clearing corporation guarantees the trades. By ensuring that the best price is available to all categories of market participants, transactions are executed on a price time priority.
In Currency Futures, mark to market obligations are settled on a daily basis, unlike a forward contract, which is an agreement to transact at a forward price on a future date and no money changes hands except on the maturity date.
FUTURE TERMINOLOGY
y SPOT PRICE : The price at which an asset trades in the spot market. The transaction in which securities and foreign exchange get traded for immediate delivery. Since the exchange of securities and cash is virtually immediate, the term, cash market, has also been used to refer to spot dealing. In the case of USDINR, spot value is T + 2.
FUTURE PRICE : The price at which the future contract traded in the future market.
CONTRACT CYCLE : The period over which a contract trades. The currency future contracts in Indian market have
one month, two month, and three month up to twelve month expiry cycles. In NSE/BSE will have 12 contracts outstanding at any given point in time.
VALUE DATE / FINAL SETTELMENT DATE : The last business day of the month will be termed the value date /final settlement date of
each contract. The last business day would be taken to the same as that for inter bank settlements in Mumbai. The rules for inter bank settlements, including those for known holidays and would be those as laid down by Foreign Exchange Dealers Association of India (FEDAI).
EXPIRY DATE :
It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. The last trading day will be two business days prior to the value date / final settlement date.
CONTRACT SIZE :
The amount of asset that has to be delivered under one contract. Also called as lot size. In case of USDINR it is USD 1000.
BASIS : In the context of financial futures, basis can be defined as the futures price minus the spot
price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.
COST OF CARRY : The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance or carry the asset till delivery less the income earned on the asset. For equity derivatives carry cost is the rate of interest.
INITIAL MARGIN : When the position is opened, the member has to deposit the margin with the clearing house
as per the rate fixed by the exchange which may vary asset to asset. Or in another words, the amount that must be deposited in the margin account at the time a future contract is first entered into is known as initial margin.
MARKING TO MARKET : At the end of trading session, all the outstanding contracts are reprised at the settlement price
of that session. It means that all the futures contracts are daily settled, and profit and loss is determined on each transaction. This procedure, called marking to market, requires that funds charge every day. The funds are added or subtracted from a mandatory margin (initial margin) that traders are required to maintain the balance in the account. Due to this adjustment, futures contract is also called as daily reconnected forwards.
MAINTENANCE MARGIN : Members account are debited or credited on a daily basis. In turn customers account are
also required to be maintained at a certain level, usually about 75 percent of the initial margin, is called the maintenance margin. This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.
It has been observed that in most futures markets, actual physical delivery of the underlying assets is very rare and hardly 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 PARAMETERS y Base Price Base price of the USD/INR Futures Contracts on the first day shall be the theoretical futures price. The base price of the Contracts on subsequent trading days will be the daily settlement price of the USD/INR futures contracts. y Closing Price The closing price for a futures contract is currently calculated as the last half an hour weighted average price of the contract. In case a futures contract is not traded on a day, or not traded during the last half hour, a 'theoretical settlement price' is computed as may be decided by the relevant authority from time to time. y Dissemination of Open, High, Low, and
Last-Traded Prices During a trading session, the Exchange continuously disseminates open, high, low, and lasttraded prices through its trading system on real time basis.
TENORS OF FUTURES CONTRACT The tenor of a contract means the period when the contract will be available for futures trading, i.e. the period between the start of trading and the day it expires. This period is also known as the trading cycle of the contract. The currency future contract will be available for trading with a maximum maturity of 12 months. y Expiry Date All contracts expire on the last working day (excluding Saturdays) of the contract months. The last day for the trading of the contract shall be two working days prior to the final settlement. y Final Settlement Rate Final Settlement rate would be the Reserve Bank (RBI) Reference rate for the date of expiry.
TYPES OF ORDERS The system allows the trading members to enter orders with various conditions attached to them as per their requirements. These conditions are broadly divided into the following categories: y y y Time conditions Price conditions Other conditions
Several combinations of the above are allowed thereby providing enormous flexibility to the users. The order types and conditions are summarized below.
Time conditions - Day order: A day order, as the name suggests is an order which is valid for the day on which it is entered. If the order is not executed during the day, the system cancels the order automatically at the end of the day. - Immediate or Cancel (IOC): An IOC order allows the user to buy or sell a contract as soon as the order is released into the system, failing which the order is cancelled from the system. Partial match is possible for the order, and the unmatched portion of the order is cancelled immediately.
Price condition - Market price: Market orders are orders for which no price is specified at the time the order is entered (i.e. price is market price). For such orders, the trading system determines the price. - Limit price: An order to a broker to buy a specified quantity of a security at or below a specified price, or to sell it at or above a specified price (called the limit price). This ensures that a person will never pay more for the futures contract than whatever price is set as his/her limit. It is also the price of orders after triggering from stop-loss book. Stop-loss: This facility allows the user to release an order into the system, after the market price of the security reaches or crosses a threshold price e.g. if for stop-loss buy order, the trigger is Rs. 42.0025, the limit price is Rs. 42.2575 , then this order is released into the system once the market price reaches or exceeds Rs. 42.0025. This order is added to the regular lot book with time of triggering as the time stamp, as a limit order of Rs. 42.2575. be less than the limit price and for the stop-loss sell order, the trigger price has to be greater than the limit price.
Other conditions - Pro: Pro means that the orders are entered on the trading member's own account. - Cli: Cli means that the trading member enters the orders on behalf of a client.
In exchange traded derivative contracts, the Clearing Corporation acts as a central counterparty to all trades and performs full notations. The risk to the clearing corporation can only be taken care of through a stringent margining framework. Also, since derivatives are leveraged instruments, margins also act as a cost and discourage excessive speculation. A robust risk management system should therefore, not only impose margins on the members of the clearing corporation but also enforce collection of margins from the clients.
Price Limit Circuit Filter There shall be no daily price bands applicable for Currency Futures contracts. However in order to prevent erroneous order entry by members, operating ranges will be kept at +/-3% of the base price for contracts with tenure upto 6 months and +/-5% for contracts with tenure greater than 6 months. In respect of orders which have come under price freeze, the members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation, the Exchange may take appropriate action.
would evolve norms and oversee the implementation of Exchange traded currency futures. The Terms of Reference to the Committee was as under: 1. To coordinate the regulatory roles of RBI and SEBI in regard to trading of Currency and Interest Rate Futures on the Exchanges. 2. To suggest the eligibility norms for existing and new Exchanges for Currency and Interest Rate Futures trading. 3. To suggest eligibility criteria for the members of such exchanges. 4. To review product design, margin requirements and other risk mitigation measures on an ongoing basis. 5. To suggest surveillance mechanism and dissemination of market information. 6. To consider microstructure issues, in the overall interest of financial stability.
y Trading Hours
The trading on currency futures would be available from 9 a.m. to 5 p.m.
y Quotation
The currency futures contract would be quoted in rupee terms. However, the outstanding positions would be in dollar terms.
y Available contracts
All monthly maturities from 1 to 12 months would be made available.
y Settlement mechanism
The currency futures contract shall be settled in cash in Indian Rupee.
y Settlement price
The settlement price would be the Reserve Bank Reference Rate on the date of expiry. The methodology of computation and dissemination of the Reference Rate may be publicly disclosed by RBI.
MCX Stock Exchange (MCX-SX), Indias new stock exchange, commenced operations in the Currency Derivatives Segment on October 7, 2008 under the regulatory framework of Securities & Exchange Board of India (SEBI) and Reserve Bank of India (RBI). The Exchange is recognized by SEBI under Section 4 of Securities Contracts (Regulation) Act, 1956. A new generation stock exchange, MCX-SX offers a world-class electronic platform for trading in currency futures contracts and is currently the market leader in this segment. Within a year of inception, MCX-SX has achieved a stupendous growth in average daily turnover and open interest. The average daily turnover increased from Rs 355 crore during its first month of operations to Rs 18,359 crore in March 2011. In line with global best practices and regulatory requirements, clearing and settlement is conducted through a separate Clearing Corporation MCX-SX Clearing Corporation Ltd. (MCX-SX CCL). MCX-SX currently witnesses participation from 555 towns and cities across India and has a strong member base of 734. MCX-SX believes in the philosophy of Systematic Development of Markets through Information, Innovation, Education and Research. The Exchange endeavours to ensure continuous innovation and to introduce various new products under the extant regulatory framework. The Exchange is in readiness to commence Equity segment and Equity Futures & Options segment besides other products such as Interest Rate Futures, SME segment securities, Index Funds and Exchange Traded Funds etc, on receiving regulatory approvals.
Does the national economy of India need currency futures? Every business exposed to foreign exchange risk needs to have a facility to hedge against such risk. Exchange-traded currency futures, as on MCX-SX, are a superior tool for such hedging because of greater transparency, liquidity, counterparty guarantee and accessibility. Since the economy is made up of businesses of all sizes, anything that is good for business is also good for the national economy.
Participants of a currency futures market A host of benefits are available to a wide range of financial market participants, including hedgers (exporters, importers, corporate and Banks), investors and arbitrageurs on MCX-SX.
Hedgers: A high-liquidity platform for hedging against the effects of unfavourable fluctuations in the foreign exchange markets is available on exchange. Banks, importers, exporters and corporate houses hedge on MCX-SX. Investors: All those interested in taking a view on appreciation (or depreciation) of exchange rate in the long and short term can participate in the MCX-SX currency futures. For example, if one expects depreciation of the Indian Rupee against the US dollar, then he can hold on long (buy) position in USDINR contract for returns. Contrarily, he can sell the contract if he sees appreciation of the Indian Rupee. Arbitrageurs: Arbitrageurs get the opportunity of trading in currency futures by simultaneous purchase and sale in two different markets, taking advantage of price differential between the markets.
Instrument Type
FUTCUR
Unit of trading
Underlying
JPY
Quotation/Price Quote
Tick size
Trading hours
Settlement price
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.
Base price
Theoretical price on the 1st day of the contract. On all other days, DSP of the contract
Tenure upto 6 months: +/-3 % of base price Tenure greater than 6 months: +/- 5% of base price
Position limits
Clients
Trading Members
Banks
Calendar spreads
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
Settlement
Mode of settlement
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.
Instrument Type
FUTCUR
Unit of trading
Underlying
EURO
Quotation/Price Quote
Tick size
Trading hours
Settlement price
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.
Base price
Theoretical price on the 1st day of the contract. On all other days, DSP of the contract
Tenure upto 6 months: +/-3 % of base price Tenure greater than 6 months: +/5% of base price
Position limits
Clients
EUR 5 million Trading Members Higher of 15% of the total open interest or EUR 25 million Banks Higher of 15% of the total open interest or EUR 50 million Minimum initial margin 2.8% on First day & 2% thereafter
Calendar spreads
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
Settlement
Mode of settlement
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.
Instrument Type
FUTCUR
Unit of trading
Underlying
POUND STERLING
Quotation/Price Quote
Tick size
Trading hours
Settlement price
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.
Base price
Theoretical price on the 1st day of the contract. On all other days, DSP of the contract
Tenure upto 6 months: +/-3 % of base price Tenure greater than 6 months: +/- 5% of base price
Position limits
Clients
Trading Members
Banks
Calendar spreads
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
Settlement
Mode of settlement
Daily settlement price (DSP) 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.
Final settlement price (FSP) Exchange rate published by the Reserve Bank in its Press Release captioned RBI Reference Rate for US$ and Euro.
Instrument Type
FUTCUR
Unit of trading
Underlying
Quotation/Price Quote
Tick size
Trading hours
Settlement price
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.
Base price
Theoretical price on the 1st day of the contract. On all other days, DSP of the contract
Tenure upto 6 months: +/-3 % of base price Tenure greater than 6 months: +/- 5% of base price
Position limits
Clients
Trading Members
Banks
1% of MTM value of gross open position. Rs. 400/- for a spread of 1 month, Rs. 500/- for a spread of 2 months, Rs. 800/- for a spread of 3 months & Rs. 1000/- for a spread of 4 months or more
Settlement
Mode of settlement
Daily settlement price (DSP) 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.
USDINR
PRICE
VOLUME
OPEN INTEREST
During May 2011, the market share of the Exchange stood at 41.18% in the Currency Futures market. The average traded daily turnover in MCX-SX was `17,023.07 crores with average daily contracts of 3,695,791.
Geo -Insights
Globally, recovery is expected to sustain in 2011 even as it is projected to moderate marginally from its 2010 pace due to the phasing out of the fiscal stimulus. However new risks have emerged with challenges like rising oil and other commodity prices, inflationary pressures in some emerging economies and after effects of tragic earthquake in Japan. Turning to the domestic macroeconomic situation as reported by RBI in its Monetary Policy Statement for 2011-12, the Indian economy is estimated to have grown by 8.6% last year. The index of industrial production (IIP), which grew by 10.7% during the first half of last year, moderated subsequently, bringing down the overall growth for April 2010 - February 2011 to 7.8%. Particularly significant were the slowdown in capital goods production and investment spending. Going forward, high oil and other commodity prices and the impact of the Reserve Banks anti-inflationary monetary stance will moderate growth. Based on the assumption of a normal monsoon, and crude oil prices averaging US$110 a barrel over the full year 2011-12, the baseline projection of real GDP growth for 2011-12, for policy purposes, is around 8%.
Can currency futures help small traders? Yes. The minimum size of the USDINR futures contract is USD 1,000. Similarly EURINR future contract is EURO 1000, GBPINR future contract is GBP 1000 and JPYINR future contract is YEN 1,00,000. These are well within the reach of most small traders. All transactions on the Exchange are anonymous and are executed on a price time priority ensuring that the best price is available to all categories of market participants irrespective of their size. As the profits or losses in the futures market are also paid / collected on a daily basis, the scope of accumulation of losses for participants gets limited.
What are the terms and conditions set by RBI for Banks to participate in exchange traded fx futures? RBI has allowed Banks to participate in currency futures market. The AD Category I Banks which fulfill stipulated prudential requirements are eligible to become a clearing member and / or trading member of the currency derivatives segment of MCX-SX.
AD Category I Banks which are urban co-operative banks or state co-operative banks can participate in the currency futures market only as a client, subject to approval thereof, from the respective regulatory department of RBI.
Which are the global exchanges that provide trading in currency futures? Internationally, exchanges such as Chicago Mercantile Exchange (CME), Johannesburg Stock Exchange, Euronext.liffe, BM&FBOVESPA and Tokyo Financial Exchange provide trading in currency futures.
Why should one trade in Indian exchanges as compared to international exchanges? Indian currency futures enable individuals and companies in India to hedge and trade their Indian Rupee risk. Most international exchanges offer contracts denominated in other currencies.
Trends in Currency Future in India Currency futures trading started in India on August 29, 2008 on National Stock Exchange. This was the first time currency derivatives got listed on an exchange in India. Till this time, the currency futures trading took place over the counter and were unorganized. With the entry of the National Stock Exchange in the picture, currency trading became more organized with the NSE acting as a counter party to all the transactions. Soon after the BSE and MCX also marked their entry into the currency derivatives market.
Volumes on currency futures exchanges (mainly NSE and MCX) have consistently increased since the start of trading. Combined daily volumes on the most active currency futures bourses MCX Stock Exchange (MCX-SX) and the National Stock Exchange (NSE) The BSE has failed to generate enough interest in this segment and the volumes remain abysmally low on the exchange. Although volatility has ensured that volumes surged after the launch, trading has been concentrated on front-month contracts as majority of users are traders, small exporters and brokers/banks. (Refer history currency)
OPPORTUNITIES
y y y Introduction of Options trading FII participation could be allowed. NRI participation could be allowed which would add to more volumes and liquidity.
Positions larger than $5 million could be allowed - a tiny limit when compared with the size of exposure that is found in a trillion dollar economy.
FINDINGS
y Cost of carry model and Interest rate parity model are useful tools to find out standard future price and also useful for comparing standard with actual future price. And its also a very help full in Arbitraging. y New concept of Exchange traded currency future trading is regulated by higher authority and regulatory. The whole function of Exchange traded currency future is regulated by SEBI/RBI, and they established rules and regulation so there is very safe trading is emerged and counter party risk is minimized in currency Future trading. And also time reduced in Clearing and Settlement process up to T+1 days basis. y Larger exporter and importer has continued to deal in the OTC counter even exchange traded currency future is available in markets because, There is a limit of USD 100 million on
open interest applicable to trading member who are banks. And the USD 25 million limit for other trading members so larger exporter and importer might continue to deal in the OTC market where there is no limit on hedges. y In India RBI and SEBI has restricted other currency derivatives except Currency future, at this time if any person wants to use other instrument of currency derivatives in this case he has to use OTC.
SUGGESTIONS
y Currency Future need to change some restriction it imposed such as cut off limit of 5 million USD, Ban on NRIs and FIIs and Mutual Funds from Participating. y Now in exchange traded currency future segment only one pair USD-INR is available to trade so there is also one more demand by the exporters and importers to introduce another pair in currency trading. Like POUNDINR, CAD-INR etc. y In OTC there is no limit for trader to buy or short Currency futures so there demand arises that in Exchange traded currency future should have increase limit for Trading Members and also at client level, in result OTC users will divert to Exchange traded currency Futures.
In India the regulatory of Financial and Securities market (SEBI) has Ban on other Currency Derivatives except Currency Futures, so this restriction seem unreasonable to exporters and importers. And according to Indian financial growth now its become necessary to introducing other currency derivatives in Exchange traded currency derivative segment.
CONCLUSIONS
By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivativesThese instruments enhances the ability to differentiate risk and allocate it to those investors most able and willing to take it- a process that has undoubtedly improved national productivity growth and standards of livings. The currency future gives the safe and standardized contract to its investors and individuals who are aware about the forex market or predict the movement of exchange rate so they will get the right platform for the trading in currency future. Because of exchange traded future contract and its standardized nature gives counter party risk minimized. Initially only NSE had the permission but now BSE and MCX has also started currency future. It is shows that how currency future covers ground in the compare of other available derivatives instruments. Not only big businessmen and exporter and importers use this but individual who are interested and having knowledge about forex market they can also invest in currency future. Exchange between USD-INR markets in India is very big and these exchange traded contract will give more awareness in market and attract the investors.
Standardised rules for lot sizes and trading, framed by the Reserve Bank of India, means exchanges and brokers have to rely on better technology and back-end support to attract clients. Currency futures today are offered only for rupeedollar contracts for longer periods (12 contracts) than the existing forward contracts (3 contracts 3 months, 6
monthsand 12 months). MCX-SX will launch 11 currency trading websites in regional languages (having launched 5 so far in Hindi, Marathi, Gujarati, Tamil and Malayalam).
Liberalisation in terms of changes in the contract size, variable lot sizes and extended trading hours could help encourage larger participation. The rupee futures have a contract size of $1,000. The position limit for a client is higher of 6% of the total open interest or $ 5 million. For the trading member it is higher of 15% of the total open interest or $25 million. If the trading member is a bank it is higher of 15% of the total open interest or $ 100 million. Hence till the total open interest rises, a participant cannot increase his open interest beyond present proportion/limits. Foreign institutional investors are excluded from the market and their inclusion as participants can help in stepping up volumes significantly. SEBI has approved a fourth exchange, promoted by a clutch of public and private sector banks, to commence trading in rupee-dollar futures. United Stock Exchange of India, expected to come on line in February 2009, is the fourth currency futures bourse after National Stock Exchange, MCX-SX and BSE. The new stock exchange has been promoted by key PSU lenders such as Bank of India, Bank of Baroda, Canara Bank, Andhra Bank, Allahabad Bank, Indian Overseas Bank and Oriental Bank of Commerce, Union Bank of India and United Bank of India jointly with MMTC that together will hold minimum 49% in the bourse. Other shareholders include Standard Chartered Bank, Federal Bank, Tata Consultancy Services and STCI, who will jointly own 25% and national-level brokers with 20% stake.