Currency+Final+Project

Project Report On

Currency Derivative

Currency Derivative: Business Perspective Page 1

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.


Contents

1. Company Profile Pg. 4

2. Introduction Pg. 5

3. Utility of Currency Derivative Pg. 6

4. Launch Of currency Derivative in India Pg. 8

5. Derivative Market Pg. 9

6. Exchanges Where Currency is traded Pg. 11

7. History of Currency Derivative Pg. 15

8. Need for the exchange traded currency futures Pg. 16

9. Derivative Market of Forex Currencies Pg. 22

10. Currency Forward Market Pg. 25

11. Foreign Exchange Quotation Pg. 31

12. Product Definitions of Currency Future on NSE Pg. 34

13. Regulatory Framework for Currency Future Pg. 38

14. Conclusion Pg. 43

15. Bibliography Pg. 44


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 industry’s

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.


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 lender’s 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, 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


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


LAUNCH OF CURRENCY FUTURES CONTRACTS ON

29 th AUGUST, 2008

India’s 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.


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 Bank’s 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.


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


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.


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


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.


United Stock Exchange, India’s 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 India’s 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, USE’s 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 Asia’s 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 India’s most preferred stock exchange, providing a range of sophisticated financial instruments for diverse market participants to trade on and manage their risks efficiently.


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 exchange’s CME Globex platform. It is the largest regulated

marketplace for FX trading. Traders of CME FX futures are a diverse group that includes

multinational corporations, hedge funds, commercial banks, investment banks financial 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.


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


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 non-

resident 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


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


‘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.


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.


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.


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 IMF’s 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.


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.


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-the-

counter

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.


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.


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.


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 Currency Futures Currency Forwards

Size of

contract

Standardized Negotiated/Tailor made

Quotation Generally U.S.

Dollar/Currency unit

US $/ Currency Unit

Maturity Standardized , generally

shorter than one year

Negotiated

Location of

trading

Futures exchanges Linkages by telephone or fax

Price Fixed on the market Quotation of rates

Settlement Generally no settlement but

compensation through reverse

operations

Generally delivery of currencies

Counterpartie

s

Generally do not know each

other

Generally in contact with each

other

Negotiation

Hours

During market sessions Round the clock

Guarantee Guarantee Deposit No guarantee deposit

Marking to

market

Gains or losses on positions

settled every day

No marking to market


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.


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.


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.


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 Indirect

The number of units of domestic the number of unit of foreign

Currency stated against one unit Currency per unit of domestic

Of foreign currency. Currency.

Re/$ = 45.7250 (or) Re 1 = $ 0.02187

$1 = Rs. 45.7250

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.

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-à-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.


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.


PRODUCT DEFINITIONS OF CURRENCY FUTURE ON NSE

The contract specification in a tabular form is as under:

Contract Specifications for Euro-INR

Symbol EURINR

Instrument Type FUTCUR

Unit of trading 1 (1 unit denotes 1000 EURO)

Underlying EURO

Quotation/Price Quote

Rs. per EUR

Tick size 0.25 paisa or INR 0.0025

Trading hoursMonday to Friday9:00 a.m. to 5:00 p.m.

Contract trading cycle

12 month trading cycle.

Settlement price RBI Reference Rate on the date of expiry

Last trading dayTwo working days prior to the last business day of the expiry month at 12 noon.

Final settlement day

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 priceTheoretical price on the 1st day of the contract. On all other days, DSP of the contract

Price operating range

Tenure up to 6 months Tenure greater than 6 months

+/-3 % of base price +/- 5% of base price

Position limits

Clients Trading Members Banks

Higher of 6% of total open interest or EUR 5 million

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

Higher of 15% of the total open interest or EUR 50 million

Minimum initial margin

2.8% on First day & 2% thereafter

Extreme loss margin

0.3% of MTM value of gross open positions.

Calendar spreadsRs.700/- for a spread of 1 month, 1000/- for a spread of 2 months, Rs.1500/- for a spread of 3 months or more

SettlementDaily settlement : T + 1 Final settlement : T + 2


Mode of settlement Cash settled in Indian Rupees

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)

RBI reference rate

Contract Specifications for Pound Sterling-INR

Symbol GBPINR


Unit of trading 1 (1 unit denotes 1000 POUND STERLING)

Underlying POUND STERLING


Rs. per GBP

Tick size 0.25 paise or INR 0.0025




Settlement priceExchange rate published by the Reserve Bank in its Press Release captioned RBI Reference Rate for US$ and Euro.



Last working day (excluding Saturdays) of the expiry month.The last working day will be the same as that for Interbank Settlements in Mumbai.





Position limits

Clients Trading Members Banks

Higher of 6% of total open interest or GBP 5 million

Higher of 15% of the total open interest or GBP 25 million

Higher of 15% of the total open interest or GBP 50 million


3.2% on first day & 2% thereafter


Extreme loss margin


Calendar spreadsRs.1500/- for a spread of 1 month, 1800/- for a spread of 2 months, Rs.2000/- for a spread of 3 months or more






Exchange rate published by the Reserve Bank in its Press Release captioned RBI Reference Rate for US$ and Euro.

Contract Specifications for Japanese Yen-INR

Symbol JPYINR


Unit of trading 1 (1 unit denotes 100000 YEN)

Underlying JPY


Rs per 100 YEN

Tick size 0.25 paise or INR 0.0025




Settlement priceExchange rate published by the Reserve Bank in its Press Release captioned RBI Reference Rate for US$ and Euro.



Last working day (excluding Saturdays) of the expiry month. The last working day will be the same as that for Interbank Settlements in Mumbai.





Position limits Clients Trading Members Banks

Higher of 6% of total Higher of 15% of the total Higher of 15% of the


open interest or JPY 200 million

open interest or JPY 1000 million

total open interest or JPY 2000 million


4.50% on first day & 2.30% thereafter

Extreme loss margin


Calendar spreadsRs. 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






Exchange rate published by the Reserve Bank in its Press Release captioned RBI Reference Rate for US$ and Euro.

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.

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.

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.


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 un−expired

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.


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.


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.


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


http://www.bseindia.org/

http://www.nseindia.com/

http://www.sebi.com/

http://www.rbi.org.in/

http://www.goforex.net/

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