finance project

REPORT ON CURRENCY DERIVATIVE

SANDEEP ARORA

ITM ,GURGAON

[Project report on Currency Derivatives]University School of Management Kurukshetra University ,Kurukshetra Page 1

ACKNOWLEDGEMENT

On the occasion of completion and submission of project we would like to

express our deep sense of gratitude to USM, KUK for providing us Platform of

management studies. We thank to our Chairman Dr.D.D.Arora, and Faculty members

for their moral support during the project.

We are too glad to give our special thanks to our project guide Mr. Shyam

Sunder for providing us an opportunity to carryout project on currency derivatives

and also for their help and tips whenever needed. Without his co-operation it was

impossible to reach up to this stage.

At last, I sincere regards to my parents and friends who have directly or indirectly

helped me in the project.


CONTENTS

CHAPTER

NO

SUBJECTS COVERED PAGE

NO

1

2

Introduction of currency derivatives

Company Profile

4

7

3 Research Methodology

Scope of Research Type of Research Source of Data collection Objective of the Study Data collection Limitations

14

4 Introduction to The topic

Introduction of Financial Derivatives Types of Financial Derivatives Derivatives Introduction in India History of currency derivatives Utility of currency derivatives Introduction to Currency Derivatives Introduction to Currency Future

17

5 Brief Overview of the foreign exchange market

Overview of foreign exchange market in India Currency Derivatives Products Foreign Exchange Spot Market Foreign Exchange Quotations Need for exchange traded currency futures Rationale for Introducing Currency Future Future Terminology Uses of currency futures Trading and settlement Process Regulatory Framework for Currency Futures

29


Comparison of Forward & Future Currency Contracts

6 Analysis

Interest Rate Parity Principle Product Definitions of currency future Currency futures payoffs Pricing Futures and Cost of Carry model Hedging with currency futures

52

Findings suggestions and Conclusions 66

Bibliography 68


INTRODUCTION OF

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 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, and foreign currency swaps.


COMPANY PROFILE


AnandRathi Securities Limited

AnandRathi (AR) is a leading full service securities firm providing the entire gamut of financial services. The firm, founded in 1994 by Mr. AnandRathi, today has a pan India presence as well as an international presence through offices in Dubai and Bangkok. AR provides a breadth of financial and advisory services including wealth management, investment banking, corporate advisory, brokerage & distribution of equities, commodities, mutual funds and insurance, structured products - all of which are supported by powerful research teams.

AnandRathi is a leading full service securities firm providing the entire gamut of financial services. The firm, founded in 1994 by Mr. AnandRathi, today has a pan India presence as well as an international presence through offices in Dubai and Bangkok. AR provides a breadth of financial and advisory services including wealth management, investment banking, corporate advisory, brokerage & distribution of equities, commodities, mutual funds and insurance, structured products - all of which are supported by powerful research teams.

The firm's philosophy is entirely client centric, with a clear focus on providing long term value addition to clients, while maintaining the highest standards of excellence, ethics and professionalism. The entire firm activities are divided across distinct client groups: Individuals, Private Clients, Corporates and Institutions and was recently ranked by Asia Money 2006 poll amongst South Asia's top 5 wealth managers for the ultra-rich.

The offices of AnandRathi in 197 cities across 28 cities and it has also branches in Dubai and Bangkok with more than 44000 employees. It has daily turnover in excess of Rs. 4billion. It has 1,00,000+ clients nationwide. It is also leading Distributor of IPO's

In year 2007 Citigroup Venture Capital International joined the group as a financial partner.

In India AnandRathi is present in 21 States:

AndhraPardesh , Assam, Bihar , Chhatisgarh, Delhi , Goa, Gujrat, Haryana Jammu & Kashmir, Jharkhand, Karnataka, Kerala,,MadhyaPardesh, Maharashtra, Orissa, Punjab, Rajasthan, Tamil Nadu, UttarPardesh, Uttranchal, WestBengal.


Mission

To be India's first multinational providing complete financial services solution acrossthe globe

Vision

"To be a shining example as leader in innovation and the first choice for clients & employees"

Milestones

1994: Started activities in consulting and Institutional equity sales with staff of 15

1995: Set up a research desk and empanelled with major institutional investors

1997: Introduced investment banking businesses Retail brokerage services launched

1999: Lead managed first IPO and executed first M & A deal

2001: Initiated Wealth Management Services

2002: Retail business expansion recommences with ownership model

2003: Wealth Management assets cross Rs1500 crores Insurance broking launched Launch of Wealth Management services in Dubai Retail Branch network exceeds 50

Products


Equity & Derivatives Mutual Funds Depository Services Commodities Insurance Broking IPOs

Equity & derivatives brokerage

AnandRathi provides end-to-end equity solutions to institutional and individual investors. Consistent delivery of high quality advice on individual stocks, sector trends and investment strategy has established us a competent and reliable research unit across the country. Clients can trade through us online on BSE and NSE for both equities and derivatives. They are supported by dedicated sales & trading teams in our trading desks across the country. Research and investment ideas can be accessed by clients either through their designated dealers, email, web or SMS.

Mutual funds

AR is one of India's top mutual fund distribution houses. Our success lies in our philosophy of providing consistently superior, independent and unbiased advice to our clients backed by in-depth research. We firmly believe in the importance of selecting appropriate asset allocations based on the client's risk profile. We have a dedicated mutual fund research cell for mutual funds that consistently churns out superior investment ideas, picking best performing funds across asset classes and providing insights into performances of select funds.

Depository services


http://www.rathi.com/ipos.asp?pageOpt=6

http://www.rathi.com/insurance.asp?pageOpt=5

http://www.rathi.com/commodities.asp?pageOpt=4

http://www.rathi.com/depositoryservices.asp?pageOpt=3

http://www.rathi.com/mutualfunds.asp?pageOpt=2

http://www.rathi.com/equity&derivatives.asp?pageOpt=1

AR Depository Services provides you with a secure and convenient way for holding your securities on both CDSL and NSDL. Our depository services include settlement, clearing and custody of securities, registration of shares and dematerialization. We offer you daily updated internet access to your holding statement and transaction summary.

commodities

Commodities broking - a whole new opportunity to hedge business risk and an attractive investment opportunity to deliver superior returns for investors. Our commodities broking services include online futures trading through NCDEX and MCX and depository services through CDSL. Commodities broking is supported by a dedicated research cell that provides both technical as well as fundamental research. Our research covers a broad range of traded commodities including precious and base metals, Oils and Oilseeds, agri-commodities such as wheat, chana, guar, guar gum and spices such as sugar, jeera and cotton. In addition to transaction execution, we provide our clients customized advice on hedging strategies, investment ideas and arbitrage opportunities.

insurance broking

As an insurance broker, we provide to our clients comprehensive risk management techniques, both within the business as well as on the personal front. Risk management includes identification, measurement and assessment of the risk and handling of the risk, of which insurance is an integral part. The firm deals with both life insurance and general insurance products across all insurance companies. Our guiding philosophy is to manage the clients' entire risk set by providing the optimal level of cover at the least possible cost. The entire sales process and product selection is research oriented and customized to the client's needs. We lay strong emphasis on timely claim settlement and post sales services.

IPO

We are a leading primary market distributor across the country. Our strong performance in IPOs has been a result of our vast experience in the Primary Market, a wide network


of branches across India, strong distribution capabilities and a dedicated research team We have been consistently ranked among the top 10 distributors of IPOs on all major offerings. Our IPO research team provides clients with indepth overviews of forthcoming IPOs as well as investment recommendations. Online filling of forms is also available.

Global Products

Structuring of trusts / investment companies Offshore Mutual Funds Structured Products / Deposits including capital-guaranteed notes on Trading in global markets (Equities, Bonds, Commodities) Real Estate investments Alternative investments (including hedge funds and fund-of-hedge funds)

Our services

Risk Management Due diligence and research on policies available Recommendation on a comprehensive insurance cover based on clients needs Maintain proper records of client policies Assist client in paying premiums Continuous monitoring of client account Assist client in claim negotiation and settlement

Management Team


AR brings together a highly professional core management team that comprises of individuals with extensive business as well as industry experience. Our senior Management comprises a diverse talent pool that brings together rich experience from across industry as well as financial services.

Mr. Anand Rathi - Group Chairman Chartered Accountant Past President, BSE Held several Senior Management positions with one of India's largest industrial groups

Mr. Pradeep Gupta - Vice Chairman Plus 17 years of experience in Financial Services

Mr. Amit Rathi - Managing Director Chartered Accountant & MBA Plus 11 years of experience in Financial Services

Why choose AR?

Superior understanding of the Indian economy & markets Ability to structure and manage your tax and regulatory compliances Dedicated relationship team Unparalleled product range - Indian and Global


RESEARCH METHODOLOGY

RESEARCH METHODOLOGY


TYPE OF RESEARCH

In this project Descriptive research methodologies were use.

The research methodology adopted for carrying out the study was at the first

stage theoretical study is attempted and at the second stage observed online trading

on NSE/BSE.

SOURCE OF DATA COLLECTION

Secondary data were used such as various books, report submitted by

RBI/SEBI committee and NCFM/BCFM modules.

OBJECTIVES OF THE STUDY

The basic idea behind undertaking Currency Derivatives project to gain

knowledge about currency future market.

To study the basic concept of Currency future

To study the exchange traded currency future

To understand the practical considerations and ways of considering currency

future price.

To analyze different currency derivatives products.

LIMITATION OF THE STUDY

The limitations of the study were

The analysis was purely based on the secondary data. So, any error in the

secondary data might also affect the study undertaken.

The currency future is new concept and topic related book was not available in

library and market.



INTRODUCTION TO THE TOPIC

INTRODUCTION TO FINANCIAL DERIVATIVES

“By far the most significant event in finance during the past decade has been the

extraordinary development and expansion of financial derivatives…These


instruments enhances the ability to differentiate risk and allocate it to those investors

most able and willing to take it- a process that has undoubtedly improved national

productivity growth and standards of livings.”

Alan Greenspan, Former

Chairman.

US Federal Reserve Bank

The past decades has witnessed the multiple growths in the volume of international

trade and business due to the wave of globalization and liberalization all over the

world. As a result, the demand for the international money and financial

instruments increased significantly at the global level. In this respect, changes in the

interest rates, exchange rate and stock market prices at the different financial market

have increased the financial risks to the corporate world. It is therefore, to manage

such risks; the new financial instruments have been developed in the financial

markets, which are also popularly known as financial derivatives.

**DEFINITION OF FINANCIALDERIVATIVES**

A word formed by derivation. It means, this word has been arisen by derivation.


Something derived; it means that some things have to be derived or arisen out of

the underlying variables. A financial derivative is an indeed derived from the

financial market.

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 :

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

TYPES OF FINANCIAL DERIVATIVES


Financial derivatives are those assets whose values are determined by the value of

some other assets, called as the underlying. Presently there are Complex varieties of

derivatives already in existence and the markets are innovating newer and newer

ones continuously. For example, various types of financial derivatives based on

their different properties like, plain, simple or straightforward, composite, joint or

hybrid, synthetic, leveraged, mildly leveraged, OTC traded, standardized or

organized exchange traded, etc. are available in the market. Due to complexity in

nature, it is very difficult to classify the financial derivatives, so in the present

context, the basic financial derivatives which are popularly in the market have been

described. In the simple form, the derivatives can be classified into different

categories which are shown below :

DERIVATIVES

Financials Commodities

Basics Complex

1. Forwards 1. Swaps

2. Futures 2.Exotics (Non STD)

3. Options

4. Warrants and Convertibles

One form of classification of derivative instruments is between commodity

derivatives and financial derivatives. The basic difference between these is the nature

of the underlying instrument or assets. In commodity derivatives, the underlying

instrument is commodity which may be wheat, cotton, pepper, sugar, jute, turmeric,


corn, crude oil, natural gas, gold, silver and so on. In financial derivative, the

underlying instrument may be treasury bills, stocks, bonds, foreign exchange, stock

index, cost of living index etc. It is to be noted that financial derivative is fairly

standard and there are no quality issues whereas in commodity derivative, the quality

may be the underlying matters.

Another way of classifying the financial derivatives is into basic and complex. In

this, forward contracts, futures contracts and option contracts have been included in

the basic derivatives whereas swaps and other complex derivatives are taken into

complex category because they are built up from either forwards/futures or options

contracts, or both. In fact, such derivatives are effectively derivatives of derivatives.

Derivatives are traded at organized exchanges and in the Over The Counter

( OTC ) market :

Derivatives Trading Forum

Organized Exchanges Over The Counter

Commodity Futures Forward Contracts

Financial Futures Swaps

Options (stock and index)

Stock Index Future


Derivatives traded at exchanges are standardized contracts having standard delivery

dates and trading units. OTC derivatives are customized contracts that enable the

parties to select the trading units and delivery dates to suit their requirements.

A major difference between the two is that of counterparty risk—the risk of default

by either party. With the exchange traded derivatives, the risk is controlled by

exchanges through clearing house which act as a contractual intermediary and

impose margin requirement. In contrast, OTC derivatives signify greater

vulnerability.

DERIVATIVES INTRODUCTION IN INDIA

The first step towards introduction of derivatives trading in India was the

promulgation of the Securities Laws (Amendment) Ordinance, 1995, which

withdrew the prohibition on options in securities. SEBI set up a 24 – member

committee under the chairmanship of Dr. L.C. Gupta on November 18, 1996 to

develop appropriate regulatory framework for derivatives trading in India, submitted

its report on March 17, 1998. The committee recommended that the derivatives

should be declared as ‘securities’ so that regulatory framework applicable to trading

of ‘securities’ could also govern trading of derivatives.

To begin with, SEBI approved trading in index futures contracts based on S&P CNX

Nifty and BSE-30 (Sensex) index. The trading in index options commenced in June

2001 and the trading in options on individual securities commenced in July 2001.

Futures contracts on individual stocks were launched in November 2001.

HISTORY OF CURRENCY DERIVATIVES


Currency futures were first created at the Chicago Mercantile Exchange (CME) in

1972.The contracts were created under the guidance and leadership of Leo Melamed,

CME Chairman Emeritus. The FX contract capitalized on the U.S. abandonment of the

Bretton Woods agreement, which had fixed world exchange rates to a gold standard

after World War II. The abandonment of the Bretton Woods agreement resulted in

currency values being allowed to float, increasing the risk of doing business. By

creating another type of market in which futures could be traded, CME currency futures

extended the reach of risk management beyond commodities, which were the main

derivative contracts traded at CME until then. The concept of currency futures at CME

was revolutionary, and gained credibility through endorsement of Nobel-prize-winning

economist Milton Friedman.

Today, CME offers 41 individual FX futures and 31 options contracts on 19 currencies,

all of which trade electronically on the exchange’s CME Globex platform. It is the

largest regulated marketplace for FX trading. Traders of CME FX futures are a diverse

group that includes multinational corporations, hedge funds, commercial banks,

investment banks, financial managers, commodity trading advisors (CTAs), proprietary

trading firms; currency overlay managers and individual investors. They trade in order

to transact business, hedge against unfavorable changes in currency rates, or to

speculate on rate fluctuations.

Source: - (NCFM-Currency future Module)

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 2 million 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.

Source :-( Recent Development in International Currency Derivative Market by

Lucjan T. Orlowski)

INTRODUCTION TO 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, and foreign currency swaps.

INTRODUCTION TO CURRENCY FUTURE

A futures contract is a standardized contract, traded on an exchange, to buy or sell a

certain underlying asset or an instrument at a certain date in the future, at a specified

price. When the underlying asset is a commodity, e.g. Oil or Wheat, the contract is

termed a “commodity futures contract”. When the underlying is an exchange rate, the

contract is termed a “currency futures contract”. In other words, it is a contract to

exchange one currency for another currency at a specified date and a specified rate in

the future.

Therefore, the buyer and the seller lock themselves into an exchange rate for a

specific value or delivery date. Both parties of the futures contract must fulfill their

obligations on the settlement date.

Currency futures can be cash settled or settled by delivering the respective obligation

of the seller and buyer. All settlements however, unlike in the case of OTC markets,

go through the exchange.

Currency futures are a linear product, and calculating profits or losses on Currency

Futures will be similar to calculating profits or losses on Index futures. In

determining profits and losses in futures trading, it is essential to know both the

contract size (the number of currency units being traded) and also what is the tick


value. A tick is the minimum trading increment or price differential at which traders

are able to enter bids and offers. Tick values differ for different currency pairs and

different 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.

Purchase price: Rs .42.2500Price increases by one tick: +Rs. 00.0025

New price: Rs .42.2525

Purchase price: Rs .42.2500

Price decreases by one tick: –Rs. 00.0025New price: Rs.42. 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 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


BRIEF OVERVIEW OF FOREIGN EXCHANGE

MARKET

OVERVIEW OF THE FOREIGN EXCHANGE MARKET IN INDIA


During the early 1990s, India embarked on a series of structural reforms in the foreign

exchange market. The exchange rate regime, that was earlier pegged, was partially

floated in March 1992 and fully floated in March 1993. The unification of the exchange

rate was instrumental in developing a market-determined exchange rate of the rupee and

was an important step in the progress towards total current account convertibility, which

was achieved in August 1994.

Although liberalization helped the Indian forex market in various ways, it led to

extensive fluctuations of exchange rate. This issue has attracted a great deal of concern

from policy-makers and investors. While some flexibility in foreign exchange markets

and exchange rate determination is desirable, excessive volatility can have an adverse

impact on price discovery, export performance, sustainability of current account

balance, and balance sheets. In the context of upgrading Indian foreign exchange market

to international standards, a well- developed foreign exchange derivative market (both

OTC as well as Exchange-traded) is imperative.

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.

Subsequently, RBI and SEBI jointly constituted a Standing Technical Committee to

analyze the Currency Forward and Future market around the world and lay down the

guidelines to introduce Exchange Traded Currency Futures in the Indian market. The

Committee submitted its report on May 29, 2008. Further RBI and SEBI also issued

circulars in this regard on August 06, 2008.

Currently, India is a USD 34 billion OTC market, where all the major currencies like

USD, EURO, YEN, Pound, Swiss Franc etc. are traded. With the help of electronic


http://www.bseindia.com/deri/Downloads/CDX/sebi_060808.pdf

http://www.bseindia.com/deri/Downloads/CDX/rbi_circular060808.pdf

http://www.bseindia.com/deri/Downloads/CDX/rbirep_290508.pdf

trading and efficient risk management systems, Exchange Traded Currency Futures will

bring in more transparency and efficiency in price discovery, eliminate counterparty

credit risk, provide access to all types of market participants, offer standardized

products and provide transparent trading platform. Banks are also allowed to become

members of this segment on the Exchange, thereby providing them with a new

opportunity. Source :-( Report of the RBI-SEBI

standing technical committee on exchange traded currency futures) 2008.

CURRENCY DERIVATIVE PRODUCTS


Derivative contracts have several variants. The most common variants are forwards,

futures, options and swaps. We take a brief look at various derivatives contracts that

have come to be used.

FORWARD :

The basic objective of a forward market in any underlying asset is to fix a price

for a contract to be carried through on the future agreed date and is intended to

free both the purchaser and the seller from any risk of loss which might incur due

to fluctuations in the price of underlying asset.

A forward contract is customized contract between two entities, where settlement

takes place on a specific date in the future at today’s pre-agreed price. The

exchange rate is fixed at the time the contract is entered into. This is known as

forward exchange rate or simply forward rate.

FUTURE :

A currency futures contract provides a simultaneous right and obligation to buy

and sell a particular currency at a specified future date, a specified price and a

standard quantity. In another word, a future contract is an agreement between

two parties to buy or sell an asset at a certain time in the future at a certain price.

Future contracts are special types of forward contracts in the sense that they are

standardized exchange-traded contracts.

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.

OPTIONS :

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.


FOREIGN EXCHANGE SPOT (CASH) MARKET

The foreign exchange spot market trades in different currencies for both spot and

forward delivery. Generally they do not have specific location, and mostly take

place primarily by means of telecommunications both within and between countries.

It consists of a network of foreign dealers which are oftenly banks, financial

institutions, large concerns, etc. The large banks usually make markets in different

currencies.

In the spot exchange market, the business is transacted throughout the world on a

continual basis. So it is possible to transaction in foreign exchange markets 24 hours

a day. The standard settlement period in this market is 48 hours, i.e., 2 days after the

execution of the transaction.

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.

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.


NEED FOR EXCHANGE TRADED 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. Exchange traded

futures as compared to OTC forwards serve the same economic purpose, yet differ in

fundamental ways. An individual entering into a forward contract agrees 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, in the case of an exchange traded

futures contract, mark to market obligations is settled on a daily basis. Since the

profits 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 counterparty risk in a futures contract is further eliminated by the presence of a

clearing corporation, which by assuming counterparty 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 transactions on an

Exchange are executed on a 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.

Source :-( Report of the RBI-SEBI standing technical committee on exchange

traded currency futures) 2008.

RATIONALE FOR INTRODUCING CURRENCY FUTURE

Futures markets were designed to solve the problems that exist in forward markets. A

futures contract is an agreement between two parties to buy or sell an asset at a certain

time in the future at a certain price. But unlike forward contracts, the futures contracts

are standardized and exchange traded. To facilitate liquidity in the futures contracts, the

exchange specifies certain standard features of the contract. A futures contract is

standardized contract with standard underlying instrument, a standard quantity and quality

of the underlying instrument that can be delivered, (or which can be used for reference

purposes in settlement) and a standard timing of such settlement. A futures contract may

be 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 units 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 (Reserve Bank of

India, April 2008) as follows;

The rationale for establishing the currency futures market is manifold. Both residents and

non-residents purchase domestic currency assets. If the exchange rate remains unchanged

from the time of purchase of the asset to its sale, no gains and losses are made out of

currency exposures. But if domestic currency depreciates (appreciates) against the

foreign currency, the exposure would result in gain (loss) for residents purchasing foreign

assets and loss (gain) for non residents purchasing domestic assets. In this backdrop,

unpredicted movements in exchange rates expose investors to currency risks.

Currency futures enable them to hedge these risks. 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 investments flows. The argument for hedging currency

risks appear to be natural in case of assets, and applies equally to trade in goods and

services, which results in income flows with leads and lags and get converted into

different currencies at the market rates. Empirically, changes in exchange rate are found

to have very low correlations with foreign equity and bond returns. This in theory should

lower portfolio risk. Therefore, sometimes argument is advanced against the need for

hedging currency risks. 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 are strong arguments to use instruments to hedge currency risks.


FUTURE TERMINOLOGY

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, 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 :


Member’s 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.

USES OF CURRENCY FUTURES

Hedging:

Presume Entity A is expecting a remittance for USD 1000 on 27 August 08.

Wants to lock in the foreign exchange rate today so that the value of inflow in

Indian rupee terms is safeguarded. The entity can do so by selling one contract

of USDINR futures since one contract is for USD 1000.

Presume that the current spot rate is Rs.43 and ‘USDINR 27 Aug 08’ contract is

trading at Rs.44.2500. Entity A shall do the following:

Sell one August contract today. The value of the contract is Rs.44,250.

Let us assume the RBI reference rate on August 27, 2008 is Rs.44.0000. The

entity shall sell on August 27, 2008, USD 1000 in the spot market and get Rs.

44,000. The futures contract will settle at Rs.44.0000 (final settlement price =

RBI reference rate).


The return from the futures transaction would be Rs. 250, i.e. (Rs. 44,250 – Rs.

44,000). As may be observed, the effective rate for the remittance received by

the entity A is Rs.44. 2500 (Rs.44,000 + Rs.250)/1000, while spot rate on that

date was Rs.44.0000. The entity was able to hedge its exposure.

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.


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 mis-pricing 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.

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 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.

REGULATORY FRAMEWORK FOR CURRENCY FUTURES


TRADER( BUYER )

TRADER( SELLER )

MEMBER( BROKER )

MEMBER( BROKER )

CLEARINGHOUSE

Purchase order Sales order

Transaction on the floor (Exchange)

Informs

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.

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

COMPARISION OF FORWARD AND FUTURES CURRENCY CONTRACT


BASIS FORWARD FUTURES

Size Structured as per

requirement of the parties

Standardized

Delivery

date

Tailored on individual

needs

Standardized

Method of

transaction

Established by the bank

or broker through

electronic media

Open auction among buyers 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.

Margins None as such, but

compensating bank

balanced may be required

Margin deposit required

Maturity Tailored to needs: from

one week to 10 years

Standardized

Settlement Actual delivery or offset

with cash settlement. No

separate clearing house

Daily settlement to the market and

variation margin requirements

Market

place

Over the telephone

worldwide and computer

networks

At recognized exchange floor with

worldwide communications

Accessibilit

y

Limited to large

customers banks,

institutions, etc.

Open to any one who is in need of

hedging facilities or has risk capital to

speculate

Delivery More than 90 percent Actual delivery has very less even


settled by actual delivery below one percent

Secured Risk is high being less

secured

Highly secured through margin

deposit.


ANALYSIS

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, 2002, 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, 2002, expiring on June 9, 2002 is : the answer will be

Rs.46.7908 per dollar. Then, this theoretical price is compared with the quoted

futures price on January 10, 2002 and the relationship is observed.


PRODUCT DEFINITIONS OF CURRENCY FUTURE ON

NSE/BSE

Underlying

Initially, currency futures contracts on US Dollar – Indian Rupee (US$-INR)

would be permitted.

Trading Hours

The trading on currency futures would be available from 9 a.m. to 5 p.m.

Size of the contract

The minimum contract size of the currency futures contract at the time of

introduction would be US$ 1000. The contract size would be periodically

aligned to ensure that the size of the contract remains close to the minimum

size.

Quotation

The currency futures contract would be quoted in rupee terms. However, the

outstanding positions would be in dollar terms.

Tenor of the contract

The currency futures contract shall have a maximum maturity of 12 months.

Available contracts

All monthly maturities from 1 to 12 months would be made available.

Settlement mechanism

[Project report on Currency Derivatives] University school of management Kurukshetra University Kurukshetra Page 55

The currency futures contract shall be settled in cash in Indian Rupee.

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.

Final settlement day

The currency futures contract would expire on the last working day (excluding

Saturdays) of the month. The last working day would be taken to be the same as

that for Interbank Settlements in Mumbai. The rules for Interbank Settlements,

including those for ‘known holidays’ and ‘subsequently declared holiday’

would be those as laid down by FEDAI.

The contract specification in a tabular form is as under:

Underlying Rate of exchange between one USD and

INRTrading Hours

(Monday to Friday)

09:00 a.m. to 05:00 p.m.

Contract Size USD 1000

Tick Size 0.25 paisa or INR 0.0025

Trading Period Maximum expiration period of 12 months

Contract Months 12 near calendar months

Final Settlement date/

Value date

Last working day of the month (subject to

holiday calendars)Last Trading Day Two working days prior to Final

SettlementSettlement Cash settled

Final Settlement Price The reference rate fixed by RBI two

working days prior to the final settlement

date will be used for final settlement


CURRENCY FUTURES PAYOFFS

A payoff is the likely profit/loss that would accrue to a market participant with

change in the price of the underlying asset. This is generally depicted in the

form of payoff diagrams which show the price of the underlying asset on the X-

axis and the profits/losses on the Y-axis. Futures contracts have linear payoffs.

In simple words, it means that the losses as well as profits for the buyer and the

seller of a futures contract are unlimited. Options do not have linear payoffs.

Their pay offs are non-linear. These linear payoffs are fascinating as they can be

combined with options and the underlying to generate various complex payoffs.

However, currently only payoffs of futures are discussed as exchange traded

foreign currency options are not permitted in India.

Payoff for buyer of futures: Long futures

The payoff for a person who buys a futures contract is similar to the payoff for a

person who holds an asset. He has a potentially unlimited upside as well as a

potentially unlimited downside. Take the case of a speculator who buys a two-

month currency futures contract when the USD stands at say Rs.43.19. The

underlying asset in this case is the currency, USD. When the value of dollar

moves up, i.e. when Rupee depreciates, the long futures position starts making


profits, and when the dollar depreciates, i.e. when rupee appreciates, it starts

making losses. Figure 4.1 shows the payoff diagram for the buyer of a futures

contract.

Payoff for buyer of future:

The figure shows the profits/losses for a long futures position. The investor bought futures when the USD was at Rs.43.19. If the price goes up, his futures position starts making profit. If the price falls, his futures position starts showing losses.

Payoff for seller of futures: Short futures


PROFIT

LOSS

USDD

0

43.19

The payoff for a person who sells a futures contract is similar to the payoff for a

person who shorts an asset. He has a potentially unlimited upside as well as a

potentially unlimited downside. Take the case of a speculator who sells a two

month currency futures contract when the USD stands at say Rs.43.19. The

underlying asset in this case is the currency, USD. When the value of dollar

moves down, i.e. when rupee appreciates, the short futures position starts 25

making profits, and when the dollar appreciates, i.e. when rupee depreciates, it

starts making losses. The Figure below shows the payoff diagram for the seller

of a futures contract.

Payoff for seller of future:

The figure shows the profits/losses for a short futures position. The investor

sold futures when the USD was at 43.19. If the price goes down, his futures

position starts making profit. If the price rises, his futures position starts

showing losses


PRICING FUTURES – COST OF CARRY MODEL

Pricing of futures contract is very simple. Using the cost-of-carry logic, we

calculate the fair value of a futures contract. Every time the observed price

deviates from the fair value, arbitragers would enter into trades to capture the

arbitrage profit. This in turn would push the futures price back to its fair value.

The cost of carry model used for pricing futures is given below:

F=Se^(r-rf)T

where:

r=Cost of financing (using continuously compounded interest rate)

rf= one year interest rate in foreign

T=Time till expiration in years

E=2.71828


PROFIT

LOSS

USDD

0

43.19

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.

HEDGING WITH CURENCY FUTURES

Exchange rates are quite volatile and unpredictable, it is possible that

anticipated profit in foreign investment may be eliminated, rather even may

incur loss. Thus, in order to hedge this foreign currency risk, the traders’ oftenly

use the currency futures. For example, a long hedge (I.e.., buying currency

futures contracts) will protect against a rise in a foreign currency value whereas

a short hedge (i.e., selling currency futures contracts) will protect against a

decline in a foreign currency’s value.


It is noted that corporate profits are exposed to exchange rate risk in many

situation. For example, if a trader is exporting or importing any particular

product from other countries then he is exposed to foreign exchange risk.

Similarly, if the firm is borrowing or lending or investing for short or long

period from foreign countries, in all these situations, the firm’s profit will be

affected by change in foreign exchange rates. In all these situations, the firm can

take long or short position in futures currency market as per requirement.

The general rule for determining whether a long or short futures position will

hedge a potential foreign exchange loss is:

Loss from appreciating in Indian rupee= Short hedge

Loss form depreciating in Indian rupee= Long hedge

The choice of underlying currency

The first important decision in this respect is deciding the currency in which

futures contracts are to be initiated. For example, an Indian manufacturer wants

to purchase some raw materials from Germany then he would like future in

German mark since his exposure in straight forward in mark against home

currency (Indian rupee). Assume that there is no such future (between rupee and

mark) available in the market then 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.

Choice of the maturity of the contract

The second important decision in hedging through currency futures is selecting

the currency which matures nearest to the need of that currency. For example,

suppose Indian importer import raw material of 100000 USD on 1st November

2008. And he will have to pay 100000 USD on 1st February 2009. And he

predicts that the value of USD will increase against Indian rupees nearest to due


date of that payment. Importer predicts that the value of USD will increase more

than 51.0000.

So what he will do to protect against depreciating in Indian rupee? Suppose

spots value of 1 USD is 49.8500. Future Value of the 1USD on NSE as below:

Price Watch

Order Book

ContractBest Buy Qty

Best Buy Price

Best Sell

Price

Best Sell Qty

LTPVolum

e

OpenInteres

t

USDINR 261108

464 49.8550 49.8575 71249.855

058506 43785

USDINR 291208

189 49.6925 49.7000 61249.730

0176453 111830

USDINR 280109

1 49.8850 49.9250 249.945

05598 16809

USDINR 250209

100 50.1000 50.2275 150.192

53771 6367

USDINR 270309

100 49.9225 50.5000 549.912

5311 892

USDINR 280409

1 50.0000 51.0000 550.500

0- 278

USDINR 270509

- - 51.0000 547.100

0- 506

USDINR 260609

25 49.0000 - -50.000

0- 116

USDINR 290709

1 48.0875 - -49.150

0- 44

USDINR 270809

2 48.1625 50.5000 150.300

06 2215

USDINR 280909

1 48.2375 - -51.200

0- 79

USDINR 281009

1 48.3100 53.1900 250.990

0- 2


http://www.nseindia.com/marketinfo/fxTracker/fxTracker.jsp?filetype=4&HistDate=25112008
























USDINR 261109

1 48.3825 - -50.927

5- -

Volume As On 26-NOV-2008 17:00:00 Hours IST

No. of Contracts244645

ArchivesAs On 26-Nov-2008 12:00:00 Hours IST

UnderlyingRBI reference

rateUSDINR 49.8500

Rules, Byelaws &

RegulationsMembership

CircularsList of Holidays

Solution:

He should buy ten contract of USDINR 28012009 at the rate of 49.8850. Value

of the contract is (49.8850*1000*100) =4988500. (Value of currency future per

USD*contract size*No of contract).

For that he has to pay 5% margin on 5988500. Means he will have to pay

Rs.299425 at present.

And suppose on settlement day the spot price of USD is 51.0000. On settlement

date payoff of importer will be (51.0000-59.8850) =1.115 per USD. And

(1.115*100000) =111500.Rs.

Choice of the number of contracts (hedging ratio)

Another important decision in this respect is to decide hedging ratio HR. The

value of the futures position should be taken to match as closely as possible the

value of the cash market position. As we know that in the futures markets due to

their standardization, exact match will generally not be possible but hedge ratio

should be as close to unity as possible. We may define the hedge ratio HR as

follows:










HR= VF / Vc

Where, VF is the value of the futures position and Vc is the value of the cash

position.

Suppose value of contract dated 28th January 2009 is 49.8850.

And spot value is 49.8500.

HR=49.8850/49.8500=1.001.

FINDINGS

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 it’s also a very help full in Arbitraging.

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 day’s basis.

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.


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

Currency Future need to change some restriction it imposed such as

cut off limit of 5 million USD, Ban on NRI’s and FII’s and Mutual

Funds from Participating.

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 POUND-INR, CAD-INR etc.

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 it’s 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 derivatives…These

instruments enhances the ability to differentiate risk and allocate it to those

investors most able and willing to take it- a process that has undoubtedly

improved national productivity growth and standards of livings.

The currency future 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.


BIBLIOGRAPHY

Financial Derivatives (theory, concepts and problems) By: S.L. Gupta.

NCFM: Currency future Module.

BCFM: Currency Future Module.

Center for social and economic research) Poland

Recent Development in International Currency Derivative Market by: Lucjan T.

Orlowski)

Report of the RBI-SEBI standing technical committee on exchange traded

currency futures) 2008

Report of the Internal Working Group on Currency Futures (Reserve Bank of

India, April 2008)

Websites:

www.sebi.gov.in

www.rbi.org.in

www.frost.com

www.wikipedia.com

www.economywatch.com

www.bseindia.com

www.nseindia.com


http://www.nseindia.com/

http://www.bseindia.com/

http://www.economywatch.com/

http://www.wikipedia.com/

http://www.frost.com/

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

http://www.sebi.gov.in/


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