Currency Derivatives Vijay Tims

8/9/2019 Currency Derivatives Vijay Tims

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Chapter 1

INTRODUCTION

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.

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 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 that was the reason behind development of currency derivatives.



1.1 THE PROJECT

The financial environment today has more risks than earlier. Successful business

firms are those that are able to manage these risks effectively. Due to changes in themacroeconomic structures and increasing internationalization of businesses, there has

been a dramatic increase in the volatility of economic variables such as interest rates,

exchange rates, commodity prices etc. Firms that monitor their risks carefully and

manage their risks with judicious policies enjoy a more stable business than those who

are unable to identify and manage their risks. There are many risks which are influenced

by factors external to the business and therefore suitable mechanisms to manage and

reduce such risks need to be adopted. One of the modern day solutions to manage

financial risks is µhedging¶.

The project is all about what are the hedging instruments (Currency Derivatives)

available in India and how the business corporations are using currency derivatives as a

risk management tool.



1.2 INDUSTRY

1.2.1 HISTORY OF CURRENCY DERIVATIVES

In 1971, the Bretton Woods system of administering fixed foreign exchange rates

was abolished in favour of market-determination of foreign exchange rates; a system of

fluctuating exchange rates was introduced. Besides market-determined fluctuations, there

was a lot of volatility in other markets around the world due to increased inflation and the

oil shock. Corporates struggled to cope up with the uncertainty in profits. It was then that

financial derivatives ± foreign currency, interest rate, and commodity derivatives

emerged as means of managing risks facing corporations.The Chicago Mercantile Exchange (CME) created FX futures, the first ever

financial futures contracts, 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. 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.



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1.2.2 DEVELOPMENT IN INDIA

In India, the economic liberalization in the early nineties provided the economic

rationale for the introduction of FX derivatives. Business houses started activelyapproaching 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 favorable 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.

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

Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on

options 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. The committee recommended that the derivatives should be

declared as µsecurities¶ so that regulatory framework applicable to trading of µsecurities¶

could also govern trading of derivatives.

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.

RBI and SEBI jointly constituted a standing technical committee to analyze the

currency 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 issued circulars in this regard on August 06, 2008.

Currently, Indian Currency market trades with all the major currencies like USD,

EURO, YEN and POUND are traded.



The rationale for introducing futures in the Indian context has been outlined in the

report of the internal working group of Currency Futures (Reserve Bank of India, April

2008) as follows:

The rationale for establishing currency futures market is diverse. 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 diversely with

fast growth in cross-border trade and investment 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 of

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.



1.2.3 Derivatives in India: A Chronology

Date Progress

14 December 1995 NSE asked SEBI for permission to trade index futures.

18 November 1996 SEBI setup L. C. Gupta Committee to draft a policy framework for index futures

11 May 1998 L. C. Gupta Committee submitted report.

7 July 1999 RBI permitted OTC forward rate agreements (FRAs) and interest rate swaps

24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian index.

25 May 2000 SEBI gave permission to NSE and BSE to do index futures trading.

9 June 2000 Trading of BSE Sensex futures commenced at BSE.

12 June 2000 Trading of Nifty futures commenced at NSE.

31 August 2000 Trading of futures and options on Nifty to commence at SIMEX

June 2001 Trading of Equity Index Options at NSE

July 2001 Trading of Stock Options at NSE

9 November 2002 Trading of Single Stock futures at BSE

June 2003 Trading of Interest Rate Futures at NSE

13 September 2004 Weekly Options at BSE

1 January 2008 Trading of Chhota(Mini) Sensex at BSE

1 January 2008 Trading of Mini Index Futures & Options at NSE

6 August 2008 Circulars regarding Currency Futures by RBI & SEBI

29 August 2008 Trading of Currency Futures at NSE

2 October 2008 Trading of Currency Futures at BSE 7 October 2008 MCX-SX came into existence with USD/INR pair

16 June 2010 The all new United Stock Exchange started mock trading in Currency Futures.



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1.3 THE COMPANY



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INTRODUCTION TO MARWADI GROUP

1.3.1 MISSION & VISION

"To be a world-class financial services provider by arranging all

conceivable financial services under one-roof at affordable costs through

cost effective delivery systems, and achieve organic growth in business by

adding newer lines of business.´

1.3.2 COMPANY PROFILE

Marwadi Shares & Finance Limited is a Gujarat based financial service group

dealing in equities / commodities broking and portfolio management services. In the last

15 years MSFL has grown into a network of more than70 branches with an 850+

committed professional people and 475+ channel partners across India. MSFL has kept

the faith of over 1.90 lakh investors and it's growing. After establishing supremacy inGujarat, now expanding nationwide and to fuel growth plans they recently raised capital

from UK-based investment companies. MSFL got 5th rank in best broking houses also.

Marwadi Group strength lies in its team of confident, young, talented, qualified

and experienced professionals to carry out different functions under the able leadership of

its management.

³Marwadi Shares and Finance Limited´ is a huge and very reputed organization in

the world of securities and finance. The organization enjoys a large market share with

highly loyal customers, who in-turn provides a huge business to them.



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1.3.3 MEMBERSHIP

Equity & Derivatives:

National Stock Exchange of India Ltd. (NSE)

Bombay Stock Exchange Ltd. (BSE)

Multi Commodity Exchange of India Ltd. (MCX & MCX-SX)

Commodities Derivatives:

National Commodity & Derivatives Exchange Ltd. (NCDEX)

Multi Commodity Exchange of India Ltd. (MCX)

Depository Participation:

National Securities Depository Ltd. (NSDL)

Central Depository Services India Ltd. (CDSL)



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1.3.4 MILESTONES

The company crossed the following milestones to reach its present position as

the leading retail broking house in India:

y 1992 - Marwadi Shares And Finance Pvt. Ltd. was incorporated.

y 1996 - Became a corporate member of National Stock Exchange Of India - (NSE)

y 1998 - Became a member of Saurashtra Kutch Stock Exchange (MARWADI

SHARES & FINANCE LTD.)

y 1999 - Launched Depository services of Depository Participant under National

Depository Security Ltd. (NSDL)

y 2000 - Commenced Derivative trading after obtaining registration as Clearing and

Trading Member in NSE.

y 2003 - (MCBPL) became a corporate member of the National Commodity and

Derivatives Exchange of India Ltd.

y 2003 - (MCBPL) became a corporate member of The Multi Commodity

Exchange of India Ltd.

y 2004 - Became a corporate member of Bombay Stock Exchange Ltd. (BSE)

y 2004 - Launched Depository Services of Depository Participant under Central

Depository Services (India) Ltd.

y 2005 - Launched Portfolio Management Services

y 2006 - MSFPL converted to Public Limited (Marwadi Shares And Finance

Limited)

y 2006 - The Company raised private equity from ICGU Limited, a wholly owned

subsidiary of India Capital Growth Fund.

y 2007 - The Company raised further private equity from Caledonia Investments.

y 2008 ± Adjudged the 5th Largest Broking House by Dun & Bradstreet.

y 2009 ± Growing Institutional Business.

y 2009 ± Moves in to 90,000 Square Feet State of Art Infrastructure.



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1.3.5 SERVICES @ MARWADI

Equity & Derivatives

Commodity

Internet Trading

Depository Participant

IPO

Mutual Fund

PMS

Research

1.3.6 CORE COMPETENCES

Commodities research & broking services

Online or offline trading facility

Depository services through CDSL

Web based 24 x 7 back office software

Good understanding of the sub-broker and retail customer needs

Professional work culture with a personal touch

Cost- effective processes

Streaming quotes & real time charts for BSE /NSE [cash / derivatives]

Single connectivity and speedy execution of trades.

Online technical support & help desk.



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1.3.7 COMPETITORS OF MSFL



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Chapter ± 2

OBJECTIVES & METHODOLOGY

2.1 OBJECTIVES OF THE PROJECT

The basic idea behind undertaking Currency Derivatives project is to gain

knowledge about currency market.

Primary objectives:

To study the basic concept of currency future. To study exchange traded currency future.

To analyze different currency derivatives products.

Secondary objective:

To know how the currency futures are used as risk management tool.

2.2 METHODOLOGY

All the data and information is collected by me from different sources for the

preparation of this report. To prepare this report, I have adopted following methodology.

Primary data:

The primary data has been collected from experts, officials and employees

working in MARWADI SHARES & FINANCE LTD.

Secondary data:

For secondary data, I have use internet. Links are given for the same.



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Chapter ± 3

3.1 WHAT IS DERIVATIVES?

Derivative is a product whose value is derived from the value of one or more

basic variables, called bases (underlying asset, index, or reference rate), in a contractual

manner. The underlying asset can be equity, foreign exchange, commodity or any other

asset.

For example, wheat farmers may wish to sell their harvest at a future date to eliminate the

risk of a change in prices by that date. Such a transaction is an example of a derivative.

The price of this derivative is driven by the spot price of wheat which is the "underlying".

In the Indian context the Securities Contracts (Regulation) Act, 1956 [SC(R)A]

defines "Derivative" to include-

1. A security derived from a debt instrument, share, loan whether secured or unsecured,

risk instrument or contract for differences or any other form of security.

2. A contract which derives its value from the prices, or index of prices, of underlying

securities.

The Underlying Securities for Derivatives are :

1. Commodities: Castor seed, Grain, Pepper, Potatoes, etc.

2. Precious Metal: Gold, Silver

3. Short Term Debt Securities: Treasury Bills

4. Interest Rates

5.

Common shares/stock 6. Currency derivatives



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3.3 TRADING OF FINANCIAL DERIVATIVES

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 liability.



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3.4 DEFINITIONS

Futures:

A futures contract is an agreement between two parties to buy or sell an asset at acertain time in the future at a certain price. Futures contracts are special types of forward

contracts in the sense that they are standardized and are generally traded on an exchange.

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.

Forwards:

A forward contract is a customized contract between two parties, 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. 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.

Swaps:

Swaps are agreements between two parties to exchange cash flows in the future

according to a prearranged formula. They can be regarded as portfolios 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.



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Options:

Options are of two types - calls and puts. Calls give the buyer the right but not the

obligation to buy a given quantity of the underlying asset, at a given price on or before a

given future date. Puts give the buyer the right, but not the obligation to sell a given

quantity of the underlying asset at a given price on or before a given 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.

In India only currency forwards and currency futures are only allowed. Currency

swaps and currency option is yet not allowed in India.

Recently MCX-SX has started to offer currency futures contracts in US Dollar-

Indian Rupee (USD-INR,) Euro-Indian Rupee (EUR-INR), Pound Sterling-Indian

Rupee (GBP-INR) and Japanese Yen-Indian Rupee (JPY-INR). Clearing and

Settlement is conducted through the MCX Stock Exchange Clearing Corporation Ltd

(MCX-SX CCL).

This year SEBI is also thinking about launching Currency Options for facilitating

all the investors, exporters, importers and MNCs.



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3.5 CURRENCY FORWARDS MARKETS

Forward contracts are agreements to exchange currencies at an agreed rate on a

specified future date. The actual settlement date is more than two working days after the

deal date. The agreed rate is called forward rate and the difference between the spot rate

and the forward rate is called as forward margin. Forward contracts are bilateral contracts

(privately negotiated), traded outside a regulated stock exchange and suffer from counter

-party risks and liquidity risks. Counter Party risk means that one party in the contract

may default on fulfilling its obligations thereby causing loss to the other party.

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 corporates, 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 re-book cancelled

contracts was suspended, which has been since relaxed for the exporters but the

restriction still remains for the importers.



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3.6 THE FUTURE MARKET

Futures is a standardized forward contract to buy (long) or sell (short) the

underlying asset at a specified price at a specified future date through a specifiedexchange. Futures contracts are traded on exchanges that work as a buyer or seller for the

counterparty. Exchange sets the standardized terms in term of quality, quantity, price

quotation, date and delivery place (in case of commodity).

Features:

The features of a futures contract may be specified as follows:

These are traded on an organized exchange like NSE, BSE, MCX etc.

These involve standardized contract terms viz. the underlying asset, the time of

maturity and the manner of maturity etc.

These are associated with a clearing house to ensure smooth functioning of the

market.

There are margin requirements and daily settlement to act as further safeguard.

These provide for supervision and monitoring of contract by a regulatory

authority.

Almost ninety percent future contracts are settled via cash settlement instead of

actual delivery of underlying asset.

Futures contracts being traded on organized exchanges impart liquidity to the

transaction. The clearinghouse, being the counter party to both sides of a transaction, provides a mechanism that guarantees the honoring of the contract and ensuring very low

level of default.



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Types:

Following are the important types of financial futures contract:

Stock Future or equity futures,

Stock Index futures,

Currency futures, and

Interest Rate bearing securities like Bonds, T- Bill Futures.



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Chapter ± 4

4.1 WHAT IS CURRENCY FUTURES?

A future 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 commodity the contract is termed as µCommodity Future

Contract¶. When the underlying is an exchange rate, the contract is termed a ³Currency

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 future contract must fulfill their

obligations on the settlement date.

Currency futures can be case settled by delivering the respective obligation of the

seller and buyer. All settlements however, unlike in the case of OTC market 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 future trading, it is essential to know both the contract size and also

what is the tick value?, A tick value is the minimum trading increment or price

differential at which traders are able to enter bids and offers. Tick value differ for

different currency pairs. In case of USD-INR currency futures contract the tick size shall

be 0.25 Paise to demonstrate how a move of one tick affects the price, imagine a trader

buys a 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.



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4.2 UTILITY OF CURRENCY DERIVATIVES

Traders in the foreign exchange market make thousands of trades daily, buying

and selling currencies while exchanging market information may be used for varied purposes:

For the import and export needs of companies and individuals

For direct foreign investment

To profit from the short-term fluctuations in exchange rates

To manage existing positions or

To purchase foreign financial instruments

Exchange rates are an important consideration when making international

investment decisions. The money invested overseas incurs an exchange rate risk.

When an investor decides to "cash out," or bring his money home, any gains

could be magnified or wiped out depending on the change in the exchange rates in the

interim. Thus, changes in exchange rates can have many effects on an economy:

Affects the prices of imported goods

Affects the overall level of price and wage inflation

Influences tourism patterns

May influence consumers¶ buying decisions and investors¶ long-term

commitments.

In the volatile FX market, traders constantly try to predict the behavior of other

market participants. If they correctly anticipate their opponents¶ strategies, they can act

first and beat the competition.



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Traders make money by purchasing currency and selling it later at a higher price,

or, anticipating the market is heading down, selling at a high price and buying back at a

lower price later.

To predict the movements of currencies, traders often try to determine whether

the currency¶s price reflects its fundamental value in terms of current economic

conditions. Examining inflation, interest rates, and the relative strength of the country¶s

economy helps them make a determination.

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.



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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.

Currency futures provide an additional tool for hedging currency risk.

Further development of domestic foreign exchange market.

Permit trades other than hedges with a view to moving gradually towards fuller

capital account convertibility.

Provide a platform to retail segment of the market to ensure broad based

participation based on equal treatment.

Efficient method of credit risk transfer through the Exchange.

Create a market to facilitate large volume transactions to go through on an

anonymous basis without distorting the levels.



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4.3 PARTIES INVOLVED IN TRADING OF CURRENCY

DERIVATIVES

Exporter:

CDs are used by exporters invoicing the receivables in foreign currency, willing

to protect the earnings foreign currency depreciation by locating the currency conversion

rate at a high level.

Importers:

Importers use CDs for hedging the payables in foreign currency when the foreigncurrency is expected to appreciate and they would always like to guarantee a low

conversion rate.

Investors:

Investors in foreign currency denominated securities would like to secure strong

foreign earnings by obtaining the right to sell the foreign currency at a high conversion

rate, thus defending their revenue from foreign currency derivatives.

MNCs:

MNCs use CDs being engaged in direct investment oversease. They want to

guarantee the rate of purchasing foreign currency for various payments related to

installation of a foreign branch or subsidiary, or to joint venture payment with foreign

partners.

A high degree of volatility creates a fertile ground for foreign exchange

speculators. Their objective is to guarantee a high selling rate of foreign currency by

obtaining a derivative contract while hoping to buy the currency at a low rate in the

future.



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The most commonly used instrument among the CDs is currency forward

contracts. These are large national value selling or buying contracts obtained by

Exporters, Importers, Investors and speculators from bank with the denomination

normally exceeding 2 million USD. The contracts guarantee the future conversion rate

between currencies and can be obtained for any customized amount and any date in the

future. They normally do not require any security deposits since their purchasers are

institutional investors etc. Their transaction costs are set by spread between banks buy

and sell price. Exporters are the most frequent users of this contract.

PARTICIPANTS OF CURRENCY MARKET

Hedgers:

They use derivatives markets to reduce or eliminate the risk associated with price

of an asset. Majority of the participants in derivatives market belongs to this category.

Speculators:

They transact futures and options contracts to get extra leverage in betting on

future movements in the price of an asset. They can increase both the potential gains and

potential losses by usage of derivatives in a speculative venture.

Arbitrageurs:

Their behavior is guided by the desire to take advantage of a discrepancy between

prices of more or less the same assets or competing assets in different markets. If, for

example, they see the futures price of an asset getting out of line with the cash price, theywill take offsetting positions in the two markets to lock in a profit.



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4.4 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.



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Chapter ± 5

EXCHANGE TRADED CURRENCY FUTURES

Future 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 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 entering into an equal and opposite transaction.



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5.1 NEED FOR 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 transect at a forward price on a future date. On the maturity date, the obligation

of the individual equals to the forward price at which the contract was executed. Except

on the maturity date no money changes hands.

On the other hand in case of exchange traded currency futures contract mark to

market obligation is settled on a daily basis. Since the profit or loss in a future market are

collected/paid on a daily basis, the scope of building mark to market loss in the books of

various participants gets limited The counter party risk in future 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 the classes of

investors whether large or small to participate in the future market. The transaction on an

exchange are executed on a price time priority ensuring that the best price is available toall categories of market participant irrespective of their size. Other advantages of an

exchange traded market would be greater transparency, efficiency and accessibility.



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5.2 FUTURES TERMINOLOGY

Spot price:

The price at which an asset trades in the spot market. In the case of USD/INR, spot valueis T + 2.

Futures price:

The price at which the futures contract trades in the futures market.

Contract cycle:

The period over which a contract trades. The currency futures contracts on the SEBIrecognized exchanges have one-month, two-month, and three-month up to twelve-month

expiry cycles. Hence, these exchanges will have 12 contracts outstanding at any given

point in time.

Value Date/Final Settlement 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 µknown

holidays¶ and µsubsequently declared holiday¶ 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. All contracts expire on the last working day

(excluding Saturdays) of the contract months. The last day for the trading of the contract

shall be two working days prior to the final settlement date or value date.



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Contract size:

The amount of asset that has to be delivered under one contract which is also called as lot

size. In the case of USD/INR it is USD 1000; EUR/INR it is EUR 1000; GBP/INR it is

GBP 1000 and in case of JPY/INR it is JPY 100,000.

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 (in commodity markets) the storage

cost plus the interest that is paid to finance or µcarry¶ the asset till delivery less the

income earned on the asset. For equity derivatives carry cost is the rate of interest.

Initial margin:

The amount that must be deposited in the margin account at the time a futures contract is

first entered into is known as initial margin.

Marking-to-market:

In the futures market, at the end of each trading day, the margin account is adjusted to

reflect the investor's gain or loss depending upon the futures closing price. This is called

marking-to-market.



3

5.3 CONTRACT SPECIFICATION



3

5.3 DETAILS OF CONTRACT SPECIFICATION OF USD/INR

FUTURES

Symbol USDINR

Instrument Type FUTCUR

Unit of trading 1 (1 unit denotes 1000 USD)

Underlying The exchange rate in Indian Rupees for a US Dollar

Tick size Rs.0.25 paise or INR 0.0025

Trading hours Monday to Friday

9:00 a.m. to 5:00 p.m

Contract trading cycle 12 month trading cycle.

Last trading day Two working days prior to the last business day of the expiry mo

at 12 noon.

Final settlement day Last working day (excluding Saturdays) of the expiry month. The

working day will be the same as that for Interbank Settlements in

Mumbai.

Quantity Freeze Above 10,000

Base price Theoretical 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 more than 6 months

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

Position limits Clients Trading members Banks

Higher of 6% of Higher of 15% Higher of

total open interest of the total open 15% of total

or USD 10 million interest or open interest

USD 50 million or USD 100

Million

Minimum initial margin 1.75% on day 1, 1% thereafter

Extreme loss margin 1% of MTM value of open position.



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NSE trades Currency Derivatives contracts having near 12 calendar month expiry

cycles. All contracts expire two working days prior to the last working day of every

calendar month (subject to holiday calendars). This is also the last trading day for the

expiring contract. The contract would cease to trade at 12:00 noon on the last trading day.

A new contract with 12th month expiry would be introduced immediately ensuring

availability of 12 monthly contracts for trading at any point.

The Instrument type: FUTCUR refers to 'Futures contract on currency' andContract symbol: USDINR denotes a currency pair of 'US Dollars ± Indian Rupee'. Each

futures contract has a separate limit order book. All passive orders are stacked in the

system in terms of price-time priority and trades take place at the passive order price

(order which has come earlier and residing in the system). The best buy order for a given

futures contract will be the order to buy at the highest price whereas the best sell order

will be the order to sell at the lowest price.

Calendar spreads Minimum Rs. 250/- per contract for all months of spread

Settlement Daily settlement : T + 1

Final settlement : T + 2

Mode of settlement Cash settled in Indian Rupees

Daily settlement price

(DSP)

Calculated on the basis of the last half an hour weighted average

price

Final settlement price

(FSP)

RBI reference rate



3

5.4 TRANSACTION OF A CONTRACT



3

5.5 FACTS & FIGURES ABOUT USD/INR FUTURES CONTRACT

Trade DateTotal

Contracts

Total ValueSpread

Volume

Open

Interest

RBI

Reference

Rate(inRs. Cr.)

19-Nov-08 179362 895.68 - 64676 49.74

01-Dec-08 192221 970.1 - 71325 50.09

01-Jan-09 97289 474.66 - 133015 48.73

01-Dec-09 1845073 8571.3 221069 580426 46.45

01-Jan-10 948881 4437.47 250133 468156 46.65

29-Jan-10 2919761 13557.42 421800 595355 46.37

17-June-2010 36,85,770 17049.6 1276594 - 46.16



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Chapter ± 6

FINDINGS & INFERENCES

6.1 EXAMPLES OF HEDGING

6.1.1

Suppose an edible oil importer wants to import edible oil worth USD 100,000 and

places his import order on June 17, 2010, with the delivery date being 4 months ahead. At

the time of placing the contract one USD is worth Rs 46.50 in the spot market. But,

suppose the Indian Rupee depreciates to INR 46.75 per USD when the payment is due in

October 2010, the value of the payment for the importer goes up to Rs 4,675,000, rather

than Rs 4,650,000. The hedging strategy for the importer, thus, would be:

Current Spot Rate (17th June '10) 46.5000

Buy 100 USD - INR Oct '10 Contracts

on 17th June ¶10

(1000 * 46.5500) * 100 (Assuming the Oct '10

contract is trading at 46.5500 on 17th June, '10)

Sell 100 USD - INR Oct '10 Contracts

in Oct '10 Profit/Loss (futures market)

46.7500

1000 * (46.75 ± 46.55) * 100 = 20,000

Purchases in spot market @ 46.75 Total

cost of hedged transaction

46.75 * 100,000

100,000 * 46.75 ± 20,000 = Rs 4,655,000



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6.1.2

A Jeweller of Rajkot who is exporting gold jewellery worth USD 50,000, wants

protection against possible Indian Rupee appreciation in Dec ¶10, i.e. when he receives

his payment. He wants to lock-in the exchange rate for the above transaction. His strategy

would be:

One USD - INR contract size USD 1,000

Sell 50 USD - INR Dec '10 Contracts

(on 17th June '10)

47.2925

Buy 50 USD - INR Dec '10 Contracts in Dec '10 47.1025

Sell USD 50,000 in spot market @ 47.1025 in Dec '10 (Assume that initially Indian rupee

depreciated , but later appreciated to 47.1025 per USD as foreseen by the exporter by end

of Dec '10)

Profit/Loss from futures (Dec '10 contract) 50 * 1000 *(47.2925 ± 47.1025)

= 0.19 *50 * 1000

= Rs 9,500

The net receipt in INR for the hedged transaction would be: 50,000 *47.1025 + 9,500 =

2,355,125 + 9500 = Rs 2,364,625. Had he not participated in futures market, he would

have got only Rs 2,355,125. Thus, he kept his sales unexposed to foreign exchange rate

risk.



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6.1.3

Suppose an Indian IT exporter receives an export order worth 100,000 from a

European Telecom major with the delivery date being in 3 months time. At the time of

placing the contract, the Euro is worth Rs 56.05 in the spot market, while a futures

contract for an expiry date that matches with order payment date is trading at Rs 56. This

puts the value of the order, when placed, at Rs 5,605,000. However, if the domestic

exchange rate appreciates significantly (to Rs 55.20) when the order is paid for (which is

one month after the delivery date), the firm would receive only Rs 5,520,000 rather than

Rs 5,605,000.

To insure against such losses, the firm can, at the time it receives the order, can

enter into 100 Euro futures contract of 1000 each to sell at Rs 56 a Euro, which involves

contracting to sell a foreign currency on expiry date at the agreed exchange rate. Suppose

on payment date the exchange rate is Rs 55.20, the exporter would receives only Rs

5,520,000 on selling the Euro in the spot market, but gains Rs 80,000 (i.e. 56 - 55.20 *

100 * 1000) in the futures market. Thus, overall the firm receives Rs 5,600,000 and

protects itself from the sharp appreciation of domestic currency against Euro.

In the short term, firms can make gains or losses from hedging. But the basic

purpose of hedging is to protect against excessive losses. Firms also tend to benefit from

knowing exactly how much they will receive from the export deals and can avoid the

uncertainty associated with future exchange rate movements.



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6.1.4

An organic chemicals dealer in India placed an import order worth 100,000 with a

German manufacturer. The current spot rate of the Euro is Rs 56.05 and at this rate the

value of the order is Rs 5,605,000. The importer is worried about sharp depreciation of

the Indian Rupee against the Euro in coming months when the payment is due. So, the

importer buys 100 Euro futures contract (1000 each) at Rs 56 a Euro. Suppose, at expiry

date, the Rupee depreciated to Rs 57, the importer would have to pay Rs 5,700,000, but

he would gain Rs 100,000 (i.e. Rs.67 - 56 * 100 * 1000) from the futures market and the

resultant outflow would be only Rs 5,600,000.

In the short term, firms can make gains or losses from hedging. But the basic

purpose of hedging is to protect against excessive losses. Firms also tend to benefit from

knowing exactly how much they will pay for the import order and avoid the uncertainty

associated with future exchange rate movements.



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6.2 ADVANTAGES OF CURRENCY FUTURES

Low Commissions:

A highly competitive market keeps a tab on brokerage, keeping fees to bare minimum.

No Middlemen:

Futures/Options currency trading allows clients to trade directly on the exchange

platform.

Standardized Lot Size:

Lots or contract sizes are determined and fixed by the exchanges.

Low Transaction Cost:

The retail transaction cost (the bid/ask spread) is typically less than 0.1 percent under

normal market conditions.

Almost Instantaneous Transactions:

High liquidity and low bid/ask spreads lead to immediate trades.

Affordability:

Margins are very low and the contract size is very small. As per the specification of NSE,

USD-INR currency future contract, lot size is 1000$. Margin is 1.75%.

Low Margins, High Leverage:

Margins of 3-5% increase leverage possibilities. These 2 factors increase the potential for

making higher profits (and losses).



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Online Access:

The advent of online (Internet) trading platforms helps you to trade at your convenience

from your home, office or on the go.

No one can corner the market:

The Forex market is so vast and has so many participants that no single entity, not even a

central bank, can control the market price for an extended period of time. Even

interventions by mighty central banks are becoming increasingly ineffectual and short-

lived. Thus central banks are becoming less and less inclined to intervene to manipulate

market prices.

Transparency:

It is possible for everyone to verify trade details on NSE if anyone have a doubt that the

broker has tried to cheat.



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6.3 DISADVANTAGES OF FUTURES

The futures are also disadvantageous in a few areas when compared to OTC

market. The major disadvantages are:

Standardization:

It is not possible to obtain a perfect hedge in terms of amount and timing.

Cost:

Forwards have no upfront cost, while margining requirements may effectively drive

the cost of hedging in futures up.

Small lots:

Generally it is not possible to hedge small exposures.



4

Chapter ± 7

CONCLUSION

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

the extraordinary development and expansion of financial derivatives. These instruments

enhance 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 futures gives the safe and standardized contract to its investors andindividuals 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

minimization.

Initially only NSE had the permission but now BSE & MCX-SX has also started

currency future contracts. It shows that how currency future covers ground in the

compare of the other available derivative instruments. Last month MCX-SX ranked top

amongst all three with more than 50% trades of currency futures contracts in India in

sense of volumes and number of contracts also.

Not only big business houses, exporters and importers use this but individuals

who are interested and having knowledge about forex market they can also invest in

currency future. At Marwadi Shares also many individual investors are investing in

currency futures.

Exchange between USD-INR markets in India is very big and along with it other

currency contracts of Euro, Pound and Japanese Yen are in the market and attracting the

investors which is the reason behind higher growth rate of currency futures in India.



Chapter ± 8

BIBLIOGRAPHY

Websites

www.mcx-sx.comwww.rbi.org.in www.economywatch.com www.nseindia.com www.commodityonline.com www.indiaaprwire.com

www.moneycontrol.com www.karvyforex.com

Books

NCFM: Currency Future Module

CDBM Workbook

Recent Development in International Currency Market

Other sources

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

currency futures, 2008

Report of the internal working group on Currency Futures

Currency Derivatives Vijay Tims

Documents

Transcript of Currency Derivatives Vijay Tims