Currency Futures - A New Leap Ahead

46JUNE 2010 | FINANCIAL PLANNING JOURNAL |

currency Futures – a new Leap aheaD

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The Indian market has been witnessing an increased participation in other financial products, moving away from the obsession with equities. The interests

for other financial products provide an alternate avenue to expand the basket of assets; it also provides hedging avenues for the domestic investors. In 1990s, India got on to a series of structural reforms in the foreign exchange market. The exchange rate being pegged earlier was floated fully in March 1993. The integration of the exchange rate was instrumental in developing a market-determined exchange rate of the rupee and an important step in the progress towards current account convertibility, which was achieved in August 1994. The RBI increased the ceiling for remittances for resident individuals under the Liberalized Remittance Scheme for Resident Individuals to US $ 2,00,000 in a phased manner. Increased overseas investments have also been allowed for corporate houses to facilitate overseas acquisitions and fund internal requirements. The prepayment limits have also been raised to liberalize the guidelines on External Commercial Borrowings (ECBs). Hence, the globalization and amalgamation of financial markets, coupled with increased foreign exchange flows have led to the need of dynamic currency risk management. The free trade flows with other countries, increased participation in international markets and strong economic environment have led to increased inflows in the form of FDIs and FIIs’ investments. Moreover, the foreign exchange market has achieved a new feat in terms of deeper participation, wide range of products, turnover and liquidity. The average daily turnover in the foreign exchange market increased from US $ 23.7 billion in March 2006 to US $ 33.0 billion in March 2007 in consonance with the increase in foreign exchange transactions.

Need for Exchange Traded Currency Futures

Before introduction of Currency Futures pairs, the Indian foreign exchange market was dominated by OTC (Over the Counter) products which were predominantly for large corporate houses. Although liberalization helped India’s forex market in various ways, there were excessive fluctuations of exchange rates in Indian forex market, leading to excessive volatility. So, in context to upgrade Indian foreign exchange market to international standards, a well-developed foreign exchange derivative market was required. The Reserve Bank of India (RBI), India’s Central Bank, set up an Internal Working Group to explore the advantages of introducing currency futures. The group recommended the introduction of Currency Futures in April 2008.

Exchange Traded Futures as compared to OTC forwards serve the same economic purpose, although it differs in fundamental ways (Kindly see Table 1).

Amar RanuSenior Manager, Mutual Fund Research Motilal Oswal Securities Limited

table 1: comparision of Forward and Futures contract

Desription Forward Contract Futures Contract

Nature of Contract

Non-standardized/Customized contract

Standardized contract

Trading Over-the-counter market; Private contract between parties

Traded on Exchange

Risk Counter Party Risk; no guarantee is provided

Exchange provides the guarantee of settlement and hence no counter party risk.

Settlement Single - Precified Daily settlement, known as Daily market settlement and Final settlement

with the availability of abundant off-shore investment opportunities, investors may get tempted to diversify their investments. however, Financial planners may help them in hedging the exchange risks through the effective use of currency Futures.

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In case of forward contract, the money exchange takes place only on maturity date while in the case of exchange traded future contract, mark to market obligations are settled on a daily basis. Since the profits or losses in the futures market are collected / paid on daily basis, the scope for building up of mark to market losses in the books of various participants gets reduced. The presence of a Clearing Corporation which provides Counterparty Guarantee reduces the counterparty risk in a future contract, thus, eliminates credit risk. Further,

in an exchange driven product, the market lot size is much smaller as compared to OTC market. It, thus, provides an equal opportunity to all classes of investors whether large or small to participate in the futures market. Other advantages of an Exchange traded market would be greater transparency, efficiency and accessibility.

Currency Futures Market – A PerspectiveInitially the RBI and Securities and Exchange Board of

India (SEBI) allowed trading in currency futures in India, based on the USD-INR exchange rate. This provided Indian corporate another tool for hedging their foreign exchange risk effectively and flexibly at transparent rates on an electronic trading platform. The contract specifications of the futures are as given below:

Underlying:• Initially, currency futures contracts on US Dollar – Indian Rupee (USD-INR) have been permitted; in April 2010. It has now been extended to Euro – Indian Rupee (EUR-INR), British Pound Sterling – Indian Rupee (GBP-INR) and Japanese Yen – Indian Rupee (JPY-INR).Size of the Contract: • The minimum contract size of the currency futures market is 1,000 USD, 1,000 Euro, 1,000 Pound Sterling and 1,00,000 YEN for USD-INR, EURO-INR, GBP-INR and JPY-INR respectively.Quotation: • The currency futures contracts are quoted in Rupee terms, however, the outstanding positions are in respective currency terms. Trading Hours:• The trading is available from 09:00 a.m. to 5 p.m. from Monday to Friday.Available Contracts:• All monthly maturities from 1 to 12 months are available.

Settlement Mechanism: • It is cash settled in Indian Rupees at RBI Reference Rate on date of expiry.Tenor of the contract: • The maximum maturity is of 12 months.Tick Size:• 0.25 paise or INR 0.0025.Price Operating Range: • +/- 3% of base price for tenure up to 6 months and +/- 5% of base price for tenure greater than 6 months.Settlement:• Daily Settlement at T+1 and Final Settlement

at T+2.Initially, forex markets were beyond the reach of small investors, speculators and arbitragers but with the introduction of currency futures trading in India, apart from exporters, importers, companies and banks, many retail traders and investors can also now take their positions in Foreign Exchange trading. The following are the benefits for different groups:

Hedgers:• Currency Futures provide a high-liquidity platform for hedging against the effects of unfavorable fluctuations in the foreign exchange markets. Exporters, Importers, Corporate and Banks can hedge with Currency Futures at low entry and exit costs.Investors:• All those who are interested in taking a view on the direction of the market i.e. appreciation or depreciation of exchange rate in the long and short term can participate in Currency Futures. For example, if a person expects an appreciation in Indian Rupee against USD, he can sell the USD-INR contract. However, if one expects depreciation of the Indian Rupee against the US dollar, he can take long (buy) position in USD-INR contract.Arbitrageurs:• Arbitrageurs get opportunity to trade in interest rate differentials of respective countries implied from currency futures.

Currency Futures for Forex players and its benefits

After the RBI increased the ceiling for remittances for resident individuals under the Liberalized Remittance Scheme for Resident Individual to US $ 2,00,000, the Currency Futures have attained a more important place due to increased forex volatility. Moreover, Indian corporate houses, including small and medium scale, have seen increased participation in terms of foreign currency borrowings as evident from the figures of External Commercial Borrowings (ECBs) and Foreign Currency Convertible Bonds (FCCBs). So, the currency futures have occupied an important place in terms of reducing foreign exchange volatility. Also, High Networth Individuals (HNIs) have started dabbling in currency futures in search of alternate investment opportunity. There is no data on the participation of retail investors in currency trade, but the

CUrreNCY MANAGeMeNt

the presence of a clearing corporation which provides counterparty Guarantee reduces the counterparty risk in a future contract, thus, eliminates credit risk.


evidence suggests that the trend has started. The reasons are many: one being the equity market is overvalued. Moreover, after the addition of the other currency pairs, there has been considerable interest in futures. The combined volume has almost doubled.

Let us understand how a currency future works in benefits of different stakeholders including individuals:

Consider an exporter XYZ exporting garments worth US $ 1,00,000 wants to protect himself from the possible appreciation in Indian Rupee in Nov 2010 i.e. when he expects to receive the payment. He will lock-in the exchange rate for the above transaction in the manner given below (Kindly see Table 2):

The net receipt in INR for the hedged transaction would be:

Rs. (1,00,000 × 44.40 + 35,000) = Rs. 44,75,000. Had he not taken exposures in Currency Futures market, he would have got only Rs. 44,40,000. Here, we have considered ‘nil’ margin for taking positions in Currency Futures. It is to be noted that the above examples do not include transaction fees and any other fees, which are essential for calculating final profit and loss.

Similarly, the opposite of the above mentioned strategy can be taken if one anticipates depreciation in Indian Rupee. Thus, we see that Currency Future is proved to be a boon for the market participants if it is used properly.

How a retail investor can benefit from Currency Futures?

Similarly, the currency futures can be used for Retail Hedging particularly to remove forex risk while investing abroad. Let us say an investor invests USD 1,00,000 for a period of six months in the NASDAQ with a perspective that the market will grow and he will earn a decent return.

In Indian Rupee, the investment is worth Rs. 45,63,000, considering USD/INR is currently quoting at Rs. 45.63.

After six months, his call goes right and his investments grew by 10%; hence his investments would be worth US $ 1,10,000. Considering the current USD-INR rate at Rs. 41.20 and his investment of US $ 1,10,000, his portfolio would be worth of Rs. 45,32,000. This is a loss making proposition for him, giving a loss of 0.68%, against actual returns of 10% on his investments. During this period, the USD has depreciated against the INR and therefore the returns are poor. Though he was successful in gauging the stock market movement in US NASDAQ but he fails to capture and manage his currency exposure.

Let us now see how he can safeguard himself against his exposures in USD. If he perceives that USD will depreciate, he can go short on currency futures i.e. he sells a USD/INR contract. The table 3 explains the mechanics of hedging through Currency Futures.

Observation: Had the exchange rate been dormant at Rs. 45.63 during the six-month period, the investment in Indian currency would have grown from Rs. 45,63,000 to Rs. 50,19,300 fetching him an absolute return of 4,56,300.

table 2: cashflows of exporter XYZ

One USD-INR Contract Size US $ 1,000

Sell 100 USD-INR Nov 10 Contracts (May 15, 2010)

Rs. 44.75

Buy 100 USD-INR Nov 10 Contracts in Nov 2010

Rs. 44.40

Strategy

Sell USD 1,00,000 in spot market @ Rs. 44.40 in Nov 2010

Assume that his predictions went right and the rupee appreciated to Rs. 44.40 per USD as predicted by the exporter by end of Nov 2010

Profit/Loss from Futures (Nov 2010 Contracts)

= 100× 1000 × (44.75-44.40)

= INR 35,000

table 3: mechanics of hedging through currency Futures

particulars spot Market Futures Market

Leg 1 The current exchange rate is INR 45.63 per USD, therefore, the current investment of USD 1,00,000 is Rs. 45,63,000.

USD-INR contract is at Rs. 45.95; hence, the price per contract is INR 45,950. The approximate number of contract he would sell is 4563000/45950 = 99.30 ≈ 99. Sell 99 contracts for Rs. 45,49,050.

Leg 2 The spot rate is INR 41.20. Receive USD 1,10,000 from his investments. His revenue in INR: 1,10,000 × 41.2 = INR 45,32,000

Buy back 99 contracts at the prevailing rate of USD-INR 41.52. Price per contract is 41,520. Hence, the value of 99 contract is Rs. 41,10,480.

Analysis

profit on Futures transaction is:

INR 45,49,050 Sale Price of Futures

(INR 41,10,480) (Buy Price of Futures)

INR 4,38,750 Profit on Futures

mitigating Forex Risk and calculating stock market Return

INR 45,32,000 Stock Proceedings

INR 4,38,750 Future Gains

INR 49,70,750 Returns

table 4: portfolio Return

without hedging hedging with currency Futures

Invest USD 1,00,000 (USD = Rs. 45.63)

Invests and sells 99 future contracts at Rs. 45.95

Investment grows to USD 1,10,000 after 6 months

After 6 months, square-off futures position at Rs. 41.52.

Sells his investment when the exchange rate is Rs. 41.2

Return (In $) = 10% Return in Rs. Terms:

Loss (In Rs.) = 0.68% Loss on Investment (In Rs.)= Rs. 31,000

(1,10,000 × 41.2 - 1,00,000 × 45.63)/ (1,10,000 × 41.2)

On Futures = Rs. 4,38,750Net Return = 8.93%

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However, during this period, the USD has depreciated by 9.71% and hence, this investment made a loss. The table 4 gives a detailed presentation how he would benefit with and without currency hedging.

Thus, he could post a better return by hedging his overseas portfolio using Currency Futures as compared to the one without hedging.

Indian Journey of Currency FuturesIndian Currency Futures market has surpassed all past

records in terms of volume in comparison to other assets classes, including equity. The total monthly turnover in the Currency Futures increased considerably, from Rs. 2.20 lakh crore in Dec 2009 (NSE and MCX Data) to Rs. 7.19 lakh crore in April 2009. Initially, when the USD-INR currency pair was launched, the average daily volume of currency futures was Rs. 2,179.83 crore in Dec 2008 which increased to Rs. 18,929.05 crore in April 2010, a whooping increase of 359.85 per cent CAGR or an absolute increase of 768 per cent. Even a report of SEBI has noted that the currency futures market is slowly chipping away the market share from the OTC market. This has resulted in reduction of bid-ask spreads (difference between the highest buying and lowest selling price) in currency futures. The report also says that the participation of merchants (importers and exporters) in the OTC market has declined from 62 per cent in November 2008 to 20 per cent in August 2009. The main reason for currency futures being tradable in large quantity is due to less initial money margin which ranges from Rs. 1,300 to Rs. 3,500 per lot, depending upon the volatility and the liquidity for the respective currency pair. Due to an affordable margin requirement and a considerably small lot, these instruments have become a favorite for traders as well as emerging companies including individuals that have a significant business exposure to the countries of the respective currency in terms of revenue earnings.

ConclusionThe exchange traded currency pairs is an extension of

a deeply penetrated OTC market but with added benefits in terms of liquidity, price transparency, standardized contracts, counterparty risk management through Clearing Corporation and no requirement of underlying exposure in the currency. However, it would be too early to predict a major shift in trading activity to exchange based Currency Futures, compared to the OTC Market as OTC Market has created a niche for itself and perhaps it would take some time for the currency futures market to create one for itself.

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Currency Futures - A New Leap Ahead

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