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CURRENCY DERIVATIVES
HAND BOOK
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1. Introduction to Currency Markets
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Introduction
Largest Asset Class
Major currencies: Dollar, Euro, Yen, British Pound, Swiss Franc
Average turnover is over US$ 4 trillion (daily)
Forex derivatives accounts for 40% of ADTV
Main trading centers are London, NY, Tokyo & Singapore
High volumes low margin game with extreme Liquidity 24 hours trading
Range of factor impacting exchange rates
Participants
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Forex Market: 24 a day7 days a week24 Hrs Market (IST)
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INDIAN FOREX MARKET
OTC EXCHANGE TRADED
OPTIONS
SPOT
MCX-SXNSE USE
FUTURES
FORWARDS
SWAPS
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Participants
Large banks
Central Banks
Government
Multinationals & Commercial Companies
Hedge Funds Institutions
Retail Forex Brokers
Speculators
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Basic Definitions simplified
Tom: One business day after deal date (T+1)
Spot: Buying a different currency for immediate delivery (T+2)
Forward: Contract between counterparties to exchange currency on any day afterspot (T+3 or later)
Base currency: In the forex market it is the first currency in any currency pair
Quote or Term Currency: In the Forex markets, is the second currency in any pairalso called the Pip currency.
Eg: USD/CHF rate equals 1.1323 (One dollar is worth CHF 1.1323)
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Basic Definitions simplified
Bid Price
Price at which the market is prepared to buy a specific currency pair in the Forexmarket and you can sell the base currency (on the left side of the quotation)
(eg: in the quote GBP/USD 2.0483/84, the bid price is 2.0483. One can sell one GBP
for 2.0483 USD)Ask (or offer)Price
Price at which the market is prepared to sell a specific currency pair in the Forexmarket and you can buy the base currency (on the right side of the quotation)
(eg: in the quote EUR/USD 1.4692/94, the ask price is 1.4694. One can buy one
Euro for 1.4694 USD)
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Global Currency Composition
Daily Averages in billions of US dollar and per cent
2001 2004 2007
Amount %share Amount %share Amount %share
US dollar/euro
US dollar/yen
US dollar/sterling
US dollar/Australian dollarUS dollar/Swiss franc
US dollar/Canadian dollar
US dollar/Swedish Krona
US dollar/other
Euro/yen
Euro/sterling
Euro/Swiss franc
Euro/other
Other Currency pairs
All currency pairs
354
231
125
4757
50
195
30
24
12
21
26
1,173
30
20
11
45
4
17
3
2
1
2
2
100
503
298
248
9878
71
295
51
43
26
39
42
1,794
28
17
14
54
4
16
3
2
1
2
2
100
840
397
361
175143
115
56
572
70
64
54
112
122
3,081
27
13
12
6
5
4
2
19
2
2
2
4
4
100
Market Turnover By Currency Pair
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Factors Affecting USDINR
ExchangeRate
RBIIntervention
Performance ofEquity Market
PolicyDecisions
Performance ofOther AsianCurrencies
PoliticalFactors
CapitalFlows
FundamentalFactors
UncertainEvents
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Factors Affecting Currency Market
Interest Rates Change in interest rates by Reserve Bank of India
Interest rates change by Federal Reserve (USA)
Interest rates change by European Commercial Bank
Expectation of change in interest rates
Interest rates are positively correlated with a strong currencyWhen interest rates increase in a country, its currency strengthens
against other currencies
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Factors Affecting Currency Market
Inflows of Foreign Funds
Strong economic fundamentals attract funds into the country
Political stability and clear economic direction
Country specific ratings based on economic indicators
Reverse is also true
Foreign funds inflows are positively correlated with a strong currencyWhen funds enter the country, they create a demand for the local
currency (read Rupee) resulting in the currency strengthening
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2. Foreign Currency Derivatives
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Futures & Options
Markets-Debt, Forex & Stocks
What is traded on a Currency exchange?
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In a Nut Shell: Manage Risk
Transfer Risk Price Discovery Integration of Markets Increase Savings in the long run Speculative trading in a controlled environment
Why do we require Currency Derivatives?
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Derivatives: Basic Definitions
Forwards: Customized contracts between two parties where settlement takes place ona pre determined negotiated date price in the future
Futures: Standardized agreement between two parties to buy or sell currency at acertain time in the future at a pre determined price.
Options: Calls & Puts
Warrants: Long dated options
LEAPS: Long Term Equity Anticipation Securities (options with upto 3 years maturity
SWAPS: Agreement between two parties to exchange cash flows in the future accordingto a pre-arranged method
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Forward Vs. Futures
Forward Contracts OTC
Counterparty risk
Terms changeable
Poor liquidity
Few Players
No Margins Relationship
Skill to Structure
Future Contracts
Exchange Traded
Exchange assumes risk
Terms defined by Exchange
High Liquidity
Many Players Margins
Price Transparency
Standard Product
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3. Exchange Traded Currency Futures
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Futures Terminology
Futures contract is a standardized contract, to buy or sell a certain underlying asset oran instrument at a certain date in the future, at a predetermined price
Futures price: price at which a contract trades in the futures market
Currency futures are a linear product
Settlement date is the last business day of the month
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Futures Terminology
Expiry date is the date specified in the contract and will be two business days prior to finalsettlement date
Contract Specifications are details on currency futures contracts as stipulated by RBI-SEBIstanding technical committee report on exchange traded currency futures
Initial margin is the amount to be deposited in the margin account.
Mark- to-Market is the daily adjustment made to the margin account based of the futuresclosing price.
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Contract Specification Snapshot
Underlying USD / INR
Trading Hours 9:00 AM to 5:00 PM
Size of Contract Minimum Lot Size is US$ 1,000
Price Quotation In INR (Tick Size INR 0.0025)
Tenor of Contract Maximum of 12 Months
Available Contracts Monthly
Settlement Mechanism In INR
Settlement Reference Rate RBI USD/INR Reference Rate
Final Settlement Date Last working day of month, except Saturday.
Note: The above product specification is as per the RBI-SEBI Standing Technical CommitteeReport on Exchange Traded Currency Futures
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Rationale behind Currency Futures
Eliminates risk caused by fluctuation in exchange rates
Liquidity to the participant where an existing contract can be offset prior tomaturity by entering into an equal and opposite transaction
Aids Business Planning
Hedging using futures reduces volatility of returns
Hedgers could be:-Corporates, Producers, Intermediaries in Spot Markets, Merchandisers,Traders, Importers & Exporters etc.
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Pricing of Currency Futures
The spot and interest rate differential impact future price perception
Following are three commonly used formulas
a) Term: Base Formula
b) Spot forward r&p Formula
c) Continuous Compounding Formula
Continuous Compounding Formula is preferred
All three methods give very close results
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Continuous Compounding Formula
F = S0e (rd-rf)T
Where,
F = Future PriceS
0
= Spot Price
rd = Domestic Rate of Interest
rf = Interest Rate in the foreign country
T = Tenure
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What is meant by Hedging?
Hedging means taking a position in the future market that is opposite to position in thephysical market with a view to reduce risk associated with unpredictable price change
A long futures hedge is appropriate when you know you will buy an asset in the future and
want to lock in the price
A short futures hedge is appropriate when you know you will sell an asset in the future &want to lock in the price
Types of Hedges
The profit (loss) in the cash position is offset by equivalent loss (profit) in the futures position
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Appreciation and Depreciation of Currency
Event Importer Exporter
Appreciation of USD Loses Money Gains Money
Depreciation of INR Loses Money Gains Money
Event Importer Exporter
Depreciation of USD Gains Money Loses Money
Appreciation of INR Gains Money Loses Money
USDINR 53
USDINR 55
USDINR 50
USDINR 53
Scenario 1
Scenario 2
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Using Futures to Hedge Currency Risk
Transaction
An exporter who has executed an export order and money is to be received on 31 May13, say USD 500,000.
Spot USD/INR was as 54.80 when contract was executed.
RiskRupee will appreciate and export will realize USD 500,000 at a rate lower than 54.80
Hedge StrategyShort (Sell) 500 contracts of each expiry 31 May 13
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Payoff of Hedge vis--vis the transaction:Hypothetical Example
Spot is at 54.80 when the exporter Sell future and
USDINR Dec futures at 55.10
Short (Sell) 500 USDINR futures contracts expiry May 2013.
On Expiry Date 31st
May
Spot on Expiry P/L on Exchange P/L on Physical
55.50 (INR 2,00,000) INR 3,50,000
54.50 INR 3,00,000 (INR 1,50,000)
So if rupee moves either way corporate is hedged against currencyfluctuation.
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Using Futures to Hedge Currency Risk
Transaction
On 1st April, 2013 a student enrolled for CMT-USA October 2013 test and he needs tomake his payment of USD 1000 on 15th September, 2013.
Spot USD/INR was at 53.26 when he got enrolled.
RiskUSD may strengthen over next 6 months causing the enrolment to cost more
Hedge StrategyLong (Buys)1 USDINR Futures contract
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Hedger (Copper Exporter)
On April 1, 2013, an Indian Copper Exporter enters into a contract to Export 1000 MT
of Copper with payment to be received in US Dollar (USD) on July 1, 2013.
The price of copper has been fixed at USD 7200/MT at the prevailing exchange rate of 1USD = INR 54.76
The Cost of One Ton of copper in INR is Rs. 394272 (7200*54.76).
The exporter has a risk of Weakening USD over next three months having negative
implication on his operating margins hence profitability and long-term sustainability
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COPPER EXPORTER
Is Long on USD 7200000 in theSpot market
Short (Sell) 7200 USDINR
futures contracts
Buys USDINR futures contractsto square-off transaction
Sell USD to meet exportrequirement in the spot market
Time t1
Time t2
HedgePeriod
If not hedged and INR weakens, the exporter makes a profit and when INRstrengthen, he will make a loss.
Risk Management Processusing currency futures
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Hedger Practical Implication
DateSpot Market Futures Market
USD-INR July USD Contract
1-April-13 54.76 54.95
1-July-13 56.53 56.72
Market Entry Date Market Price Total Value Exit Date Market Price Total Value Profit / Loss
Spot1-Apr-13
54.76 (L) 3942720001-Jul-13
56.53 (S) 407016000 12744000
Futures 54.95 (S) 395640000 56.72 (L) 408384000 -12744000
The Loss in Futures Market is set off by Profit in Spot Market.
By Hedging, we have locked-in the price i.e. Selling price in spot market Rs. 40701600 + lossfrom Futures market Rs. (-12744000)= Rs. 394272000
Price of Copper = Rs. 7200/MT
Exported Qty. = 1000 MT
No Basis Risk : PerfectHedge situation exists
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SPREADS
What is a Spread?
Difference in price of two futures contractsA spread involves buying one futures contract in one month and simultaneouslyselling another futures contract of a different month.
Participants: Investors / Traders
Objective:
To earn profit from existing spread between near month futures contract and farmonth futures contract.
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What influences spreads?
Interest Rate Differentials Liquidity in the banking system Monetary policy decisions Inflation Intra-Currency Pair Spread Inter-Currency Pair Spread
Normal Market: When the price of the far month futures contract is higherthan the near month one, then it is referred to as normal market.
Inverted Market: If the price of the far month futures contract is lower thanthe near month one, then it is referred to as invertedmarket.
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Arbitrage
Involves buying a contract on one exchange at one price andsimultaneously selling an identical contract on another exchangeat a higher price.
Inter-market arbitrage is possible only when there are pricedifferences between two exchanges.
I M k A bi
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Inter Market Arbitrage
Price difference between currency futures traded on different exchanges results in
arbitrage positions
E.g. On 2 Feb 2013, following is the USDINR Oct futures contract prices
NSE USD/INR 56.0750MCX-SX USD/INR 56.0275
Buy on MCX-SX and simultaneously sell on NSE
Hold until maturity. Final settlement of both contracts at same price of RBI reference rate
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5. Trading
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Market Operations: Trading features
Automated screen-based trading on TWS
National reach
Order driven trading system
Transparent, Objective and Fair system of order matching
Identity of the trader undisclosed
Daily Turnover limits for Buy and Sell for each User linked to deposit
Flexibility in placing orders
Complete Online Market Information
Square-off facility
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Terms
Tenors of Contracts: Period for which the contract is available for trading also calledtrading cycle of the contract
Final Settlement Rate:is the Reserve Bank Reference rate on the date of expiry.
Expiry Date: Contracts expire on last working day (except Saturday) of the contractmonth. The last day for the trading of the contract shall be two days prior to the finalsettlement
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Types of order
Price conditions
Limit Order :- specifying the price at which the trade shouldbe executed
Market Order:-To be executed at prevailing price. For suchorders, the trading system determines the price.
Stop loss Order:- Remains in the system inactive/abeyance
mode and is activated only on trigger of a threshold price,defined by member.
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Time Conditions
Day Order
Available for execution during the Trading Day until executed or cancelled
Unexecuted Day orders get cancelled at EOD
Good Till Cancelled (GTC)
Available for execution till expiry of the contract or till it is cancelled,whichever is earlier
Types of order
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Trading Parameters
Open Price: On the first day is the theoretical futures price & on subsequent tradingdays will be daily settlement price
Close Price:
System generated at the end of the day
Close price is the weighted average price of all trades executed during last 30
minutes in a given contract.
If less than 5 trades during last 30 minutes, then last 10 trades executed during a
trading day
If less than 5 trades during the day, then all trades.
If no trade is executed, last closing price.
l h d S
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Players In the Trading System
Trading Member
Clearing Member
Trading-cum-Clearing Member
Professional Clearing Member
Participants
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6. Clearing Settlement and Risk Management
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Risk Management Tools
Price Circuit filter (Price Range)
Pre-defined in the Contract Specifications
Computed on the previous days Close Price
+/-3% & +/-5%
Position Limits
Margins
Mark-to-Market
Above all- Financial soundness of members
Open Position
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Open Position
SEBI has specified Position Limits for Clients, TM and Clearing Member :
1. At Client level Gross Open Position of client across all contracts cannot exceed 6% oftotal open interest or 10 million USD whichever is higher
2. At Trading Member level Gross Open Position of the Trading Member across allcontracts should not exceed 15% of the total open interest or 50 million USDwhichever is higher.
3. At Clearing Member level No separate position limit prescribed. However shouldensured that all trading position are within above mentioned limits
Margins
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Margins
Type of Margin Description
Initial Margin Subject to a minimum of 1.75 % on the first day of currency futures
trading and 1% thereafter. Initial Margin shall be deducted from LiquidNet worth on an online, real-time basis
Extreme Loss Margin Computed at 1% on the mark to market value of the Gross Open
Position. Extreme loss margin shall be deducted from the liquid assets of
the Clearing Member.
The SPAN based methodology is adopted
o The client-wise margins would be grossed across various clients
at Trading/Clearing member level
o Proprietary positions of the Trading/ Clearing Member treated asthat of a client
Real Time alerts for margin utilization beyond specified percentages
(60%, 75%, 90%)
l l
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Margin Calculation
Day 1. Purchase: One contract of $1000 (Launch of new contract)
a) @ say 51.75 X1000 X (1.75%+1%) = Rs.1423.125 (margin blocked)
(Initial+ELM)
Day 2. Exchange rate weakens
a) @ say 51.95 X 1000 X (1%+2.6%) = Rs.1870..200 (margin )
(ELM+SPAN)
= 447.075 (further margin blocked)
b) M2M = 51.95 - 51.75 X 1000 = Rs.200 Payout
Extreme Loss Margin is calculated at 1% on M2M value of Gross Open Position
M gi C l l ti
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Margin Calculation
Day 3. Exchange rate strengthens
a) @ say 51.25 X 1000 X (1%+2.4%) = Rs.1742.500 (margin)
(ELM+SPAN)
= 127.7 (margin released)
b) M2M = 51.25 - 51.95 X 1000 = Rs.700 Payin
Day 4. Square up open position ie. sell one contract
@ say 52.00 51.25 X 1000 =750 payout + 1742.5 margin released
Calendar Spread Margins
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Calendar Spread Margins
Calendar Spread Margins are only Rs. 250 per lot + (20% of ELM of far
month contract )
Far month contract of $1000 @ Rs.50 = Rs 50000
ELM = 1% = 500
20% of ELM = 100 (note 33.33% instead of 20%)
Spread Margin = 100+250 = Rs. 350
Surveillance System
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Surveillance System
Large Open interest, cost of carry and volatility monitored
Monitor closing prices
Capture and process client level details
Automatically generates alerts highlighting material aberrations
Inspections
Builds database based on trading information
The Exchange as the first level regulator has an online surveillance capabilitythat monitors prices, positions & volumes in real time so as
to deter market manipulation
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Online Monitoring
Price Volatility (RPF file captures the information on periodic basis)
Daily Price Range ( DPR )
Margin Utilization by Members
Marked-to-Market of Members
Maximum Allowable Open Position
Clearing Mechanism
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Clearing Mechanism
Undertaken by Clearing Corporation which undertakes clearing & settlement of alltrades executed in currency derivatives
Clearing members & Clearing banks
Clearing mechanism:
Working out open positions & obligations of TM and CM (aggregating)
Proprietary positions on net basis
Client position by summing buy & sell position
Daily margins generated
Example: Open Position (contracts)
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Example: Open Position (contracts)
TM clearingthrough CM
ProprietaryTrades
Client 1 Client 2 Open Position
XYZ Buy 40
Sell 20
Buy 30
Sell 10
Buy 40
Sell 20
Long 110
Short 50
FRX Buy 20
Sell 30
Buy 80
Sell 60
Buy 30
Sell 70
Short 160
Long 130
Total Long 40
Short 50
Long 110
Short 70
Short 90
Long 70
Net Long 30
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7. Regulatory Framework
A t
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Acts
RBI-SEBI standing technical committee on exchange traded currency and
interest rate derivatives
Provides comprehensive guidelines on the usage of foreign currency forwards,swaps and options in the OTC market
Recommends the introduction of exchange traded currency futures Constituted a technical committees on Exchange Traded Currency and Interest
Rate Derivatives
Foreign Exchange Management Act, 1999 - Provisions
Provided different guidelines and notifications for Currency Trading under RBIsregulation in India.
Provides the Currency Contract Specifications with limits and regulations to befollowed
Regulatory Framework for Exchanges
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Regulatory Framework for Exchanges
Recognized Stock exchanges by SEBI having national reach are allowed to set-upCurrency Futures Segment. Following guidelines are to be fulfilled:
1. The trading should take place through an online screen-based trading system, whichalso has a disaster recovery site.
2. Clearing of currency derivatives should be done by an independent ClearingCorporation.
3. The exchange must have an online surveillance capability which monitors positions,prices and volumes in real time so as to deter market manipulation.
4. The exchange shall have a balance sheet net worth of at least Rs. 100 crores.5. Information about trades, quantities, and quotes should be disseminated by the
exchange in real time to at least two information vending networks6. The exchange should have arbitration and investor grievances redressal mechanism7. The exchange should have adequate inspection capability.
A recognized stock exchange where other securities are also being traded may set upa separate currency futures segment in the following manner:
1. The trading and the order driven platform of currency futures should be separate fromthe trading platforms of the other segments.
2. The membership of the currency futures segment should be separate from themembership of the other segments.
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A Clearing Corporation can function only after obtaining SEBI approval. Its
conditions are as follows:
The Clearing Corporation should be a company incorporated under theCompanies Act, 1956 and should be distinct from the exchange.
The Clearing Corporation must perform full novation.
The Clearing Corporation should enforce the stipulated margin requirements,mark to market settlement, electronic funds transfer, etc.
A separate settlement guarantee fund should be created and maintained.
Regulatory Framework for Clearing Corporations
Eligibility Criteria's for members
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Members in Currency Derivatives segment are required to seek separate
registration from SEBI
Following Entities are eligible to apply:
Individuals
Partnership Firms registered under the Indian Partnership Act, 1932;
Corporations, Companies or Institutions or subsidiaries of such Corporations,Companies or Institutions set up for providing financial services;
Such other person as may be permitted under the Securities Contracts(Regulation) Rules 1957
Eligibility Criteria s for members
Eligibility Criteria's for Banks
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Eligibility Criteria s for Banks
AD Category - I bankauthorized by the Reserve Bank of India under FEMA Act, 1999 arepermitted to become trading and clearing members of the currency futures market, subjectto fulfilling the following minimum prudential requirements:
a) Minimum net worth of Rs. 500 crores.b) Minimum CRAR of 10 per cent.c) Net NPA should not exceed 3 per cent.d) Made net profit for last 3 years.
Banks are required to lay down detailed guidelines with the approval of their Boards fortrading and clearing in currency futures contracts & management of risks.
Urban Co-operative banks or State Co-operative banks who cannot fulfill aboverequirements, can participate in the currency futures market only as clients, subject to
approval from the respective regulatory Departments of the Reserve Bank.
Eligibilit Criteria's for Corporate
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Eligibility Criteria's for Corporate
A company shall be eligible to be a member: such company is formed in compliance with the provisions of Section 12 of the said Act
it undertakes to comply with financial requirements and norms as may be specified by
the SEBI for the registration of such company
the directors of such company are not disqualified for being members of a stockexchange under the Securities Contracts (Regulation) Rules, 1957 and the directors ofthe company had not held the offices of the directors in any company which had been amember of the stock exchange and had been declared defaulter or expelled by theexchange.
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8. Accounting
Accounting
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Accounting
Accounting at Inception of contract
Initial margin will reflect in Current Assets as currency futures account
Bank guarantees & securities lodged will be disclosed in notes to accounts
Accounting at time of daily settlement
Daily credit/debit will reflect in bank account and double entry will be M2Mmargin currency futures account
If client pays lump sum for the purpose of margin/M2M, a separate account tobe debited Deposit for M2M Margin account
At year end the balance in Deposit for M2M Margin account will be reflected incurrent assets.
Accounting for Open Position
Based on valuation on the balance sheet date, profit & loss affected (As30)
Accounting
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Accounting
Accounting in case of default Amount not paid is adjusted against margin (Debit m2m-currency futures
account and credit currency futures account)
Losses on the contract will be recognised on the profit & loss account.
Disclosure Requirements AS32
Taxation:
Income or loss carried out on recognised exchanges is not taxed as speculativeincome or loss. Thus loss can be set off against any other income during theyear (or subsequent assessment year- can be carried forward upto 8 years)
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9. Code of Conduct
Code of Conduct
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Code of Conduct
Brokers
integrity
Exercise of skill & care
Manipulation (for person gain, rumors, deceptive txn)
Malpractices- (False entries/excessively speculative)
Compliance with Statutory requirements -(Govt/SEBI/SE) Breach of Trust (disclose discuss client information)
Not encourage transactions for sole purpose of brokerage
Fairness to client
Protect client interest
Comply with his obligations in completing settlement of transactions
Advertisement & Publicity (unless permitted by exchange)
Code of Conduct
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Code of Conduct
Trading Members
Adequate disclosure in his dealings with clients
No trading member will guarantee against a loss
Observe high standards of commercial honor
Adherence to Trading practices
Act honestly and fairly
Employ resources effectively for performance of business activity Ensue that the fiduciary and other obligations imposed on them and staff by
statutory acts, rules & regulations is complied with.
Responsible for all actions originating through-trading member id & user id
Client is responsibility of the trading member-must ensure compliance
No discretionary powers in the constituents account unless written authorization
given by client Will not disclose name and beneficial identity of a constituent except to currency
derivative segment of the exchange
Code of Conduct
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Code of Conduct
Grievance Redresses Mechanism for Investors
Exchange has a dedicated department to handle grievance Investor to submit in a prescribed compliant form along with supporting to
substantiate claim Exchange scrutinizes the complaint and issues a complaint number and gives an
acknowledgement to the aggrieved
Exchange tries to resolve the matter If differences persist then exchange holds meetings with the parties at exchange
premises Party at fault is enlightened on the correct position on the matter SEBI has instructed exchanges to have arbitration committees which are governed
by exchange by-laws Parties to arbitration are required to select the arbitrator from a panel of
arbitrators Arbitration award is binding on both parties Aggrieved party can within 15 days file an appeal to the arbitration tribunal Final award is enforceable as if it were the decree of the court
7/28/2019 Currency-Hand Book (1)
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UPDATES WILL CONTINUE
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