Currency Derivatives

Presented By

Kalpak K Bhore

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 ACKNOWLEDGEMENT

On the occasion of completion and submission of project, I would like to express

our deep sense of gratitude to B.Y.K.C.C for providing us Platform of studies. I thank to

our Faculty members for their moral support during the project.

I am too glad to give our special thanks to our project guide Mr. Vaibhav

Khandelwal for providing me an opportunity to carryout project on currency derivatives

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

impossible to reach up to this stage.

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

indirectly helped me in the project.

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Research Methodology

Type Of Research

In this project Descriptive research methodologies were use.

The research methodology adopted for carrying out the study was

theoretical study is attempted.

Source Of Data Collection

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

RBI/SEBI committee and NCFM/BCFM modules.

Objectives Of The Study

The basic idea behind undertaking Currency Derivatives project to gain

knowledge about currency future market.

• To study the basic concept of Currency future

• To study the exchange traded currency future

• To study the newly introduced currency derivative products in India.

• To study different currency derivatives products.

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Limitation Of The Study

The limitations of the study were:

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

secondary data might also affect the study undertaken.

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

available in library and market.

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Contents
Currency Derivatives.......................................................................................1

Research Methodology....................................................................................3

Type Of Research .........................................................................................3

Source Of Data Collection.............................................................................3

Objectives Of The Study................................................................................3

Limitation Of The Study................................................................................4

Contents..........................................................................................................5

INTRODUCTION OF CURRENCY DERIVATIVES..................................................9

INTRODUCTION TO FINANCIAL DERIVATIVES.................................................11

DEFINITION OF FINANCIAL DERIVATIVES.....................................................13

Types of Financial Derivatives....................................................................15

Introduction of derivatives in India.............................................................19

Introduction To Currency Derivatives............................................................20

History Of Currency Derivatives.................................................................22

Introduction To Foreign Exchange Market.....................................................23

Foreign Exchange Spot (Cash) Market........................................................24

Foreign Exchange Quotations.....................................................................26

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 The Foreign Exchange Market In India........................................................29

Currency Derivative Products........................................................................31

FORWARD : .............................................................................................31

FUTURE :..................................................................................................31

SWAP : .....................................................................................................32

OPTIONS : ................................................................................................32

Introduction To Currency Future.................................................................34

Need For Exchange Traded Currency Futures.............................................36

Rationale For Introducing Currency Future .............38

Future Terminology.....................................................................................40

SPOT PRICE :............................................................................................40

FUTURE PRICE :........................................................................................40

CONTRACT CYCLE :..................................................................................40

VALUE DATE / FINAL SETTELMENT DATE :...............................................41

EXPIRY DATE :.........................................................................................41

CONTRACT SIZE :....................................................................................41

BASIS :......................................................................................................41

COST OF CARRY : ....................................................................................42

INITIAL MARGIN :......................................................................................42

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 MARKING TO MARKET :............................................................................42

MAINTENANCE MARGIN :.........................................................................43

Uses Of Currency Futures...........................................................................43

Hedging:...................................................................................................43

Speculation: Bullish, buy futures..............................................................44

Speculation: Bearish, sell futures.............................................................45

Arbitrage:.................................................................................................46

Trading Process And Settlement Process ...................................................48

Regulatory Framework For Currency Futures.............................................49

Comparision Of Forward And Futures Currency Contract...........................51

Product Definitions Of Currency .................................................53

Future On NSE/BSE ..............................................53

Underlying................................................................................................53

Trading Hours...........................................................................................53

Size of the contract..................................................................................53

Quotation.................................................................................................53

Tenor of the contract...............................................................................53

Available contracts...................................................................................54

Settlement mechanism............................................................................54

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 Settlement price......................................................................................54

Final settlement day................................................................................54

Contract specification in a tabular form is as under:...............................55

Conclusion.....................................................................................................56

Bibliography...................................................................................................57

Websites:....................................................................................................57

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INTRODUCTION OF CURRENCY DERIVATIVES

Each country has its own currency through which both national and

international transactions are performed. All the international business

transactions involve an exchange of one currency for another.

For example,

If any Indian firm borrows funds from international financial market in US

dollars for short or long term then at maturity the same would be refunded in

particular agreed currency along with accrued interest on borrowed money.

It means that the borrowed foreign currency brought in the country will be

converted into Indian currency, and when borrowed fund are paid to the

lender then the home currency will be converted into foreign lender’s

currency. Thus, the currency units of a country involve an exchange of one

currency for another. The price of one currency in terms of other currency is

known as exchange rate.

The foreign exchange markets of a country provide the mechanism of

exchanging different currencies with one and another, and thus, facilitating

transfer of purchasing power from one country to another.

With the multiple growths of international trade and finance all over the

world, trading in foreign currencies has grown tremendously over the past

several decades. Since the exchange rates are continuously changing, so

the firms are exposed to the risk of exchange rate movements. As a result

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the assets or liability or cash flows of a firm which are denominated in

foreign currencies undergo a change in value over a period of time due to

variation in exchange rates.

This variability in the value of assets or liabilities or cash flows is referred to

exchange rate risk. Since the fixed exchange rate system has been fallen in

the early 1970s, specifically in developed countries, the currency risk has

become substantial for many business firms. As a result, these firms are

increasingly turning to various risk hedging products like foreign currency

futures, foreign currency forwards, foreign currency options, and foreign

currency swaps.

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INTRODUCTION TO FINANCIAL DERIVATIVES

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

been the extraordinary development and expansion of financial

derivatives…These instruments enhances the ability to differentiate risk and

allocate it to those investors most able and willing to take it- a process that

has undoubtedly improved national productivity growth and standards of

livings.”

Alan Greenspan,

Former Chairman.

US Federal

Reserve Bank

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

international trade and business due to the wave of globalization and

liberalization all over the world. As a result, the demand for the

international money and financial instruments increased significantly at the

global level. In this respect, changes in the interest rates, exchange rate and

stock market prices at the different financial market have increased the

financial risks to the corporate world. It is therefore, to manage such risks;

the new financial instruments have been developed in the financial markets,

which are also popularly known as financial derivatives.

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DEFINITION OF FINANCIAL DERIVATIVES

The word is formed by word derivatives. Means this word is arise from the

mathematical term derivation. Which means something derived; some things

are arised or derived out of some underlying variables. The financial

derivatives indeed derived from the financial market.

Derivatives are financial contracts whose value/price is independent on the

behavior of the price of the one or more basic underlying assets. These

contracts are legally binding agreements, made on the trading screen of the

stock exchanges, to buy or sell an asset in future. These assets can be share,

index, interest rates, bond, rupee dollar exchange rate, sugar crude oil,

soyabean, cotton, coffee, and what you have.

A very simple example of derivatives is curd, which is a derivative of milk.

The price of curd depends upon the price of milk which intern depends upon

demand and supply of milk.

Underlying securities for derivatives are following:

• Commodities: castor seeds, grain, potatoes, pepper, etc.

• Precious metals: gold, silver, platinum.

• Short term debt securities: treasury bills.

• Interest rates

• Common shares/stocks
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• Stock index value: NSE Nifty

• Currency: exchange rate

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Types of Financial Derivatives

Financial derivatives are those assets whose values are determined by the

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

Complex varieties of derivatives already in existence and the markets are

innovating newer and newer ones continuously. For example, various types

of financial derivatives based on their different properties like, plain, simple

or straightforward, composite, joint or hybrid, synthetic, leveraged, mildly

leveraged, OTC traded, standardized or organized exchange traded, etc. are

available in the market. Due to complexity in nature, it is very difficult to

classify the financial derivatives, so in the present context, the basic

financial derivatives which are popularly in the market have been described.

In the simple form, the derivatives can be classified into different categories

which are shown below:

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One form of classification of derivative instruments is between commodity

derivatives and financial derivatives. The basic difference between these is

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

the underlying instrument is commodity which may be wheat, cotton,

pepper, sugar, jute, turmeric, corn, crude oil, natural gas, gold, silver and so

on. In financial derivative, the underlying instrument may be treasury bills,

stocks, bonds, foreign exchange, stock index, cost of living index etc. It is to

be noted that financial derivative is fairly standard and there are no quality

issues whereas in commodity derivative, the quality may be the underlying

matters.

Another way of classifying the financial derivatives is into basic and

complex. In this, forward contracts, futures contracts and option contracts

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have been included in the basic derivatives whereas swaps and other

complex derivatives are taken into complex category because they are built

up from either forwards/futures or options contracts, or both. In fact, such

derivatives are effectively derivatives of derivatives

Derivatives traded at organized markets or over the counter (OTC) markets:

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

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controlled by exchanges through clearing house which act as a contractual

intermediary and impose margin requirement. In contrast, OTC derivatives

signify greater vulnerability.

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Introduction of derivatives in India

The gradual liberalization of Indian economy has resulted in substantial

inflow of foreign capital into India. Simultaneously dismantling of trade

barriers has also facilitated the integration of domestic economy with world

economy. With the globalization of trade and relatively free movement of

financial assets, risk management through derivatives products has become

a necessity in India also, like in other developed and developing countries. As

Indian businesses become more global in their approach, evolution of a

broad based, active and liquid forex derivatives markets is required to

provide them with a spectrum of hedging products for effectively managing

their foreign exchange exposures.

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

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

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

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

to develop appropriate regulatory framework for derivatives trading in India,

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

the derivatives should be declared as ‘securities’ so that regulatory

framework applicable to trading of ‘securities’ could also govern trading of

derivatives.

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To begin with, SEBI approved trading in index futures contracts based on

S&P CNX Nifty and BSE-30 (Sensex) index. The trading in index options

commenced in June 2001 and the trading in options on individual securities

commenced in July 2001. Futures contracts on individual stocks were

launched in November 2001.

Introduction To Currency Derivatives

Each country has its own currency through which both national and

international transactions are performed. All the international business

transactions involve an exchange of one currency for another.

For example,

If any Indian firm borrows funds from international financial market in US

dollars for short or long term then at maturity the same would be refunded in

particular agreed currency along with accrued interest on borrowed money.

It means that the borrowed foreign currency brought in the country will be

converted into Indian currency, and when borrowed fund are paid to the

lender then the home currency will be converted into foreign lender’s

currency. Thus, the currency units of a country involve an exchange of one

currency for another.

The price of one currency in terms of other currency is known as exchange

rate.

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The foreign exchange markets of a country provide the mechanism of

exchanging different currencies with one and another, and thus, facilitating

transfer of purchasing power from one country to another.

With the multiple growths of international trade and finance all over the

world, trading in foreign currencies has grown tremendously over the past

several decades. Since the exchange rates are continuously changing, so

the firms are exposed to the risk of exchange rate movements. As a result

the assets or liability or cash flows of a firm which are denominated in

foreign currencies undergo a change in value over a period of time due to

variation in exchange rates.

This variability in the value of assets or liabilities or cash flows is referred to

exchange rate risk. Since the fixed exchange rate system has been fallen in

the early 1970s, specifically in developed countries, the currency risk has

become substantial for many business firms. As a result, these firms are

increasingly turning to various risk hedging products like foreign currency

futures, foreign currency forwards, foreign currency options, and foreign

currency swaps.

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History Of Currency Derivatives

Currency futures were first created at the Chicago Mercantile Exchange

(CME) in 1972.The contracts were created under the guidance and

leadership of Leo Melamed, CME Chairman Emeritus. The FX contract

capitalized on the U.S. abandonment of the Bretton Woods agreement, which

had fixed world exchange rates to a gold standard after World War II. The

abandonment of the Bretton Woods agreement resulted in currency values

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

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

futures extended the reach of risk management beyond commodities, which

were the main derivative contracts traded at CME until then. The concept of

currency futures at CME was revolutionary, and gained credibility through

endorsement of Nobel-prize-winning economist Milton Friedman.

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

currencies, all of which trade electronically on the exchange’s CME Globex

platform. It is the largest regulated marketplace for FX trading. Traders of

CME FX futures are a diverse group that includes multinational corporations,

hedge funds, commercial banks, investment banks, financial managers,

commodity trading advisors (CTAs), proprietary trading firms; currency

overlay managers and individual investors. They trade in order to transact

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

speculate on rate fluctuations.

Introduction To Foreign Exchange Market

The foreign exchange market is a market in which foreign exchange

transactions take place. In other words, it is a market in which national

currencies are bought or sold against one another.

In words of H.E.Evitt, “it is a that section of economic science which deals

with the means and methods by which right to wealth in one country’s

currency are converted into rights to wealth in terms of another country’s

currency. It also involves the investigation of the method by which render

such exchange necessary, the forms which such exchange may take, and the

ratios or equivalent values at which such exchanges are effected.”

The foreign exchange market in terms value of transactions, is largest

market in the world, with daily turnover of over USD 2 trillion. It is a 24 hrs

market. The participants in his markets are:

• Corporates

• Commercial banks

• Exchange brokers and

• Commercial banks.

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Foreign Exchange Spot (Cash) Market

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

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

mostly take place primarily by means of telecommunications both within and

between countries.

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

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

different currencies.

In the spot exchange market, the business is transacted throughout the

world on a continual basis. So it is possible to transaction in foreign

exchange markets 24 hours a day. The standard settlement period in this

market is 48 hours, i.e., 2 days after the execution of the transaction.

The spot foreign exchange market is similar to the OTC market for securities.

There is no centralized meeting place and no fixed opening and closing time.

Since most of the business in this market is done by banks, hence,

transaction usually do not involve a physical transfer of currency, rather

simply book keeping transfer entry among banks.

Exchange rates are generally determined by demand and supply force in

this market. The purchase and sale of currencies stem partly from the need

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to finance trade in goods and services. Another important source of demand

and supply arises from the participation of the central banks which would

emanate from a desire to influence the direction, extent or speed of

exchange rate movements.

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Foreign Exchange Quotations

Foreign exchange quotations can be confusing because currencies are

quoted in terms of other currencies. It means exchange rate is relative

price.

For example,

If one US dollar is worth of Rs. 45 in Indian rupees then it implies that 45

Indian rupees will buy one dollar of USA, or that one rupee is worth of 0.022

US dollar which is simply reciprocal of the former dollar exchange rate.

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

Currency stated against one unit currency per unit of domestic

of foreign currency. currency.

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

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$1 = Rs. 45.7250

There are two ways of quoting exchange rates: the direct and indirect.

Most countries use the direct method. In global foreign exchange market,

two rates are quoted by the dealer: one rate for buying (bid rate), and

another for selling (ask or offered rate) for a currency. This is a unique

feature of this market. It should be noted that where the bank sells dollars

against rupees, one can say that rupees against dollar. In order to separate

buying and selling rate, a small dash or oblique line is drawn after the dash.

For example,

If US dollar is quoted in the market as Rs 46.3500/3550, it means that the

forex dealer is ready to purchase the dollar at Rs 46.3500 and ready to sell

at Rs 46.3550. The difference between the buying and selling rates is called

spread.

It is important to note that selling rate is always higher than the buying rate.

Traders, usually large banks, deal in two way prices, both buying and selling,

are called market makers.

Base Currency/ Terms Currency:

In foreign exchange markets, the base currency is the first currency in a

currency pair. The second currency is called as the terms currency.

Exchange rates are quoted in per unit of the base currency. That is the
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expression Dollar-Rupee, tells you that the Dollar is being quoted in terms of

the Rupee. The Dollar is the base currency and the Rupee is the terms

currency.

Exchange rates are constantly changing, which means that the value of one

currency in terms of the other is constantly in flux. Changes in rates are

expressed as strengthening or weakening of one currency vis-à-vis the

second currency.

Changes are also expressed as appreciation or depreciation of one

currency in terms of the second currency. Whenever the base currency buys

more of the terms currency, the base currency has strengthened /

appreciated and the terms currency has weakened / depreciated.

For example,

If Dollar – Rupee moved from 43.00 to 43.25. The Dollar has appreciated

and the Rupee has depreciated. And if it moved from 43.0000 to 42.7525 the

Dollar has depreciated and Rupee has appreciated.

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The Foreign Exchange Market In India

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

the foreign exchange market. The exchange rate regime, that was earlier

pegged, was partially floated in March 1992 and fully floated in March 1993.

The unification of the exchange rate was instrumental in developing a

market-determined exchange rate of the rupee and was an important step in

the progress towards total current account convertibility, which was

achieved in August 1994.

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

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

deal of concern from policy-makers and investors. While some flexibility in

foreign exchange markets and exchange rate determination is desirable,

excessive volatility can have an adverse impact on price discovery, export

performance, sustainability of current account balance, and balance sheets.

In the context of upgrading Indian foreign exchange market to international

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

as well as Exchange-traded) is imperative.

With a view to enable entities to manage volatility in the currency market,

RBI on April 20, 2007 issued comprehensive guidelines on the usage of

foreign currency forwards, swaps and options in the OTC market. At the

same time, RBI also set up an Internal Working Group to explore the

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advantages of introducing currency futures. The Report of the Internal

Working Group of RBI submitted in April 2008, recommended the

introduction of Exchange Traded Currency Futures.

Subsequently, RBI and SEBI jointly constituted a Standing Technical

Committee to analyze the Currency Forward and Future market around the

world and lay down the guidelines to introduce Exchange Traded Currency

Futures in the Indian market. The Committee submitted its report on May 29,

2008. Further RBI and SEBI also issued circulars in this regard on August 06,

2008.

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

currencies like USD, EURO, YEN, Pound, Swiss Franc etc. are traded. With the

help of electronic trading and efficient risk management systems, Exchange

Traded Currency Futures will bring in more transparency and efficiency in

price discovery, eliminate counterparty credit risk, provide access to all

types of market participants, offer standardized products and provide

transparent trading platform. Banks are also allowed to become members of

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

opportunity.

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Currency Derivative Products

Derivative contracts have several variants. The most common variants are

forwards, futures, options and swaps. We take a brief look at various

derivatives contracts that have come to be used.

FORWARD :

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

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

intended to free both the purchaser and the seller from any risk of loss which

might incur due to fluctuations in the price of underlying asset.

A forward contract is customized contract between two entities, where

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

price. The exchange rate is fixed at the time the contract is entered into.

This is known as forward exchange rate or simply forward rate.

FUTURE :

A currency futures contract provides a simultaneous right and obligation to

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

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

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

a certain price. Future contracts are special types of forward contracts in the

sense that they are standardized exchange-traded contracts.

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SWAP :

Swap is private agreements between two parties to exchange cash flows in

the future according to a prearranged formula. They can be regarded as

portfolio of forward contracts.

The currency swap entails swapping both principal and interest between the

parties, with the cash flows in one direction being in a different currency

than those in the opposite direction. There are a various types of currency

swaps like as fixed-to-fixed currency swap, floating to floating swap, fixed to

floating currency swap.

In a swap normally three basic steps are involve:

1. Initial exchange of principal amount

2. Ongoing exchange of interest

3. Re - exchange of principal amount on maturity.

OPTIONS :

Currency option is a financial instrument that give the option holder a right

and not the obligation, to buy or sell a given amount of foreign exchange at

a fixed price per unit for a specified time period ( until the expiration date ).

In other words, a foreign currency option is a contract for future delivery of a

specified currency in exchange for another in which buyer of the option has

to right to buy (call) or sell (put) a particular currency at an agreed price for

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or within specified period. The seller of the option gets the premium from

the buyer of the option for the obligation undertaken in the contract. Options

generally have lives of up to one year, the majority of options traded on

options exchanges having a maximum maturity of nine months. Longer

dated options are called warrants and are generally traded OTC.

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Introduction To Currency Future

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

or sell a certain underlying asset or an instrument at a certain date in the

future, at a specified price. When the underlying asset is a commodity, e.g.

Oil or Wheat, the contract is termed a “commodity futures contract”. When

the underlying is an exchange rate, the contract is termed a “currency

futures contract”. In other words, it is a contract to exchange one currency

for another currency at a specified date and a specified rate in the future.

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

for a specific value or delivery date. Both parties of the futures contract must

fulfill their obligations on the settlement date.

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

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

of OTC markets, go through the exchange.

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

Currency Futures will be similar to calculating profits or losses on Index

futures. In determining profits and losses in futures trading, it is essential to

know both the contract size (the number of currency units being traded) and

also what is the tick value. A tick is the minimum trading increment or price

differential at which traders are able to enter bids and offers. Tick values

differ for different currency pairs and different underlying. For e.g. in the

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case of the USD-INR currency futures contract the tick size shall be 0.25

paise or 0.0025 Rupees. To demonstrate how a move of one tick affects the

price, imagine a trader buys a contract (USD 1000 being the value of each

contract) at Rs.48.2500. One tick move on this contract will translate to

Rs.48.2475 or Rs.48.2525 depending on the direction of market movement.

Purchase price 48.2500

Price increases by one tick 00.0025

New price 48.2525

Purchase price 48.2500

Price decrease by one tick 00.0025

New price. 48.2475

The value of one tick on each contract is Rupees 2.50. So if a trader buys 5

contracts and the price moves up by 4 tick, she makes Rupees 50.

Step 1: 42.2600 – 42.2500

Step 2: 4 ticks * 5 contracts = 20 points

Step 3: 20 points * Rupees 2.5 per tick = Rupees 50

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Need For Exchange Traded Currency Futures

With a view to enable entities to manage volatility in the currency market,

RBI on April 20, 2007 issued comprehensive guidelines on the usage of

foreign currency forwards, swaps and options in the OTC market. At the

same time, RBI also set up an Internal Working Group to explore the

advantages of introducing currency futures. The Report of the Internal

Working Group of RBI submitted in April 2008, recommended the

introduction of exchange traded currency futures. Exchange traded futures

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

fundamental ways. An individual entering into a forward contract agrees to

transact at a forward price on a future date. On the maturity date, the

obligation of the individual equals the forward price at which the contract

was executed. Except on the maturity date, no money changes hands. On

the other hand, in the case of an exchange traded futures contract, mark to

market obligations is settled on a daily basis. Since the profits or losses in

the futures market are collected / paid on a daily basis, the scope for building

up of mark to market losses in the books of various participants gets limited.

The counterparty risk in a futures contract is further eliminated by the

presence of a clearing corporation, which by assuming counterparty

guarantee eliminates credit risk.

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Further, in an Exchange traded scenario where the market lot is fixed at a

much lesser size than the OTC market, equitable opportunity is provided to

all classes of investors whether large or small to participate in the futures

market. The transactions on an Exchange are executed on a price time

priority ensuring that the best price is available to all categories of market

participants irrespective of their size. Other advantages of an Exchange

traded market would be greater transparency, efficiency and accessibility.

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Rationale For Introducing Currency Future

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

markets. A futures contract is an agreement between two parties to buy or

sell an asset at a certain time in the future at a certain price. But unlike

forward contracts, the futures contracts are standardized and exchange

traded. To facilitate liquidity in the futures contracts, the exchange specifies

certain standard features of the contract. A futures contract is standardized

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

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

reference purposes in settlement) and a standard timing of such settlement. A

futures contract may be offset prior to maturity by entering into an equal and

opposite transaction.

The standardized items in a futures contract are:

• Quantity of the underlying

• Quality of the underlying

• The date and the month of delivery

• The units of price quotation and minimum price change

• Location of settlement

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

outlined in the Report of the Internal Working Group on Currency Futures

(Reserve Bank of India, April 2008) as follows;

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

residents and non-residents purchase domestic currency assets. If the

exchange rate remains unchanged from the time of purchase of the asset to

its sale, no gains and losses are made out of currency exposures. But if

domestic currency depreciates (appreciates) against the foreign currency, the

exposure would result in gain (loss) for residents purchasing foreign assets

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

unpredicted movements in exchange rates expose investors to currency risks.

Currency futures enable them to hedge these risks. Nominal exchange rates

are often random walks with or without drift, while real exchange rates over

long run are mean reverting. As such, it is possible that over a long – run, the

incentive to hedge currency risk may not be large. However, financial

planning horizon is much smaller than the long-run, which is typically inter-

generational in the context of exchange rates. As such, there is a strong need

to hedge currency risk and this need has grown manifold with fast growth in

cross-border trade and investments flows. The argument for hedging currency

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

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

converted into different currencies at the market rates. Empirically, changes

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in exchange rate are found to have very low correlations with foreign equity

and bond returns. This in theory should lower portfolio risk. Therefore,

sometimes argument is advanced against the need for hedging currency risks.

But there is strong empirical evidence to suggest that hedging reduces the

volatility of returns and indeed considering the episodic nature of currency

returns, there are strong arguments to use instruments to hedge currency

risks.

Future Terminology

SPOT PRICE :

The price at which an asset trades in the spot market. The transaction in

which securities and foreign exchange get traded for immediate delivery.

Since the exchange of securities and cash is virtually immediate, the term,

cash market, has also been used to refer to spot dealing. In the case of

USDINR, spot value is T + 2.

FUTURE PRICE :

The price at which the future contract traded in the future market.

CONTRACT CYCLE :

The period over which a contract trades. The currency future contracts in

Indian market have one month, two month, three month up to twelve month

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expiry cycles. In NSE/BSE will have 12 contracts outstanding at any given

point in time.

VALUE DATE / FINAL SETTELMENT DATE :

The last business day of the month will be termed the value date /final

settlement date of each contract. The last business day would be taken to

the same as that for inter bank settlements in Mumbai. The rules for inter

bank settlements, including those for ‘known holidays’ and would be those

as laid down by Foreign Exchange Dealers Association of India (FEDAI).

EXPIRY DATE :

It is the date specified in the futures contract. This is the last day on which

the contract will be traded, at the end of which it will cease to exist. The last

trading day will be two business days prior to the value date / final

settlement date.

CONTRACT SIZE :

The amount of asset that has to be delivered under one contract.

Also called as lot size. In case of USDINR it is USD 1000.

BASIS :

In the context of financial futures, basis can be defined as the futures price

minus the spot price. There will be a different basis for each delivery month

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for each contract. In a normal market, basis will be positive. This reflects

that futures prices normally exceed spot prices.

COST OF CARRY :

The relationship between futures prices and spot prices can be summarized

in terms of what is known as the cost of carry. This measures the storage

cost plus the interest that is paid to finance or ‘carry’ the asset till delivery

less the income earned on the asset. For equity derivatives carry cost is the

rate of interest.

INITIAL MARGIN :

When the position is opened, the member has to deposit the margin with the

clearing house as per the rate fixed by the exchange which may vary asset

to asset. Or in another words, the amount that must be deposited in the

margin account at the time a future contract is first entered into is known as

initial margin.

MARKING TO MARKET :

At the end of trading session, all the outstanding contracts are reprised at

the settlement price of that session. It means that all the futures contracts

are daily settled, and profit and loss is determined on each transaction. This

procedure, called marking to market, requires that funds charge every day.

The funds are added or subtracted from a mandatory margin (initial margin)

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that traders are required to maintain the balance in the account. Due to this

adjustment, futures contract is also called as daily reconnected forwards.

MAINTENANCE MARGIN :

Member’s account are debited or credited on a daily basis. In turn

customers’ account are also required to be maintained at a certain level,

usually about 75 percent of the initial margin, is called the maintenance

margin. This is somewhat lower than the initial margin.

This is set to ensure that the balance in the margin account never becomes

negative. If the balance in the margin account falls below the maintenance

margin, the investor receives a margin call and is expected to top up the

margin account to the initial margin level before trading commences on the

next day.

Uses Of Currency Futures

Hedging:

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

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

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

contract of USDINR futures since one contract is for USD 1000.

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

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

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

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

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

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

= RBI reference rate).

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

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

received by the entity A is Rs.44. 2500 (Rs.44,000 + Rs.250)/1000, while

spot rate on that date was Rs.44.0000. The entity was able to hedge its

exposure.

Speculation: Bullish, buy futures

Take the case of a speculator who has a view on the direction of the market.

He would like to trade based on this view. He expects that the USD-INR rate

presently at Rs.42, is to go up in the next two-three months. How can he

trade based on this belief? In case he can buy dollars and hold it, by

investing the necessary capital, he can profit if say the Rupee depreciates

to Rs.42.50. Assuming he buys USD 10000, it would require an investment

of Rs.4,20,000. If the exchange rate moves as he expected in the next three

months, then he shall make a profit of around Rs.10000. This works out to

an annual return of around 4.76%. It may please be noted that the cost of

funds invested is not considered in computing this return.

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A speculator can take exactly the same position on the exchange rate by

using futures contracts. Let us see how this works. If the INR- USD is Rs.42

and the three month futures trade at Rs.42.40. The minimum contract size is

USD 1000. Therefore the speculator may buy 10 contracts. The exposure

shall be the same as above USD 10000. Presumably, the margin may be

around Rs.21, 000. Three months later if the Rupee depreciates to Rs.

42.50 against USD, (on the day of expiration of the contract), the futures

price shall converge to the spot price (Rs. 42.50) and he makes a profit of

Rs.1000 on an investment of Rs.21, 000. This works out to an annual return

of 19 percent. Because of the leverage they provide, futures form an

attractive option for speculators.

Speculation: Bearish, sell futures

Futures can be used by a speculator who believes that an underlying is over-

valued and is likely to see a fall in price. How can he trade based on his

opinion? In the absence of a deferral product, there wasn't much he could do

to profit from his opinion. Today all he needs to do is sell the futures.

Let us understand how this works. Typically futures move correspondingly

with the underlying, as long as there is sufficient liquidity in the market. If

the underlying price rises, so will the futures price. If the underlying price

falls, so will the futures price. Now take the case of the trader who expects to

see a fall in the price of USD-INR. He sells one two-month contract of futures

on USD say at Rs. 42.20 (each contact for USD 1000). He pays a small
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margin on the same. Two months later, when the futures contract expires,

USD-INR rate let us say is Rs.42. On the day of expiration, the spot and the

futures price converges. He has made a clean profit of 20 paise per dollar.

For the one contract that he sold, this works out to be Rs.2000.

Arbitrage:

Arbitrage is the strategy of taking advantage of difference in price of the

same or similar product between two or more markets. That is, arbitrage is

striking a combination of matching deals that capitalize upon the imbalance,

the profit being the difference between the market prices. If the same or

similar product is traded in say two different markets, any entity which has

access to both the markets will be able to identify price differentials, if any. If

in one of the markets the product is trading at higher price, then the entity

shall buy the product in the cheaper market and sell in the costlier market

and thus benefit from the price differential without any additional risk.

One of the methods of arbitrage with regard to USD-INR could be a trading

strategy between forwards and futures market. As we discussed earlier, the

futures price and forward prices are arrived at using the principle of cost of

carry. Such of those entities who can trade both forwards and futures shall

be able to identify any mis-pricing between forwards and futures. If one of

them is priced higher, the same shall be sold while simultaneously buying

the other which is priced lower. If the tenor of both the contracts is same,

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since both forwards and futures shall be settled at the same RBI reference

rate, the transaction shall result in a risk less profit.

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Trading Process And Settlement Process

Like other future trading, the future currencies are also traded at organized

exchanges. The following diagram shows how operation take place on

currency future market:

TRADER TRADER

( BUYER ) ( SELLER )

Purchase
Sales order
order
Transaction on the floor
MEMBER (Exchange) MEMBER

( BROKER ) ( BROKER )

Inform

CLEARING

HOUSE

It has been observed that in most futures markets, actual physical delivery of

the underlying assets is very rare and hardly it ranges from 1 percent to 5

percent. Most often buyers and sellers offset their original position prior to

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delivery date by taking an opposite positions. This is because most of futures

contracts in different products are predominantly speculative instruments.

For example, X purchases American Dollar futures and Y sells it. It leads to

two contracts, first, X party and clearing house and second Y party and

clearing house. Assume next day X sells same contract to Z, then X is out of

the picture and the clearing house is seller to Z and buyer from Y, and hence,

this process is goes on.

Regulatory Framework For Currency Futures

With a view to enable entities to manage volatility in the currency market,

RBI on April 20, 2007 issued comprehensive guidelines on the usage of

foreign currency forwards, swaps and options in the OTC market. At the

same time, RBI also set up an Internal Working Group to explore the

advantages of introducing currency futures. The Report of the Internal

Working Group of RBI submitted in April 2008, recommended the

introduction of exchange traded currency futures. With the expected benefits

of exchange traded currency futures, it was decided in a joint meeting of RBI

and SEBI on February 28, 2008, that an RBI-SEBI Standing Technical

Committee on Exchange Traded Currency and Interest Rate Derivatives

would be constituted. To begin with, the Committee would evolve norms and

oversee the implementation of Exchange traded currency futures. The Terms

of Reference to the Committee was as under:

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1. To coordinate the regulatory roles of RBI and SEBI in regard to trading

of Currency and Interest Rate Futures on the Exchanges.

2. To suggest the eligibility norms for existing and new Exchanges for

Currency and Interest Rate Futures trading.

3. To suggest eligibility criteria for the members of such exchanges.

4. To review product design, margin requirements and other risk

mitigation measures on an ongoing basis.

5. To suggest surveillance mechanism and dissemination of market

information.

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

stability.

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Comparision Of Forward And Futures Currency Contract

BASIS FORWARD FUTURES

Size Structured as per requirement of the Standardized

parties

Delivery date Tailored on individual needs Standardized

Method of Established by the bank or broker Open auction among buyers and seller on the floor of

transaction through electronic media recognized exchange.

Participants Banks, brokers, forex dealers, Banks, brokers, multinational companies, institutional

multinational companies, institutional investors, small traders, speculators, arbitrageurs, etc.

investors, arbitrageurs, traders, etc.

Margins None as such, but compensating bank Margin deposit required

balanced may be required

Maturity Tailored to needs: from one week to 10 Standardized

years

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Settlement Actual delivery or offset with cash Daily settlement to the market and variation margin

settlement. No separate clearing house requirements

Market place Over the telephone worldwide and At recognized exchange floor with worldwide

computer networks communications

Accessibility Limited to large customers banks, Open to any one who is in need of hedging facilities or has

institutions, etc. risk capital to speculate

Delivery More than 90 percent settled by actual Actual delivery has very less even below one percent

delivery

Secured Risk is high being less secured Highly secured through margin deposit.

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Product Definitions Of Currency

Future On NSE/BSE

Underlying

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

would be permitted.

Trading Hours

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

Size of the contract

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

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

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

size.

Quotation

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

outstanding positions would be in dollar terms.

Tenor of the contract

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

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Available contracts

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

Settlement mechanism

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

Settlement price

The settlement price would be the Reserve Bank Reference Rate on the date

of expiry. The methodology of computation and dissemination of the

Reference Rate may be publicly disclosed by RBI.

Final settlement day

The currency futures contract would expire on the last working day

(excluding Saturdays) of the month. The last working day would be taken to

be the same as that for Interbank Settlements in Mumbai. The rules for

Interbank Settlements, including those for ‘known holidays’ and

‘subsequently declared holiday’ would be those as laid down by FEDAI.

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Contract specification in a tabular form is as under:

Underlying Rate of exchange between one USD

and

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

(Monday to Friday)

Contract Size USD 1000

Tick Size 0.25 paisa or INR 0.0025

Trading Period Maximum expiration period of 12

Contract Months months

12 near calendar months

Final Settlement date/ Last working day of the month (subject

to
Value date

Last Trading Day Two working days prior to Final

Settlement

Settlement Cash settled

Final Settlement Price The reference rate fixed by RBI two

working days prior to the final

settlement date will be used for final

settlement

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Conclusion

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

the extraordinary development and expansion of financial derivatives…

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

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

undoubtedly improved national productivity growth and standards of livings.

The currency future gives the safe and standardized contract to its investors

and individuals who are aware about the forex market or predict the

movement of exchange rate so they will get the right platform for the trading

in currency future. Because of exchange traded future contract and its

standardized nature gives counter party risk minimized.

Initially only NSE had the permission but now BSE and MCX has also started

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

compare of other available derivatives instruments. Not only big

businessmen and exporter and importers use this but individual who are

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

currency future.

Exchange between USD-INR markets in India is very big and these exchange

traded contract will give more awareness in market and attract the investors.

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Bibliography

1. Foreign Exchange By: C. Jivanandam

2. NCFM: Currency future Module.

3. BCFM: Currency Future Module.

4. International business by: Francis Cherunilam

5. Report of the RBI-SEBI standing technical committee on exchange

traded currency futures) 2008

6. Report of the Internal Working Group on Currency Futures (Reserve

Bank of India, April 2008)

Websites:

www.sebi.gov.in

www.rbi.org.in

www.wikipedia.org

www.economywatch.com

www.bseindia.com

www.nseindia.com

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