A project Report On

“Currency derivatives”

BY
Nazneen Sultan (08fc032)

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DECLIARATION I hereby declare that the project title “A study on currency derivatives” submitted by us in partial

fulfillment of the requirement for “Post Graduate Diploma in Finance & Control” by IMIS, Bhubaneswar, is our original work and not submitted elsewhere for the award of any other degree or diploma. Anisha Khandelwal Ankita Singha Roy Kavita Chetry Nazneen Sultan Nidhi Kedia Swarnalata Panigrahi

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ACKNOWLADGEMENT
With regard to our project we would like to thank each and every one who offered help, guideline and support whenever required. We wish to express our deep sense gratitude, profound and venerable thanks to Prof.S.Dev, IMIS-Bhubaneswar who gave us a golden opportunity to do a major concurrent project under his excellent guidance and assistance with his knowledge and in depth outlook of the Derivative Market and critical suggestions, inspiring encouragement.

Anisha Khandalwal (08fc010) Ankita Singha Roy (08fc011) Kavita Chetri (08fc024) Nazneen Sultan (08fc032) Nidhi Kedia (08fc033) Swarnalata Panigrahi (08fc058)

Table of content

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What is Currency Derivatives?
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Currency derivatives is a contract between the seller and the buyer, whose value is to be derived from the underlying asset, the currency amount. A derivative based on currency exchange rates is a future contract which stipulates the rate at which a given currency can be exchanged for another currency as at a future date.

History of currency derivative:Currency derivative are created in the Chicago Mercantile Exchange (CME) in the year of 1972. the contracts are created under the guidance & leadership of leo me lamed, 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 increases the risk of doing a business, by creating another market in which futures could be treaded, CME currency futures extended the reach of risk management beyond commodities which were main derivative contracts traded at CME unit then. The concept of currency futures at CME was revolutionary, & gained credibility through endorsement of nobel-prize-winning economist Milton Friedman. Today, CME offers 41 individual FX futures & 31, options contracts on 19 currencies, all of which trade electronically on the exchanges CME Globex platform. It is a largest regulated marketplace for FX trading. Traders of CME FX futures are a diverse group that includes multinational corporations, hedge funds, commertial banks, investment banks, financial managers, commodity trading advisors, proprietary trading firms. Currency overlay managers & individual investors. They trade in order to transact business hedge against unfavorable changes in currency rates or to speculate on rate fluctuations.

Brief history or overview of foreign exchange market
During early 1990’s.india embarked on a series of structural reforms in the foreign 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 developing a market determined exchange rate of the rupee and was important steps in the progress towards total current account convertibility, which was achieved in 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 concen from policy makers and investors. While some flexibility in foreign exchange markets and exchange rate determination is desirable, excessive volatility can have an adverse effect on price discovery ,export performance , sustainability of current account balance & balance sheet.

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In the content of upgrading Indian foreign market exchange to international standards a well developed foreign exchange market (both PTC as well as exchange traded ) is imperative. With a view to entities to manage volatilities in the currency market, RBI on April 207, issued comprehensive guidelines on the wage of foreign currency forwards, swaps ,& options in the OTC market. At the same time, RBI also set up an internal working group to explore the advantage of introducing currency futures.The report of the internal working group of RBI submitted in April 2008, recommended the introduction of exchange traded currency derivative. Subsequently , RBI & SEBI jointly constituted the standing technical committee to analyse the currency forward and future market around the world and lay down the guidelines to introduce traded currency futures in the Indian market. The committee submitted it’s report on may 29,2008, further RBI& SEBI also issued circular on this regard, on August 06,2008. Currently, India is a US D 34 billion OTC market, where all the major currencies like USD, EURO, YEN, Pound , Swiss and France are trade. 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 counter party credit risk, provide access to all types of market participants, offer standard products and provide transparent trading platform, marks are allowed to become of this segment on the exchange , thereby providing them with a new oppurtinity.

Product definition of currency futures on NSE / BSE
UDERLYING: Initially, currency futures contracts on USD- INDIAN RUPEE(US$-INR) would be permitted. TRADING HOURS: The trading on currency futures would be available from 9a.m to 5p.m SIZE OF THE CONTRACT: The minimum contract size of the currency futures contract at the time of introduction would be US$100.The contract size would be predically aligned to ensure that the size of the contract remains close to minmum size. QUATATION: The currency futures contrac would be quated in rupee terms. However the outstanding postion would be in dollar terms. TENOR OF CONTRACT: The currency contract shall have maximum maturity of 12 months. AVAILABLE CONTRACT: All monthly maturities from 1to 12months would be made available. SETTLEMENT MECHANISM:

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The currency futures contract shall be settled in cash in Indian rupee. SETTLEMENT PRICE: The settlement price would the reserve bank reference rate on the date of expiry. The methodology of computation and dissemination of refrence rate may be publicly disclosed by RBI. FINAL SETTLEMENT DAY: The currency futures date 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 of interbank settlement in Mumbai. The rules for interbank settlement, including those for known holidays and subsequently declared holiday would be those as laid down by FEDAI.

Utility of Currency Derivatives Exporter: - CDs are used by exporters invoicing the receivables in foreign currency,
willing to protect the earnings foreign currency depreciation by locating the currency conversion rate at a high level.

Importers: - Importers use CDs for hedging the payables in foreign currency when the
foreign currency is expected to appreciate and they would always like to guarantee a low conversion rate. Investors: - Investors in foreign currency denominated securities would like to secure strong foreign earnings by obtaining the right to sell the foreign currency at a high conversion rate, thus defending their revenue from foreign currency derivatives.

MNCs: - MNCs use CDs being engaged in direct investment oversease.They want to
guarantee the rate of purchasing foreign currency for various payments related to installation of a foreign branch or subsidiary, or to joint venture payment with foreign partners. A high degree of volatility creates a fertile ground for foreign exchange speculators. Their objective is to guarantee a high selling rate of foreign currency by obtaining a derivative contract while hoping to bye the currency at a low rate in the future. The most commonly used instrument among the CDs is currency forward contracts. These are large national value selling or buying contracts obtained by Exporters, Importers, Investors and speculators from bank with the denomination normally exceeding 2 million USD. The contracts guarantee the future conversion rate between currencies and can be obtained for any customized amount and any date in the future. They normally do not require any security deposits since their purchasers are institutional investors etc.Their

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transaction costs are set by spread between banks buy and sell price. Exporters are the most frequent users of this contract.

USE of currency future
Hedging : suppose entity A expects a remmitance for USD 1000 and he wants to lock in the foreign exchange rate today his value of inflows in Indian rupees. A can do so by selling one contract of USD-INR future since one contract is for USD 1000. Suppose the spot market prices Rs.43 The future market price is Rs. 44.2500 If he sales one future contract today he will get: 44.25*1000 = Rs.44250 Suppose on 20th December the reference rate by RBI is Rs.44 .00 if he sale the USD at the spot market he will get 44000 and the future contract will also settle at 44000. Return = 44250 – 44000 = 250 For the remittance rate = ( 44000 + 250 )/1000 = 44.25 While the spot rate is 44.00 the entity is able to hedge his exposure

speculation
bullish market : suppose the speculator has the idea about market movement and he wants to go by his view. If the USD-INR rate today is Rs.45(say). And he expects it to go up in next two three months to 45.50(say). In this scenario he will buy the future to get profit. Bearish market: The speculator expects the market to go down in near 2-3 months then he will sale the future.

Arbitrage
It is the strategy of taking advantage of difference of price between two or more markets. One of the methods of arbitrage with regard to USD-INR could be the trading strategy between forward and future market. If the USD-INR Rate in future is low and in forward market is high then the investor can buy a contract in future market and sale in forward market having same maturity. Currency derivatives: A survey on Indian corporate The paper examines management motivations of foreign currency derivatives usage in corporate India and identifies significant differences, if any, in the motivations of the firms who are either using foreign currency derivatives or having a documented foreign exchange risk management policy vis-à-vis the firms who do not. It also captures the management motivations of foreign currency derivatives usage in a factor-analytic framework.

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The universe of companies selected for this study consisted of 640 companies, which are common across two most widely used Indian stock market indices namely S&P CNX 500 and BSE 500 firms as at the end of March 31, 2004 having foreign exchange exposure, which is a fair representation of corporate India. A nationwide questionnaire-based survey was conducted to capture the management motivations of foreign currency derivatives usage. 55 responses were received leading to a response rate of 8.59%. The most of the respondent firms (70.4%) have documented foreign exchange risk management plan/policy/programme. The transaction exposure as a foreign currency risk is more critical to the firms (74.5%) followed by translation exposure (58.3% responded as moderate degree of risk) and economic exposure (54.3% responded as low degree of risk). To reduce the volatility in profits after tax, cash flows, and to reduce the cost of capital and thus increase the value of the firm on one side of the pole and to reduce the risks faced by the management on the other side of the pole are the major motivations of the firms using foreign currency derivatives in India. The firms with high debt ratio are more likely to use foreign currency derivatives. The major objective of using derivatives is hedging the risk (96.1% responded as rank one objective), for arbitrage purpose (55.3% assigned rank two) and price discovery (36.4% assigned rank two and 33.3% assigned rank three). The speculation as objective of using foreign currency derivative is the least preferred option (62.1% assigned it as rank four). The management motivations for the use of foreign currency derivatives captured in factor-analytic framework are 'hedging to improve value of firm', 'management utility and compensation', 'accounting and disclosure requirements', 'strengthen control systems’, and 'avail tax benefits and reduce cost of capital'. The firm characteristics such as high degree of debt ratio and ESOPs usage influence the use of foreign currency derivatives. These seven factors explain 59.28% of the total variance.

Foreign exchange quotation
Foreign exchange quotations may be confusing because currencies are quoted in terms of another currency. Mainly there are two methods of quoting: 1. Direct method and 2. Indirect method Direct method is followed by most of the countries in which the numbers of domestic currency is stated against one unit of foreign currency. For example: in we have to spent Rs.45 to purchase one unit dollar than quotation can be written as: Rs. /$ = 45 or $1 = Rs. 45 In case of indirect method of quoting value of one unit of domestic currency is stated against foreign currency. If we continue with the previous example then it can be quoted as: Rs. 1 = 1/45 or 0.02222 In the global foreign exchange market two rates are quoted by dealers – one rate is buying rate which is also called the BID RATE and another is selling rate which is also known as 9

ASK RATE. To separate the buying and selling rate a small desh or oblique line is drawn. For example: Rs. = 45.6600/6650 Here the bid price is Rs.45.6600 and ask price is Rs. 45.6650 and the difference between these two rates is known as SPREAD. SPREAD = 45.6650 – 45. 6600 = .0050

Trading process of currency derivative

Like other future trading the future currency is also traded in organised exchange. Above flow diagram of trading is shown. When the market opens transaction takes place at the floor of the exchange when the trader wants to sell or purchase he/she has to place the sale or purchase order to the broker who are issued an unique identification number by the exchange. Traders directly cannot make any transaction directly in the exchange, they have to trade through brokers after placing the sales or purchase order all the transactions are done by broker in exchange and exchange informs it to the clearing house. In any transaction seller and buyer does not know each other. Also beyond the trading hours transactions may take place through an electronic system, called GLOBEX. It connects the market of Chikago, Paris, London and others from 2.30 pm to 7.05 am the following morning. GLOBEX system also matches the purchase and selling order for each type of currency future contracts. NEED FOR EXCHANGE TRADED CURRENCY FUTURES Exchange traded futures as compared to OTC forwards serve the same economic purpose yet differ in fundamental ways. An individual entering into a forward contract agrees to transect at a forward price on a future date. On the maturity date, the obligation of the individual equals to the forward price at which the contract was executed. Except on the maturity date no money changes hands. On the other hand in case of exchange traded currency futures contract mark to market obligation is settled on a daily basis. Since the profit or loss in a future market are collected/paid on a daily basis, the scope of building mark to market loss in the books of various participants gets limited The counter party risk in future contract is further eliminated by the presence of a clearing corporation, which by assuming counterparty guarantee eliminates credit risk. Further in an exchange traded scenario where the market lot is fixed at a much lesser size than the OTC market, equitable opportunity is provided to all the classes of investors whether large or small to participate in the future market. The transaction on an exchange 10

are executed on a price time priority ensuring that the best price is available to all categories of market participant irrespective of their size. Other advantages of an exchange traded market would be greater transparency, efficiency and accessibility.

REGULATORY FRAMEWORK FOR EXCHANGE TRADED CURRENCY FUTURES With a view to enable entities to manage volatility in the currency market, RBI on Feb. 20 2007 Issued comprehensive guidelines on the usage of currency forward, swaps, and option in the OTC market. At the same time RBI also set up an Internal Working Group to explore the advantage of introducing the 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 benefit of exchange traded currency futures it was decided in a joint meeting of RBI and SEBI on Feb. 2008 that the RBISEBI standing technical committee on exchange traded currency and interest rate derivative would be constituted. To begin with the committee would evolve norms and oversee the implementation of exchange traded currency future. The terms of reference to the committee were as under. To co-ordinate the regulatory roles of RBI and SEBI in regard to currency and interest rate futures on the exchanges. To suggests the eligibility norms for existing and new exchanges for currency and interest rate futures trading. To suggest the eligibility criteria for member of such exchanges. To review the product design, margin requirement and other risk mitigation measures on an ongoing basis To suggest surveillance mechanism and dissemination of market information To consider microstructure issues in the overall interest of the financial stability

FINDINGS: Exchange traded currency future trading is regulated by higher authority and regulator .The whole function of Exchange traded currency future is regulated by SEBI/RBI,they establishes rules and regulations so that trading is done safely and counter party risk is minimized. Larger exporter and importer has continued to deal in the OTC. In India RBI and SEBI has restricted other currency derivatives except Currency Future, at this time if any person wants to use other instrument of currency derivatives in this case he has to use OTC. 11

SUGGESTIONS: Currency future need to change some restrictions it imposed like NRI’s, FII, Mutual funds are not allowed to participate. In Currency Future segment only one pair USD-INR is available to trade , other pair should also be introduced like POUND-INR. In India SEBI has banned other currency derivatives except currency futures. According, to the Indian financial growth now it’s become necessary to introduce other currency derivatives in Exchange traded currency derivatives segment. CONCLUSION: During the past decade, basically in finance ,an extraordinary development and expansion of financial derivatives. These instruments enhances the ability to differentiate risk and allocate it to those investors who are most able and willing to take it. 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 get the right platform from the trading in currency future. Initially only NSE had the permission but now BSE and MCX has also starter currency future. It shows that how currency future covers grounds in compare of other available derivatives instruments. Not only big business and exporters and importers use this but individuals who are interested and having knowledge about forex market they can also invest in currency future.

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