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A Project on ANALYTICAL STUDY ON CURRENCY DERIVATIVES IN INDIA (Submitted in partial fulfillment of the requirement of Master of Business Administration, Distance

Education Guru Jambheshwar University of Science & Technology , Hisar

Research Supervisor: Mr. Nikhil Kulshrestha (Associate Prof.) NSB

Submitted by : Lavnish jaitly Enrolment No.08061148429 Specialization :- FINANCE

Session 2008-10 Directorate of Distance Education Guru Jambheshwar University of Science & Technology Hisar (India)

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CERTIFICATE

This is to certify that MR LAVNISH JAITLY, Enrolment No. 08061148429 has preceded under by supervision her Research Project Report on ANALYTICAL STUDY ON CURRENCY DERIVATIVE IN INDIA in the specialization area FINANCE.

The work embodied in this report is original and is of the standard expected of an MBA student and has not been submitted in part or full to this or any other university for the award of any degree or diploma. She has completed all requirements of guidelines for Research Project Report and the work is fit for evaluation.

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DECLARATION
This is to certify that the project Report entitled ANALYTICAL STUDY ON CURRENCY DERIVATIVE IN INDIA is an original work and has not been submitted is part or full to this or any other university/institution the award of any degree or diploma.

Signature of candidateNAME: ENROLMENT NO.: SPECILIZATION: SESSION: Lavnish Jaitly 08061148429 FINANCE 2008-2010

TABLE OF CONTENTS
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1) Introduction 2) Objectives of the study

3) Literature review & problem formulation i) History and Development of Currency Derivative ii) Brief overview of foreign exchange market. iii) Rationale for Introducing Currency Futures 4) Research methodology 5) Analysis & Interpretation 6) Key findings 7) Suggestion 8) Limitation of the study 9) Annexture 10)Biblioagraphy

INTRODUCTION
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Each country has its own currency through which both national and international transactions are performed. another. The foreign exchange markets of a country provide the mechanism of exchanging different currencies with one and another, and thus, facilitating another . With the multiple growths of international trade and finance all over the world, trading in foreign currencies has grown tremendously over the past several decades. Since the exchange rates are continuously changing, so the firms are exposed to the risk of exchange rate movements. As a result the assets or liability or cash flows of a firm which are denominated in foreign currencies undergo a change in value over a period of time due to variation in exchange rates. This variability in value of assets or liabilities or cash flows is referred to exchange rate risk. Since the fixed exchange rate system has been fallen in the early 1970s, specifically in developed countries, the currency risk become substantial behind development of currency derivatives. has for many business fir ms that was the reason transfer of purchasing power from one country to All the inter national business transactions involve an exchange of one currency for

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Each country has its own currency through which both national and international transactions are performed. 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 lenders currency. 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 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. 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 All the international business transactions involve an exchange of one currency for another.

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OBJECTIVES OF STUDY
The primary objective of the study is first to gain some practical knowledge

regarding the functioning of Currency Derivatives and how are they traded in the market. Also it is necessary to understand there primary functions and knowledge about various future derivatives instruments.

The other objectives were:

To study the Importance of Currency Derivatives.

To study the role of working of future and options market.

To study the process and functions of Currency Derivatives .To explore the

methodology and types of Derivatives provided in India.

To study the purpose, process, principle, functions of the Currency Derivatives.

To study the different types of methods/techniques used to evaluate them.

To study the level of evaluations. know the challenges which are faced in present market scenario.

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Literature review and problem formulation

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 derivativesThese 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.

**DEFINITION OF FINANCIALDERIVATIVES**
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A word formed by derivation. It means, this word has been arisen by derivation. Something derived; it means that some things have to be derived or arisen out of the underlying variables. A financial derivative is an indeed derived from the financial market. Derivatives are financial contracts whose value/price is independent on the behavior of the price of one or more basic underlying assets. These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future. These assets can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil, soybeans, cotton, coffee and what you have. A very simple example of derivatives is curd, which is derivative of milk. The price of curd depends upon the price of milk which in turn depends upon the demand and supply of milk. The Underlying Securities for Derivatives are : Commodities: Castor seed, Grain, Pepper, Potatoes, etc. Precious Metal : Gold, Silver Short Term Debt Securities : Treasury Bills Interest Rates Common shares/stock Stock Index Value : NSE Nifty Currency : Exchange Rate

TYPES OF FINANCIAL DERIVATIVES


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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 : DERIVATIVES

Financials

Commodities

Basics 1. Forwards 2. Futures 3. Options 4. Warrants and Convertibles

Complex 1. Swaps 2.Exotics (Non STD)

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. [Project report on Currency Derivatives] IBMR-Ahmedabad Page 10

Another way of classifying the financial derivatives is into basic and complex. In this, forward contracts, futures contracts and option contracts 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 are traded at organized exchanges and in the Over The Counter ( OTC ) market : Derivatives Trading Forum

Organized Exchanges Commodity Futures Financial Futures Options (stock and index) Stock Index Future

Over The Counter Forward Contracts Swaps

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 riskthe risk of default by either party. With the exchange traded derivatives, the risk is controlled by exchanges through clearing house which act as a contractual intermediary and impose margin requirement. In contrast, OTC derivatives signify greater vulnerability.

DERIVATIVES INTRODUCTION IN INDIA


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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. 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.

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 exchanges 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 [Project report on Currency Derivatives] IBMR-Ahmedabad Page 12

managers, commodity trading advisors (CTAs), proprietary trading firms; currency overlay managers and individual investors. They trade in order to transact business, hedge against unfavorable changes in currency rates, or to speculate on rate fluctuations. Source: - (NCFM-Currency future Module)

UTILITY OF CURRENCY DERIVATIVES

Currency-based derivatives are used by exporters invoicing receivables in foreign currency, willing to protect their earnings from the foreign currency depreciation by locking the currency conversion rate at a high level. Their use by importers hedging foreign currency payables is effective when the payment currency is expected to appreciate and the importers would like to guarantee a lower conversion rate. Investors in foreign currency denominated securities would like to secure strong foreign earnings by obtaining the right to sell foreign currency at a high conversion rate, thus defending their revenue from the foreign currency depreciation. Multinational companies use currency derivatives being engaged in direct investment overseas. They want to guarantee the rate of purchasing foreign currency for various payments related to the installation of a foreign branch or subsidiary, or to a joint venture with a foreign partner. A high degree of volatility of exchange rates creates a fertile ground for foreign exchange speculators. Their objective is to guarantee a high selling rate of a foreign currency by obtaining a derivative contract while hoping to buy the currency at a low rate in the future. Alternatively, they may wish to obtain a foreign currency forward buying contract, expecting to sell the appreciating currency at a high future rate. In either case, they are exposed to the risk of currency fluctuations in the future betting on the pattern of the spot exchange rate adjustment consistent with their initial expectations.

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The most commonly used instrument among the currency derivatives are currency forward contracts. These are large notional value selling or buying contracts obtained by exporters, importers, investors and speculators from banks with denomination normally exceeding 2 million USD. The contracts guarantee the future conversion rate between two currencies and can be obtained for any customized amount and any date in the future. They normally do not require a security deposit since their purchasers are mostly large business firms and investment institutions, although the banks may require compensating deposit balances or lines of credit. Their transaction costs are set by spread between bank's buy and sell prices.

Exporters invoicing receivables in foreign currency are the most frequent users of these contracts. They are willing to protect themselves from the currency depreciation by locking in the future currency conversion rate at a high level. A similar foreign currency forward selling contract is obtained by investors in foreign currency denominated bonds (or other securities) who want to take advantage of higher foreign that domestic interest rates on government or corporate bonds and the foreign currency forward premium. They hedge against the foreign currency depreciation below the forward selling rate which would ruin their return from foreign financial investment. Investment in foreign securities induced by higher foreign interest rates and accompanied by the forward selling of the foreign currency income is called a covered interest arbitrage. Source :-( Recent Development in International Currency Derivative Market by Lucjan T. Orlowski)

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INTRODUCTION TO CURRENCY DERIVATIVES


Each country has its own currency through which both national and international transactions are performed. 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 lenders currency. 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 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 Thus, the currency units of a country involve an exchange of one All the international business transactions involve an exchange of one currency for another.

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foreign currency futures, foreign currency forwards, foreign currency options, and foreign currency swaps.

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 case of the USD-INR currency futures contract the tick size shall be 0.25 paise or 0.0025 [Project report on Currency Derivatives] IBMR-Ahmedabad Page 16

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.42.2500. One tick move on this contract will translate to Rs.42.2475 or Rs.42.2525 depending on the direction of market movement.

Purchase price: Price increases by one tick: New price: Purchase price: Price decreases by one tick: New price:

Rs .42.2500 +Rs. 00.0025 Rs .42.2525 Rs .42.2500 Rs. 00.0025 Rs.42. 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: Step 2: Step 3: 42.2600 42.2500 4 ticks * 5 contracts = 20 points 20 points * Rupees 2.5 per tick = Rupees 50

BRIEF OVERVIEW OF FOREIGN EXCHANGE MARKET

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OVERVIEW OF 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 policymakers 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 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.

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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. Source :-( Report of the RBI-SEBI standing technical committee on exchange traded currency futures) 2008.

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.

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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 todays pre-agreed price. The exchange rate is fixed at the time the contract is entered into. 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. This is known as forward

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

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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 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.

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.

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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 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.

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,

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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.

EXCHANGE RATE

Direct The number of units of domestic Currency stated against one unit of foreign currency. Re/$ = 45.7250 ( or ) $1 = Rs. 45.7250

Indirect The number of unit of foreign currency per unit of domestic currency. Re 1 = $ 0.02187

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,

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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 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--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,

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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.

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. 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 [Project report on Currency Derivatives] IBMR-Ahmedabad Page 25

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. Source :-( Report of the RBI-SEBI standing technical committee on exchange traded currency futures) 2008.

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

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Location of settlement

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 nonresidents 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 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.

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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. [Project report on Currency Derivatives] IBMR-Ahmedabad Page 28 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 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.

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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 for each contract. In a normal market, basis will be positive. exceed spot prices. This reflects that futures prices normally

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 : [Project report on Currency Derivatives] IBMR-Ahmedabad Page 30

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) 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 :

Members 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

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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: 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.

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 [Project report on Currency Derivatives] IBMR-Ahmedabad Page 32

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 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 [Project report on Currency Derivatives] IBMR-Ahmedabad Page 33

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 mispricing 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, since both forwards and futures shall be settled at the same RBI reference rate, the transaction shall result in a risk less profit.

TRADING PROCESS AND SETTLEMENT PROCESS

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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 ( BUYER )

TRADER ( SELLER )

Purchase order

Sales order

Transaction on the floor (Exchange)

MEMBER ( BROKER )

MEMBER ( BROKER )

Informs 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 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


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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: 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.

COMPARISION OF FORWARD AND FUTURES CURRENCY CONTRACT


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BASIS Size Delivery date Method of transaction Participants

FORWARD Structured as per

FUTURES Standardized

requirement of the parties Tailored on individual needs Standardized Established by the bank or broker through electronic media Banks, brokers, forex dealers, multinational companies, institutional investors, arbitrageurs, traders, etc. None as such, but compensating bank balanced may be required Tailored to needs: from one Open auction among buyers and seller on the floor of recognized exchange. Banks, brokers, multinational companies, institutional investors, small traders, speculators, arbitrageurs, etc.

Margins

Margin deposit required

Maturity Settlement

Standardized

week to 10 years Actual delivery or offset with Daily settlement to the market and cash settlement. No variation margin requirements At recognized exchange floor with worldwide communications separate clearing house Over the telephone worldwide and computer networks

Market place

Accessibilit y Delivery Secured

Limited to large customers banks, institutions, etc. More than 90 percent settled by actual delivery Risk is high being less secured

Open to any one who is in need of hedging facilities or has risk capital to speculate Actual delivery has very less even below one percent Highly secured through margin deposit.

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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 at the first stage theoretical study is attempted and at the second stage observed online trading on NSE/BSE.

SOURCE OF DATA COLLECTION

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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 understand the practical considerations and ways of considering currency future price. To analyze different currency derivatives products.

SCOPE OF PROPOSED STUDY: Currency-based derivatives are used by exporters invoicing

receivables in foreign currency, willing to protect their earnings from the foreign currency depreciation by locking the currency conversion rate at a high level. Their use by importers hedging foreign currency payables is effective when the payment currency is expected to appreciate and the importers would like to guarantee a lower conversion rate. Investors in foreign currency denominated securities would like to secure strong foreign earnings by obtaining the right to sell foreign currency at a high conversion rate, thus defending their
[Project report on Currency Derivatives] IBMR-Ahmedabad Page 39

revenue

from use

the

foreign

currency

depreciation. being

Multinational in direct

companies

currency

derivatives

engaged

investment overseas. They want to guarantee the rate of purchasing foreign currency for various payments related to the installation of a foreign branch or subsidiary, or to a joint venture with a foreign partner. A high degree of volatility of exchange rates creates a fertile ground for foreign exchange speculators. Their objective is to guarantee a high selling rate of a foreign currency by obtaining a derivative contract while hoping to buy the currency at a low rate in the future. Alternatively, they may wish to obtain a foreign currency forward buying contract, expecting to sell the appreciating currency at a high future rate. In either case, they are exposed to the risk of currency fluctuations in the future betting on the pattern of the spot exchange rate adjustment consistent with their initial expectations. The most commonly used instrument among the currency derivatives are currency forward contracts. These are large notional value selling or buying contracts obtained by exporters, importers, investors and speculators from banks with denomination normally exceeding 2 million USD. The contracts guarantee the future conversion rate between two currencies and can be obtained for any customized amount and any date in the future. They normally do not require a security deposit since their purchasers are mostly large business firms and investment institutions, although the banks may require compensating deposit balances or lines of credit. Their transaction costs are set by spread between bank's buy and sell prices.
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Exporters invoicing receivables in foreign currency are the most frequent users of these contracts. They are willing to protect themselves from the currency depreciation by locking in the future currency conversion rate at a high level. A similar foreign currency forward selling contract is obtained by investors in foreign currency denominated bonds (or other securities) who want to take advantage of higher foreign that domestic interest rates on government or corporate bonds and the foreign currency forward premium. They hedge against the foreign currency depreciation below the forward selling rate which would ruin their return from foreign financial investment. Investment in foreign securities induced by higher foreign interest rates and accompanied by the forward selling of the foreign currency income is called a covered interest arbitrage.

DATA COLLECTION Data collection is a term used to describe a process of preparing and collecting business data - for example as part of a process improvement or similar project. Data collection usually takes place early on in an improvement project, and is often formalized through a data collection Plan which often contains the following activity.

1. Pre collection activity Agree goals, target data, definitions, methods 2. Collection data collection

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3. Present Findings usually involves some form of sorting analysis and/or presentation

There are two methods of data collection which are discussed below:

DATA COLLECTION

Primary Data (Data collection techniques)

Secondary Data

Questionnaire

Interview

External Source

Internet

Intrenal source

PRIMARY DATA In primary data collection, you collect the data yourself using methods such as interviews and questionnaires. The key point here is that the data you collect is unique to you and your research and, until you publish, no one else has access to it.

I have tried to collect the data using methods such as interviews and questionnaires. The key point here is that the data collected is unique and research and, no one else has access to it. It is done to get the real scenario and
[Project report on Currency Derivatives] IBMR-Ahmedabad Page 42

to get the original data of present.

DATA COLLECTION TECHNIQUE

Questionnaire: Questionnaire are a popular means of collecting data, but are difficult to design and often require many rewrites before an acceptable questionnaire is produced. The features included in questionnaire are: Theme and covering letter Instruction for completion Types of questions Length

Interview: This technique is primarily used to gain an understanding of the underlying reasons and motivations for peoples attitudes, preferences or behavior. The interview was done by asking a general question. I encourage the respondent to talk freely. I have used an unstructured format, the subsequent direction of the interview being determined by the respondents initial reply, and come to know what is its initial problem is.

SAMPLING METHODOLOGY
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Sampling technique:

Initially, a rough draft was prepared keeping in mind the objective of the research. A pilot study was done in order to know the accuracy of the questionnaire. The final questionnaire was arrived only after certain important changes were done. Thus my sampling came out to be judgmental and continent.

Sampling Unit: The respondents who were asked to fill out questionnaires are the sampling units.

Sampling Size: 20 SECONDARY DATA All methods of data collection can supply quantitative data (numbers, statistics or financial) or qualitative data (usually words or text). Quantitative data may often be presented in tabular or graphical form. Secondary data is data that has already been collected by someone else for a different purpose to yours.

Need of using secondary data 1. Data is of use in the collection of primary data.
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2. They are one of the cheapest and easiest means of access to information. 3. Secondary data may actually provided enough information to resolve the Problem being investigated. 4. Secondary data can be a valuable source of new ideas that can be explored later through primary research.

Limitation of secondary data 1. May be outdated. 2. No control over data collection. 3. May not be reported in the required form. 4. May not be reported in the required form. 5. May not be very accurate. 6. Collection for some other purpose.

ANALYSIS

INTEREST RATE PARITY PRINCIPLE


For currencies which are fully convertible, the rate of exchange for any date other than spot is a function of spot and the relative interest rates in each currency. The assumption is that, any funds held will be invested in a time deposit of that currency. Hence, the forward rate is the rate which neutralizes the effect of differences in the interest rates in both the currencies. The forward rate is a function of the spot rate and the interest rate [Project report on Currency Derivatives] IBMR-Ahmedabad Page 45

differential between the two currencies, adjusted for time. In the case of fully convertible currencies, having no restrictions on borrowing or lending of either currency the forward rate can be calculated as follows;

Future Rate = (spot rate) {1 + interest rate on home currency * period} / {1 + interest rate on foreign currency * period}

For example, Assume that on January 10, 2002, six month annual interest rate was 7 percent p.a. on Indian rupee and US dollar six month rate was 6 percent p.a. and spot ( Re/$ ) exchange rate was 46.3500. Using the above equation the theoretical future price on January 10, 2002, expiring on June 9, 2002 is : the answer will be Rs.46.7908 per dollar. Then, this theoretical price is compared with the quoted futures price on January 10, 2002 and the relationship is observed.

[Project report on Currency Derivatives] IBMR-Ahmedabad Page 46

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.

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.

The contract specification in a tabular form is as under: Underlying Trading Hours (Monday to Friday) Contract Size Tick Size Trading Period Contract Months Final Settlement Value date Last Trading Day Settlement date/ USD 1000 0.25 paisa or INR 0.0025 Maximum expiration period of 12 months 12 near calendar months Last working day of the month (subject to Holiday calendars) Two working days prior to Final Settlement Date Cash settled Rate of exchange between one USD and INR 09:00 a.m. to 05:00 p.m.

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Final Settlement Price

The reference rate fixed by RBI two working days prior to the final settlement date will be used for final settlement

CURRENCY FUTURES PAYOFFS


A payoff is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on the X-axis and the profits/losses on the Y-axis. Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. Options do not have linear payoffs. Their pay offs are nonlinear. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. However, currently only payoffs of futures are discussed as exchange traded foreign currency options are not permitted in India.

Payoff for buyer of futures: Long futures


The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who buys a twomonth currency futures contract when the USD stands at say Rs.43.19. The underlying asset in this case is the currency, USD. When the value of dollar moves up, i.e. when Rupee depreciates, the long futures position starts making profits, and when the dollar depreciates, i.e. when rupee appreciates, it starts making losses. Figure 4.1 shows the payoff diagram for the buyer of a futures contract.

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Payoff for buyer of future:


The figure shows the profits/losses for a long futures position. The investor bought futures when the USD was at Rs.43.19. If the price goes up, his futures position starts making profit. If the price falls, his futures position starts showing losses.

P R O F I T
43.19

0 USD
D

L O S S

Payoff for seller of futures: Short futures


The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells a two month currency futures contract when the USD stands at say Rs.43.19. The underlying

50

asset in this case is the currency, USD. When the value of dollar moves down, i.e. when rupee appreciates, the short futures position starts 25 making profits, and when the dollar appreciates, i.e. when rupee depreciates, it starts making losses. The Figure below shows the payoff diagram for the seller of a futures contract.

Payoff for seller of future:


The figure shows the profits/losses for a short futures position. The investor sold futures when the USD was at 43.19. If the price goes down, his futures position starts making profit. If the price rises, his futures position starts showing losses

P R O F I T
43.19

0 USD
D

L O S S

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PRICING FUTURES COST OF CARRY MODEL


Pricing of futures contract is very simple. Using the cost-of-carry logic, we calculate the fair value of a futures contract. Every time the observed price deviates from the fair value, arbitragers would enter into trades to capture the arbitrage profit. This in turn would push the futures price back to its fair value. The cost of carry model used for pricing futures is given below: F=Se^(r-rf)T where: r=Cost of financing (using continuously compounded interest rate) rf= one year interest rate in foreign T=Time till expiration in years E=2.71828 The relationship between F and S then could be given as F Se^(r rf )T - = This relationship is known as interest rate parity relationship and is used in international finance. To explain this, let us assume that one year interest rates in US and India are say 7% and 10% respectively and the spot rate of USD in India is Rs. 44. From the equation above the one year forward exchange rate should be F = 44 * e^(0.10-0.07 )*1=45.34

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It may be noted from the above equation, if foreign interest rate is greater than the domestic rate i.e. rf > r, then F shall be less than S. The value of F shall decrease further as time T increase. If the foreign interest is lower than the domestic rate, i.e. rf < r, then value of F shall be greater than S. The value of F shall increase further as time T increases.

HEDGING WITH CURENCY FUTURES


Exchange rates are quite volatile and unpredictable, it is possible that anticipated profit in foreign investment may be eliminated, rather even may incur loss. Thus, in order to hedge this foreign currency risk, the traders oftenly use the currency futures. For example, a long hedge (I.e.., buying currency futures contracts) will protect against a rise in a foreign currency value whereas a short hedge (i.e., selling currency futures contracts) will protect against a decline in a foreign currencys value. It is noted that corporate profits are exposed to exchange rate risk in many situation. For example, if a trader is exporting or importing any particular product from other countries then he is exposed to foreign exchange risk. Similarly, if the firm is borrowing or lending or investing for short or long period from foreign countries, in all these situations, the firms profit will be affected by change in foreign exchange rates. In all these situations, the firm can take long or short position in futures currency market as per requirement. The general rule for determining whether a long or short futures position will hedge a potential foreign exchange loss is: Loss from appreciating in Indian rupee= Short hedge Loss form depreciating in Indian rupee= Long hedge

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The choice of underlying currency


The first important decision in this respect is deciding the currency in which futures contracts are to be initiated. For example, an Indian manufacturer wants to purchase some raw materials from Germany then he would like future in German mark since his exposure in straight forward in mark against home currency (Indian rupee). Assume that there is no such future (between rupee and mark) available in the market then the trader would choose among other currencies for the hedging in futures. Which contract should he choose? Probably he has only one option rupee with dollar. This is called cross hedge.

Choice of the maturity of the contract


The second important decision in hedging through currency futures is selecting the currency which matures nearest to the need of that currency. For example, suppose Indian importer import raw material of 100000 USD on 1st November 2008. And he will have to pay 100000 USD on 1st February 2009. And he predicts that the value of USD will increase against Indian rupees nearest to due date of that payment. Importer predicts that the value of USD will increase more than 51.0000. So what he will do to protect against depreciating in Indian rupee? Suppose spots value of 1 USD is 49.8500. Future Value of the 1USD on NSE as below:
Price Watch
Order Book Contract USDINR 261108 USDINR 291208 USDINR 280109 USDINR 250209 USDINR 270309 USDINR 280409 USDINR 270509 USDINR 260609 USDINR 290709 Best Buy Qty 464 189 1 100 100 1 25 1 Best Buy Price 49.8550 49.6925 49.8850 50.1000 49.9225 50.0000 49.0000 48.0875 Best Sell Price 49.8575 49.7000 49.9250 50.2275 50.5000 51.0000 51.0000 Best Sell Qty 712 612 2 1 5 5 5 LTP 49.8550 49.7300 49.9450 50.1925 49.9125 50.5000 47.1000 50.0000 49.1500 Volume 58506 176453 5598 3771 311 Open Interest 43785 111830 16809 6367 892 278 506 116 44

54

USDINR 270809 USDINR 280909 USDINR 281009 USDINR 261109

2 1 1 1

48.1625 48.2375 48.3100 48.3825

50.5000 53.1900 -

1 2 -

50.3000 51.2000 50.9900 50.9275

6 -

2215 79 2 -

Volume As On 26-NOV-2008 17:00:00 Hours IST

No. of Contracts 244645


Archives As On 26-Nov-2008 12:00:00 Hours IST

Rules, Byelaws & Regulations Membership Circulars List of Holidays

Underlying USDINR

RBI reference rate 49.8500

Solution: He should buy ten contract of USDINR 28012009 at the rate of 49.8850. Value of the contract is (49.8850*1000*100) =4988500. (Value of currency future per USD*contract size*No of contract). For that he has to pay 5% margin on 5988500. Means he will have to pay Rs.299425 at present. And suppose on settlement day the spot price of USD is 51.0000. On settlement date payoff of importer will be (51.0000-59.8850) =1.115 per USD. And (1.115*100000) =111500.Rs.

Choice of the number of contracts (hedging ratio)

55

Another important decision in this respect is to decide hedging ratio HR. The value of the futures position should be taken to match as closely as possible the value of the cash market position. As we know that in the futures markets due to their standardization, exact match will generally not be possible but hedge ratio should be as close to unity as possible. We may define the hedge ratio HR as follows: HR= VF / Vc Where, VF is the value of the futures position and Vc is the value of the cash position. Suppose value of contract dated 28th January 2009 is 49.8850. And spot value is 49.8500. HR=49.8850/49.8500=1.001.

FINDINGS

56

Cost of carry model and Interest rate parity model are useful tools to find out standard future price and also useful for comparing standard with actual future price. And its also a very help full in Arbitraging. New concept of Exchange traded currency future trading is regulated by higher authority and regulatory. The whole function of Exchange traded currency future is regulated by SEBI/RBI, and they established rules and regulation so there is very safe trading is emerged and counter party risk is minimized in currency Future trading. And also time reduced in Clearing and Settlement process up to T+1 days basis. Larger exporter and importer has continued to deal in the OTC counter even exchange traded currency future is available in markets because, There is a limit of USD 100 million on open interest applicable to trading member who are banks. And the USD 25 million limit for other trading members so larger exporter and importer might continue to deal in the OTC market where there is no limit on hedges. 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.

SUGGESTIONS
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Currency Future need to change some restriction it imposed such as cut off limit of 5 million USD, Ban on NRIs and FIIs and Mutual Funds from Participating.

Now in exchange traded currency future segment only one pair USD-INR is available to trade so there is also one more demand by the exporters and importers to introduce another pair in currency trading. Like POUNDINR, CAD-INR etc. In OTC there is no limit for trader to buy or short Currency futures so there demand arises that in Exchange traded currency future should have increase limit for Trading Members and also at client level, in result OTC users will divert to Exchange traded currency Futures.

In India the regulatory of Financial and Securities market (SEBI) has Ban on other Currency Derivatives except Currency Futures, so this restriction seem unreasonable to exporters and importers. And according to Indian financial growth now its become necessary to introducing other currency derivatives in Exchange traded currency derivative segment.

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CONCLUSIONS
By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivativesThese 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.

LIMITATION OF THE STUDY

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The limitations of the study were The analysis 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.

The study is based only on secondary & primary data so lack of keen

observations and interactions were also the limiting factors in the proper

conclusion of the study

ANNEXURE

QUESTIONNAIRE
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1) What do you understand by training? a) Learning b) Enhancement of knowledge, skill and aptitude c) Sharing information d) All of above 2) Training is must for enhancing productivity and performance. a) Completely agree b) Partially agree c) Disagree d) Unsure 3) (i) Have you attended any training programme in the last 01 year? a) Yes b) No (ii) If yes ,which module of soft skill development training? a) Personality and positive attitude b) Business communication c) Team building and leadership d) Stress management and work-life balance e) Business etiquettes and corporate grooming f) All of above g) If any other please specify ___________________________

4) (i) After the training ,have you given feedback of it? a) Yes b) No (ii) If yes, through which method?(can select more than one) a) Questionnaire

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b) Interview c) Supplement test d) If any other please specify _______________

5) Which method of post training feedback according to you is more appropriate? a) Observation b) Questionnaire c) Interviews d) Self diaries e) Supplement test 6) (i) Do you think that the feedback can evaluate the training effectiveness? a) Yes b) No (ii) If yes, how can the post training feedbacks can help the participants? (can select more than one) a) Improve job performance b) An aid to future planning c) Motivate to do better d) All of the above e) None 7) Post training evaluation focus on result rather than on the effort expended in conducting training. a) Completely agree b) Partially agree c) Disagree d) Unsure 8) What should be the ideal time to evaluate the training? a) Immediate after training
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b) After 15 days c) After 1 month d) Cant say 9) Should the post training evaluation procedure reviewed and revised periodically? a) Yes b) No c) Cant say 10) Is the whole feedback exercise after the training worth the time, money and effort? a) Yes b) No c) Cant say 11) The post training feedbacks can be used : a) To identify the effectiveness and valuation of the training programme b) To identify the ROI( return on investment) c) To identify the need of retraining d) To provide the points to improve the training e) All of above 12) Any suggestion for improving the post training feedback procedure exists in Sahara India Pariwar?

BIBLIOGRAPHY

Financial Derivatives (theory, concepts and problems) By: S.L. Gupta. NCFM: Currency future Module.

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BCFM: Currency Future Module. Center for social and economic research) Poland Recent Development in International Currency Derivative Market by: Lucjan T. Orlowski) Report of the RBI-SEBI standing technical committee on exchange traded currency futures) 2008 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.frost.com www.wikipedia.com www.economywatch.com www.bseindia.com www.nseindia.com

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