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EvoIution of Currency Futures Trading and its Impact

on Exchange Rate VoIatiIity in India (2000 - 2012)

Sarang VK
M.Sc. Economics
(2011 - 2013)
Symbiosis School oI Economics
CONSTITUENT OF
SYMBIOSIS INTERNATIONAL UNIVERSITY
(Established Under Section 3 OI The UGC Act 1956, By NotiIication No F9-12/2001-U.3 OI
Government OI India)
An Internship report submitted to www.investorsareidiots.com in partial IulIillment oI the
requirements Ior the M.Sc. degree at Symbiosis School oI Economics.
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Acknowledgement
I would like to grateIully acknowledge the enthusiastic supervision oI Arjun
Parthsarathy during this work. I thank ProI. Ishita Ghosh (Symbiosis School oI
Economics) Ior the technical discussions on the econometric models and her
earnest support throughout the completion oI this paper. Finally, I am Iorever
indebted to my parents Ior their endless patience and encouragement when it was
most required.
Author
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Evolution of Currency Futures Trading and its Impact on Exchange Rate
Volatility in India (2000- 2012)
Sarang VK
sarangvkymail.com
www.investorsareidiots.com
Report Date: 06 July, 2012
__________________________________________________________
Abstract
This report documents the work done during the summer internship at
www.investorsarediots.com under the supervision oI Arjun Parthsarathy. The
report Iirst shall give an overview oI the Currency Futures with details on reason
behind its introduction and its growth trajectory. Further, the impact oI this
derivative on the volatility oI the exchange system is analyzed with empirical
evidences. I have tried my best to keep report simple yet technically correct. I hope
I succeed in my attempt.
Currency Futures is a Iinancial derivative Iirst introduced at the Chicago
Mercantile Exchange (CME) in 1972. National Stock Exchange (NSE) was the
Iirst stock exchange in India, permitted by the SEBI, to set up a separate currency
derivatives segment with trading starting on 28 August, 2008 in NSE. Similarly,
the BSE and MCX started trading the currency Iutures Irom 1st and 7th October,
2008 respectively. The major objective oI using this derivative is hedging the
currency risk. The currency Iutures market in India has passed a journey oI almost
three years and many changes have been employed in the exchange system over
the period.
The main theme oI this paper is to understand and analyze the growth trajectory
and evolution oI currency Iutures in India and the participation oI currency Iutures
in the volatility oI the trade system. The Iirst section oI introduction studies the
rationale behind introducing currency Iutures in India. In order to understand the
growth trajectory oI currency Iutures Ior studying volatility, the growth in two
variables that are open interest and contracts traded are analyzed. The next section
explains a simple Future currency contract pricing model and mechanism oI
trading at NSE. The third section oI the paper studies whether introduction oI
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currency Iuture trading activity has increased the volatility oI spot market or not
and concludes with statically supporting data with Iew literature reviews where its
partially justiIied that trading in Currency Iutures do contribute to a higher
volatility in spot market.
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Table of Contents
1 ..... Introduction
1.2 .. Background
1.3 .. Rationale for Introducing Currency Futures
1.4 .. Currency Futures Trading Mechanism
1.5 .. Pricing Currency Futures Contracts
1.6 .. The Growth trajectory of Currency Futures
1.7 ..... Turnover of Derivatives Segment at NSE
1.7.1 .. Turnover of Futures and Options (F&O) Derivatives Segment at NSE.
1.7.2 .. Growth of Currency Futures Derivative Segment at NSE
1.7.3 .. Top Five Currency Futures Contracts
2 ...... Literature Review
3 ..... Empirical testing of currency futures on exchange rate volatility
3.1 ..... Empirical Methodology
3.2 ..... Analysis
3.3 ..... Interpretation
4 ........ Conclusion
5 ........ References
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List of Charts, Tables and Figures
Chart 1.3.1 .... USD/INR Historical Volatility from 2000 to 2008
Chart 1.7.1 ...... Average Daily Turnover of Currency Futures Derivative Segment
Table 1.7.1 .... Business Growth of Derivatives Segment
Table 1.7.2 .... Growth of Currency Futures derivative at NSE
Table 1.7.3 .... Top Five Currency Futures Contracts
Table 3.1.1 .... Test of Stationary series
Table 3.1.2 .... Volatility estimates before and after the introduction of Currency
Futures
Figure 1.6.1 .... Graph plotted of correlation between Total Contracts traded and total
Open Interest at NSE and MCX.

List of Abbreviations
CME Chicago Mercantile Exchange
CBOT Chicago Board oI Trade
USD United States Dollar
INR Indian Rupee
NEAT National Exchange Ior Automated Trading
CDS Currency Derivatives Segment
NSE National Stock Exchange
MCX Multi Commodity Exchange
F&O Futures and Options
ARCH Autoregressive Conditional Heteroskedasticity
RBI Reserve Bank oI India
Alt Alternative
CAD Current Account DeIicit
GDP Gross Domestic Product
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1. Introduction
Currency Futures are a standardized Ioreign exchange derivative contract traded on
a recognized stock exchange to buy or sell one currency against another on a
speciIied Iuture date, at a price speciIied on the date oI contract, but does not
include a Iorward contract. The Chicago Mercantile Exchange (CME) Iirst
envisaged the idea oI a currency Iutures exchange and it launched it in 1972 with
considerable skepticism, since traditionally Iutures market had traded agricultural
commodities and not Iinancial instruments. Thus, the CME commissioned
ProIessor Milton Friedman to write a paper on currency Iutures in order to gain
credibility in the market.
ProI. Milton Friedman stated: 'Changes in the international Iinancial structure will
create a great expansion in the demand Ior Ioreign cover. It is highly desirable that
this demand be met by as broad, as deep, as resilient a Iutures market in Ioreign
currencies as possible in order to Iacilitate Ioreign trade and investment. Such a
wider market is almost certain to develop in response to the demand. The major
open question is where. The U.S. is a natural place and it is very much in the
interests oI the U.S. that it should develop here. The Chicago Board oI Trade
(CBOT) saw this as a competitive challenge, as also a prospect to launch other
Iinancial Iutures and proposed trading options and Iutures on stocks.
1.1 Background
The existence oI Gold standard until 1971 was meant to guarantee that currencies
would always have a Iixed value, determined by the amount oI gold in each
country's vaults. Most countries had already abandoned the gold standard in the
1930s, when insuIIicient gold reserves Iorced governments to adopt a system oI
Iixed exchange rates, where each country's government decided its own value oI
currency. This artiIicial system oI Iixed rates gave way to a Iree market oI currency
values when the Smithsonian Agreement oI Iixed exchange rates collapsed in
1973. The world's major currencies were then allowed to "Iloat" Ireely on the
international markets.
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These global transIormations aIIected Indian economy and its market Ioundations.
The Indian Iorex system saw, major changes initiated with the breakdown oI the
Bretton Woods system in the early 1970s, India switched over to a system oI
managed exchange rates. With several ramiIications in the system, the Iorex
system in India evolved through very extensive and competitive phases.
In recent years, the Indian Ioreign exchange system encountered increasing levels
oI Iluctuations with high volatility rates (Chart 1.3.1) which lead to needs oI
hedging instruments in the market and in order to advance Indian Ioreign exchange
market to international standards, a well developed Ioreign exchange derivative
market was essential. Currency Futures trading in India was launched with this
perspective. The trading in currency Iutures in India started on 28 August, 2008 in
NSE. Till January 2010, exchange rate Iutures were available only Ior US Dollar
vis-a-vis Indian Rupee. Exchange-traded currency Iutures have now been
expanded to the euro, pound and yen pairing. These currency Iutures are beneIicial
over overseas Iorex trading especially to comparatively small traders and retail
investors. The rationale behind introducing currency Iutures in India is explained
elaborately in section 1.3.
1.3 Rationale for Introducing Currency Futures
There are strong empirical evidences (Chatrath, Ramchander and Song 1996 to
suggest that hedging reduces the volatility oI returns and considering the episodic
nature oI currency returns there are strong arguments to use instruments to hedge
currency risks. As such, there is a strong need to hedge currency risk and this need
has grown with Iast growth in cross-border trade and investments Ilows and thus
the rationale Ior establishing the currency Iutures market has increased radically.
Also, both residents and non-residents purchase domestic currency assets and iI the
exchange rate remains unchanged Irom the time oI purchase oI the asset to its sale,
no gains and losses are made out oI currency exposures. However, iI domestic
currency depreciates (appreciates) against the Ioreign currency, the exposure
would result in gain (loss) Ior residents purchasing Ioreign assets and loss (gain)
Ior non residents purchasing domestic assets. In this backdrop, unpredicted
movements in exchange rates expose investors to currency risks.
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Chart 1.3.1 USD/INR Historical Volatility from 2000 to 2008
Source: Currency Futures, how do banks benefit? (FT Knowledge Management Dec 2008.)
Currency Iutures enable investors to hedge these risks. As observed in the last
decade, the volatility in USD/INR has increased the need to mitigate risk hedging
in derivatives market. Currency trading was launched Irom this perspective.
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1.4 Currency Futures Trading Mechanism
Exchanges offering currency futures trading in India:
National Stock Exchange (NSE),
Multi-Commodity Exchange (MCX).
United Stock Exchange (USE).
Currency Pairs available for futures trading:
USDINR- Futures and Options (US Dollar, Indian Rupee)
EURINR- Futures (European Euro, Indian Rupee)
GBPINR- Futures (British Pound, Indian Rupee)
JPYINR- Futures (Japanese Yen, Indian Rupee)
The Currency derivatives trading system oI NSE, called NEAT-CDS (National
Exchange Ior Automated Trading Currency Derivatives Segment) trading
system, provides a Iully automated screen-based trading Ior currency Iutures. All
quantity Iields are in contracts and price in Indian rupees. From time to time the
exchange notiIies the contract size and tick size Ior each oI the contracts traded on
this segment. Any order entering the trading system will be an active order. It tries
to Iind a match on the opposite side oI the book. II it Iinds a match, a trade is
generated. II it does not Iind a match, the order becomes passive and sits in the
respective order book in the system. Trading hours are usually Irom 9am to 5 pm.
Currency

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1.5 Pricing Currency Futures Contracts
The pricing oI currency Iutures contracts is determined by the interest rate as well
as the spot rates Ior currencies listed in the Iutures contracts. The Iollowing
Iormula
2
is used to set the price Ior a contract Ior a given currency pair:
F S (1 + RQ x T) (1 + RB x T)
Where:
F the price Ior the currency Iutures contract
S the spot rate Ior the currency pair
RQ the interest rate oI the quote currency
RB the interest rate oI the base currency
T the tenor or time to maturity (in days)
2. Note: This Currency Futures pricing model is a very general and simple currency Iutures
pricing model Ior just understanding the basics oI the working oI pricing nature oI this derivative
and is not completely applicable in real estimations which may need Iurther consideration oI
many other Iactors and variables. Also, this model is not Iurther used anywhere Ior any other
purpose in this document.
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1.6 The Growth trajectory of Currency Futures
International experience oI the emerging markets with the introduction oI currency
Iutures is a mixed one. In many studies, the volatility is Iound to be reduced
Iollowing the constitution oI currency Iutures market (Figlewski, 1980), though
empirical evidence to the contrary also exists (Bae, Kwon and Park. 2004).
The Indian currency Iutures market has experienced an impressive growth since its
introduction. The growth oI the currency Iutures can be assessed by measuring the
growth in two variables which are open interest and contracts traded. Open interest
is the total number oI outstanding contracts that are held by the market participants
and also considered as the numbers oI Iutures contracts that have not yet been
closed out. It measures the Ilow oI money into the Iutures market. In currency
Iutures, the trend oI the volumes (contracts traded) and open interest Ior currency
Iutures in both NSE and Multi Commodity Exchange (MCX) explains this growth
trajectory
1
. This is explained with econometric analysis in Fig. 1.6.1 and its Iurther
analysis.
1 Typically, trading volume is used as the indicator oI Iutures trading activity, and there is a
large body oI literature examining how Iutures trading volume is used as an inIormation to relate
to price volatility (see KarpoII, 1987). In contrast, relatively little research has used the existence
oI open interest data (see Bessembinder and Seguin 1993)
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The correlation between open interest and contracts traded at NSE:
Figure 1.6.1: Graph plotted of correlation between Total Contracts traded and total Open
Interest at NSE and MCX.
Source: Currency Futures in India: An Introduction (Dharen Kumar Pandey, Faculty oI Commerce,
Banaras Hindu University, Varanasi, India.
Null Hypothesis: Open interest and contracts traded have insigniIicant correlation.
Alt Hypothesis: Open interest and contracts traded have signiIicant correlation.
Inference: A linear correlation is found

Alt Hypothesis is accepted with extreme signiIicance.
Number oI points 320
Correlation coeIIicient (r) 0.8324 95
conIidence interval: 0.7953 to 0.8632
CoeIIicient oI determination (r squared) 0.6928
The two-tailed P value is 0.0001, considered extremely signiIicant.
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In order to understand growth trajectory, the number oI contracts traded and open
interest at NSE and MCX have been compared and explained in Figure 1.6.1 and
Iurther explained and statically supported. A correlation between the two was
calculated and the result depicted that they have a signiIicant relationship with a
correlation coeIIicient oI 0.83 in case oI NSE which concludes growth in both the
variables.
1.7 Turnover of Derivatives Segment at NSE
1.7.1 Turnover of Futures and Options (F&O) Derivatives Segment at
NSE.
An increase in the contracts traded on an exchange expresses the growth oI trade in
that particular stock exchange Ior a particular currency Iuture. The business growth
in F&O derivatives segment at NSE had a tremendous development aIter the
introduction oI currency Iutures.
Table 1.7.1 Business Growth of Derivatives Segment
Source: http://www.nseindia.com/
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The contracts traded in the NSE increased to 1205045464 contracts on 2011-12
Irom 90580 contracts in 2000-01. Also, the open interest in NSE has been
increasing with a stable pace since the currency Iutures were initiated. The open
interest in the NSE was 406200 on 31 Dec. 2009 as compared to 16332 on 28 Aug.
2008. These changes in these Iigures with a signiIicance correlation in open
interest, which is amount oI liquidity in the currency market and the contracts
traded shows the growth oI this currency and other derivative in an exchange. The
monthly turnover (shown in table 1.7.1) oI the stock exchange NSE also
experienced an upward trend in the year 2009-10 with a total oI Rs. 17663664.57
cr. showing a clear sign oI better growth and expansion oI exchange market.
1.7.2 Growth of Currency Futures Derivative Segment at NSE
The trading activity in currency Iutures has been witnessing a rapid growth. The
total traded volume in initial one year Irom August 2008 till March 2009 was
162,272 cr. and increased by 998.53 to ` 17, 82,608 cr. in 2009-10. Total number
oI contracts traded during 2009-10 was 378,606,983. The average traded volumes
during the same period were 7,428 cr. The growth oI currency Iutures is shown on
table 1.7.2 and Chart 1.7.1.
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Table 1.7.2 Growth of Currency Futures derivative at NSE
Source: http://www.nseindia.com/
Chart 1.7.1 Average Daily Turnover of Currency Futures Derivative Segment
Source: http://nseindia.com/
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Although this segment had a lower growth in 2011-12 to June 2012 period due to
issues in global markets (Eurozone debt crisis being a large Iactor and due to issues
oI rising CAD in India), the currency Iutures derivative segment had a tremendous
growth since its introduction.
1.7.3 Top Five Currency Futures Contracts
During 2009-10, currency Iutures had an incredible growth. The top Iive currency
Iutures contracts in terms oI turnover in 2009-10 are shown in the table 1.7.3.
Table 1.7.3 Top Five Currency Future Contracts
Source: http://nseindia.com/
Note: In Section 1.7, the transactions in NSE are considered and transactions in MCX and BSE
are not considered due to limitations in data availability.
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2.1 Literature Review
In spite oI the popular belieI that increased volatility in numerous Iinancial markets
was enhanced by trading in derivatives, the empirical evidence regarding this issue
is Iar Irom conclusive. Some studies provide empirical results that support the
opinion that trading in Iutures can destabilize the spot market.
There are only Iew studies that consider trading volumes and price volatility due to
currency Iutures trading. Despite the size oI the currency market and the Iact that
Iutures contracts are only one oI three popular means the other two being currency
Iorwards and options, there are some indications that the level oI Iutures trading
may aIIect currency price volatility.
Grammatikos and Saunders (1986) studied the spot rates oI the British pound,
Canadian dollar, Japanese yen, Swiss Iranc and Deutsche mark on the International
Monetary Market over the period oI 1978-1983. AIter using numerous causality
tests, the researchers could not reject the null hypothesis that volume (price
variability) causes price variability (volume), a Iinding that is consistent with the
presence oI signiIicant bidirectional causality in Iutures market transactions.
Kumar and Seppi (1992) reported that this speculation can also increase the
manipulation oI market by big players and hence can increase the volatility in spot
market. So, we can`t completely rule out the possibility that currency trading can
increase the spot price volatility.

3. Empirical testing of currency futures on exchange rate volatility
3.1 Empirical Methodology
Following the literature (An empirical analysis oI the relationship between
currency Iutures and exchange rate volatility in India, Reserve Bank oI India
(RBI), March 2011) exchange rate volatility is modeled as a Autoregressive
Conditional Heteroskedasticity (ARCH) process, which addresses the well-
documented time-varying pattern oI exchange rate volatility, the daily data on
exchange rate oI dollar with respect to Indian rupee Ior period Irom January 2000
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to 2011 is collected by taking average oI each month`s exchange rate during this
period totaling 144 observations. Then, the entire data is divided into 2 periods:
The Iirst period, beIore (103 observations) the introduction oI currency Iutures and
second period, aIter the introduction oI currency Iutures (41 observations).
3.2 Analysis
The results in Table 3.1.1 show the stationary properties oI the three variables
beIore the introduction oI currency Iutures, aIter the introduction oI currency
Iutures and the entire period year 2000 to 2011. Using Augmented Dickey Fuller
test it`s Iound all the variables are stationary and do not possess unit root leading to
appropriateness oI Iurther analysis. Further computing the volatility in 2 periods
using ARCH models beIore and aIter the introduction oI currency Iutures are
estimated in table 3.1.2 showing moderate existence oI volatility shocks in period 2
compared to period one. Thus the second period volatility shocks is almost
insigniIicant compared to Iirst period and can be concluded that the introduction oI
currency Iutures has led to signiIicant level oI absorption oI volatility in exchange
market.
Table 3.1.1 Test of Stationary series
arLlcular Augmented D|ckey Iu||er 1est - Un|t root 1est Inference
1esL
SLaLlsLlc
1
CrlLlcal
value
3 CrlLlcal
value
10
CrlLlcal
value
8efore
lnLroducLlon
-1.167 -3.309 -2.890 -2.380 8e[ecLed
AfLer
lnLroducLlon
-1.324 -2.938 -3.648 -2.618 8e[ecLed
LnLlre
observaLlons
-1.161 -3.496 -2.887 -2.377 8e[ecLed
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Table 3.1.2 Volatility estimates before and after the introduction of currency futures
Volatility
Estimates
ARCH
CoefflclenL Z value > |Z| 93 Confldence lnLerval
BeIore
introduction
.0217326 492.01 0.000 .0216333 - .0218319
AIter
Introduction
.0215552 212.29 0.000 .0213562 - .0217542
3.3 Interpretation
Test of Stationary series:
Null Hypothesis: The series is non-stationary with unit-root.
Alt Hypothesis: The series is stationary without unit-root.
Inference: In all three periods it was Iound the series is stationary and possess no unit root. All the three
cases the Null Hypothesis is Rejected.
ARCH: Volatility estimates before and after the introduction of Currency
Futures:
Null Hypothesis: The volatility shocks in Iirst period are more than second period.
Alt Hypothesis: The volatility shocks in Iirst period are less than second period.
Inference: The ARCH coeIIicient oI second period is less than Iirst period signiIying lesser volatility
shocks in second period compared to Iirst period.
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4. Conclusion
This paper investigated the Growth oI Currency Futures in India, the volatility
pattern in the Indian exchange market and the inIluence oI currency Iutures as a
hedging instrument in the volatility oI the exchange market. Although currency
Iutures introduction has reduced volatility asymmetric and have led to
enhancement in the quality and speed oI market transactions and inIormation, the
Iact that the currency Iutures market just Iour plus years old does to some extent
cloud the conclusion as volatility has increased substantially in 2011-12 to June
2012 period due to issues coming out oI global markets (Eurozone debt crisis being
a large Iactor) and due to issues oI rising Current Account DeIicit (CAD) (4.2 oI
Gross Domestic Product (GDP), the highest ever Ior India).
5. References
1. The Foundations oI Modern Time Series Analysis - T. Mills (Palgrave Macmillan,
2011) BBS
2. Report oI the Internal Working Group on Currency Futures (RBI April 2008)
3. Volatility models oI currency Iutures in emerging and developed countries (John
M Sequeira March 2003)
4. Options, Futures and Other Derivatives 7th John Hull
3. Basic Econometrics (Gujarati)
6. An empirical analysis oI the relationship between currency Iutures and exchange
rate volatility in India (RBI, March 2011)
7. Indian Securities Market ( National Stock Exchange oI India Limited, Volume XII
2009)
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