REPORT ON CURRENCY DERIVATIVE

AMIT BHANSALI, IBS-MUMBAI

[Project report on Currency Derivatives]University School of Management Kurukshetra University ,Kurukshetra Page 1

ACKNOWLEDGEMENT

On the occasion of completion and submission of project we would like to express our deep sense of gratitude to USM, KUK for providing us Platform of management studies. We thank to our Chairman Dr.D.D.Arora, and Faculty members for their moral support during the project. We are too glad to give our special thanks to our project guide Mr. Shyam Sunder for providing us an opportunity to carryout project on currency derivatives and also for their help and tips whenever needed. Without his co-operation it was impossible to reach up to this stage.

At last, I sincere regards to my parents and friends who have directly or indirectly helped me in the project.

[Project report on Currency Derivatives]University School of Management Kurukshetra University ,Kurukshetra Page 2

CONTENTS CHAPTER NO 1 2 3 Introduction of currency derivatives Company Profile Research Methodology  Scope of Research  Type of Research  Source of Data collection  Objective of the Study  Data collection  Limitations Introduction to The topic  Introduction of Financial Derivatives  Types of Financial Derivatives  Derivatives Introduction in India  History of currency derivatives  Utility of currency derivatives  Introduction to Currency Derivatives  Introduction to Currency Future Brief Overview of the foreign exchange market          Overview of foreign exchange market in India Currency Derivatives Products Foreign Exchange Spot Market Foreign Exchange Quotations Need for exchange traded currency futures Rationale for Introducing Currency Future Future Terminology Uses of currency futures Trading and settlement Process SUBJECTS COVERED PAGE NO 4 7 14

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[Project report on Currency Derivatives]University School of Management Kurukshetra University ,Kurukshetra Page 3

6  Regulatory Framework for Currency Futures  Comparison of Forward & Future Currency Contracts Analysis  Interest Rate Parity Principle  Product Definitions of currency future  Currency futures payoffs  Pricing Futures and Cost of Carry model  Hedging with currency futures Findings suggestions and Conclusions Bibliography 52 66 68 [Project report on Currency Derivatives]University School of Management Kurukshetra University .Kurukshetra Page 4 .

Kurukshetra Page 5 .INTRODUCTION OF CURRENCY DERIVATIVES [Project report on Currency Derivatives]University School of Management Kurukshetra University .

The price of one currency in terms of other currency is known as exchange rate. trading in foreign currencies has grown tremendously over the past several decades. Since the exchange rates are continuously changing. facilitating transfer of purchasing power from one country to another. 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. As a result the assets or liability or cash flows of a [Project report on Currency Derivatives]University School of Management Kurukshetra University .INTRODUCTION OF CURRENCY DERIVATIVES Each country has its own currency through which both national and international transactions are performed. and when borrowed fund are paid to the lender then the home currency will be converted into foreign lender’s currency. For example. With the multiple growths of international trade and finance all over the world. The foreign exchange markets of a country provide the mechanism of exchanging different currencies with one and another. so the firms are exposed to the risk of exchange rate movements. the currency units of a country involve an exchange of one currency for another. Thus. and thus. All the international business transactions involve an exchange of one currency for another.Kurukshetra Page 6 . It means that the borrowed foreign currency brought in the country will be converted into Indian currency.

Kurukshetra Page 7 . and foreign currency swaps. This variability in the value of assets or liabilities or cash flows is referred to exchange rate risk. specifically in developed countries. foreign currency forwards. the currency risk has become substantial for many business firms. As a result. Since the fixed exchange rate system has been fallen in the early 1970s.firm which are denominated in foreign currencies undergo a change in value over a period of time due to variation in exchange rates. [Project report on Currency Derivatives]University School of Management Kurukshetra University . these firms are increasingly turning to various risk hedging products like foreign currency futures. foreign currency options.

Kurukshetra Page 8 .COMPANY PROFILE [Project report on Currency Derivatives]University School of Management Kurukshetra University .

with a clear focus on providing long term value addition to clients. It has daily turnover in excess of Rs. structured products .AnandRathi Securities Limited AnandRathi (AR) is a leading full service securities firm providing the entire gamut of financial services. AR provides a breadth of financial and advisory services including wealth management. founded in 1994 by Mr. The offices of AnandRathi in 197 cities across 28 cities and it has also branches in Dubai and Bangkok with more than 44000 employees. brokerage & distribution of equities. The entire firm activities are divided across distinct client groups: Individuals. commodities. today has a pan India presence as well as an international presence through offices in Dubai and Bangkok. today has a pan India presence as well as an international presence through offices in Dubai and Bangkok. investment banking.00. while maintaining the highest standards of excellence.all of which are supported by powerful research teams. mutual funds and insurance.all of which are supported by powerful research teams. ethics and professionalism. The firm. Private Clients.Kurukshetra Page 9 . corporate advisory. investment banking. 4billion. Corporates and Institutions and was recently ranked by Asia Money 2006 poll amongst South Asia's top 5 wealth managers for the ultra-rich. It is also leading Distributor of IPO's In year 2007 Citigroup Venture Capital International joined the group as a financial partner. structured products . [Project report on Currency Derivatives]University School of Management Kurukshetra University . commodities. mutual funds and insurance. The firm.000+ clients nationwide. founded in 1994 by Mr. AR provides a breadth of financial and advisory services including wealth management. AnandRathi. corporate advisory. AnandRathi is a leading full service securities firm providing the entire gamut of financial services. It has 1. AnandRathi. The firm's philosophy is entirely client centric. brokerage & distribution of equities.

Goa. Rajasthan. WestBengal. Karnataka.MadhyaPardesh. Haryana Jammu & Kashmir. Maharashtra.In India AnandRathi is present in 21 States: AndhraPardesh . UttarPardesh. Mission To be India's first multinational providing complete financial services solution acrossthe globe Vision "To be a shining example as leader in innovation and the first choice for clients & employees" Milestones • • • • • • • 1994: Started activities in consulting and Institutional equity sales with staff of 15 1995: Set up a research desk and empanelled with major institutional investors 1997: Introduced investment banking businesses Retail brokerage services launched 1999: Lead managed first IPO and executed first M & A deal 2001: Initiated Wealth Management Services 2002: Retail business expansion recommences with ownership model 2003: Wealth Management assets cross Rs1500 crores Insurance broking launched Launch of Wealth Management services in Dubai Retail Branch network exceeds 50 [Project report on Currency Derivatives]University School of Management Kurukshetra University .. Bihar . Gujrat. Assam. Orissa. Jharkhand. Punjab. Uttranchal. Tamil Nadu. Kerala.Kurukshetra Page 10 . Delhi . Chhatisgarh.

independent and unbiased advice to our clients backed by in-depth research.Products • • • • • • Equity & Derivatives Mutual Funds Depository Services Commodities Insurance Broking IPOs Equity & derivatives brokerage AnandRathi provides end-to-end equity solutions to institutional and individual investors.Kurukshetra Page 11 . sector trends and investment strategy has established us a competent and reliable research unit across the country. Consistent delivery of high quality advice on individual stocks. They are supported by dedicated sales & trading teams in our trading desks across the country. Mutual funds AR is one of India's top mutual fund distribution houses. Clients can trade through us online on BSE and NSE for both equities and derivatives. Research and investment ideas can be accessed by clients either through their designated dealers. We firmly believe in the importance of selecting appropriate asset allocations based on the client's risk profile. email. picking best performing funds across asset classes and providing insights into performances of select funds. web or SMS. [Project report on Currency Derivatives]University School of Management Kurukshetra University . Our success lies in our philosophy of providing consistently superior. We have a dedicated mutual fund research cell for mutual funds that consistently churns out superior investment ideas.

In addition to transaction execution. clearing and custody of securities. chana. Our guiding philosophy is to manage the clients' entire risk set by providing the optimal level of cover at the least possible cost. [Project report on Currency Derivatives]University School of Management Kurukshetra University . Risk management includes identification. The firm deals with both life insurance and general insurance products across all insurance companies. guar gum and spices such as sugar. The entire sales process and product selection is research oriented and customized to the client's needs.Kurukshetra Page 12 . registration of shares and dematerialization. of which insurance is an integral part. measurement and assessment of the risk and handling of the risk. We offer you daily updated internet access to your holding statement and transaction summary. Our research covers a broad range of traded commodities including precious and base metals. commodities Commodities broking . Our commodities broking services include online futures trading through NCDEX and MCX and depository services through CDSL. we provide to our clients comprehensive risk management techniques. Oils and Oilseeds. we provide our clients customized advice on hedging strategies. agri-commodities such as wheat. jeera and cotton.a whole new opportunity to hedge business risk and an attractive investment opportunity to deliver superior returns for investors. investment ideas and arbitrage opportunities. guar. We lay strong emphasis on timely claim settlement and post sales services. both within the business as well as on the personal front. Commodities broking is supported by a dedicated research cell that provides both technical as well as fundamental research.Depository services AR Depository Services provides you with a secure and convenient way for holding your securities on both CDSL and NSDL. insurance broking As an insurance broker. Our depository services include settlement.

Kurukshetra Page 13 . Bonds. Our strong performance in IPOs has been a result of our vast experience in the Primary Market. strong distribution capabilities and a dedicated research team We have been consistently ranked among the top 10 distributors of IPOs on all major offerings. Global Products • • • • • • Structuring of trusts / investment companies Offshore Mutual Funds Structured Products / Deposits including capital-guaranteed notes on Trading in global markets (Equities. Our IPO research team provides clients with indepth overviews of forthcoming IPOs as well as investment recommendations. Commodities) Real Estate investments Alternative investments (including hedge funds and fund-of-hedge funds) Our services • • • • • • • Risk Management Due diligence and research on policies available Recommendation on a comprehensive insurance cover based on clients needs Maintain proper records of client policies Assist client in paying premiums Continuous monitoring of client account Assist client in claim negotiation and settlement [Project report on Currency Derivatives]University School of Management Kurukshetra University .IPO We are a leading primary market distributor across the country. a wide network of branches across India. Online filling of forms is also available.

Our senior Management comprises a diverse talent pool that brings together rich experience from across industry as well as financial services. Amit Rathi .Kurukshetra Page 14 .Indian and Global [Project report on Currency Derivatives]University School of Management Kurukshetra University .Managing Director Chartered Accountant & MBA Plus 11 years of experience in Financial Services Why choose AR? • • • • Superior understanding of the Indian economy & markets Ability to structure and manage your tax and regulatory compliances Dedicated relationship team Unparalleled product range . Pradeep Gupta .Management Team AR brings together a highly professional core management team that comprises of individuals with extensive business as well as industry experience.Group Chairman Chartered Accountant Past President. Mr.Vice Chairman Plus 17 years of experience in Financial Services Mr. BSE Held several Senior Management positions with one of India's largest industrial groups Mr. Anand Rathi .

RESEARCH METHODOLOGY [Project report on Currency Derivatives]University School of Management Kurukshetra University .Kurukshetra Page 15 .

 SOURCE OF DATA COLLECTION Secondary data were used such as various books.Kurukshetra Page 16 . 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.  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. report submitted by RBI/SEBI committee and NCFM/BCFM modules.  LIMITATION OF THE STUDY [Project report on Currency Derivatives]University School of Management Kurukshetra University . To analyze different currency derivatives products.RESEARCH METHODOLOGY  TYPE OF RESEARCH In this project Descriptive research methodologies were use.

So.The limitations of the study were The analysis was purely based on the secondary data. [Project report on Currency Derivatives]University School of Management Kurukshetra University . The currency future is new concept and topic related book was not available in library and market. any error in the secondary data might also affect the study undertaken.Kurukshetra Page 17 .

INTRODUCTION TO THE TOPIC [Project report on Currency Derivatives]University School of Management Kurukshetra University .Kurukshetra Page 18 .

the new financial instruments have been developed in the financial markets. changes in the interest rates. which are also popularly known as financial derivatives. the demand for the international money and financial instruments increased significantly at the global level.Kurukshetra Page 19 . 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.” Alan Greenspan.INTRODUCTION TO FINANCIAL DERIVATIVES “By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives…These instruments enhances the ability to differentiate risk and allocate it to those investors most able and willing to take it. Former Chairman. exchange rate and stock market prices at the different financial market have increased the financial risks to the corporate world. It is therefore. In this respect. [Project report on Currency Derivatives]University School of Management Kurukshetra University . to manage such risks. As a result.a process that has undoubtedly improved national productivity growth and standards of livings.

 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. Grain. rupee dollar exchange rate. cotton. crude oil. The price of curd depends upon the price of milk which in turn depends upon the demand and supply of milk.Kurukshetra Page 20 .  A very simple example of derivatives is curd. this word has been arisen by derivation. bond. These assets can be a share. etc. Pepper.  Something derived. Silver  Short Term Debt Securities : Treasury Bills  Interest Rates  Common shares/stock  Stock Index Value : NSE Nifty  Currency : Exchange Rate [Project report on Currency Derivatives]University School of Management Kurukshetra University .**DEFINITION OF FINANCIALDERIVATIVES**  A word formed by derivation.  The Underlying Securities for Derivatives are :  Commodities: Castor seed.  Precious Metal : Gold. Potatoes. It means. interest rate. A financial derivative is an indeed derived from the financial market. it means that some things have to be derived or arisen out of the underlying variables. sugar. which is derivative of milk. soybeans. made on the trading screen of stock exchanges. to buy or sell an asset in future. coffee and what you have. index.

the derivatives can be classified into different categories which are shown below : DERIVATIVES Financials Commodities Basics 1. standardized or organized exchange traded. synthetic. leveraged. plain. it is very difficult to classify the financial derivatives. etc. Due to complexity in nature. mildly leveraged. composite. OTC traded. joint or hybrid. called as the underlying. simple or straightforward. Presently there are Complex varieties of derivatives already in existence and the markets are innovating newer and newer ones continuously. are available in the market. Futures 3. Options Complex 1.Kurukshetra Page 21 . the basic financial derivatives which are popularly in the market have been described. various types of financial derivatives based on their different properties like. In the simple form. Forwards 2. Swaps 2. For example.TYPES OF FINANCIAL DERIVATIVES Financial derivatives are those assets whose values are determined by the value of some other assets.Exotics (Non STD) [Project report on Currency Derivatives]University School of Management Kurukshetra University . so in the present context.

The basic difference between these is the nature of the underlying instrument or assets. 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. In this. the underlying instrument is commodity which may be wheat. In commodity derivatives. foreign exchange. natural gas. corn. stocks. such derivatives are effectively derivatives of derivatives. the underlying instrument may be treasury bills. crude oil. Warrants and Convertibles One form of classification of derivative instruments is between commodity derivatives and financial derivatives. turmeric. Another way of classifying the financial derivatives is into basic and complex. cotton. the quality may be the underlying matters. stock index.4.Kurukshetra Page 22 . gold. silver and so on. In financial derivative. sugar. cost of living index etc. In fact. or both. jute. forward contracts.  Derivatives are traded at organized exchanges and in the Over The Counter ( OTC ) market : Derivatives Trading Forum Organized Exchanges Over The Counter [Project report on Currency Derivatives]University School of Management Kurukshetra University . pepper. It is to be noted that financial derivative is fairly standard and there are no quality issues whereas in commodity derivative. bonds.

A major difference between the two is that of counterparty risk—the risk of default by either party. OTC derivatives signify greater DERIVATIVES INTRODUCTION IN INDIA The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance. which withdrew the prohibition on options in securities. In contrast. Gupta on November 18. L. OTC derivatives are customized contracts that enable the parties to select the trading units and delivery dates to suit their requirements. 1995.Kurukshetra Page 23 .Commodity Futures Financial Futures Options (stock and index) Stock Index Future Forward Contracts Swaps Derivatives traded at exchanges are standardized contracts having standard delivery dates and trading units. [Project report on Currency Derivatives]University School of Management Kurukshetra University . submitted its report on March 17. SEBI set up a 24 – member committee under the chairmanship of Dr.C. 1998. 1996 to develop appropriate regulatory framework for derivatives trading in India. With the exchange traded derivatives. 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. the risk is controlled by exchanges through clearing house which act as a contractual intermediary and impose margin requirement. vulnerability.

CME Chairman Emeritus. CME offers 41 individual FX futures and 31 options contracts on 19 currencies. hedge against unfavorable changes in currency rates.(NCFM-Currency future Module) [Project report on Currency Derivatives]University School of Management Kurukshetra University . The abandonment of the Bretton Woods agreement resulted in currency values being allowed to float. CME currency futures extended the reach of risk management beyond commodities. commodity trading advisors (CTAs). Traders of CME FX futures are a diverse group that includes multinational corporations. HISTORY OF CURRENCY DERIVATIVES Currency futures were first created at the Chicago Mercantile Exchange (CME) in 1972.S. and gained credibility through endorsement of Nobel-prize-winning economist Milton Friedman. Futures contracts on individual stocks were launched in November 2001. increasing the risk of doing business. which had fixed world exchange rates to a gold standard after World War II. The concept of currency futures at CME was revolutionary. financial managers. commercial banks. abandonment of the Bretton Woods agreement. or to speculate on rate fluctuations. investment banks. Today.To begin with. which were the main derivative contracts traded at CME until then. By creating another type of market in which futures could be traded. SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE-30 (Sensex) index. currency overlay managers and individual investors. Source: . proprietary trading firms. The FX contract capitalized on the U.Kurukshetra Page 24 . hedge funds. It is the largest regulated marketplace for FX trading. They trade in order to transact business. The trading in index options commenced in June 2001 and the trading in options on individual securities commenced in July 2001. all of which trade electronically on the exchange’s CME Globex platform.The contracts were created under the guidance and leadership of Leo Melamed.

expecting to sell the appreciating currency at a high future rate.Kurukshetra Page 25 .UTILITY OF CURRENCY DERIVATIVES Currency-based derivatives are used by exporters invoicing receivables in foreign currency. A high degree of volatility of exchange rates creates a fertile ground for foreign exchange speculators. 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. 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. or to a joint venture with a foreign partner. Multinational companies use currency derivatives being engaged in direct investment overseas. 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. In either case. willing to protect their earnings from the foreign currency depreciation by locking the currency conversion rate at a high level. They want to guarantee the rate of purchasing foreign currency for various payments related to the installation of a foreign branch or subsidiary. they may wish to obtain a foreign currency forward buying contract. thus defending their revenue from the foreign currency depreciation. 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. [Project report on Currency Derivatives]University School of Management Kurukshetra University . Alternatively.

investors and speculators from banks with denomination normally exceeding 2 million USD. These are large notional value selling or buying contracts obtained by exporters. They are willing to protect themselves from the currency depreciation by locking in the future currency conversion rate at a high level.The most commonly used instrument among the currency derivatives are currency forward contracts. The contracts guarantee the future conversion rate between two currencies and can be obtained for any customized amount and any date in the future.Kurukshetra Page 26 . although the banks may require compensating deposit balances or lines of credit. Exporters invoicing receivables in foreign currency are the most frequent users of these contracts. Their transaction costs are set by spread between bank's buy and sell prices. Orlowski) [Project report on Currency Derivatives]University School of Management Kurukshetra University . They hedge against the foreign currency depreciation below the forward selling rate which would ruin their return from foreign financial investment. Source :-( Recent Development in International Currency Derivative Market by Lucjan T. 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 normally do not require a security deposit since their purchasers are mostly large business firms and investment institutions. 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. importers.

It means that the borrowed foreign currency brought in the country will be converted into Indian currency. The price of one currency in terms of other currency is known as exchange rate. 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. and when borrowed fund are paid to the lender then the home currency will be converted into foreign lender’s currency. trading in foreign currencies has grown tremendously over the past several decades. With the multiple growths of international trade and finance all over the world.INTRODUCTION TO CURRENCY DERIVATIVES Each country has its own currency through which both national and international transactions are performed. facilitating transfer of purchasing power from one country to another. All the international business transactions involve an exchange of one currency for another. and thus. the currency units of a country involve an exchange of one currency for another.Kurukshetra Page 27 . Since the exchange rates are continuously changing. Thus. For example. The foreign exchange markets of a country provide the mechanism of exchanging different currencies with one and another. so the firms are exposed to the [Project report on Currency Derivatives]University School of Management Kurukshetra University .

and foreign currency swaps.g. the buyer and the seller lock themselves into an exchange rate for a specific value or delivery date. When the underlying asset is a commodity. [Project report on Currency Derivatives]University School of Management Kurukshetra University . the contract is termed a “currency futures contract”. traded on an exchange. This variability in the value of assets or liabilities or cash flows is referred to exchange rate risk. foreign currency options. to buy or sell a certain underlying asset or an instrument at a certain date in the future. it is a contract to exchange one currency for another currency at a specified date and a specified rate in the future.risk of exchange rate movements. specifically in developed countries. the currency risk has become substantial for many business firms. foreign currency forwards. INTRODUCTION TO CURRENCY FUTURE A futures contract is a standardized contract. these firms are increasingly turning to various risk hedging products like foreign currency futures. at a specified price. As a result. When the underlying is an exchange rate. the contract is termed a “commodity futures contract”. e. In other words. Both parties of the futures contract must fulfill their obligations on the settlement date. Since the fixed exchange rate system has been fallen in the early 1970s.Kurukshetra Page 28 . Therefore. Oil or Wheat. 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.

2475 or Rs.2500.42.2525 Rs .42.2500 –Rs. Currency futures are a linear product. In determining profits and losses in futures trading. All settlements however.0025 Rs .42. So if a trader buys 5 contracts and the price moves up by 4 tick.0025 Rs. Purchase price: Price increases by one tick: New price: Purchase price: Price decreases by one tick: New price: Rs . Tick values differ for different currency pairs and different underlying. 2475 The value of one tick on each contract is Rupees 2. One tick move on this contract will translate to Rs.42.42. and calculating profits or losses on Currency Futures will be similar to calculating profits or losses on Index futures. in the case of the USD-INR currency futures contract the tick size shall be 0.2525 depending on the direction of market movement.42. unlike in the case of OTC markets.2500 +Rs.Currency futures can be cash settled or settled by delivering the respective obligation of the seller and buyer.0025 Rupees. A tick is the minimum trading increment or price differential at which traders are able to enter bids and offers. To demonstrate how a move of one tick affects the price.50. For e.g.25 paise or 0. 00.42. [Project report on Currency Derivatives]University School of Management Kurukshetra University . 00. it is essential to know both the contract size (the number of currency units being traded) and also what is the tick value.Kurukshetra Page 29 . imagine a trader buys a contract (USD 1000 being the value of each contract) at Rs. go through the exchange. she makes Rupees 50.

5 per tick = Rupees 50 BRIEF OVERVIEW OF FOREIGN EXCHANGE MARKET [Project report on Currency Derivatives]University School of Management Kurukshetra University .Step 1: Step 2: Step 3: 42.2500 4 ticks * 5 contracts = 20 points 20 points * Rupees 2.2600 – 42.Kurukshetra Page 30 .

The exchange rate regime.OVERVIEW OF THE FOREIGN EXCHANGE MARKET IN INDIA During the early 1990s. With a view to enable entities to manage volatility in the currency market. excessive volatility can have an adverse impact on price discovery. In the context of upgrading Indian foreign exchange market to international standards. [Project report on Currency Derivatives]University School of Management Kurukshetra University . which was achieved in August 1994. 2007 issued comprehensive guidelines on the usage of foreign currency forwards. 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. a well.developed foreign exchange derivative market (both OTC as well as Exchange-traded) is imperative. and balance sheets. This issue has attracted a great deal of concern from policy-makers and investors. sustainability of current account balance. recommended the introduction of Exchange Traded Currency Futures. The Report of the Internal Working Group of RBI submitted in April 2008. Although liberalization helped the Indian forex market in various ways. export performance. At the same time. was partially floated in March 1992 and fully floated in March 1993. that was earlier pegged.Kurukshetra Page 31 . RBI also set up an Internal Working Group to explore the advantages of introducing currency futures. While some flexibility in foreign exchange markets and exchange rate determination is desirable. India embarked on a series of structural reforms in the foreign exchange market. it led to extensive fluctuations of exchange rate. swaps and options in the OTC market. RBI on April 20.

thereby providing them with a new opportunity.Kurukshetra Page 32 . Banks are also allowed to become members of this segment on the Exchange. 2008. Source :-( Report of the RBI-SEBI standing technical committee on exchange traded currency futures) 2008. Exchange Traded Currency Futures will bring in more transparency and efficiency in price discovery. provide access to all types of market participants. Currently. Swiss Franc etc.Subsequently. eliminate counterparty credit risk. offer standardized products and provide transparent trading platform. Pound. 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. YEN. Further RBI and SEBI also issued circulars in this regard on August 06. The Committee submitted its report on May 29. EURO. [Project report on Currency Derivatives]University School of Management Kurukshetra University . where all the major currencies like USD. are traded. With the help of electronic trading and efficient risk management systems. India is a USD 34 billion OTC market. 2008.

Kurukshetra Page 33 . a future contract is an agreement between [Project report on Currency Derivatives]University School of Management Kurukshetra University . a specified price and a standard quantity. We take a brief look at various derivatives contracts that have come to be used.  FUTURE : A currency futures contract provides a simultaneous right and obligation to buy and sell a particular currency at a specified future date. The most common variants are forwards. futures.CURRENCY DERIVATIVE PRODUCTS Derivative contracts have several variants. This is known as forward exchange rate or simply forward rate.  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. In another word. A forward contract is customized contract between two entities. options and swaps. where settlement takes place on a specific date in the future at today’s pre-agreed price. The exchange rate is fixed at the time the contract is entered into.

Kurukshetra Page 34 . In other words. fixed to floating currency swap. There are a various types of currency swaps like as fixed-to-fixed currency swap.two parties to buy or sell an asset at a certain time in the future at a certain price. In a swap normally three basic steps are involve___ (1) Initial exchange of principal amount (2) Ongoing exchange of interest (3) Re . 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 [Project report on Currency Derivatives]University School of Management Kurukshetra University . They can be regarded as portfolio of forward contracts. Future contracts are special types of forward contracts in the sense that they are standardized exchange-traded contracts. 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 ).exchange of principal amount on maturity.  SWAP : Swap is private agreements between two parties to exchange cash flows in the future according to a prearranged formula. The currency swap entails swapping both principal and interest between the parties. with the cash flows in one direction being in a different currency than those in the opposite direction. floating to floating swap.  OPTIONS : Currency option is a financial instrument that give the option holder a right and not the obligation.

Kurukshetra Page 35 . the majority of options traded on options exchanges having a maximum maturity of nine months. financial institutions. large concerns. The large banks usually make markets in different currencies. etc. Generally they do not have specific location. In the spot exchange market. Options generally have lives of up to one year. It consists of a network of foreign dealers which are oftenly banks. FOREIGN EXCHANGE SPOT (CASH) MARKET The foreign exchange spot market trades in different currencies for both spot and forward delivery. and mostly take place primarily by means of telecommunications both within and between countries.(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. the business is transacted throughout the world on a continual basis. Longer dated options are called warrants and are generally traded OTC. So it is possible to transaction in foreign exchange markets 24 [Project report on Currency Derivatives]University School of Management Kurukshetra University .

. hence. Exchange rates are generally determined by demand and supply force in this market. Since most of the business in this market is done by banks. For example.Kurukshetra Page 36 . 45 in Indian rupees then it implies that 45 Indian rupees will buy one dollar of USA. extent or speed of exchange rate movements.e. 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.022 US dollar which is simply reciprocal of the former dollar exchange rate. 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.hours a day. [Project report on Currency Derivatives]University School of Management Kurukshetra University . transaction usually do not involve a physical transfer of currency. If one US dollar is worth of Rs. rather simply book keeping transfer entry among banks. i. or that one rupee is worth of 0. It means exchange rate is relative price. The standard settlement period in this market is 48 hours. The purchase and sale of currencies stem partly from the need to finance trade in goods and services. FOREIGN EXCHANGE QUOTATIONS Foreign exchange quotations can be confusing because currencies are quoted in terms of other currencies. 2 days after the execution of the transaction.

7250 Indirect The number of unit of foreign currency per unit of domestic currency. and another for selling (ask or offered rate) for a currency. a small dash or oblique line is drawn after the dash. [Project report on Currency Derivatives]University School of Management Kurukshetra University . In order to separate buying and selling rate. This is a unique feature of this market. Most countries use the direct method. For example. Re/$ = 45.7250 ( or ) $1 = Rs. 45. two rates are quoted by the dealer: one rate for buying (bid rate). one can say that rupees against dollar. Re 1 = $ 0.EXCHANGE RATE Direct The number of units of domestic Currency stated against one unit of foreign currency. In global foreign exchange market. It should be noted that where the bank sells dollars against rupees.02187 There are two ways of quoting exchange rates: the direct and indirect.Kurukshetra Page 37 .

Exchange rates are constantly changing. Traders. usually large banks. Whenever the base currency buys more of the terms [Project report on Currency Derivatives]University School of Management Kurukshetra University . That is the expression Dollar-Rupee. Changes are also expressed as appreciation or depreciation of one currency in terms of the second currency. are called market makers. The second currency is called as the terms currency. deal in two way prices. It is important to note that selling rate is always higher than the buying rate. both buying and selling. Exchange rates are quoted in per unit of the base currency. which means that the value of one currency in terms of the other is constantly in flux. The difference between the buying and selling rates is called spread.3550. the base currency is the first currency in a currency pair. Changes in rates are expressed as strengthening or weakening of one currency vis-à-vis the second currency.If US dollar is quoted in the market as Rs 46.3500 and ready to sell at Rs 46. tells you that the Dollar is being quoted in terms of the Rupee. it means that the forex dealer is ready to purchase the dollar at Rs 46.Kurukshetra Page 38 .3500/3550. Base Currency/ Terms Currency: In foreign exchange markets. The Dollar is the base currency and the Rupee is the terms currency.

[Project report on Currency Derivatives]University School of Management Kurukshetra University . Exchange traded futures as compared to OTC forwards serve the same economic purpose.Kurukshetra Page 39 . mark to market obligations is settled on a daily basis. in the case of an exchange traded futures contract. Except on the maturity date.00 to 43. If Dollar – Rupee moved from 43.25. On the other hand. The Report of the Internal Working Group of RBI submitted in April 2008. the obligation of the individual equals the forward price at which the contract was executed.currency. For example. swaps and options in the OTC market. Since the profits or losses in the futures market are collected / paid on a daily basis.7525 the Dollar has depreciated and Rupee has appreciated. 2007 issued comprehensive guidelines on the usage of foreign currency forwards. NEED FOR EXCHANGE TRADED CURRENCY FUTURES With a view to enable entities to manage volatility in the currency market. the base currency has strengthened / appreciated and the terms currency has weakened / depreciated. RBI on April 20. At the same time. yet differ in fundamental ways. the scope for building up of mark to market losses in the books of various participants gets limited. no money changes hands. recommended the introduction of exchange traded currency futures. And if it moved from 43. The Dollar has appreciated and the Rupee has depreciated. An individual entering into a forward contract agrees to transact at a forward price on a future date. On the maturity date. RBI also set up an Internal Working Group to explore the advantages of introducing currency futures.0000 to 42.

A futures contract is standardized contract with standard underlying instrument. The standardized items in a futures contract are: [Project report on Currency Derivatives]University School of Management Kurukshetra University . the futures contracts are standardized and exchange traded. equitable opportunity is provided to all classes of investors whether large or small to participate in the futures market.The counterparty risk in a futures contract is further eliminated by the presence of a clearing corporation.Kurukshetra Page 40 . To facilitate liquidity in the futures contracts. which by assuming counterparty guarantee eliminates credit risk. 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. efficiency and accessibility. Source :-( Report of the RBI-SEBI standing technical committee on exchange traded currency futures) 2008. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. (or which can be used for reference purposes in settlement) and a standard timing of such settlement. a standard quantity and quality of the underlying instrument that can be delivered. Further. Other advantages of an Exchange traded market would be greater transparency. the exchange specifies certain standard features of the contract. 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. in an Exchange traded scenario where the market lot is fixed at a much lesser size than the OTC market. But unlike forward contracts. RATIONALE FOR INTRODUCING CURRENCY FUTURE Futures markets were designed to solve the problems that exist in forward markets.

financial planning horizon is much smaller than the long-run. the incentive to hedge currency risk may not be large. and applies equally to trade in goods and [Project report on Currency Derivatives]University School of Management Kurukshetra University . The argument for hedging currency risks appear to be natural in case of assets. Currency futures enable them to hedge these risks. But if domestic currency depreciates (appreciates) against the foreign currency. which is typically inter-generational in the context of exchange rates. Both residents and non-residents purchase domestic currency assets. unpredicted movements in exchange rates expose investors to currency risks. 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. Nominal exchange rates are often random walks with or without drift. In this backdrop. the exposure would result in gain (loss) for residents purchasing foreign assets and loss (gain) for non residents purchasing domestic assets. it is possible that over a long – run. As such. The rationale for establishing the currency futures market is manifold. As such.Kurukshetra Page 41 . no gains and losses are made out of currency exposures. If the exchange rate remains unchanged from the time of purchase of the asset to its sale. while real exchange rates over long run are mean reverting. However. April 2008) as follows.• Quantity of the underlying • Quality of the underlying • The date and the month of delivery • The units of price quotation and minimum price change • Location of settlement 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.

services. which results in income flows with leads and lags and get converted into different currencies at the market rates. The transaction in which securities and foreign exchange get traded for immediate delivery. Since the exchange of securities and cash is virtually immediate. The currency future contracts in Indian market have one month. two month. spot value is T + 2. changes in exchange rate are found to have very low correlations with foreign equity and bond returns.  FUTURE PRICE : The price at which the future contract traded in the future market. This in theory should lower portfolio risk. But there is strong empirical evidence to suggest that hedging reduces the volatility of returns and indeed considering the episodic nature of currency returns. sometimes argument is advanced against the need for hedging currency risks. three month up to twelve month expiry [Project report on Currency Derivatives]University School of Management Kurukshetra University . there are strong arguments to use instruments to hedge currency risks. FUTURE TERMINOLOGY  SPOT PRICE : The price at which an asset trades in the spot market. cash market. has also been used to refer to spot dealing. In the case of USDINR. the term.  CONTRACT CYCLE : The period over which a contract trades. Empirically. Therefore.Kurukshetra Page 42 .

In NSE/BSE will have 12 contracts outstanding at any given point in time.  EXPIRY DATE : It is the date specified in the futures contract.cycles.  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.Kurukshetra Page 43 . This is the last day on which the contract will be traded. including those for ‘known holidays’ and would be those as laid down by Foreign Exchange Dealers Association of India (FEDAI). at the end of which it will cease to exist. Also called as lot size. The rules for inter bank settlements. The last trading day will be two business days prior to the value date / final settlement date. In case of USDINR it is USD 1000.  CONTRACT SIZE : The amount of asset that has to be delivered under one contract.  BASIS : [Project report on Currency Derivatives]University School of Management Kurukshetra University .

basis will be positive. For equity derivatives carry cost is the rate of interest. Or in another words. 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. 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.  INITIAL MARGIN : When the position is opened. There will be a different basis for each delivery month for each contract.Kurukshetra Page 44 . This reflects that futures prices normally exceed spot prices. In a normal market. 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.  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. basis can be defined as the futures price minus the spot price.In the context of financial futures.  MARKING TO MARKET : [Project report on Currency Derivatives]University School of Management Kurukshetra University .

It means that all the futures contracts are daily settled. is called the maintenance 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 funds are added or subtracted from a mandatory margin (initial margin) that traders are required to maintain the balance in the account. This is somewhat lower than the initial margin. requires that funds charge every day. usually about 75 percent of the initial 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. This procedure.Kurukshetra Page 45 .At the end of trading session. called marking to market.  MAINTENANCE MARGIN : Member’s account are debited or credited on a daily basis. Due to this adjustment. In turn customers’ account are also required to be maintained at a certain level. USES OF CURRENCY FUTURES  Hedging: Presume Entity A is expecting a remittance for USD 1000 on 27 August 08. and profit and loss is determined on each transaction. futures contract is also called as daily reconnected forwards. Wants to lock in the foreign exchange rate today so that the value of inflow in [Project report on Currency Derivatives]University School of Management Kurukshetra University . all the outstanding contracts are reprised at the settlement price of that session.

he can profit if say the Rupee depreciates to Rs. the effective rate for the remittance received by the entity A is Rs. USD 1000 in the spot market and get Rs. He expects that the USD-INR rate presently at Rs.Kurukshetra Page 46 . i.42. while spot rate on that date was Rs.44. The value of the contract is Rs. Entity A shall do the following: Sell one August contract today. Assuming he buys USD 10000.0000. then he shall make a profit of around Rs. The return from the futures transaction would be Rs. Presume that the current spot rate is Rs.44. If the exchange rate moves as he expected in the next three months.10000. Let us assume the RBI reference rate on August 27.000 + Rs. It may please be noted that the cost of funds invested is not considered in computing this return. 2008. 2500 (Rs. [Project report on Currency Derivatives]University School of Management Kurukshetra University . The entity can do so by selling one contract of USDINR futures since one contract is for USD 1000. 44.20. 250.e. is to go up in the next two-three months.4.000.76%. 2008 is Rs. This works out to an annual return of around 4.250.0000.44. The futures contract will settle at Rs. by investing the necessary capital.44. As may be observed.42.0000 (final settlement price = RBI reference rate). buy futures Take the case of a speculator who has a view on the direction of the market.  Speculation: Bullish.000). (Rs. The entity shall sell on August 27.000.43 and ‘USDINR 27 Aug 08’ contract is trading at Rs.2500. He would like to trade based on this view.44.44.44. The entity was able to hedge its exposure. How can he trade based on this belief? In case he can buy dollars and hold it.Indian rupee terms is safeguarded.50.250 – Rs.250)/1000. 44. it would require an investment of Rs. 44.

42 and the three month futures trade at Rs. If the INR. How can he trade based on his opinion? In the absence of a deferral product.21. This works out to an annual return of 19 percent. Let us understand how this works. Typically futures move correspondingly with the underlying. Presumably. Because of the leverage they provide. (on the day of expiration of the contract).40.USD is Rs. 000. 42. the margin may be around Rs. Two months later. so will the futures price. The minimum contract size is USD 1000. USD-INR rate let us say is Rs. On the day of expiration.42.Kurukshetra Page 47 .  Speculation: Bearish. sell futures Futures can be used by a speculator who believes that an underlying is overvalued and is likely to see a fall in price. If the underlying price falls. when the futures contract expires. If the underlying price rises. He pays a small margin on the same.50 against USD.1000 on an investment of Rs. 42. [Project report on Currency Derivatives]University School of Management Kurukshetra University . Let us see how this works. as long as there is sufficient liquidity in the market. Therefore the speculator may buy 10 contracts. He sells one two-month contract of futures on USD say at Rs. Today all he needs to do is sell the futures. the futures price shall converge to the spot price (Rs. 000.50) and he makes a profit of Rs. so will the futures price. there wasn't much he could do to profit from his opinion.42. The exposure shall be the same as above USD 10000. futures form an attractive option for speculators. Three months later if the Rupee depreciates to Rs. 42.20 (each contact for USD 1000).A speculator can take exactly the same position on the exchange rate by using futures contracts. Now take the case of the trader who expects to see a fall in the price of USD-INR.21. the spot and the futures price converges.

Kurukshetra Page 48 . [Project report on Currency Derivatives]University School of Management Kurukshetra University .2000. For the one contract that he sold. the futures price and forward prices are arrived at using the principle of cost of carry. this works out to be Rs. If one of them is priced higher. the transaction shall result in a risk less profit. If in one of the markets the product is trading at higher price.He has made a clean profit of 20 paise per dollar. If the tenor of both the contracts is same. the profit being the difference between the market prices.  Arbitrage: Arbitrage is the strategy of taking advantage of difference in price of the same or similar product between two or more markets. As we discussed earlier. any entity which has access to both the markets will be able to identify price differentials. the same shall be sold while simultaneously buying the other which is priced lower. 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. If the same or similar product is traded in say two different markets. One of the methods of arbitrage with regard to USD-INR could be a trading strategy between forwards and futures market. if any. Such of those entities who can trade both forwards and futures shall be able to identify any mis-pricing between forwards and futures. arbitrage is striking a combination of matching deals that capitalize upon the imbalance. That is. since both forwards and futures shall be settled at the same RBI reference rate.

TRADING PROCESS AND SETTLEMENT PROCESS Like other future trading, the future currencies are also traded at organized exchanges. The following diagram shows how operation take place on currency future market:

TRADER ( BUYER )

TRADER ( SELLER )

Purchase order

Sales order

Transaction on the floor (Exchange)

MEMBER ( BROKER )

MEMBER ( BROKER )

Informs CLEARING HOUSE

[Project report on Currency Derivatives]University School of Management Kurukshetra University ,Kurukshetra Page 49

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 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.
[Project report on Currency Derivatives]University School of Management Kurukshetra University ,Kurukshetra Page 50

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 BASIS Size Delivery date Method of transaction Participants FORWARD Structured as per requirement of the parties Tailored on individual needs Established by the bank or broker through electronic media Banks, brokers, forex dealers, multinational companies, institutional investors, arbitrageurs, Margins traders, etc. None as such, but compensating bank Maturity balanced may be required Tailored to needs: from one week to 10 years
[Project report on Currency Derivatives]University School of Management Kurukshetra University ,Kurukshetra Page 51

FUTURES Standardized Standardized Open auction among buyers and seller on the floor of recognized exchange. Banks, brokers, multinational companies, institutional investors, small traders, speculators, arbitrageurs, etc. Margin deposit required

Standardized

Settlement Actual delivery or offset with cash settlement.Kurukshetra Page 52 . No separate clearing house Over the telephone worldwide and computer networks Limited to large customers banks. More than 90 percent settled by actual delivery Risk is high being less secured Daily settlement to the market and variation margin requirements At recognized exchange floor with worldwide communications 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. etc. institutions. Market place Accessibilit y Delivery Secured [Project report on Currency Derivatives]University School of Management Kurukshetra University .

Kurukshetra Page 53 .ANALYSIS [Project report on Currency Derivatives]University School of Management Kurukshetra University .

a. any funds held will be invested in a time deposit of that currency. Using the above equation the theoretical future price on January 10. The forward rate is a function of the spot rate and the interest rate differential between the two currencies. 2002.Kurukshetra Page 54 . In the case of fully convertible currencies.3500. expiring on June 9. having no restrictions on borrowing or lending of either currency the forward rate can be calculated as follows. 2002 is : the answer will be [Project report on Currency Derivatives]University School of Management Kurukshetra University .INTEREST RATE PARITY PRINCIPLE For currencies which are fully convertible. Assume that on January 10. adjusted for time. 2002. and spot ( Re/$ ) exchange rate was 46. Future Rate = (spot rate) {1 + interest rate on home currency * period} / {1 + interest rate on foreign currency * period} For example. Hence. The assumption is that. six month annual interest rate was 7 percent p. the rate of exchange for any date other than spot is a function of spot and the relative interest rates in each currency.a. on Indian rupee and US dollar six month rate was 6 percent p. the forward rate is the rate which neutralizes the effect of differences in the interest rates in both the currencies.

Kurukshetra Page 55 . Then.Rs. [Project report on Currency Derivatives]University School of Management Kurukshetra University .46. this theoretical price is compared with the quoted futures price on January 10.7908 per dollar. 2002 and the relationship is observed.

However. to 5 p. Trading Hours The trading on currency futures would be available from 9 a. Size of the contract The minimum contract size of the currency futures contract at the time of introduction would be US$ 1000.m. Available contracts All monthly maturities from 1 to 12 months would be made available. Tenor of the contract The currency futures contract shall have a maximum maturity of 12 months.PRODUCT DEFINITIONS OF CURRENCY FUTURE ON NSE/BSE Underlying Initially. Quotation The currency futures contract would be quoted in rupee terms.m. currency futures contracts on US Dollar – Indian Rupee (US$-INR) would be permitted. Settlement mechanism [Project report on Currency Derivatives] University school of management Kurukshetra University Kurukshetra Page 56 . the outstanding positions would be in dollar terms. The contract size would be periodically aligned to ensure that the size of the contract remains close to the minimum size.

Final settlement day The currency futures contract would expire on the last working day (excluding Saturdays) of the month. 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 date/ Value date Last Trading Day Settlement Final Settlement Price Rate of exchange between one USD and INR 09:00 a. The rules for Interbank Settlements. The methodology of computation and dissemination of the Reference Rate may be publicly disclosed by RBI.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 Cash settled The reference rate fixed by RBI two working days prior to the final settlement date will be used for final settlement [Project report on Currency Derivatives] University school of management Kurukshetra University Kurukshetra Page 57 . Settlement price The settlement price would be the Reserve Bank Reference Rate on the date of expiry. including those for ‘known holidays’ and ‘subsequently declared holiday’ would be those as laid down by FEDAI. to 05:00 p.The currency futures contract shall be settled in cash in Indian Rupee. USD 1000 0.m.m.25 paisa or INR 0. The last working day would be taken to be the same as that for Interbank Settlements in Mumbai.

These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. Their pay offs are non-linear. Options do not have linear payoffs. However.19. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on the Xaxis and the profits/losses on the Y-axis. 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. currently only payoffs of futures are discussed as exchange traded foreign currency options are not permitted in India. Futures contracts have linear payoffs. i. the long futures position starts making [Project report on Currency Derivatives] University school of management Kurukshetra University Kurukshetra Page 58 . He has a potentially unlimited upside as well as a potentially unlimited downside. when Rupee depreciates.43. USD. In simple words.e. Take the case of a speculator who buys a twomonth currency futures contract when the USD stands at say Rs. The underlying asset in this case is the currency.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. it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. When the value of dollar moves up.

his futures position starts showing losses. and when the dollar depreciates.1 shows the payoff diagram for the buyer of a futures contract. i.19.profits. P R O F I T 43. it starts making losses. If the price goes up. If the price falls. when rupee appreciates.43. his futures position starts making profit. The investor bought futures when the USD was at Rs.19 0 USD D L O S S Payoff for seller of futures: Short futures [Project report on Currency Derivatives] University school of management Kurukshetra University Kurukshetra Page 59 . Payoff for buyer of future: The figure shows the profits/losses for a long futures position.e. Figure 4.

it starts making losses. The underlying asset in this case is the currency. when rupee depreciates. and when the dollar appreciates. The investor sold futures when the USD was at 43.The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. his futures position starts showing losses [Project report on Currency Derivatives] University school of management Kurukshetra University Kurukshetra Page 60 .e.19. If the price rises. i. when rupee appreciates. USD. Payoff for seller of future: The figure shows the profits/losses for a short futures position. 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. If the price goes down.19. The Figure below shows the payoff diagram for the seller of a futures contract.43.e. When the value of dollar moves down. his futures position starts making profit. i. the short futures position starts 25 making profits.

19 0 USD D L O S S PRICING FUTURES – COST OF CARRY MODEL Pricing of futures contract is very simple. we calculate the fair value of a futures contract. Using the cost-of-carry logic. This in turn would push the futures price back to its fair value.71828 [Project report on Currency Derivatives] University school of management Kurukshetra University Kurukshetra Page 61 . 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. Every time the observed price deviates from the fair value. arbitragers would enter into trades to capture the arbitrage profit.P R O F I T 43.

10-0. i. [Project report on Currency Derivatives] University school of management Kurukshetra University Kurukshetra Page 62 .e.= This relationship is known as interest rate parity relationship and is used in international finance. the traders’ oftenly use the currency futures. selling currency futures contracts) will protect against a decline in a foreign currency’s value. in order to hedge this foreign currency risk. rf > r. then value of F shall be greater than S.The relationship between F and S then could be given as F Se^(r rf )T . The value of F shall decrease further as time T increase. If the foreign interest is lower than the domestic rate. HEDGING WITH CURENCY FUTURES Exchange rates are quite volatile and unpredictable. buying currency futures contracts) will protect against a rise in a foreign currency value whereas a short hedge (i. rather even may incur loss.07 )*1=45. 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.e.. The value of F shall increase further as time T increases. 44. rf < r.. if foreign interest rate is greater than the domestic rate i. For example. Thus..e. To explain this. then F shall be less than S.34 It may be noted from the above equation. From the equation above the one year forward exchange rate should be F = 44 * e^(0. a long hedge (I. it is possible that anticipated profit in foreign investment may be eliminated.e.

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 The choice of underlying currency The first important decision in this respect is deciding the currency in which futures contracts are to be initiated. Which contract should he choose? Probably he has only one option rupee with dollar. This is called cross hedge. And he will have to pay 100000 USD on 1st February 2009. 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. 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). if a trader is exporting or importing any particular product from other countries then he is exposed to foreign exchange risk. And he predicts that the value of USD will increase against Indian rupees nearest to due [Project report on Currency Derivatives] University school of management Kurukshetra University Kurukshetra Page 63 . For example. Similarly. For example. the firm’s profit will be affected by change in foreign exchange rates.It is noted that corporate profits are exposed to exchange rate risk in many situation. 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. suppose Indian importer import raw material of 100000 USD on 1st November 2008. the firm can take long or short position in futures currency market as per requirement. in all these situations. if the firm is borrowing or lending or investing for short or long period from foreign countries. In all these situations. For example.

9225 50.0000. 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 USDINR 270809 USDINR 280909 USDINR 281009 Best Best Best Best Buy Qty Buy Price Sell Price Sell Qty 464 189 1 100 100 1 25 1 2 1 1 49.date of that payment.1925 5 49.0000 51.51.1900 LTP Volume 58506 Open Interest 43785 712 49.1625 48.8500.3100 49.9900 5598 3771 311 6 16809 6367 892 278 506 116 44 2215 79 2 [Project report on Currency Derivatives] University school of management Kurukshetra University Kurukshetra Page 64 .8575 49.5000 5 47.6925 49.0875 48. Importer predicts that the value of USD will increase more than 51.5000 51.9450 1 50.1500 1 50.0000 .9250 50.8550 612 49.3000 . So what he will do to protect against depreciating in Indian rupee? Suppose spots value of 1 USD is 49.50.5000 53.49.0000 48.9125 5 50.7300 176453 111830 2 49.2375 48.2000 2 50.2275 50.0000 49.8850 50.1000 .1000 49.7000 49.8550 49.0000 50.

Rs. And suppose on settlement day the spot price of USD is 51. We may define the hedge ratio HR as follows: [Project report on Currency Derivatives] University school of management Kurukshetra University Kurukshetra Page 65 . Choice of the number of contracts (hedging ratio) Another important decision in this respect is to decide hedging ratio HR.3825 - .8500 Solution: Rules.50. Byelaws & Regulations Membership Circulars List of Holidays He should buy ten contract of USDINR 28012009 at the rate of 49.8850) =1. As we know that in the futures markets due to their standardization. (Value of currency future per USD*contract size*No of contract).115*100000) =111500.8850. For that he has to pay 5% margin on 5988500.0000.299425 at present. of Contracts 244645 Archives As On 26-Nov-2008 12:00:00 Hours IST Underlying RBI reference rate USDINR 49.8850*1000*100) =4988500.115 per USD. The value of the futures position should be taken to match as closely as possible the value of the cash market position. And (1.0000-59. Value of the contract is (49.9275 - - Volume As On 26-NOV-2008 17:00:00 Hours IST No. On settlement date payoff of importer will be (51.USDINR 261109 1 48. Means he will have to pay Rs. exact match will generally not be possible but hedge ratio should be as close to unity as possible.

8850. 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. and they established rules and regulation so there is very safe trading is emerged and counter party risk is minimized in currency Future trading.  Larger exporter and importer has continued to deal in the OTC counter even exchange traded currency future is available in markets because.8500=1.  There is a limit of USD 100 million on open interest applicable to trading member who are banks. VF is the value of the futures position and Vc is the value of the cash position.8500.001. The whole function of Exchange traded currency future is regulated by SEBI/RBI. And it’s also a very help full in Arbitraging.8850/49. [Project report on Currency Derivatives] University school of management Kurukshetra University Kurukshetra Page 66 . And spot value is 49. HR=49.HR= VF / Vc Where. Suppose value of contract dated 28th January 2009 is 49. And also time reduced in Clearing and Settlement process up to T+1 day’s basis.  New concept of Exchange traded currency future trading is regulated by higher authority and regulatory. FINDINGS  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.

[Project report on Currency Derivatives] University school of management Kurukshetra University Kurukshetra Page 67 . 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.

so this restriction seem unreasonable to exporters and importers. And according to Indian financial growth now it’s become necessary to introducing other currency derivatives in Exchange traded currency derivative segment.  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. Ban on NRI’s and FII’s and Mutual Funds from Participating. CAD-INR etc. In India the regulatory of Financial and Securities market (SEBI) has Ban on other Currency Derivatives except Currency Futures. [Project report on Currency Derivatives] University school of management Kurukshetra University Kurukshetra Page 68 .SUGGESTIONS  Currency Future need to change some restriction it imposed such as cut off limit of 5 million USD. Now in exchange traded currency future segment only one pair USDINR is available to trade so there is also one more demand by the exporters and importers to introduce another pair in currency trading. Like POUND-INR. in result OTC users will divert to Exchange traded currency Futures.

Initially only NSE had the permission but now BSE and MCX has also started currency future.a process that has undoubtedly improved national productivity growth and standards of livings.CONCLUSIONS By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives…These instruments enhances the ability to differentiate risk and allocate it to those investors most able and willing to take it. Because of exchange traded future contract and its standardized nature gives counter party risk minimized. 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. [Project report on Currency Derivatives] University school of management Kurukshetra University Kurukshetra Page 69 . It is shows that how currency future covers ground in the compare of other available derivatives instruments. 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. 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.

BCFM: Currency Future Module.com www. 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.in www.frost.org. Center for social and economic research) Poland Recent Development in International Currency Derivative Market by: Lucjan T.sebi.com www.wikipedia. Gupta.nseindia.com [Project report on Currency Derivatives] University school of management Kurukshetra University Kurukshetra Page 70 .com www.BIBLIOGRAPHY Financial Derivatives (theory. April 2008) Websites: www.in www.com www.gov.L. concepts and problems) By: S.economywatch.rbi. NCFM: Currency future Module.bseindia.

[Project report on Currency Derivatives] University school of management Kurukshetra University Kurukshetra Page 71 .

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