State of Currency Derivatives Trading in India: Futures Vs Forwards

Tulsi Lingareddy£
Foreign exchange market in India has made significant strides in the recent years gaining
depth and volumes and introduction of increasing number of derivatives instruments for
hedging against price risk. Further, with the rapid increase in global integration of
financial markets and to facilitate the increased cross boarder transfer of funds, the RBI
has permitted exchange trade of currency futures in 2008. Consequently, currency futures
contracts were introduced for trading on the National Stock Exchange Ltd (NSE) with the
effect from Aug 29, 2008. Following this, two more exchanges, Bombay Stock Exchange
(BSE) and Multi Commodity Exchange-Stock Exchange (MCX-SX), also started offering
currency futures trade in Sept and Oct respectively, in 2008. Soon after their introduction,
trading in currency futures picked up momentum rather quickly and the total volumes
reached Rs.5.14 lakh crore by the end of May 2009.
The main advantage of currency futures over its closest substitute product, viz.,
forwards which are traded over-the-counter (OTC) lies in price transparency, elimination
of counterparty credit risk and greater reach in terms of easy accessibility to all.
However, futures’ trading also involves speculators and arbitragers who don’t have any
underlying physical exposure but participate in trading with profit motive. As a result,
there are apprehensions that the excessive speculation may adversely affect both futures
as well as the underlying spot markets. Considering these developments, an attempt is
made to study the pattern of trade, comparative economics forex derivates and the impact
of futures on forwards and spot.

Trends in forex derivatives market trade

Forex forwards (OTC products): The trends in the trade of forex forwards indicated
that majority of the trades were concentrated in the tenor of 6 months to one year
followed by less than 30days and 30-90days tenor. The shares of less than 30days and 30-
90 days were almost equal during most of the time though, the trade concentration in the
shortest tenor (<30 days) has increased significantly during 2007-08. On the other hand,
the share of 90-180 days tenor has steadily declined through the past 7 years.

Table 1: Tenor-wise trade analysis (%)

< 30 Days 30 to 90 Days 90 to 180 Days 180 to 365 Days > 1 Year
2002-03 16.1 22.9 22.4 37.2 1.4
2003-04 22.5 24.8 20.2 31.8 0.7
2004-05 20.0 24.1 17.9 36.3 1.8
2005-06 22.8 24.2 15.2 36.2 1.6
2006-07 25.6 25.1 17.2 30.5 1.6
2007-08 31.5 25.8 17.2 24.5 1.0
2008-09 23.6 23.4 18.6 32.0 2.4
Apr -09 33.2 19.3 12.4 34.2 0.9
May-09 20.2 20.1 12.9 45.2 1.7
Apr-May ‘09 26.8 19.7 12.7 39.6 1.3
Source: Rakshitra, May 2009.

£
Deputy Manager, Research & Surveillance Dept, CCIL. Views expressed are authors personal

Electronic copy available at: http://ssrn.com/abstract=1469400

Exchange traded futures: Currency futures ga ined significant volumes soon after their
introduction on domestic exchanges and have grown many folds, from about Rs 5
thousand crore in September 2008 to Rs.124 thousand crore in May 2009. Unlike the case
of OTC forward market, where trading is well diversified across different tenors and the
long tenors are relatively more active, futures volumes have largely been confined to near
month contracts accounting for about 90 per cent. Although three trading platforms are
available for trading, the BSE could not gain much volume while the MCX-SX and NSE
have been contributing nearly equal share to the total traded volumes of currency futures
market.

Table 2: Trends in trade volumes of currency futures

Total Volume Share (%)
(Rs. crore) 1M 2M 3M
Sep-08 5174.5 84.3 9 6.7
Oct-08 16663.1 83.9 8 8.1
Nov-08 31083.2 81.1 10 8.9
Dec-08 45776.6 87.2 9 3.8
Jan-09 48394.9 86.7 9 4.3
Feb-09 63956.3 87.9 9 3.1
Mar-09 99461.2 86.6 9 4.4
Apr-09 77921.8 92.1 6 1.9
May-09 124900.7 93.3 5 1.7

Data & Methodology

Data on forward rates for various term structures were collected from traded as well as
polled data. Source for traded data was the CCIL while the polled rates were collected
from the RBI. The extent of match/mismatch between the polled and traded forward rates
were studied for pooled as well as individual categories of major trading members such
as foreign banks, nationalized banks and private banks. Further, in order to bring
comparability, the traded data were collated into different term structures like 1-month, 3-
month, 6- month and one- year.

Test Statistics:
The data were analyzed using simple statistical tools such as correlations and t-tests to
find out the extent of association between the data of two sources viz., traded and polled.
T-test for paired two sample means was used in order to test the statistical significance of
mean differences in the data from the two sources.

Comparative economics of forwards and futures

Spread: Simultaneous trade of foreign exchange on different platforms as well as in the

OTC market provides arbitrage opportunity if there is any significant difference in the
rates traded across different platforms. Lesser the spread, efficient are the markets.
Hence, the spread between the exchange traded futures and OTC forwards was calculated
and tested for its statistical significance. In addition, the RBI also fixes daily exchange

Electronic copy available at: http://ssrn.com/abstract=1469400

rates for reference based on the polled information and the exchange traded futures have
to be settled based on the RBI’s reference rate.

Table 3: Spread among exchange rates from three different sources

Spread (paise) t-stat p value
Between Sep’08 and Dec ‘8
Futures - Fwd traded 6.33 -2.465 0.008
Fwd polled - Futures 5.05 2.627 0.005
Fwd polled - Fwd traded 11.38 -6.202 0.000
Between Jan ’09 and Mar ‘09
Futures - Fwd traded 3.09 -2.465 0.008
Fwd polled - Futures 7.01 2.627 0.005
Fwd polled - Fwd traded 10.10 -6.202 0.000
Between Sep’08 and Mar ‘09
Futures - Fwd traded 4.99 -2.465 0.008
Fwd polled - Futures 5.86 2.627 0.005
Fwd polled - Fwd traded 10.85 -6.202 0.000

The results based on paired t-statistic indicated that the daily average spreads among all
three exchange rates were falling in the range of 5 to 11 paise and was found to be
statistically significant. Among the three different exchange rates, the OTC forward rates
were the lowest, followed by the exchange traded futures and polled rates by the RBI. As
a result, the spread between traded forward rate and polled forward rate by the RBI was
found to be the maximum at 11.38 paise.
The daily average spread between futures and polled forward rates during the initial
three months of futures trade was the lowest at 5.05 paise. However, the futures rates
moved relatively closer to traded forwards, apparently due to the existence of arbitrage
activity. The spread between futures and traded forwards narrowed to 3.09 paise, while
the spread between the futures and polled forward rates widened to 7.01 paise during Jan-
Mar ‘09 despite the fact that the futures contracts are settled based on the RBI reference
rate.
Thus, on average, the daily average spread between the traded exchange rates has
narrowed to half within six months of introduction of futures trading, suggesting that the
foreign exchange markets in India are becoming efficient over a period.

Volatility: Volatility in the three exchange rates was measured by using the standard
deviation and coefficient of variation for different periods. The results indicated that the
volatility was relatively lower, though only marginally, in the case of OTC traded
forwards and futures compared to the polled RBI reference rate in the three periods
considered for the study.
Although the increase in volatility during Sep-Dec‘08 coincided with the
introduction of futures, the volatility level in Jan-Mar ’09 returned to the level that
existed prior to the introduction of futures. Hence, the rise in volatility during Sep-Dec
‘08 could possibly be on account of the turmoil in the global markets that transmitted to
Indian markets during the same period. Thus, there was no significant change in the
volatility of foreign exchange markets after the introduction of trading futures contracts.
 Table 4: Volatility trends in exchange rate

Standard Deviation Co-efficient of Variation (%)

OTC traded Futures Polled RBI OTC traded Futures Polled RBI
forward reference rate forward reference rate
Apr-Aug 1.216 NA 1.246 2.880 NA 2.943
Sep-Dec 1.680 1.713 1.743 3.506 3.569 3.629
Jan-Mar 1.227 1.246 1.256 2.462 2.500 2.515
Sep-Mar 1.776 1.791 1.815 3.645 3.672 3.718

Costs involved in trading

Cost of trading becomes another important factor for the participants to choose the
platform and product for trading. For the sake of comparability, total costs involved from
the entry into the contract till the delivery or settlement of the contract.

Forwards : The cost of trading in case of forwards, as they are over the counter contracts,
comes into picture only when it enters into the settlement guaranteed clearing system
(provided by the CCIL in India). If it is mutually settled out of the guaranteed settlement
system then there are no costs in case of OTC contracts (forwards). However, majority of
the trades are settled through the guaranteed settlement provided by the CCIL and fees
charged by the CCIL becomes cost of trading for forwards. The details of the costs
involved in the settlement of forwards through CCIL are specified in Table 5.

Table 5: Charges per trade accepted per segment

Trade Value (in USD) Charges
Less than 1 million Rs 90/-
1 million to less than 3 million Rs 110/-
3 million to less than 5 million Rs 125/-
5 million to less than 10 million Rs 150/-
10 million to less than 20 million Rs 175/-
20 million and above Rs 200/
Source: www.ccilindia.com

Futures: In the case of futures, there are two major costs that involve in trading on
exchange platform apart from the brokerage ; one is in the form of margins and the other
is the transaction charges. Margin costs are not paid out costs to the exchange but are
held by the exchange till the settlement day, adjusting daily on a mark-to-market basis
and settled at the expiry of contracts.
Though the exchanges normally charge transaction fee for using the platform to
trade, at present, transaction costs for trading in currency futures are nil, plausibly to
encourage and promote the participation in futures. Nevertheless, the participants have to
pay a nominal fee of Rs 20/- per crore towards SEBI turnover fee and outstanding fee of
Rs.10/- per million per month on the outstanding contract, based on its residual maturity.
To illustrate, a participant with a position of Rs.10 million in a futures contract that
expires after five months will have to pay Rs.500 per month towards outstanding fee.
However, the charges are levied daily on a pro-rata basis. This may also be a reason for
the concentration of trades in near month contract especially in view of the zero
transaction costs that facilitate frequent rollover of contracts.
In addition, brokerage charges also need to be considered when the trading is
done through brokers in both forward and futures trading. Although precise information
is not available on the level of brokerage, the brokerage charges of futures trading
reported to be considerably lower than that in forward (OTC) trading. Nevertheless,
brokerage charges are optional in both markets.
Thus, taking into account of various costs involved except the brokerage charges,
trading on exchange appears to be relatively costly even when the transaction charges are
not yet levied by the exchanges. Further, as evident from the composition of trade in
established forex derivatives market (OTC), majority (about 50%) of trades are
concentrated in longer tenors of 6 months to 1-year. If such long-term hedgers want to
use futures platform, they need to rollover their position to meet their requirement, as the
liquidity is largely concentrated in the near month contract in futures markets. Once the
exchanges start charging transaction costs, the rollover in currency futures may become
expensive.

Impact of futures on forward trade

There was no perceptible impact of futures trading on forward trade volumes so far as the
trading in both derivatives exhibited a similar growth trend. Trade volumes in forwards
declined steadily after Oct ’08 except in Dec ’08, coinciding with the initiation of
currency futures trade. But, the period also coincided with the deepening of global
financial crisis that led to less activity in financial markets in general. The decline in
activity was evident from the similar pattern of fall in spot market volumes during the
corresponding period as shown in Chart 1. Further, the trade activity in futures and
forwards showed a similar growth trend since the introduction of futures in Oct ‘08.

Growth trends in Foreign Exchange Volumes

120
100
80
60
Growth (%)

40
20
0
Aug-08
Jul-08

Sep-08

Feb-09
Jun-08

Jan-09
Dec-08

Mar-09
Apr-08

May-08

Nov-08
Oct-08

-20
-40
-60
FWD Spot Futures
 Thus, based on the available trends in futures and forwards so far, it is not evident
that the futures trading has caused any significant shift in OTC forward volumes. In
addition, considering the nature and concentration of trade in both the markets (OTC and
futures) and in view of the similar trends in their volumes, it appears that at present the
objective of participation in both markets is different. The OTC market is predominantly
used by hedgers with physical exposure, while futures market apparently used mostly for
the arbitrage and speculation purposes. Hence, there was no notable shift in volumes
from forwards to futures, despite the rapid and significant increase in futures volumes.

Factors discouraging futures trading

Mismatch of Contract size:

Since the futures contracts are standardized with a fixed amount of quantity that may not
match the actual requirement of the participants many times. As a result, the participants
may prefer to take positions in OTC market where the contracts can be customized to
their required amount or size.

Mismatch in maturity:
Another difficulty the hedgers may face in case of futures is the mismatch between the
date of requirement and the maturity date of the contract. The hedgers who actually
interested to take the delivery will find it difficult when the date of maturity of the
contract does not match with the date of their requirement.

Position limits:
Another important factor that may be discouraging the participation in futures is the
position limits. The exchange fixes the upper limit on the position taken by each
participant. The details of the limits fixed by the exchanges are given below. Because of
these limitations, the participants cannot take position beyond this limit and to the extent
they need and hence it becomes a constraint.

Clients Trading Members Banks

higher of 6% of total open higher of 15% of the total higher of 15% of the total
interest or USD 10 million open interest or USD 50 open interest or USD 100
million million

No physical delivery
Lack of physical delivery option and only cash settlement in futures trading become s a
problem for hedgers when they have payment obligations in foreign currency. Hence, this
may discourage participants, who need physical delivery of foreign currency.

Restriction on the participation of FIIs

Another important factor that discourages the active trading in futures is the restriction of
foreign institutional investors (FIIs) participation. According to guidelines of the Reserve
Bank of India, trade participation of FIIs in futures trading is not yet allowed.
Factors encourage futures trading

Easy entry and exit

The facility to easily enter into and exit from the contract encourages participation from
those who do not have specifications of physical delivery in the terms of quantity,
maturity date and position limits which generally are the speculators and arbitrageurs.

Anonymity and Transparency in dealing

Since the deals occur online on the exchange platform, there is transparency in pricing
and arriving at the deal.

Conclusions
The existing trends so far suggest that despite the significant rise in futures volumes,
there was no notable shift in volumes from forwards to futures market. The fee structure
and near-month liquidity in currency futures possibly attracted the participation of
arbitragers and speculators, while the hedgers continued to prefer OTC forward contracts
due to the flexibility and customization particularly in case of long term requirements.
Thus, the remarkable growth in futures could not bring any notable changes in forward
markets so far since the purpose as well as nature of participation in futures was different
from that of the forwards market.