Currency Derivatives

Presented By

Kalpak K Bhore

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ACKNOWLEDGEMENT
On the occasion of completion and submission of project, I would like to express our deep sense of gratitude to B.Y.K.C.C for providing us Platform of studies. I thank to our Faculty members for their moral support during the project. I am too glad to give our special thanks to our project guide Mr. Vaibhav Khandelwal for providing me 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, my sincere regards to my parents and friends who have directly or indirectly helped me in the project.

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Research Methodology
Type Of Research
In this project Descriptive research methodologies were use. The research methodology adopted for carrying out the study was theoretical study is attempted.

Source Of Data Collection
Secondary data were used such as various books, report submitted by RBI/SEBI committee and NCFM/BCFM modules.

Objectives Of The Study
The basic idea behind undertaking Currency Derivatives project to gain knowledge about currency future market. • • • • To study the basic concept of Currency future To study the exchange traded currency future To study the newly introduced currency derivative products in India. To study different currency derivatives products.

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Limitation Of The Study
The limitations of the study were: • The study was purely based on the secondary data. So, any error in the secondary data might also affect the study undertaken. • The currency future is new concept and topic related book was not available in library and market.

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Contents
Currency Derivatives.......................................................................................1 Research Methodology....................................................................................3 Type Of Research .........................................................................................3 Source Of Data Collection.............................................................................3 Objectives Of The Study................................................................................3 Limitation Of The Study................................................................................4 Contents..........................................................................................................5 INTRODUCTION OF CURRENCY DERIVATIVES..................................................9 INTRODUCTION TO FINANCIAL DERIVATIVES.................................................11 DEFINITION OF FINANCIAL DERIVATIVES.....................................................13 Types of Financial Derivatives....................................................................15 Introduction of derivatives in India.............................................................19 Introduction To Currency Derivatives............................................................20 History Of Currency Derivatives.................................................................22 Introduction To Foreign Exchange Market.....................................................23 Foreign Exchange Spot (Cash) Market........................................................24 Foreign Exchange Quotations.....................................................................26 Page | 5

...............40 SPOT PRICE :...............................................42 INITIAL MARGIN :...................................................................................29 Currency Derivative Products...........................................................40 CONTRACT CYCLE :.................................32 Introduction To Currency Future.................40 VALUE DATE / FINAL SETTELMENT DATE :...41 CONTRACT SIZE :....................................36 Rationale For Introducing Currency Future ...........................................................................................................................32 OPTIONS : ........................................................................................41 EXPIRY DATE :..........................................................................................The Foreign Exchange Market In India...........................................31 FUTURE :................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................42 Page | 6 .....................41 BASIS :......................................................................38 Future Terminology......................................................................................................40 FUTURE PRICE :...31 FORWARD : ...............................41 COST OF CARRY : .................................................31 SWAP : .....................34 Need For Exchange Traded Currency Futures.................

.............................................53 Trading Hours.........................................................48 Regulatory Framework For Currency Futures....................45 Arbitrage:................43 Speculation: Bullish..................................................................................................................................................................53 Quotation..54 Settlement mechanism....................................................................................53 Tenor of the contract..........................................................................53 .......49 Comparision Of Forward And Futures Currency Contract................................42 MAINTENANCE MARGIN :..........................................................................................46 Trading Process And Settlement Process ...........................................................................................................................................................................................................53 Available contracts....53 Underlying..................................................................................................................................................................................................................................43 Hedging:............MARKING TO MARKET :................................................. sell futures.......... buy futures..........43 Uses Of Currency Futures..............................................51 Product Definitions Of Currency Future On NSE/BSE ..........................................................................53 Size of the contract...............................................54 Page | 7 .......44 Speculation: Bearish...........................................................................................

...................................................................................................................................................................................55 Conclusion.............................Settlement price...................................................54 Final settlement day....................................57 Page | 8 .......................................................54 Contract specification in a tabular form is as under:..........................................................................57 Websites:.........56 Bibliography.................................................................

trading in foreign currencies has grown tremendously over the past several decades. facilitating transfer of purchasing power from one country to another. For example. All the international business transactions involve an exchange of one currency for another. The foreign exchange markets of a country provide the mechanism of exchanging different currencies with one and another. and when borrowed fund are paid to the lender then the home currency will be converted into foreign lender’s currency. It means that the borrowed foreign currency brought in the country will be converted into Indian currency.INTRODUCTION OF CURRENCY DERIVATIVES Each country has its own currency through which both national and international transactions are performed. With the multiple growths of international trade and finance all over the world. the currency units of a country involve an exchange of one currency for another. so the firms are exposed to the risk of exchange rate movements. The price of one currency in terms of other currency is known as exchange rate. Since the exchange rates are continuously changing. 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 thus. Thus. As a result Page | 9 .

these firms are increasingly turning to various risk hedging products like foreign currency futures.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. foreign currency forwards. specifically in developed countries. As a result. the currency risk has become substantial for many business firms. Since the fixed exchange rate system has been fallen in the early 1970s. Page | 10 . foreign currency options. This variability in the value of assets or liabilities or cash flows is referred to exchange rate risk. and foreign currency swaps.

to manage such risks.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.a process that has undoubtedly improved national productivity growth and standards of livings. As a result. exchange rate and stock market prices at the different financial market have increased the financial risks to the corporate world. In this respect. the demand for the international money and financial instruments increased significantly at the global level.” Alan Greenspan. changes in the interest rates. 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. It is therefore. Page | 11 . which are also popularly known as financial derivatives. the new financial instruments have been developed in the financial markets.

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which is a derivative of milk. bond. etc. Precious metals: gold. to buy or sell an asset in future. These contracts are legally binding agreements. rupee dollar exchange rate. grain. Which means something derived. made on the trading screen of the stock exchanges. Short term debt securities: treasury bills. interest rates. and what you have. silver. cotton. A very simple example of derivatives is curd. platinum. coffee. These assets can be share. Interest rates Common shares/stocks Page | 13 . Means this word is arise from the mathematical term derivation. Derivatives are financial contracts whose value/price is independent on the behavior of the price of the one or more basic underlying assets. Underlying securities for derivatives are following: • • • • • Commodities: castor seeds. The financial derivatives indeed derived from the financial market. soyabean.DEFINITION OF FINANCIAL DERIVATIVES The word is formed by word derivatives. index. pepper. some things are arised or derived out of some underlying variables. sugar crude oil. The price of curd depends upon the price of milk which intern depends upon demand and supply of milk. potatoes.

• • Stock index value: NSE Nifty Currency: exchange rate Page | 14 .

it is very difficult to classify the financial derivatives. plain. the derivatives can be classified into different categories which are shown below: Page | 15 . synthetic. In the simple form. called as the underlying. simple or straightforward. the basic financial derivatives which are popularly in the market have been described. For example. leveraged. various types of financial derivatives based on their different properties like. mildly leveraged. are available in the market. Due to complexity in nature. joint or hybrid. composite. so in the present context. OTC traded.Types of Financial Derivatives Financial derivatives are those assets whose values are determined by the value of some other assets. etc. Presently there are Complex varieties of derivatives already in existence and the markets are innovating newer and newer ones continuously. standardized or organized exchange traded.

cotton. In financial derivative. crude oil. stocks. forward contracts. In this. gold. pepper. turmeric. bonds. Another way of classifying the financial derivatives is into basic and complex. jute. corn. cost of living index etc. the quality may be the underlying matters.One form of classification of derivative instruments is between commodity derivatives and financial derivatives. natural gas. It is to be noted that financial derivative is fairly standard and there are no quality issues whereas in commodity derivative. stock index. In commodity derivatives. silver and so on. the underlying instrument is commodity which may be wheat. the underlying instrument may be treasury bills. foreign exchange. sugar. futures contracts and option contracts Page | 16 . The basic difference between these is the nature of the underlying instrument or assets.

or both. OTC derivatives are customized contracts that enable the parties to select the trading units and delivery dates to suit their requirements. With the exchange traded derivatives. In fact. A major difference between the two is that of counterparty risk—the risk of default by either party.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. the risk is Page | 17 . such derivatives are effectively derivatives of derivatives Derivatives traded at organized markets or over the counter (OTC) markets: Derivatives traded at exchanges are standardized contracts having standard delivery dates and trading units.

OTC derivatives signify greater vulnerability. In contrast.controlled by exchanges through clearing house which act as a contractual intermediary and impose margin requirement. Page | 18 .

which withdrew the prohibition on options in securities. 1998. The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance. risk management through derivatives products has become a necessity in India also. With the globalization of trade and relatively free movement of financial assets.Introduction of derivatives in India The gradual liberalization of Indian economy has resulted in substantial inflow of foreign capital into India. 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. As Indian businesses become more global in their approach. Page | 19 . 1996 to develop appropriate regulatory framework for derivatives trading in India. L. SEBI set up a 24 – member committee under the chairmanship of Dr. Gupta on November 18.C. submitted its report on March 17. evolution of a broad based. like in other developed and developing countries. active and liquid forex derivatives markets is required to provide them with a spectrum of hedging products for effectively managing their foreign exchange exposures. 1995. Simultaneously dismantling of trade barriers has also facilitated the integration of domestic economy with world economy.

and when borrowed fund are paid to the lender then the home currency will be converted into foreign lender’s currency. Page | 20 . Thus. The price of one currency in terms of other currency is known as exchange rate. Futures contracts on individual stocks were launched in November 2001. The trading in index options commenced in June 2001 and the trading in options on individual securities commenced in July 2001. the currency units of a country involve an exchange of one currency for another.To begin with. Introduction To Currency Derivatives Each country has its own currency through which both national and international transactions are performed. All the international business transactions involve an exchange of one currency for another. It means that the borrowed foreign currency brought in the country will be converted into Indian currency. SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE-30 (Sensex) index. For example. If any Indian firm borrows funds from international financial market in US dollars for short or long term then at maturity the same would be refunded in particular agreed currency along with accrued interest on borrowed money.

foreign currency options.The foreign exchange markets of a country provide the mechanism of exchanging different currencies with one and another. these firms are increasingly turning to various risk hedging products like foreign currency futures. facilitating transfer of purchasing power from one country to another. As a result. and foreign currency swaps. Since the fixed exchange rate system has been fallen in the early 1970s. Page | 21 . foreign currency forwards. so the firms are exposed to the risk of exchange rate movements. With the multiple growths of international trade and finance all over the world. 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. and thus. specifically in developed countries. the currency risk has become substantial for many business firms. Since the exchange rates are continuously changing. This variability in the value of assets or liabilities or cash flows is referred to exchange rate risk. trading in foreign currencies has grown tremendously over the past several decades.

increasing the risk of doing business. which had fixed world exchange rates to a gold standard after World War II. currency overlay managers and individual investors.S. abandonment of the Bretton Woods agreement. CME offers 41 individual FX futures and 31 options contracts on 19 currencies. By creating another type of market in which futures could be traded. Traders of CME FX futures are a diverse group that includes multinational corporations. proprietary trading firms. The FX contract capitalized on the U. The concept of currency futures at CME was revolutionary. financial managers. 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. and gained credibility through endorsement of Nobel-prize-winning economist Milton Friedman. Today. They trade in order to transact Page | 22 .History Of Currency Derivatives Currency futures were first created at the Chicago Mercantile Exchange (CME) in 1972. CME Chairman Emeritus. hedge funds. commodity trading advisors (CTAs). It is the largest regulated marketplace for FX trading. which were the main derivative contracts traded at CME until then.The contracts were created under the guidance and leadership of Leo Melamed. commercial banks. all of which trade electronically on the exchange’s CME Globex platform. investment banks.

E. In other words. The participants in his markets are: • • • • Corporates Commercial banks Exchange brokers and Commercial banks. Page | 23 . with daily turnover of over USD 2 trillion. the forms which such exchange may take. In words of H.Evitt. Introduction To Foreign Exchange Market The foreign exchange market is a market in which foreign exchange transactions take place.business. It also involves the investigation of the method by which render such exchange necessary. or to speculate on rate fluctuations.” The foreign exchange market in terms value of transactions. and the ratios or equivalent values at which such exchanges are effected. it is a market in which national currencies are bought or sold against one another. hedge against unfavorable changes in currency rates. “it is a that section of economic science which deals with the means and methods by which right to wealth in one country’s currency are converted into rights to wealth in terms of another country’s currency. It is a 24 hrs market. is largest market in the world.

2 days after the execution of the transaction. The standard settlement period in this market is 48 hours.e. rather simply book keeping transfer entry among banks. financial institutions. hence. Since most of the business in this market is done by banks. The large banks usually make markets in different currencies. the business is transacted throughout the world on a continual basis. It consists of a network of foreign dealers which are oftenly banks. etc. In the spot exchange market. large concerns. The purchase and sale of currencies stem partly from the need Page | 24 . So it is possible to transaction in foreign exchange markets 24 hours a day. There is no centralized meeting place and no fixed opening and closing time. transaction usually do not involve a physical transfer of currency. Exchange rates are generally determined by demand and supply force in this market.. Generally they do not have specific location. The spot foreign exchange market is similar to the OTC market for securities. i. and mostly take place primarily by means of telecommunications both within and between countries.Foreign Exchange Spot (Cash) Market The foreign exchange spot market trades in different currencies for both spot and forward delivery.

extent or speed of exchange rate movements. Page | 25 . 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.to finance trade in goods and services.

45 in Indian rupees then it implies that 45 Indian rupees will buy one dollar of USA. The number of units of domestic Currency stated against one unit of foreign currency.Foreign Exchange Quotations Foreign exchange quotations can be confusing because currencies are quoted in terms of other currencies. If one US dollar is worth of Rs.02187 Page | 26 . For example. or that one rupee is worth of 0. It means exchange rate is relative price. Re 1 = $ 0. Re/$ = 45.7250 ( or ) The number of unit of foreign currency per unit of domestic currency.022 US dollar which is simply reciprocal of the former dollar exchange rate.

If US dollar is quoted in the market as Rs 46. usually large banks. a small dash or oblique line is drawn after the dash. and another for selling (ask or offered rate) for a currency.3500/3550. the base currency is the first currency in a currency pair. both buying and selling. That is the Page | 27 . two rates are quoted by the dealer: one rate for buying (bid rate). This is a unique feature of this market. Traders. Most countries use the direct method. It is important to note that selling rate is always higher than the buying rate. are called market makers.3550.$1 = Rs.7250 There are two ways of quoting exchange rates: the direct and indirect. It should be noted that where the bank sells dollars against rupees. In global foreign exchange market. it means that the forex dealer is ready to purchase the dollar at Rs 46. Base Currency/ Terms Currency: In foreign exchange markets. one can say that rupees against dollar. For example. In order to separate buying and selling rate. 45. deal in two way prices.3500 and ready to sell at Rs 46. The difference between the buying and selling rates is called spread. Exchange rates are quoted in per unit of the base currency. The second currency is called as the terms currency.

25. If Dollar – Rupee moved from 43.expression Dollar-Rupee. Page | 28 . Changes in rates are expressed as strengthening or weakening of one currency vis-à-vis the second currency. which means that the value of one currency in terms of the other is constantly in flux.7525 the Dollar has depreciated and Rupee has appreciated. the base currency has strengthened / appreciated and the terms currency has weakened / depreciated. Exchange rates are constantly changing. Changes are also expressed as appreciation or depreciation of one currency in terms of the second currency. For example. Whenever the base currency buys more of the terms currency. The Dollar has appreciated and the Rupee has depreciated.0000 to 42. tells you that the Dollar is being quoted in terms of the Rupee. The Dollar is the base currency and the Rupee is the terms currency. And if it moved from 43.00 to 43.

which was achieved in August 1994. 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.developed foreign exchange derivative market (both OTC as well as Exchange-traded) is imperative. export performance. Although liberalization helped the Indian forex market in various ways. it led to extensive fluctuations of exchange rate. In the context of upgrading Indian foreign exchange market to international standards. This issue has attracted a great deal of concern from policy-makers and investors. a well. At the same time. and balance sheets. The exchange rate regime. was partially floated in March 1992 and fully floated in March 1993. that was earlier pegged. swaps and options in the OTC market. 2007 issued comprehensive guidelines on the usage of foreign currency forwards. 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. sustainability of current account balance. RBI also set up an Internal Working Group to explore the Page | 29 . excessive volatility can have an adverse impact on price discovery. With a view to enable entities to manage volatility in the currency market. RBI on April 20.The Foreign Exchange Market In India During the early 1990s.

The Report of the Internal Working Group of RBI submitted in April 2008. Further RBI and SEBI also issued circulars in this regard on August 06. provide access to all types of market participants.advantages of introducing currency futures. offer standardized products and provide transparent trading platform. Currently. 2008. With the help of electronic trading and efficient risk management systems. Page | 30 . Subsequently. Swiss Franc etc. 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. eliminate counterparty credit risk. EURO. 2008. thereby providing them with a new opportunity. are traded. Exchange Traded Currency Futures will bring in more transparency and efficiency in price discovery. where all the major currencies like USD. Banks are also allowed to become members of this segment on the Exchange. YEN. The Committee submitted its report on May 29. recommended the introduction of Exchange Traded Currency Futures. Pound. India is a USD 34 billion OTC market.

A forward contract is customized contract between two entities.Currency Derivative Products Derivative contracts have several variants. a future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. 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. Page | 31 . The most common variants are forwards. The exchange rate is fixed at the time the contract is entered into. We take a brief look at various derivatives contracts that have come to be used. Future contracts are special types of forward contracts in the sense that they are standardized exchange-traded contracts. This is known as forward exchange rate or simply forward rate. options and swaps. a specified price and a standard quantity. FUTURE : A currency futures contract provides a simultaneous right and obligation to buy and sell a particular currency at a specified future date. futures. where settlement takes place on a specific date in the future at today’s pre-agreed price. In another word.

Initial exchange of principal amount 2. with the cash flows in one direction being in a different currency than those in the opposite direction. Ongoing exchange of interest 3. They can be regarded as portfolio of forward contracts. fixed to floating currency swap.SWAP : Swap is private agreements between two parties to exchange cash flows in the future according to a prearranged formula. OPTIONS : Currency option is a financial instrument that give the option holder a right and not the obligation. There are a various types of currency swaps like as fixed-to-fixed currency swap. floating to floating swap. a foreign currency option is a contract for future delivery of a specified currency in exchange for another in which buyer of the option has to right to buy (call) or sell (put) a particular currency at an agreed price for Page | 32 . In a swap normally three basic steps are involve: 1. Re . The currency swap entails swapping both principal and interest between the parties. In other words.exchange of principal amount on maturity. 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 ).

the majority of options traded on options exchanges having a maximum maturity of nine months.or within specified period. Options generally have lives of up to one year. Longer dated options are called warrants and are generally traded OTC. Page | 33 . The seller of the option gets the premium from the buyer of the option for the obligation undertaken in the contract.

and calculating profits or losses on Currency Futures will be similar to calculating profits or losses on Index futures. at a specified price. traded on an exchange. to buy or sell a certain underlying asset or an instrument at a certain date in the future. In other words.g. Oil or Wheat.g. the buyer and the seller lock themselves into an exchange rate for a specific value or delivery date. e. go through the exchange. When the underlying asset is a commodity. All settlements however. the contract is termed a “commodity futures contract”. A tick is the minimum trading increment or price differential at which traders are able to enter bids and offers. Therefore. Both parties of the futures contract must fulfill their obligations on the settlement date. the contract is termed a “currency futures contract”. For e. Currency futures can be cash settled or settled by delivering the respective obligation of the seller and buyer. it is a contract to exchange one currency for another currency at a specified date and a specified rate in the future. When the underlying is an exchange rate.Introduction To Currency Future A futures contract is a standardized contract. In determining profits and losses in futures trading. Tick values differ for different currency pairs and different underlying. in the Page | 34 . Currency futures are a linear product. it is essential to know both the contract size (the number of currency units being traded) and also what is the tick value. unlike in the case of OTC markets.

case of the USD-INR currency futures contract the tick size shall be 0.2500 4 ticks * 5 contracts = 20 points 20 points * Rupees 2. So if a trader buys 5 contracts and the price moves up by 4 tick.50.25 paise or 0.2500 00.2525 depending on the direction of market movement.2475 or Rs.2500 00. 48.5 per tick = Rupees 50 Page | 35 .2600 – 42. To demonstrate how a move of one tick affects the price.0025 Rupees. Step 1: Step 2: Step 3: 42.0025 48.48. Purchase price Price increases by one tick New price Purchase price Price decrease by one tick New price. she makes Rupees 50.0025 48.2500. imagine a trader buys a contract (USD 1000 being the value of each contract) at Rs. One tick move on this contract will translate to Rs.48.48.2475 The value of one tick on each contract is Rupees 2.2525 48.

the obligation of the individual equals the forward price at which the contract was executed. Exchange traded futures as compared to OTC forwards serve the same economic purpose. Page | 36 . At the same time. RBI on April 20. Except on the maturity date. which by assuming counterparty guarantee eliminates credit risk. On the other hand. On the maturity date. the scope for building up of mark to market losses in the books of various participants gets limited. Since the profits or losses in the futures market are collected / paid on a daily basis. RBI also set up an Internal Working Group to explore the advantages of introducing currency futures. 2007 issued comprehensive guidelines on the usage of foreign currency forwards. recommended the introduction of exchange traded currency futures. mark to market obligations is settled on a daily basis. The Report of the Internal Working Group of RBI submitted in April 2008. The counterparty risk in a futures contract is further eliminated by the presence of a clearing corporation. in the case of an exchange traded futures contract. An individual entering into a forward contract agrees to transact at a forward price on a future date. swaps and options in the OTC market.Need For Exchange Traded Currency Futures With a view to enable entities to manage volatility in the currency market. yet differ in fundamental ways. no money changes hands.

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.Further. efficiency and accessibility. Other advantages of an Exchange traded market would be greater transparency. Page | 37 . equitable opportunity is provided to all classes of investors whether large or small to participate in the futures market. in an Exchange traded scenario where the market lot is fixed at a much lesser size than the OTC market.

the futures contracts are standardized and exchange traded. The standardized items in a futures contract are: • • • • • Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change Location of settlement Page | 38 . But unlike forward contracts. (or which can be used for reference purposes in settlement) and a standard timing of such settlement. the exchange specifies certain standard features of the contract. To facilitate liquidity in the futures contracts. a standard quantity and quality of the underlying instrument that can be delivered. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. 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.Rationale For Introducing Currency Future Futures markets were designed to solve the problems that exist in forward markets. A futures contract is standardized contract with standard underlying instrument.

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. Empirically. which results in income flows with leads and lags and get converted into different currencies at the market rates. As such. financial planning horizon is much smaller than the long-run. no gains and losses are made out of currency exposures. April 2008) as follows. If the exchange rate remains unchanged from the time of purchase of the asset to its sale. unpredicted movements in exchange rates expose investors to currency risks. Currency futures enable them to hedge these risks. But if domestic currency depreciates (appreciates) against the foreign currency. changes Page | 39 . However. Both residents and non-residents purchase domestic currency assets. The rationale for establishing the currency futures market is manifold. As such. and applies equally to trade in goods and services. it is possible that over a long – run. The argument for hedging currency risks appear to be natural in case of assets. the incentive to hedge currency risk may not be large.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. while real exchange rates over long run are mean reverting. which is typically intergenerational in the context of exchange rates. 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.

two month. The transaction in which securities and foreign exchange get traded for immediate delivery.in exchange rate are found to have very low correlations with foreign equity and bond returns. sometimes argument is advanced against the need for hedging currency risks. This in theory should lower portfolio risk. Therefore. FUTURE PRICE : The price at which the future contract traded in the future market. Future Terminology SPOT PRICE : The price at which an asset trades in the spot market. The currency future contracts in Indian market have one month. In the case of USDINR. has also been used to refer to spot dealing. three month up to twelve month Page | 40 . CONTRACT CYCLE : The period over which a contract trades. the term. But there is strong empirical evidence to suggest that hedging reduces the volatility of returns and indeed considering the episodic nature of currency returns. cash market. there are strong arguments to use instruments to hedge currency risks. Since the exchange of securities and cash is virtually immediate. spot value is T + 2.

CONTRACT SIZE : The amount of asset that has to be delivered under one contract. The rules for inter bank settlements. BASIS : In the context of financial futures.expiry cycles. In NSE/BSE will have 12 contracts outstanding at any given point in time. including those for ‘known holidays’ and would be those as laid down by Foreign Exchange Dealers Association of India (FEDAI). There will be a different basis for each delivery month Page | 41 . at the end of which it will cease to exist. basis can be defined as the futures price minus the spot price. The last trading day will be two business days prior to the value date / final settlement date. Also called as lot size. VALUE DATE / FINAL SETTELMENT DATE : The last business day of the month will be termed the value date /final settlement date of each contract. This is the last day on which the contract will be traded. In case of USDINR it is USD 1000. EXPIRY DATE : It is the date specified in the futures contract. The last business day would be taken to the same as that for inter bank settlements in Mumbai.

In a normal market. MARKING TO MARKET : At the end of trading session. 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. Or in another words.for each contract. and profit and loss is determined on each transaction. requires that funds charge every day. all the outstanding contracts are reprised at the settlement price of that session. COST OF CARRY : The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This reflects that futures prices normally exceed spot prices. The funds are added or subtracted from a mandatory margin (initial margin) Page | 42 . basis will be positive. 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. This procedure. INITIAL MARGIN : When the position is opened. the member has to deposit the margin with the clearing house as per the rate fixed by the exchange which may vary asset to asset. It means that all the futures contracts are daily settled. For equity derivatives carry cost is the rate of interest. called marking to market.

is called the maintenance margin. If the balance in the margin account falls below the maintenance margin. the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day. Uses Of Currency Futures Hedging: Presume Entity A is expecting a remittance for USD 1000 on 27 August 08. This is somewhat lower than the initial margin. Entity A shall do the following: Page | 43 . The entity can do so by selling one contract of USDINR futures since one contract is for USD 1000. In turn customers’ account are also required to be maintained at a certain level.2500. MAINTENANCE MARGIN : Member’s account are debited or credited on a daily basis.44. futures contract is also called as daily reconnected forwards.43 and ‘USDINR 27 Aug 08’ contract is trading at Rs. Due to this adjustment.that traders are required to maintain the balance in the account. Wants to lock in the foreign exchange rate today so that the value of inflow in Indian rupee terms is safeguarded. This is set to ensure that the balance in the margin account never becomes negative. Presume that the current spot rate is Rs. usually about 75 percent of the initial margin.

The futures contract will settle at Rs.10000.44.20. He would like to trade based on this view. then he shall make a profit of around Rs. USD 1000 in the spot market and get Rs.42.42. The return from the futures transaction would be Rs. As may be observed. the effective rate for the remittance received by the entity A is Rs.250)/1000. How can he trade based on this belief? In case he can buy dollars and hold it.000. by investing the necessary capital. (Rs. i. he can profit if say the Rupee depreciates to Rs. It may please be noted that the cost of funds invested is not considered in computing this return. Assuming he buys USD 10000.44. This works out to an annual return of around 4. The entity was able to hedge its exposure. 44.44.4. Page | 44 . 2008.Sell one August contract today.44.000 + Rs.0000 (final settlement price = RBI reference rate).e. The entity shall sell on August 27.76%.250 – Rs. it would require an investment of Rs.000. 44.000).0000. while spot rate on that date was Rs.50. The value of the contract is Rs.44. He expects that the USD-INR rate presently at Rs.44. Let us assume the RBI reference rate on August 27. If the exchange rate moves as he expected in the next three months.250. 250.0000. 2008 is Rs. is to go up in the next two-three months. buy futures Take the case of a speculator who has a view on the direction of the market. 44. Speculation: Bullish. 2500 (Rs.

If the underlying price rises.42 and the three month futures trade at Rs. Three months later if the Rupee depreciates to Rs.42. 000. so will the futures price.20 (each contact for USD 1000).USD is Rs.40. This works out to an annual return of 19 percent. 42.21. Speculation: Bearish. Typically futures move correspondingly with the underlying. the futures price shall converge to the spot price (Rs. 42. Presumably. as long as there is sufficient liquidity in the market. He pays a small Page | 45 . the margin may be around Rs. (on the day of expiration of the contract). Because of the leverage they provide. The exposure shall be the same as above USD 10000. How can he trade based on his opinion? In the absence of a deferral product. He sells one two-month contract of futures on USD say at Rs.1000 on an investment of Rs. Today all he needs to do is sell the futures. Let us see how this works. 42. Now take the case of the trader who expects to see a fall in the price of USD-INR. 000. Therefore the speculator may buy 10 contracts.50 against USD. Let us understand how this works. there wasn't much he could do to profit from his opinion. If the underlying price falls.A speculator can take exactly the same position on the exchange rate by using futures contracts.50) and he makes a profit of Rs. If the INR. futures form an attractive option for speculators. so will the futures price. The minimum contract size is USD 1000. 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.21.

when the futures contract expires. Arbitrage: Arbitrage is the strategy of taking advantage of difference in price of the same or similar product between two or more markets. That is.2000. One of the methods of arbitrage with regard to USD-INR could be a trading strategy between forwards and futures market. If in one of the markets the product is trading at higher price. then the entity shall buy the product in the cheaper market and sell in the costlier market and thus benefit from the price differential without any additional risk. He has made a clean profit of 20 paise per dollar. the profit being the difference between the market prices. Page | 46 .margin on the same. if any. If the same or similar product is traded in say two different markets. the futures price and forward prices are arrived at using the principle of cost of carry. Two months later. any entity which has access to both the markets will be able to identify price differentials. For the one contract that he sold. On the day of expiration. If the tenor of both the contracts is same. Such of those entities who can trade both forwards and futures shall be able to identify any mis-pricing between forwards and futures.42. the spot and the futures price converges. USD-INR rate let us say is Rs. the same shall be sold while simultaneously buying the other which is priced lower. As we discussed earlier. arbitrage is striking a combination of matching deals that capitalize upon the imbalance. If one of them is priced higher. this works out to be Rs.

since both forwards and futures shall be settled at the same RBI reference rate. Page | 47 . the transaction shall result in a risk less profit.

Trading Process And Settlement Process Like other future trading. The following diagram shows how operation take place on currency future market: TRADER ( BUYER ) Purchase TRADER ( SELLER ) Sales order order MEMBER ( BROKER ) Inform s CLEARING HOUSE Transaction on the floor (Exchange) MEMBER ( BROKER ) 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 Page | 48 . the future currencies are also traded at organized exchanges.

swaps and options in the OTC market. X purchases American Dollar futures and Y sells it. It leads to two contracts. 2007 issued comprehensive guidelines on the usage of foreign currency forwards. and hence. To begin with. first. The Report of the Internal Working Group of RBI submitted in April 2008. then X is out of the picture and the clearing house is seller to Z and buyer from Y. this process is goes on. it was decided in a joint meeting of RBI and SEBI on February 28. 2008. RBI on April 20. the Committee would evolve norms and oversee the implementation of Exchange traded currency futures. This is because most of futures contracts in different products are predominantly speculative instruments. The Terms of Reference to the Committee was as under: Page | 49 . recommended the introduction of exchange traded currency futures. X party and clearing house and second Y party and clearing house. With the expected benefits of exchange traded currency futures. At the same time.delivery date by taking an opposite positions. Assume next day X sells same contract to Z. For example. RBI also set up an Internal Working Group to explore the advantages of introducing currency futures. Regulatory Framework For Currency Futures With a view to enable entities to manage volatility in the currency market. that an RBI-SEBI Standing Technical Committee on Exchange Traded Currency and Interest Rate Derivatives would be constituted.

4. in the overall interest of financial stability. To suggest eligibility criteria for the members of such exchanges. margin requirements and other risk mitigation measures on an ongoing basis. To suggest the eligibility norms for existing and new Exchanges for Currency and Interest Rate Futures trading. 5. To coordinate the regulatory roles of RBI and SEBI in regard to trading of Currency and Interest Rate Futures on the Exchanges. To review product design. To consider microstructure issues.1. 6. Page | 50 . 2. To suggest surveillance mechanism and dissemination of market information. 3.

brokers. brokers. arbitrageurs. Banks. but compensating bank balanced may be required Margin deposit required Maturity Tailored to needs: from one week to 10 years Standardized Page | 51 . forex dealers. Participants Banks. arbitrageurs. multinational companies. institutional investors. small traders. institutional investors. traders. etc. etc. speculators. Margins None as such.Comparision Of Forward And Futures Currency Contract BASIS Size FORWARD Structured as per requirement of the parties Standardized FUTURES Delivery date Tailored on individual needs Standardized Method of transaction Established by the bank or broker through electronic media Open auction among buyers and seller on the floor of recognized exchange. multinational companies.

Page | 52 . institutions. No separate clearing house Daily settlement to the market and variation margin requirements Market place Over the telephone worldwide and computer networks At recognized exchange floor with worldwide communications Accessibility Limited to large customers banks. 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 Delivery More than 90 percent settled by actual delivery Secured Risk is high being less secured Highly secured through margin deposit.Settlement Actual delivery or offset with cash settlement. etc.

The contract size would be periodically aligned to ensure that the size of the contract remains close to the minimum size.m.Product Definitions Of Currency Future On NSE/BSE Underlying Initially. Tenor of the contract The currency futures contract shall have a maximum maturity of 12 months. Size of the contract The minimum contract size of the currency futures contract at the time of introduction would be US$ 1000. However.m. Page | 53 . the outstanding positions would be in dollar terms. Quotation The currency futures contract would be quoted in rupee terms. to 5 p. currency futures contracts on US Dollar – Indian Rupee (US$-INR) would be permitted. Trading Hours The trading on currency futures would be available from 9 a.

Available contracts All monthly maturities from 1 to 12 months would be made available. Page | 54 . The last working day would be taken to be the same as that for Interbank Settlements in Mumbai. Settlement price The settlement price would be the Reserve Bank Reference Rate on the date of expiry. The rules for Interbank Settlements. including those for ‘known holidays’ and ‘subsequently declared holiday’ would be those as laid down by FEDAI. The methodology of computation and dissemination of the Reference Rate may be publicly disclosed by RBI. Settlement mechanism The currency futures contract shall be settled in cash in Indian Rupee. Final settlement day The currency futures contract would expire on the last working day (excluding Saturdays) of the month.

Contract specification in a tabular form is as under: Underlying Rate of exchange between one USD and Trading Hours (Monday to Friday) Contract Size Tick Size Trading Period Contract Months Final Settlement date/ Value date Last Trading Day USD 1000 0.m.m.25 paisa or INR 0. to 05:00 p. Page | 55 .0025 Maximum expiration period of 12 months calendar months 12 near Last working day of the month (subject to Two working days prior to Final Settlement Settlement Final Settlement Price Cash settled The reference rate fixed by RBI two working days prior to the final settlement date will be used for final settlement 09:00 a.

Page | 56 . It is shows that how currency future covers ground in the compare of other available derivatives instruments. Because of exchange traded future contract and its standardized nature gives counter party risk minimized. 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. 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.Conclusion 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. Initially only NSE had the permission but now BSE and MCX has also started currency future. 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.a process that has undoubtedly improved national productivity growth and standards of livings.

org. NCFM: Currency future Module.nseindia. Report of the Internal Working Group on Currency Futures (Reserve Bank of India.in www. International business by: Francis Cherunilam 5.economywatch. 3.gov. BCFM: Currency Future Module.in www.com www. Jivanandam 2.wikipedia.rbi.sebi.bseindia.com Page | 57 . Report of the RBI-SEBI standing technical committee on exchange traded currency futures) 2008 6.org www. Foreign Exchange By: C.Bibliography 1.com www. 4. April 2008) Websites: www.

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