Managing Foreign Exchange Risk via Currency Derivatives

INTRODUCTION

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

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Managing Foreign Exchange Risk via Currency Derivatives
THE PROJECT

The financial environment today has more risks than earlier. Successful business firms are those that are able to manage these risks effectively. Due to changes in the macroeconomic structures and increasing internationalization of businesses, there has been a dramatic increase in the volatility of economic variables such as interest rates, exchange rates, commodity prices etc. Firms that monitor their risks carefully and manage their risks with judicious policies enjoy a more stable business than those who are unable to identify and manage their risks. There are many risks which are influenced by factors external to the business and therefore suitable mechanisms to manage and reduce such risks need to be adopted. One of the modern day solutions to manage financial risks is µhedging¶. The project is all about what are the hedging instruments (Currency Derivatives) available in India and how the business corporations are using currency derivatives as a risk management tool.

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Managing Foreign Exchange Risk via Currency Derivatives
INDUSTRY HISTORY OF CURRENCY DERIVATIVES
In 1971, the Bretton Woods system of administering fixed foreign exchange rates was abolished in favour of market-determination of foreign exchange rates; a system of fluctuating exchange rates was introduced. Besides market-determined fluctuations, there was a lot of volatility in other markets around the world due to increased inflation and the oil shock. Corporates struggled to cope up with the uncertainty in profits. It was then that financial derivatives ± foreign currency, interest rate, and commodity derivatives emerged as means of managing risks facing corporations. The Chicago Mercantile Exchange (CME) created FX futures, the first ever financial futures contracts, in 1972. The contracts were created under the guidance and leadership of Leo Melamed, CME Chairman Emeritus. The FX contract capitalized on the U.S. abandonment of the Bretton Woods agreement, which had fixed world exchange rates to a gold standard after World War II. By creating another type of market in which futures could be traded, CME currency futures extended the reach of risk management beyond commodities, which were the main derivative contracts traded at CME until then. The concept of currency futures at CME was revolutionary, and gained credibility through endorsement of Nobel-prize-winning economist Milton Friedman.

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Managing Foreign Exchange Risk via Currency Derivatives
DEVELOPMENT IN INDIA:
In India, the economic liberalization in the early nineties provided the economic rationale for the introduction of FX derivatives. Business houses started actively approaching foreign markets not only with their products but also as a source of capital and direct investment opportunities. With limited convertibility on the trade account being introduced in 1993, the environment became even more favorable for the introduction of these hedge products. Hence, the development in the Indian forex derivatives market should be seen along with the steps taken to gradually reform the Indian financial markets. The first step towards introduction of derivatives trading in India was the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options securities. SEBI set up a 24 member committee under the chairmanship of Dr. L. C. Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee recommended that the derivatives should be declared as µsecurities¶ so that regulatory framework applicable to trading of µsecurities¶ could also govern trading of derivatives. The trading in index options commenced in June 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. RBI and SEBI jointly constituted a standing technical committee to analyze the currency market around the world and lay down the guidelines to introduce Exchange Traded Currency Futures in the Indian market. The committee submitted its report on May 29, 2008. Further RBI and SEBI issued circulars in this regard on August 06, 2008. Currently, India is USD XXXX billion Currency market, where all the majir currencies like USD, EURO, YEN and POUND are traded.

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unpredicted movements in exchange rates expose investors to currency risks. Both residents and non-residents purchase domestic currency assets. there is a strong need to hedge currency risk and this need has grown diversely with fast growth in cross-border trade and investment flows. which is typically inter ± generational in the context of exchange rates. Empirically. financial planning horizon is much smaller than the long-run. while real exchange rates over long run are mean reverting.Managing Foreign Exchange Risk via Currency Derivatives The rationales for introducing futures in the Indian context has been outlined in the report of the internal working group of Currency Futures (Reserve Bank of India. Currency futures enable them to hedge these risks. The argument for hedging currency risks appear to be natural in case of assets and applies equally to trade in goods and services. Tolani Institute of Management Studies Page 5 . As such. the exposure would result in gain (loss) for residents purchasing foreign assets and loss (gain) for non residents purchasing domestic assets. This in theory should lower portfolio risk. April 2008) as follows: The rationale for establishing currency futures market is diverse. As such. There are strong arguments to use instruments to hedge currency risks. it is possible that over a long ± run. which results in income flows with leads and lags and get converted into different currencies at the market rates. no gains and losses are made out of currency exposures. Therefore. If the exchange rate remains unchanged from the time of purchase of the asset to its sale. the incentive to hedge currency risk may not be large. Nominal exchange rates are often random walks with or without drift. changes in exchange rate are found to have very low correlations with foreign equity and bond returns. But if domestic currency depreciates (appreciates) against the foreign currency. sometimes argument is advanced against the need of hedging currency risks but there is strong empirical evidence to suggest that hedging reduces the volatility of returns and indeed considering the episodic nature of currency returns. In this backdrop. However.

Trading of Nifty futures commenced at NSE. Gupta Committee to draft a policy framework for index futures L. Gupta Committee submitted report. Trading of futures and options on Nifty to commence at SIMEX Trading of Equity Index Options at NSE Trading of Stock Options at NSE Trading of Single Stock futures at BSE Trading of Interest Rate Futures at NSE Weekly Options at BSE Trading of Chhota(Mini) Sensex at BSE Trading of Mini Index Futures & Options at NSE Circulars regarding Currency Futures by RBI & SEBI Trading of Currency Futures at NSE Trading of Currency Futures at BSE MCX-SX came into existence with USD/INR pair Tolani Institute of Management Studies Page 6 . Trading of BSE Sensex futures commenced at BSE.Managing Foreign Exchange Risk via Currency Derivatives Derivatives in India: A Chronology Date 14 December 1995 18 November 1996 11 May 1998 7 July 1999 24 May 2000 25 May 2000 9 June 2000 12 June 2000 31 August 2000 June 2001 July 2001 9 November 2002 June 2003 13 September 2004 1 January 2008 1 January 2008 6 August 2008 29 August 2008 2 October 2008 7 October 2008 Progress NSE asked SEBI for permission to trade index futures. SEBI setup L. C. C. SEBI gave permission to NSE and BSE to do index futures trading. RBI permitted OTC forward rate agreements (FRAs) and interest rate swaps SIMEX chose Nifty for trading futures and options on an Indian index.

Managing Foreign Exchange Risk via Currency Derivatives THE COMPANY Tolani Institute of Management Studies Page 7 .

now expanding nationwide and to fuel growth plans they recently raised capital from UK-based investment companies. who in-turn provides a huge business to them. MSFL has kept the faith of over 1. Tolani Institute of Management Studies Page 8 . ³Marwadi Shares and Finance Limited´ is a huge and very reputed organization in the world of securities and finance. COMPANY PROFILE Marwadi Shares & Finance Limited is a Gujarat based financial service group dealing in equities / commodities broking and portfolio management services. Marwadi Group strength lies in its team of confident. qualified and experienced professionals to carry out different functions under the able leadership of its management. MSFL got 5th rank in best broking houses also. and achieve organic growth in business by adding newer lines of business. The organization enjoys a large market share with highly loyal customers. In the last 15 years MSFL has grown into a network of more than70 branches with an 850+ committed professional people and 475+ channel partners across India.90 lakh investors and it's growing.Managing Foreign Exchange Risk via Currency Derivatives INTRODUCTION TO MARWADI GROUP MISSION & VISION "To be a world-class financial services provider by arranging all conceivable financial services under one-roof at affordable costs through cost effective delivery systems. young. talented. After establishing supremacy in Gujarat.

Managing Foreign Exchange Risk via Currency Derivatives MEMBERSHIP: Equity & Derivatives:  National Stock Exchange of India Ltd. (NSDL)  Central Depository Services India Ltd. (CDSL) Tolani Institute of Management Studies Page 9 . (NSE)  Bombay Stock Exchange Ltd. Commodities Derivatives:  National Commodity & Derivatives Exchange Ltd.  Multi Commodity Exchange of India Ltd. (BSE)  Multi Commodity Exchange of India Ltd. Depository participation of:  National Securities Depository Ltd.

y 2007 .Became a corporate member of National Stock Exchange Of India . was incorporated. y 2003 . (NSDL) y 2000 .(MCBPL) became a corporate member of The Multi Commodity Exchange of India Ltd.) y 1999 . a wholly owned subsidiary of India Capital Growth Fund.Managing Foreign Exchange Risk via Currency Derivatives MILESTONES The company crossed the following milestones to reach its present position as the leading retail broking house in India: y y y 1992 . Tolani Institute of Management Studies Page 10 .Launched Portfolio Management Services 2006 .The Company raised private equity from ICGU Limited. y 2003 .MSFPL converted to Public Limited (Marwadi Shares And Finance Limited) 2006 . 1996 .Became a corporate member of Bombay Stock Exchange Ltd.Commenced Derivative trading after obtaining registration as Clearing and Trading Member in NSE. Ltd.Became a member of Saurashtra Kutch Stock Exchange (MARWADI SHARES & FINANCE LTD.(NSE) 1998 . y y y 2005 .Launched Depository Services of Depository Participant under Central Depository Services (India) Ltd.The Company raised further private equity from Caledonia Investments plc. y y 2004 .Launched Depository services of Depository Participant under National Depository Security Ltd. (BSE) 2004 .Marwadi Shares And Finance Pvt.(MCBPL) became a corporate member of the National Commodity and Derivatives Exchange of India Ltd.

Managing Foreign Exchange Risk via Currency Derivatives SERVICES @ MARWADI:  Equity & Derivatives  Commodity  Internet Trading  Depository Participant  IPO  Mutual Fund  PMS  Research CORE COMPETENCE:  Commodities research & broking services  Online or offline trading facility  Depository services through CDSL  Web based 24 x 7 back office software  Good understanding of the sub-broker and retail customer needs  Professional work culture with a personal touch  Cost.effective processes  Streaming quotes & real time charts for BSE /NSE [cash / derivatives]  Single connectivity and speedy execution of trades. Tolani Institute of Management Studies Page 11 .  Online technical support & help desk.

Managing Foreign Exchange Risk via Currency Derivatives COMPETITORS: Tolani Institute of Management Studies Page 12 .

Secondary objective:  To know how the currency futures are used as risk management tool. PRIMARY DATA  The primary data has been collected from experts. To prepare this report. officials and employees working in MARWADI SHARES & FINANCE LTD.  To analyze different currency derivatives products. I have adopted following methodology. Primary objectives:  To study the basic concept of currency future.  To study exchange traded currency future. Links are given for the same. Tolani Institute of Management Studies Page 13 .Managing Foreign Exchange Risk via Currency Derivatives OBJECTIVES & METHODOLOGY OBJECTIVES OF THE PROJECT The basic idea behind undertaking Currency Derivatives project is to gain knowledge about currency market. SECONDARY DATA  For secondary data. I have use internet. METHODOLOGY All the data and information is collected by me from different sources for the preparation of this report.

But in general it can be said that. its value is entirely "derived" from the value of the underlying asset. option or any other hybrid contract of pre determined fixed duration. 2.  The Underlying Securities for Derivatives are : 1.e. Tolani Institute of Management Studies Page 14 . etc. Short Term Debt Securities: Treasury Bills 4. Commodities: Castor seed. Grain. Potatoes. i. Interest Rates 5.  The underlying asset can be securities. "Derivative" is an instrument which does not have its own independent value. currency. Currency derivatives  Derivative includes forward. commodities. future. bullion. Pepper. Precious Metal: Gold. Silver 3.Managing Foreign Exchange Risk via Currency Derivatives INTRODUCTION Introduction to derivative  There is no universally satisfactory definition available for the term ³Derivative´. linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities. Common shares/stock 6. livestock or anything else.

Research in the area of efficiency of foreign exchange markets has thus far been able to establish only a weak form of the efficient market hypothesis conclusively which implies that successive changes in exchange rates cannot be predicted by analyzing the historical sequence of exchange rates. This implies that exchange rates react to new information in an immediate and unbiased fashion. when the efficient markets theory is applied to the foreign exchange market under floating exchange rates there is some evidence to suggest that the present prices properly reflect all available information. information on direction of the rates arrives randomly so exchange rates also fluctuate. Tolani Institute of Management Studies Page 15 . However. so that no one party can make a profit by this information and in any case.Managing Foreign Exchange Risk via Currency Derivatives NECESSITY OF MANAGING FOREIGN EXCHANGE RISK A key assumption in the concept of foreign exchange risk is that exchange rate changes are not predictable and that this is determined by how efficient the markets for foreign exchange are.

The exchange rate is fixed at the time the contract is entered into.  FUTURE A currency futures contract provides a simultaneous right and obligation to buy and sell a particular currency at a specified future date. Tolani Institute of Management Studies Page 16 . Future contracts are special types of forward contracts in the sense that they are standardized exchange-traded contracts.Managing Foreign Exchange Risk via Currency Derivatives CURRENCY DERIVATIVE PRODUCTS Derivative contracts have several variants. The most common variants are forwards. We take a brief look at various derivatives contracts that have come to be used. In another word. A forward contract is customized contract between two entities. a specified price and a standard quantity. 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. where settlement takes place on a specific date in the future at today¶s pre-agreed price. futures. options and swaps.  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. This is known as forward exchange rate or simply forward rate.

with the cash flows in one direction being in a different currency than those in the opposite direction. 2. Initial exchange of principal amount Ongoing exchange of interest Re . fixed to floating currency swap. The currency swap entails swapping both principal and interest between the parties. In a swap normally three basic steps are involve___ 1. 3. floating to floating swap. There are a various types of currency swaps like as fixed-to-fixed currency swap. They can be regarded as portfolio of forward Tolani Institute of Management Studies Page 17 .exchange of principal amount on maturity. contracts.Managing Foreign Exchange Risk via Currency Derivatives  SWAP Swap is private agreements between two parties to exchange cash flows in the future according to a prearranged formula.

Recently MCX-SX has started to offer currency futures contracts in US DollarIndian Rupee (USD-INR. the majority of options traded on options exchanges having a maximum maturity of nine months.) Euro-Indian Rupee (EUR-INR). In India only currency forwards and currency futures are only allowed. Pound Sterling-Indian Rupee (GBP-INR) and Japanese Yen-Indian Rupee (JPY-INR). The seller of the option gets the premium from the buyer of the option for the obligation undertaken in the contract. Options generally have lives of up to one year. Longer dated options are called warrants and are generally traded OTC. Tolani Institute of Management Studies Page 18 . a foreign currency option is a contract for future delivery of a specified currency in exchange for another in which buyer of the option has to right to buy (call) or sell (put) a particular currency at an agreed price for or within specified period.Managing Foreign Exchange Risk via Currency Derivatives  OPTIONS Currency option is a financial instrument that give the option holder a right and not the obligation. to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period ( until the expiration date ) In other words. Clearing and Settlement is conducted through the MCX Stock Exchange Clearing Corporation Ltd (MCX-SX CCL). Currency swaps and currency option is yet not allowed in India.

Managing Foreign Exchange Risk via Currency Derivatives DIFFRENCE BETWEEN FORWARDS & FUTURES  Standardization:In forward contracts.  Mark ± to ± market:Buyers of the futures contract have to provide with the additional margin. if the price of the futures contract decreases or increases. but in the case of forwards contract such margin is not settled on daily basis. Tolani Institute of Management Studies Page 19 . but in the forward contract there is no margin money to be kept at the time of purchase of the forward contractbecause it is between buyer and seller.  Margins:Trading in futures requires keeping the margin money with the broker while purchasing the futures contract. the amount of the assets to be delivered and the maturity date are negotiated between the buyer and seller and can be tailor made. while infutures contract amount of the asset and maturity date both are standardized by the exchange on which the contract is to be traded.

In the volatile FX market. traders constantly try to predict the behavior of other market participants. buying and selling currencies while exchanging market information may be used for varied purposes:  For the import and export needs of companies and individuals  For direct foreign investment  To profit from the short-term fluctuations in exchange rates  To manage existing positions or  To purchase foreign financial instruments Exchange rates are an important consideration when making international investment decisions. they can act first and beat the competition. any gains could be magnified or wiped out depending on the change in the exchange rates in the interim. When an investor decides to "cash out.Managing Foreign Exchange Risk via Currency Derivatives UTILITY OF CURRENCY DERIVATIVES Traders in the foreign exchange market make thousands of trades daily. changes in exchange rates can have many effects on an economy:  Affects the prices of imported goods  Affects the overall level of price and wage inflation  Influences tourism patterns  May influence consumers¶ buying decisions and investors¶ long-term commitments. Thus. If they correctly anticipate their opponents¶ strategies." or bring his money home. Tolani Institute of Management Studies Page 20 . The money invested overseas incurs an exchange rate risk.

thus defending their revenue from the foreign currency depreciation. 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. interest rates. Currency underpriced Currency overpriced Price will go up Price will go down Currency-based derivatives are used by exporters invoicing receivables in foreign currency. Examining inflation. Trader purchases a lot of currency Trader sells a lot of a currency long on the currency Short on the currency To predict the movements of currencies. traders often try to determine whether the currency¶s price reflects its fundamental value in terms of current economic conditions. 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.Managing Foreign Exchange Risk via Currency Derivatives Traders make money by purchasing currency and selling it later at a higher price. Tolani Institute of Management Studies Page 21 . or. selling at a high price and buying back at a lower price later. anticipating the market is heading down. and the relative strength of the country¶s economy helps them make a determination. willing to protect their earnings from the foreign currency depreciation by locking the currency conversion rate at a high level.

Their transaction costs are set by spread between bank's buy and sell prices. Alternatively. They want to guarantee the rate of purchasing foreign currency for various payments related to the installation of a foreign branch or subsidiary. or to a joint venture with a foreign partner. investors and speculators from banks with denomination normally exceeding 2 million USD. 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. The most commonly used instrument among the currency derivatives are currency forward contracts.Managing Foreign Exchange Risk via Currency Derivatives Multinational companies use currency derivatives being engaged in direct investment overseas. Tolani Institute of Management Studies Page 22 . they may wish to obtain a foreign currency forward buying contract. expecting to sell the appreciating currency at a high future rate. These are large notional value selling or buying contracts obtained by exporters. They normally do not require a security deposit since their purchasers are mostly large business firms and investment institutions. A high degree of volatility of exchange rates creates a fertile ground for foreign exchange speculators. The contracts guarantee the future conversion rate between two currencies and can be obtained for any customized amount and any date in the future. although the banks may require compensating deposit balances or lines of credit. 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. In either case. importers.

Tolani Institute of Management Studies Page 23 . 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.  Further development of domestic foreign exchange market. They hedge against the foreign currency depreciation below the forward selling rate which would ruin their return from foreign financial investment.  Create a market to facilitate large volume transactions to go through on an anonymous basis without distorting the levels.Managing Foreign Exchange Risk via Currency Derivatives Exporters invoicing receivables in foreign currency are the most frequent users of these contracts. Currency futures provide an additional tool for hedging currency risk.  Permit trades other than hedges with a view to moving gradually towards fuller capital account convertibility.  Provide a platform to retail segment of the market to ensure broad based participation based on equal treatment. They are willing to protect themselves from the currency depreciation by locking in the future currency conversion rate at a high level.  Efficient method of credit risk transfer through the Exchange. 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.

with notional value of $342 billion. forward market turnover was nudging $2 billion a day. Singapore.  Even though it an OTC market. currency forward markets have pricing that is controlled by Covered Interest Parity (CIP).Managing Foreign Exchange Risk via Currency Derivatives THE FORWARD MARKET The rupee-dollar forward market is a bilaterally negotiated market: there was no pretrade or post-trade transparency in 2006-2007. Dubai and London on what are termed no deliverable forwards (NDF).  However. it trades standardized contracts that expire on the last business day of each month.106 numbers of forward transactions came to CCIL for settlement.  Ordinarily. Hence. the system of capital controls involves considerable barriers on CIP arbitrage. Tolani Institute of Management Studies Page 24 . There are three remarkable features about the Indian currency forwards market:  Even though trading is negotiated off exchange. so that credit risk is eliminated. In late 2006. there is netting by novation at CCIL. In addition to the onshore rupee-dollar forward market. 85. there is active trading for cash-settled rupee-dollar forwards in Hong Kong. it is often the case that the forward price strays away from fair value.

to buy or sell a certain underlying asset or an instrument at a certain date in the future. traded on an exchange. Oil or Wheat.g. go through the exchange. All settlements however.  Therefore.  Currency futures are a linear product.  A futures contract is a standardized contract. at a specified price. the contract is termed a ³commodity futures contract´. the contract is termed a ³currency futures contract´. it is a contract to exchange one currency for another currency at a specified date and a specified rate in the future.Managing Foreign Exchange Risk via Currency Derivatives THE CURRENCY FUTURE MARKET  A futures contract is a promise to buy or to deliver a certain quantity of a standardized good by a specific future date. Both parties of the futures contract must fulfill their obligations on the settlement date. Tolani Institute of Management Studies Page 25 . unlike in the case of OTC markets.  Currency futures can be cash settled or settled by delivering the respective obligation of the seller and buyer. When the underlying is an exchange rate. In other words.  When the underlying asset is a commodity. the buyer and the seller lock themselves into an exchange rate for a specific value or delivery date. e. and calculating profits or losses on Currency Futures will be similar to calculating profits or losses on Index futures.

One tick move on this contract will translate to Rs.0025 Rs.42.25 paisa or 0. imagine a trader buys a contract (USD 1000 being the value of each contract) at Rs. 42.2500 +Rs.5 per tick = Rupees 50 Tolani Institute of Management Studies Page 26 . So if a trader buys 5 contracts and the price moves up by 4 ticks.2525 Rs.2500 ± Rs.2500. 2475  The value of one tick on each contract is Rupees 2.50.42.42.2600 ± 42.0025 Rupees. it is essential to know both the contract size (the number of currency units being traded) and also what is the value of tick (minimum trading price differential at which traders are able to enter bids and offers)?  A tick is the minimum trading increment or price differential at which traders are able to enter bids and offers. Tick values differ for different currency pairs and different underlying.42.2475 or Rs.42.Managing Foreign Exchange Risk via Currency Derivatives  In determining profit and loss in futures trading.  To demonstrate how a move of one tick affects the price. he/ shemake Rupees 50.2525 depending on the direction of market movement Purchase price: Price increases by one tick: New price: Purchase price: Price decreases by one tick: New price: Rs.2500 4 ticks * 5 contracts = 20 points 20 points * Rupees 2. For e.g. in the case of the USD-INR currency futures contract the tick size shall be 0.0025 Rs. Step 1 : Step 2 : Step 3 : 42. 00.42. 00.

Also called as lot size. The last trading day will be two business days prior to the Value date / Final Settlement Date. Tolani Institute of Management Studies Page 27 . In the case of USD/INR it is USD 1000. spot value is T + 2 days (T = Trading day). This is the last day on which the contract will be traded.  Contract size:The amount of asset that has to be delivered under one contract.  Contract cycle:The period over which a contract trades. The rules for Inter-bank Settlements.  Value Date/Final Settlement Date:The last business day of the month will be termed the Value date/ Final Settlement date of each contract. Hence. including those for µknown holidays¶ and µsubsequently declared holiday¶ would be those as laid down by Foreign Exchange Dealers¶ Association of India (FEDAI). In the case of USD/INR.  Expiry date:It is the date specified in the futures contract. The currency futures contracts on the SEBI recognized exchanges have one-month. two-month. and threemonth up to twelve-month expiry cycles.  Futures price:The price at which the futures contract trades in the futures market. these exchanges will have 12 contracts outstanding at any given point in time.Managing Foreign Exchange Risk via Currency Derivatives FUTURES TERMINOLOGY  Spot price:The price at which an asset trades in the spot market. at the end of which it will cease to exist. The last business day would be taken to the same as that for Inter-bank Settlements in Mumbai.

Tolani Institute of Management Studies Page 28 . basis can be defined as the futures price minus the spot price. For equity derivatives carry cost is the rate of interest.Managing Foreign Exchange Risk via Currency Derivatives  Basis: In the context of financial futures.  Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. This measures (in commodity markets) the storage cost plus the interest that is paid to finance or µcarry¶ the asset till delivery less the income earned on the asset. the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This reflects that futures prices normally exceed spot prices.  Marking-to-market: In the futures market. basis will be positive. at the end of each trading day. In a normal market. This is called marking-to-market.  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. There will be a different basis for each delivery month for each contract.

1 = $ 0.7250 (or) Rs. 45. For example. 45 in Indian rupees then it implies that 45 Indian rupees will buy one dollar of USA. or that one rupee is worth of 0.022 US dollar which is simply reciprocal of the former dollar exchange rate.02187 $1 = Rs.7250 Tolani Institute of Management Studies Page 29 ./$ = 45. if one US dollar is worth of Rs. QUOTATION DIRECT INDIRECT Types of exchange rates The number of units of domestic Currency stated against one unit Of foreign currency the number of unit of foreign currency per unit of domestic currency Rs. It means exchange rate is relative price.Managing Foreign Exchange Risk via Currency Derivatives FOREIGN EXCHANGE QUOTATIONS Foreign exchange quotations can be confusing because currencies are quoted in terms of other currencies.

Tolani Institute of Management Studies Page 30 . are called market makers. It should be noted that where the bank sells dollars against rupees. In global foreign exchange market. one can say that rupees against dollar. Indirect.3500/3550. and another for selling (ask or offered rate) for a currency. Direct and 2. a small dash or oblique line is drawn after the dash. If US dollar is quoted in the market as Rs 46. For example. This is a unique feature of this market. Most countries use the direct method. both buying and selling. The difference between the buying and selling rates is called spread. deal in two way prices. In order to separate buying and selling rate. Traders. usually large banks.3500 and ready to sell at Rs 46. it means that the forex dealer is ready to purchase the dollar at Rs 46.Managing Foreign Exchange Risk via Currency Derivatives There are two ways of quoting exchange rates: 1. two rates are quoted by the dealer: one rate for buying (bid rate).3550. It is important to note that selling rate is always higher than the buying rate.

tells you that the Dollar is being quoted in terms of the Rupee.25. Exchange rates are constantly changing. Whenever the base currency buys more of the terms currency. Some day late: say after a month. And if it moved from 43.0000 to 42. The second currency is called as the terms currency. Changes in rates are expressed as strengthening or weakening of one currency vis-à-vis the second currency. Tolani Institute of Management Studies Page 31 . Exchange rates are quoted in per unit of the base currency. That is the expression Dollar-Rupee. The transactions in the interbank market may place for settlement1. For example. or 3.00 to 43. the base currency has strengthened / appreciated and the terms currency has weakened / depreciated. If Dollar ± Rupee moved from 43. Two days later. which means that the value of one currency in terms of the other is constantly in flux. Changes are also expressed as appreciation or depreciation of one currency in terms of the second currency. the base currency is the first currency in a currency pair.Managing Foreign Exchange Risk via Currency Derivatives Base Currency/ Terms Currency: In foreign exchange markets. The Dollar is the base currency and the Rupee is the terms currency. The Dollar has appreciated and the Rupee has depreciated. On the same day.7525 the Dollar has depreciated and Rupee has appreciated. or 2.

the transaction is known as: Ready or cash ± value today. Forward rate may be the same as the spot rate for the currency. The transaction in which the exchange of currencies takes place at a specified future date. Similarly. or next working day The transaction where the exchange of currencies takes place two days after the date of the contract is known as spot transaction ± value two business days after the trading day. Then it is said to be µat par¶ with the spot rate. More often the forward rate for a currency may be costlier or cheaper than its spot rate. But this rarely happens. subsequent to the spot date. currencies will change hands the following Monday. Tolani Institute of Management Studies Page 32 . for a spot transaction done Monday. currencies will change hands the following Wednesday assuming this is a working day in both the centers. for a spot transaction done Thursday. Thus. is known as a forward transaction.Managing Foreign Exchange Risk via Currency Derivatives Where the agreement to buy and sell is agreed upon and executed on the same day. Tomorrow (³tom´) ± value tomorrow.

DSP of the contract Price operating range Tenure up to 6 months +\.0. to 5:00 p.3% of base price Tenure more than 6 months +\.Managing Foreign Exchange Risk via Currency Derivatives DETAILS OF CONTRACT SPECIFICATION OF USD/INR FUTURES Symbol Instrument Type USDINR FUTCUR Unit of trading Underlying Tick size Trading hours 1 (1 unit denotes 1000 USD) The exchange rate in Indian Rupees for a US Dollar Rs.m.000 Theoretical price on the 1st day of the contract.5% of base price Banks Higher of 15% of total open interest or USD 100 Million Position limits Clients Higher of 6% of total open interest Trading members Higher of 15% of the total open interest or USD 50 million or USD 10 million Tolani Institute of Management Studies Page 33 .m Contract trading cycle Last trading day 12 month trading cycle. The last working day will be the same as that for Interbank Settlements in Mumbai. On all other days.0025 Monday to Friday 9:00 a. Quantity Freeze Base price Above 10. Two working days prior to the last business day of the expiry month at 12 noon.25 paise or INR 0. Final settlement day Last working day (excluding Saturdays) of the expiry month.

Rs. 800/. 1% thereafter 1% of MTM value of open position.Managing Foreign Exchange Risk via Currency Derivatives Minimum initial margin Extreme loss margin Calendar spreads 1. Rs. Rs.for a spread of 3 months & Rs.for a spread of 4 months or more Settlement Daily settlement : T + 1 Final settlement : T + 2 Mode of settlement Daily settlement price (DSP) Cash settled in Indian Rupees Calculated on the basis of the last half an hour weighted average price Final settlement price (FSP) RBI reference rate Tolani Institute of Management Studies Page 34 .for a spread of 2 months.for a spread of 1 month. 500/. 400/.75% on day 1. 1000/.

37 19-Nov-08 01-Dec-08 01-Jan-09 01-Dec-09 01-Jan-10 29-Jan-10 895. Cr.74 50.68 970. we can see that there is constant increase in the value of the contracts and event in number of the contracts traded in Indian market.1 From the above table.) Spread Volume 221069 250133 421800 Open Interest 64676 71325 133015 580426 468156 595355 RBI Reference Rate 49.45 46.Managing Foreign Exchange Risk via Currency Derivatives FACTS & FIGURES ABOUT THE MOVEMENTS OF TRADING IN USD/INR FUTURES CONTRACT Trade Date Total Contracts 179362 192221 97289 1845073 948881 2919761 Total Value (inRs.09 48.1 474.3 4437.65 46.66 8571.73 46.47 13557. Tolani Institute of Management Studies Page 35 .42 Table .

Managing Foreign Exchange Risk via Currency Derivatives ADVANTAGES OF CURRENCY FUTURES  EASY ACCESSIBILITY: Currency future is being offered on the recognized exchanges in India. It is as easy as trading in a blue chip stock on any of your favorite exchange. In overseas Forex trading you have to pay commissions to the banks or foreign exchange agents in the form of spread. Spread is the difference in the buy/sell price over the reference rate.Small investors would get an easy access to currency futures trading on the popular exchanges. BSE (Bombay Stock Exchange) have commenced currency futures trading. Margin is 1. which can be very high.  TRANSPERANCY: It is possible for you to verify trade details on NSE if you have a doubt that the broker has tried to cheat you.75%. you have to pay a small amount of brokerage fees and statutory duties and taxes. MCX (Multi-Commodity Exchange). lot size is 1000$.  EASY AFFORDABILITY: Margins are very low and the contract size is very small. USD-INR currency future contract. NSE (National Stock Exchange). As per the specification of NSE.  LOW TRANSACTION COSTS :When you trade in INT currency futures on NSE in India. Tolani Institute of Management Studies Page 36 .

With its state of the art automated electronic trading system where the orders are executed on the basis of price-time priority.Managing Foreign Exchange Risk via Currency Derivatives  EFFICIENT PRICE DISCOVERY: Internationally it has been established that currency future is a better and efficient mechanism for price discovery. Retail investors with their limited resources would find it tremendously beneficial to take positions in standardized USD INR futures contracts Tolani Institute of Management Studies Page 37 . NSE is well poised to offer efficient price discovery.  STANDARDIZED CONTRACTS: Exchange Traded currency futures are standardized in respect of lot size (1000$) and maturity (12 monthly contracts). NSCCL (National Securities Clearing Corporation Limited) carries out all the novation. clearing and settlement process of currency futures trading.  COUNTER-PARTY DEFAULT RISKS: All the trades done on the recognized exchanges are guaranteed by the clearing corporations and hence it eliminates the risks associated with counter party default.

The major disadvantages are: 1. while margining requirements may effectively drive the cost of hedging in futures up. 2. Cost: Forwards have no upfront cost. Standardization: It is not possible to obtain a perfect hedge in terms of amount and timing. 3. Small lots: Not possible to hedge small exposures generally Tolani Institute of Management Studies Page 38 .Managing Foreign Exchange Risk via Currency Derivatives DISADVANTAGES OF FUTURES The futures are also disadvantageous in a few areas when compared to OTC market.

Managing Foreign Exchange Risk via Currency Derivatives CONCLUSION Tolani Institute of Management Studies Page 39 .

mcx-sx.htm Books P.com/SitePages/mkt_data.Managing Foreign Exchange Risk via Currency Derivatives BIBLIOGRAPHY  http://www.International financial management Workbook for NISM-Series-I Currency Derivatives Certification Examination Tolani Institute of Management Studies Page 40 .aspx?ID=532  http://www.org.com/abt_us.rbi.investopedia. SHARAN .G.mcx-sx.com/terms/c/currencyrisk.in/scripts/PublicationReportDetails.indiatimes.cms  http://www.asp  http://timesofindia.International financial management V. APTE .aspx  http://www.com/biz/india-business/Currency-futures-clock1500-growth-in-1-year/articleshow/4952394.

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