Professional Documents
Culture Documents
Page | 1
**DEFINITION OF FINANCIALDERIVATIVES**
A word formed by derivation. It means, this word has been arisen by derivation. Something derived; it means that some things have to be derived or arisen out of the underlying variables. A financial derivative is an indeed derived from the financial market. Derivatives are financial contracts whose value/price is independent on the behavior of the price of one or more basic underlying assets. These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future. These assets can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil, soybeans, cotton, coffee and what you have. A very simple example of derivatives is curd, which is derivative of milk. The price of curd depends upon the price of milk which in turn depends upon the demand and supply of milk.
Page | 2
The Underlying Securities for Derivatives are : Commodities: Castor seed, Grain, Pepper, Potatoes, etc. Precious Metal : Gold, Silver Short Term Debt Securities : Treasury Bills Interest Rates Common shares/stock Stock Index Value : NSE Nifty Currency : Exchange Rate
DERIVATIVES
Financials
Commodities
3. Options 4. Warrants and Convertibles One form of classification of derivative instruments is between commodity derivatives and financial derivatives. The basic difference between these is the nature of the underlying instrument or assets. In commodity derivatives, the underlying instrument is commodity which may be wheat, cotton, pepper, sugar, jute, turmeric, corn, crude oil, natural gas, gold, silver and so on. In financial derivative, the underlying instrument may be treasury bills, stocks, bonds, foreign exchange, stock index, cost of living index etc. It is to be noted that financial derivative is fairly standard and there are no quality issues whereas in commodity derivative, the quality may be the underlying matters. Another way of classifying the financial derivatives is into basic and complex. In this, forward contracts, futures contracts and option contracts have been included in the basic derivatives whereas swaps and other complex derivatives are taken into complex category because they are built up from either forwards/futures or options contracts, or both. In fact, such derivatives are effectively derivatives of derivatives.
Derivatives are traded at organized exchanges and in the Over The Counter ( OTC ) market :
Derivatives Trading Forum
Organized Exchanges Commodity Futures Financial Futures Options (stock and index) Stock Index Future
Derivatives traded at exchanges are standardized contracts having standard delivery dates and trading units. OTC derivatives are customized contracts that enable the parties to select the trading units and delivery dates to suit their requirements. Page | 4
A major difference between the two is that of counterparty riskthe risk of default by either party. With the exchange traded derivatives, the risk is controlled by exchanges through clearing house which act as a contractual intermediary and impose margin requirement. In contrast, OTC derivatives signify greater vulnerability.
revolutionary, and gained credibility through endorsement of Nobel-prize-winning economist Milton Friedman. Today, CME offers 41 individual FX futures and 31 options contracts on 19 currencies, all of which trade electronically on the exchanges CME Globex platform. It is the largest regulated marketplace for FX trading. Traders of CME FX futures are a diverse group that includes multinational corporations, hedge funds, commercial banks, investment banks, financial managers, commodity trading advisors (CTAs), proprietary trading firms; currency overlay managers and individual investors. They trade in order to transact business, hedge against unfavorable changes in currency rates, or to speculate on rate fluctuations.
Page | 6
The most commonly used instrument among the currency derivatives are currency forward contracts. These are large notional value selling or buying contracts obtained by exporters, importers, investors and speculators from banks with denomination normally exceeding 2 million USD. The contracts guarantee the future conversion rate between two currencies and can be obtained for any customized amount and any date in the future. They normally do not require a security deposit since their purchasers are mostly large business firms and investment institutions, although the banks may require compensating deposit balances or lines of credit. Their transaction costs are set by spread between bank's buy and sell prices. Exporters invoicing receivables in foreign currency are the most frequent users of these contracts. They are willing to protect themselves from the currency depreciation by locking in the future currency conversion rate at a high level. A similar foreign currency forward selling contract is obtained by investors in foreign currency denominated bonds (or other securities) who want to take advantage of higher foreign that domestic interest rates on government or corporate bonds and the foreign currency forward premium. They hedge against the foreign currency depreciation below the forward selling rate which would ruin their return from foreign financial investment. 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.
The price of one currency in terms of other currency is known as exchange rate. 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 the 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. As a result, these firms are increasingly turning to various risk hedging products like foreign currency futures, foreign currency forwards, foreign currency options, and foreign currency swaps.
Page | 8
Currency futures can be cash settled or settled by delivering the respective obligation of the seller and buyer. All settlements however, unlike in the case of OTC markets, go through the exchange. Currency futures are a linear product, and calculating profits or losses on Currency Futures will be similar to calculating profits or losses on Index futures. In determining profits and losses in futures trading, it is essential to know both the contract size (the number of currency units being traded) and also what the tick value is. 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. For e.g. in the case of the USD-INR currency futures contract the tick size shall be 0.25 paise or 0.0025 Rupees. To demonstrate how a move of one tick affects the price, imagine a trader buys a contract (USD 1000 being the value of each contract) at Rs.42.2500. One tick move on this contract will translate to Rs.42.2475 or Rs.42.2525 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:
The value of one tick on each contract is Rupees 2.50. So if a trader buys 5 contracts and the price moves up by 4 tick, she makes Rupees 50. Step 1: Step 2: Step 3: 42.2600 42.2500 4 ticks * 5 contracts = 20 points 20 points * Rupees 2.5 per tick = Rupees 50
Page | 9
COMPANY PROFILE
Page | 10
AnandRathi (AR) is a leading full service securities firm providing the entire gamut of financial services. The firm, founded in 1994 by Mr. AnandRathi, today has a pan India presence as well as an international presence through offices in Dubai and Bangkok. AR provides a breadth of financial and advisory services including wealth management, investment banking, corporate advisory, brokerage & distribution of equities, commodities, mutual funds and insurance, structured products - all of which are supported by powerful research teams. The firm's philosophy is entirely client centric, with a clear focus on providing long term value addition to clients, while maintaining the highest standards of excellence, ethics and professionalism. The entire firm activities are divided across distinct client groups: Individuals, Private Clients, Corporate and Institutions and was recently ranked by Asia Money 2006 poll amongst South Asia's top 5 wealth managers for the ultra-rich. The offices of AnandRathi are located in 197 cities across 28 cities and it also has branches in Dubai and Bangkok with more than 44000 employees. It has a daily turnover in excess of Rs. 4billion. It has 1,00,000+ clients nationwide. It is also a leading Distributor of IPO's In the year 2007 Citigroup Venture Capital International joined the group as a financial partner.
Mission
To be India's first multinational providing complete financial services solution across the globe.
Page | 11
Vision
"To be a shining example as leader in innovation and the first choice for clients & employees"
Milestones
1994: Started activities in consulting and Institutional equity sales with staff of 15 1995: Set up a research desk and empanelled with major institutional investors 1997: Introduced investment banking businesses Retail brokerage services launched
1999: Lead managed first IPO and executed first M & A deal 2001: Initiated Wealth Management Services 2002: Retail business expansion recommences with ownership model 2003: Wealth Management assets cross Rs1500 crores Insurance broking launched Launch of Wealth Management services in Dubai Retail Branch network exceeds 50
2009: Anand Rathi has been Ranked as the #1 Private Bank - Domestic in India by Asiamoney Polls 2009 and Ranked as the #2 Private Bank - Overall in India by Asiamoney Polls 2009
2010: Anand Rathi Private Wealth adjudged Best Domestic Private Bank (India) by Asia Money Polls 2010 for the second consecutive year.
Page | 12
Products
Equities I Bonds I Mutual Funds I Derivatives Managed Investment Services / PMS Commodities FX Trading Life Insurance General Insurance Alternative Assets - Private Equity Funds - Structured Products - Real Estate Oppurtunities Fund Special Situation Oppurtunities Offshore Structures & Global Investments
Services
Creation of a customized financial strategy Diversification of assets based on a formal process of asset allocation Active tracking, monitoring and review of portfolios Creation of private trusts Tax planning Estate planning Structuring of family wealth
Clients can trade through us online on BSE and NSE for both equities and derivatives. They are supported by dedicated sales & trading teams in our trading desks across the country. Research and
investment ideas can be accessed by clients either through their designated dealers, email, web or SMS.
Mutual funds
AR is one of India's top mutual fund distribution houses. Our success lies in our philosophy of providing consistently superior, independent and unbiased advice to our clients backed by in-depth research. We firmly believe in the importance of selecting appropriate asset allocations based on the client's risk profile. We have a dedicated mutual fund research cell for mutual funds that consistently churns out superior investment ideas, picking best performing funds across asset classes and providing insights into performances of select funds.
Depository services
AR Depository Services provides you with a secure and convenient way for holding your securities on both CDSL and NSDL. Our depository services include settlement, clearing and custody of securities, registration of shares and dematerialization. We offer you daily updated internet access to your holding statement and transaction summary.
Commodities
Commodities broking - A whole new opportunity to hedge business risk and an attractive investment opportunity to deliver superior returns for investors.
Our commodities broking services include online futures trading through NCDEX and MCX and depository services through CDSL. Commodities broking is supported by a dedicated research cell that provides both technical as well as fundamental research. Our research covers a broad range of Page | 14
traded commodities including precious and base metals, Oils and Oilseeds, agri-commodities such as wheat, chana, guar, guar gum and spices such as sugar, jeera and cotton.
In addition to transaction execution, we provide our clients customized advice on hedging strategies, investment ideas and arbitrage opportunities.
Insurance broking
As an insurance broker, we provide to our clients comprehensive risk management techniques, both within the business as well as on the personal front. Risk management includes identification, measurement and assessment of the risk and handling of the risk, of which insurance is an integral part. The firm deals with both life insurance and general insurance products across all insurance companies. Our guiding philosophy is to manage the clients' entire risk set by providing the optimal level of cover at the least possible cost. The entire sales process and product selection is research oriented and customized to the client's needs. We lay strong emphasis on timely claim settlement and post sales services.
IPO
AnandRathi Securities Ltd. is a leading primary market distributor across the country. Their strong performance in IPOs has been a result of their vast experience in the Primary Market, a wide network of branches across India, strong distribution capabilities and a dedicated research team. They have been consistently ranked among the top 10 distributors of IPOs on all major offerings. Our IPO research team provides clients with in-depth overviews of forthcoming IPOs as well as investment recommendations. Online filling of forms is also available.
Global Products
Structuring of trusts / investment companies Offshore Mutual Funds Structured Products / Deposits including capital-guaranteed notes on Trading in global markets (Equities, Bonds, Commodities) Real Estate investments Alternative investments (including hedge funds and fund-of-hedge funds)
Page | 15
Our services
Risk Management Due diligence and research on policies available Recommendation on a comprehensive insurance cover based on clients needs Maintain proper records of client policies Assist client in paying premiums Continuous monitoring of client account Assist client in claim negotiation and settlement.
Management Team
AR brings together a highly professional core management team that comprises of individuals with extensive business as well as industry experience. Our senior Management comprises a diverse talent pool that brings together rich experience from across industry as well as financial services.
Mr. Anand Rathi - Group Chairman Chartered Accountant Past President, BSE Held several Senior Management positions with one of India's largest industrial groups Mr. Pradeep Gupta - Vice Chairman plus 17 years of experience in Financial Services Mr. Amit Rathi - Managing Director Chartered Accountant & MBA plus 11 years of experience in Financial Services
Superior understanding of the Indian economy & markets Ability to structure and manage your tax and regulatory compliances Dedicated relationship team Unparalleled product range - Indian and Global Page | 16
RESEARCH METHODOLOGY
Page | 17
RESEARCH METHODOLOGY
TYPE OF RESEARCH In this project Descriptive research methodologies were used. The research methodology adopted for carrying out the study was at the first stage theoretical study is attempted and at the second stage observed online trading on NSE/BSE.
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 is to gain knowledge about currency future market. To study the basic concept of Currency future To study the exchange traded currency future To understand the ways of considering currency future price. To analyze different currency derivatives products.
LIMITATION OF THE STUDY The limitations of the study were:The analysis 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. Page | 18
Page | 19
participants, offer standardized products and provide transparent trading platform. Banks are also allowed to become members of this segment on the Exchange, thereby providing them with a new opportunity.
currency swap entails swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. There are a various types of currency swaps like as fixed-to-fixed currency swap, floating to floating swap, fixed to floating currency swap. In a swap normally three basic steps are involve___ (1) Initial exchange of principal amount (2) Ongoing exchange of interest (3) Re - exchange of principal amount on maturity. 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, 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. 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, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer dated options are called warrants and are generally traded OTC.
Page | 22
In the spot exchange market, the business is transacted throughout the world on a continual basis. So it is possible to transaction in foreign exchange markets 24 hours a day. The standard settlement period in this market is 48 hours, i.e., 2 days after the execution of the transaction.
The spot foreign exchange market is similar to the OTC market for securities. There is no centralized meeting place and no fixed opening and closing time. Since most of the business in this market is done by banks, hence, transaction usually do not involve a physical transfer of currency, rather simply book keeping transfer entry among banks. Exchange rates are generally determined by demand and supply force in this market. The
purchase and sale of currencies stem partly from the need to finance trade in goods and services. 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, extent or speed of exchange rate movements.
Direct The number of units of domestic Currency stated against one unit
Indirect The number of unit of foreign currency per unit of domestic Page | 23
currency. Re 1 = $ 0.02187
There are two ways of quoting exchange rates: the direct and indirect. Most countries use the direct method. In global foreign exchange market, two rates are quoted by the dealer: one rate for buying (bid rate), and another for selling (ask or offered rate) for a currency. This is a unique feature of this market. It should be noted that where the bank sells dollars against rupees, one can say that rupees against dollar. In order to separate buying and selling rate, a small dash or oblique line is drawn after the dash. For example, If US dollar is quoted in the market as Rs 46.3500/3550, it means that the forex dealer is ready to purchase the dollar at Rs 46.3500 and ready to sell at Rs 46.3550. The difference between the buying and selling rates is called spread. It is important to note that selling rate is always higher than the buying rate. Traders, usually large banks, deal in two way prices, both buying and selling, are called market makers.
Page | 24
Changes are also expressed as appreciation or depreciation of one currency in terms of the second currency. Whenever the base currency buys more of the terms currency, the base currency has strengthened / appreciated and the terms currency has weakened / depreciated.
For example, If Dollar Rupee moved from 43.00 to 43.25. The Dollar has appreciated and the Rupee has depreciated. And if it moved from 43.0000 to 42.7525 the Dollar has depreciated and Rupee has appreciated.
participate in the futures market. 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. Other advantages of an Exchange traded market would be greater transparency, efficiency and accessibility.
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, April 2008) as follows; The rationale for establishing the currency futures market is manifold. Both residents and nonresidents purchase domestic currency assets. If the exchange rate remains unchanged from the time of purchase of the asset to its sale, no gains and losses are made out of currency exposures. But if domestic currency depreciates (appreciates) against the foreign currency, the exposure would result Page | 26
in gain (loss) for residents purchasing foreign assets and loss (gain) for non residents purchasing domestic assets. In this backdrop, unpredicted movements in exchange rates expose investors to currency risks. Currency futures enable them to hedge these risks. Nominal exchange rates are often random walks with or without drift, while real exchange rates over long run are mean reverting. As such, it is possible that over a long run, the incentive to hedge currency risk may not be large. However, financial planning horizon is much smaller than the long-run, which is typically inter-
generational in the context of exchange rates. As such, 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. The argument for hedging currency risks appear to be natural in case of assets, and applies equally to trade in goods and services, which results in income flows with leads and lags and get converted into different currencies at the market rates. Empirically, changes in exchange rate are found to have very low correlations with foreign equity and bond returns. This in theory should lower portfolio risk. Therefore, sometimes argument is advanced against the need for 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, there are strong arguments to use instruments to hedge currency risks.
FUTURE PRICE :
The price at which the future contract is traded in the future market.
CONTRACT CYCLE :
Page | 27
The period over which a contract trades. The currency future contracts in Indian market have one month, two month, three month up to twelve month expiry cycles. In NSE/BSE will have 12 contracts outstanding at any given point in time.
EXPIRY DATE :
It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. The last trading day will be two business days prior to the value date / final settlement date.
CONTRACT SIZE :
The amount of asset that has to be delivered under one contract. Also called as lot size. In case of USDINR it is USD 1000
BASIS :
In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.
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 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. For equity derivatives carry cost is the rate of interest.
INITIAL MARGIN :
Page | 28
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. Or in another words, 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.
MARKING TO MARKET :
At the end of trading session, all the outstanding contracts are reprised at the settlement price of that session. It means that all the futures contracts are daily settled, and profit and loss is determined on each transaction. This procedure, called marking to market, requires that funds charge every day. The funds are added or subtracted from a mandatory margin (initial margin) that traders are required to maintain the balance in the account. Due to this adjustment, futures contract is also called as daily reconnected forwards.
MAINTENANCE MARGIN :
Members account are debited or credited on a daily basis. In turn customers account are also required to be maintained at a certain level, usually about 75 percent of the initial margin, is called the maintenance margin. This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the 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.
Page | 29
Presume Entity A is expecting a remittance for USD 1000 on 27 August 08 wants to lock in the foreign exchange rate today so that the value of inflow in Indian rupee terms is safeguarded. The entity can do so by selling one contract of USDINR futures since one contract is for USD 1000. Presume that the current spot rate is Rs.43 and USDINR 27 Aug 08 contract is trading at Rs.44.2500. Entity A shall do the following: Sell one August contract today. The value of the contract is Rs.44,250.
Let us assume the RBI reference rate on August 27, 2008 is Rs.44.0000. The entity shall sell on August 27, 2008, USD 1000 in the spot market and get Rs. 44,000. The futures contract will settle at Rs.44.0000 (final settlement price = RBI reference rate). The return from the futures transaction would be Rs. 250, i.e. (Rs. 44,250 Rs. 44,000). As may be observed, the effective rate for the remittance received by the entity A is Rs.44. 2500 (Rs.44,000 + Rs.250)/1000, while spot rate on that date was Rs.44.0000. The entity was able to hedge its exposure .
A speculator can take exactly the same position on the exchange rate by using futures contracts. Let us see how this works. If the INR- USD is Rs.42 and the three month futures trade at Rs.42.40. The minimum contract size is USD 1000. Therefore the speculator may buy 10 contracts. The exposure shall be the same as above USD 10000. Presumably, the margin may Page | 30
be around Rs.21, 000. Three months later if the Rupee depreciates to Rs. 42.50 against USD, (on the day of expiration of the contract), the futures price shall converge to the spot price (Rs. 42.50) and he makes a profit of Rs.1000 on an investment of Rs.21, 000. This works out to an annual return of 19 percent. Because of the leverage they provide, futures form an attractive option for speculators.
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, arbitrage is striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. If the same or similar product is traded in say two different markets, any entity which has access to both the markets will be able to identify price differentials, if any. If in one of the Page | 31
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. One of the methods of arbitrage with regard to USD-INR could be a trading strategy between forwards and futures market. As we discussed earlier, the futures price and forward prices are arrived at using the principle of cost of carry. Such of those entities who can trade both forwards and futures shall be able to identify any mis-pricing between forwards and futures. If one of them is priced higher, the same shall be sold while simultaneously buying the other which is priced lower. If the tenor of both the contracts is same, since both forwards and futures shall be settled at the same RBI reference rate, the transaction shall result in a risk less profit.
Page | 32
TRADER ( BUYER )
TRADER ( SELLER )
Purchase order
Sales order
MEMBER ( BROKER )
MEMBER ( BROKER )
It has been observed that in most futures markets, actual physical delivery of the underlying assets is very rare and it hardly ranges from 1 percent to 5 percent. Most often buyers and sellers offset their original position prior to delivery date by taking an opposite positions. This is because most of futures contracts in different products are predominantly speculative instruments. For example, X purchases American Dollar futures and Y sells it. It leads to two contracts, first, X party and clearing house and second Y party and clearing house. Assume next day X sells same contract to Z, then X is out of the picture and the clearing house is seller to Z and buyer from Y, and hence, this process is goes on.
Page | 33
swaps and options in the OTC market. At the same time, RBI also set up an Internal Working Group to explore the advantages of introducing currency futures. The Report of the Internal Working Group of RBI submitted in April 2008, recommended the introduction of exchange traded currency futures. With the expected benefits of exchange traded currency futures, it was decided in a joint meeting of RBI and SEBI on February 28, 2008, that an RBI-SEBI Standing Technical Committee on Exchange Traded Currency and Interest Rate Derivatives would be constituted. To begin with, the Committee would evolve norms and oversee the implementation of Exchange traded currency futures. The Terms of Reference to the Committee was as under: 1. To coordinate the regulatory roles of RBI and SEBI in regard to trading of Currency and Interest Rate Futures on the Exchanges. 2. To suggest the eligibility norms for existing and new Exchanges for Currency and Interest Rate Futures trading. 3. To suggest eligibility criteria for the members of such exchanges. 4. To review product design, margin requirements and other risk mitigation measures on an ongoing basis. 5. To suggest surveillance mechanism and dissemination of market information. 6. To consider microstructure issues, in the overall interest of financial stability.
Established by the bank or broker through electronic media Banks, brokers, forex dealers, multinational companies, institutional investors, arbitrageurs, traders, etc. None as such, but compensating bank balanced may be required Tailored to needs: from one week to 10 years Actual delivery or offset with cash settlement. No separate clearing house Over the telephone worldwide
Open auction among buyers and seller on the floor of recognized exchange. Banks, brokers, multinational companies, institutional investors, small traders, speculators, arbitrageurs, etc. Margin deposit required
Margins
Maturity Settlement
Standardized Daily settlement to the market and variation margin requirements At recognized exchange floor with worldwide communications Open to any one who is in need of hedging facilities or has risk capital to speculate Actual delivery has very less even below one percent Highly secured through margin deposit.
Market
place and computer networks Accessibility Limited to large customers Delivery Secured banks, institutions, etc. More than 90 percent settled by actual delivery Risk is high being less secured
Page | 35
ANALYSIS
For currencies which are fully convertible, the rate of exchange for any date other than spot is a function of spot and the relative interest rates in each currency. The assumption is that, any funds held will be invested in a time deposit of that currency. Hence, the forward rate is the rate which neutralizes the effect of differences in the interest rates in both the currencies. The forward rate is a function of the spot rate and the interest rate differential between the two currencies, adjusted for time. In the case of fully convertible currencies, having no restrictions on borrowing or lending of either currency the forward rate can be calculated as follows; Page | 36
Future Rate = (spot rate) {1 + interest rate on home currency * period} / {1 + interest rate on foreign currency * period} For example, Assume that on January 10, 2002, six month annual interest rate was 7 percent p.a. on Indian rupee and US dollar six month rate was 6 percent p.a. and spot ( Re/$ ) exchange rate was 46.3500. Using the above equation the theoretical future price on January 10, 2002, expiring on June 9, 2002 is: the answer will be Rs.46.7908 per dollar. Then, this theoretical price is compared with the quoted futures price on January 10, 2002 and the relationship is observed.
Page | 37
Underlying
Initially, 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.m. to 5 p.m.
Quotation
The currency futures contract would be quoted in rupee terms. However, the outstanding positions would be in dollar terms.
Available contracts
All monthly maturities from 1 to 12 months would be made available.
Page | 38
Settlement mechanism
The currency futures contract shall be settled in cash in Indian Rupee.
Settlement price
The settlement price would be the Reserve Bank Reference Rate on the date of expiry. The methodology of computation and dissemination of the Reference Rate may be publicly disclosed by RBI.
Page | 39
The reference rate fixed by RBI two working days prior to the final settlement date will be used for final settlement
Page | 40
P R O F I T
43.19
0 USD L O S S
D
Page | 41
P R O F I T
43.19
0 USD L O S S
D
Pricing of futures contract is very simple. Using the cost-of-carry logic, we calculate the fair value of a futures contract. Every time the observed price deviates from the fair value, arbitragers would enter into trades to capture the arbitrage profit. This in turn would push the futures price back to its fair value. The cost of carry model used for pricing futures is given below: F=Se^(r-rf)T where: r=Cost of financing (using continuously compounded interest rate) rf= one year interest rate in foreign T=Time till expiration in years E=2.71828
Page | 42
The relationship between F and S then could be given as F Se^(r rf )T - = This relationship is known as interest rate parity relationship and is used in international finance. To explain this, let us assume that one year interest rates in US and India are say 7% and 10% respectively and the spot rate of USD in India is Rs. 44. From the equation above the one year forward exchange rate should be F = 44 * e^(0.10-0.07 )*1=45.34 It may be noted from the above equation, if foreign interest rate is greater than the domestic rate i.e. rf > r, then F shall be less than S. The value of F shall decrease further as time T increase. If the foreign interest is lower than the domestic rate, i.e. rf < r, then value of F shall be greater than S. The value of F shall increase further as time T increases.
Page | 43
Similarly, if the firm is borrowing or lending or investing for short or long period from foreign countries, in all these situations, the firms profit will be affected by change in foreign exchange rates. In all these situations, the firm can take long or short position in futures currency market as per requirement. The general rule for determining whether a long or short futures position will hedge a potential foreign exchange loss is: Loss from appreciating in Indian rupee= Short hedge Loss form depreciating in Indian rupee= Long hedge
Page | 44
So what he will do to protect against depreciating in Indian rupee? Suppose spots value of 1 USD is 49.8500. Future Value of the 1USD on NSE as below:
Price Watch Contract USDINR 261108 USDINR 291208 USDINR 280109 USDINR 250209 USDINR 270309 USDINR 280409 USDINR 270509 USDINR 260609 USDINR 290709 USDINR 270809 USDINR 280909 USDINR 281009 USDINR 261109 Best Buy Qty 464 189 1 100 100 1 25 1 2 1 1 1 Order Book Best Best Buy Sell Price Price 49.8550 49.8575 49.6925 49.8850 50.1000 49.9225 50.0000 49.0000 48.0875 48.1625 48.2375 48.3100 48.3825 49.7000 49.9250 50.2275 50.5000 51.0000 51.0000 50.5000 53.1900 Best LTP Volum Open Sell e Interes Qty t 712 49.855 58506 43785 0 612 49.730 17645 111830 0 3 2 49.945 5598 16809 0 1 50.192 3771 6367 5 5 49.912 311 892 5 5 50.500 278 0 5 47.100 506 0 - 50.000 116 0 - 49.150 44 0 1 50.300 6 2215 0 - 51.200 79 0 2 50.990 2 0 - 50.927 5
Page | 45
244645
Archives As On 26-Nov-2008 12:00:00 Hours IST RBI reference Underlying rate USDINR 49.8500
Solution:
He should buy ten contract of USDINR 28012009 at the rate of 49.8850. Value of the contract is (49.8850*1000*100) =4988500. (Value of currency future per USD*contract size*No of contract). For that he has to pay 5% margin on 5988500. Means he will have to pay Rs.299425 at present. And suppose on settlement day the spot price of USD is 51.0000. On settlement date payoff of importer will be (51.0000-59.8850) =1.115 per USD. And (1.115*100000) =Rs. 111500.
Page | 46
HR= VF / Vc Where, VF is the value of the futures position and Vc is the value of the cash position. Suppose value of contract dated 28th January 2009 is 49.8850. And spot value is 49.8500. HR=49.8850/49.8500=1.001.
FINDINGS
Cost of carry model and Interest rate parity model are useful tools to find out standard future price and also useful for comparing standard with actual future price. And its also a very help full in Arbitraging. New concept of Exchange traded currency future trading is regulated by higher authority and regulatory. The whole function of Exchange traded currency future is regulated by SEBI/RBI, and they established rules and regulation so there is very safe trading is emerged and counter party risk is minimized in currency Future trading. And also time reduced in Clearing and Settlement process up to T+1 days basis. Larger exporter and importer has continued to deal in the OTC counter, even exchange traded currency future is available in markets. There is a limit of USD 100 million on open interest applicable to trading member who are banks. And the USD 25 million limit for other trading members so larger exporter and importer might continue to deal in the OTC market where there is no limit on hedges. In India RBI and SEBI has restricted other currency derivatives except Currency future, at this time if any person wants to use other instrument of currency derivatives in this case he has to use OTC.
Page | 47
SUGGESTIONS
Currency Future need to change some restriction it imposed such as cut off limit of 5 million USD, Ban on NRIs and FIIs and Mutual Funds from Participating. Now in exchange traded currency future segment only one pair USD-INR is available to trade so there is also one more demand by the exporters and importers to introduce another pair in currency trading. Like POUND-INR, CAD-INR etc. In OTC there is no limit for trader to buy or short Currency futures so there demand arises that in Exchange traded currency future should have increase limit for Trading Members and also at client level, in result OTC users will divert to Exchange traded currency Futures.
In India the regulatory of Financial and Securities market (SEBI) has Ban on other Currency Derivatives except Currency Futures, so this restriction seem unreasonable to exporters and importers. And according to Indian financial growth now its become necessary to introducing other currency derivatives in Exchange traded currency derivative segment.
Page | 48
CONCLUSIONS
By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivativesThese instruments enhances the ability to differentiate risk and allocate it to those investors most able and willing to take it- a process that has undoubtedly improved national productivity growth and standards of livings. 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. Because of exchange traded future contract and its standardized nature gives counter party risk minimized. Initially only NSE had the permission but now BSE and MCX has also started currency future. It is shows that how currency future covers ground in the compare of other available derivatives instruments. 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. 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.
Page | 49
BIBLIOGRAPHY
Financial Derivatives (theory, concepts and problems) By: S.L. Gupta. NCFM: Currency future Module. BCFM: Currency Future Module. Center for social and economic research) Poland Recent Development in International Currency Derivative Market by: Lucjan T. Orlowski) Report of the RBI-SEBI standing technical committee on exchange traded currency futures) 2008 Report of the Internal Working Group on Currency Futures (Reserve Bank of India, April 2008)
Page | 50