Professional Documents
Culture Documents
Leshilie Markey
ACKNOWLEDGEMENT
We are too glad to give our special thanks to our project guide Mr. Shyam
Sunder for providing us an opportunity to carryout project on currency derivatives and
also for their help and tips whenever needed. Without his co-operation it was impossible
to reach up to this stage.
At last, I sincere regards to my parents and friends who have directly or indirectly
helped me in the project.
CONTENTS
CHAPTER SUBJECTS COVERED PAGE
NO NO
1 Introduction of currency derivatives 4
2 Company Profile 7
3 Research Methodology 14
Scope of Research
Type of Research
Source of Data collection
Objective of the Study
Data collection
Limitations
4 Introduction to The topic 17
Introduction of Financial Derivatives
Types of Financial Derivatives
Derivatives Introduction in India
History of currency derivatives
Utility of currency derivatives
Introduction to Currency Derivatives
Introduction to Currency Future
5 Brief Overview of the foreign exchange market 29
Overview of foreign exchange market in India
Currency Derivatives Products
Foreign Exchange Spot Market
Foreign Exchange Quotations
Need for exchange traded currency futures
Rationale for Introducing Currency Future
Future Terminology
Uses of currency futures
Trading and settlement Process
Regulatory Framework for Currency Futures
Comparison of Forward & Future Currency
Contracts
6 Analysis 52
Interest Rate Parity Principle
Product Definitions of currency future
Currency futures payoffs
Pricing Futures and Cost of Carry model
Hedging with currency futures
Findings suggestions and Conclusions 66
Bibliography 68
INTRODUCTION OF
CURRENCY DERIVATIVES
INTRODUCTION OF 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.
For example,
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.
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.
AnandRathi 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, Corporates 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 in 197 cities across 28 cities and it has also branches in
Dubai and Bangkok with more than 44000 employees. It has daily turnover in
excess of Rs. 4billion. It has 1,00,000+ clients nationwide. It is also leading
Distributor of IPO's
In year 2007 Citigroup Venture Capital International joined the group as a financial
partner.
AndhraPardesh , Assam, Bihar , Chhatisgarh, Delhi , Goa, Gujrat, Haryana Jammu &
Kashmir, Jharkhand, Karnataka, Kerala,,MadhyaPardesh, Maharashtra, Orissa, Punjab,
Rajasthan, Tamil Nadu, UttarPardesh, Uttranchal, WestBengal.
Mission
"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
Products
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.
Commodities
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 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
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
We are a leading primary market distributor across the country. Our strong performance
in IPOs has been a result of our vast experience in the Primary Market, a wide network
of branches across India, strong distribution capabilities and a dedicated research team
We have been consistently ranked among the top 10 distributors of IPOs on all major
offerings. Our IPO research team provides clients with indepth overviews of
forthcoming IPOs as well as investment recommendations. Online filling of forms is
also available.
Global Products
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
TYPE OF RESEARCH
In this project Descriptive research methodologies were use.
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.
―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- a process that has undoubtedly improved national
productivity growth and standards of livings.‖
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. As a result, the demand for the international money and financial
instruments increased significantly at the global level. In this respect, changes in the
interest rates, exchange rate and stock market prices at the different financial market
have increased the financial risks to the corporate world. It is therefore, to manage
such risks; the new financial instruments have been developed in the financial
markets, which are also popularly known as financial derivatives.
**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.
Financial derivatives are those assets whose values are determined by the value of
some other assets, called as the underlying. Presently there are Complex varieties of
derivatives already in existence and the markets are innovating newer and newer
ones continuously. For example, various types of financial derivatives based on
their different properties like, plain, simple or straightforward, composite, joint or
hybrid, synthetic, leveraged, mildly leveraged, OTC traded, standardized or
organized exchange traded, etc. are available in the market. Due to complexity in
nature, it is very difficult to classify the financial derivatives, so in the present
context, the basic financial derivatives which are popularly in the market have been
described. In the simple form, the derivatives can be classified into different
categories which are shown below :
DERIVATIVES
Financials Commodities
Basics Complex
1. Forwards 1. Swaps
2. Futures 2.Exotics (Non STD)
3. Options
4. Warrants and Convertibles
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 :
A major difference between the two is that of counterparty risk—the 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.
The first step towards introduction of derivatives trading in India was the
promulgation of the Securities Laws (Amendment) Ordinance, 1995, which
withdrew the prohibition on options in 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, submitted
its report on March 17, 1998. 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.
To begin with, SEBI approved trading in index futures contracts based on S&P CNX
Nifty and BSE-30 (Sensex) index. 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.
HISTORY OF CURRENCY DERIVATIVES
Currency futures were first created at the Chicago Mercantile Exchange (CME) 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. The abandonment of the Bretton Woods agreement resulted in
currency values being allowed to float, increasing the risk of doing business. 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.
A high degree of volatility of exchange rates creates a fertile ground for foreign
exchange speculators. 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. Alternatively, they may wish to obtain a foreign currency forward
buying contract, expecting to sell the appreciating currency at a high future rate. In
either case, 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.
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.
Source :-( Recent Development in International Currency Derivative Market by
Lucjan T. Orlowski)
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.
For example,
The price of one currency in terms of other currency is known as exchange rate.
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.
Therefore, the buyer and the seller lock themselves into an exchange rate for a
specific value or delivery date. Both parties of the futures contract must fulfill their
obligations on the settlement date.
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 is the tick
value. 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.
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.
During the early 1990s, India embarked on a series of structural reforms in the foreign
exchange market. The exchange rate regime, that was earlier pegged, was partially
floated in March 1992 and fully floated in March 1993. 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, which
was achieved in August 1994.
Although liberalization helped the Indian forex market in various ways, it led to
extensive fluctuations of exchange rate. This issue has attracted a great deal of concern
from policy-makers and investors. While some flexibility in foreign exchange markets
and exchange rate determination is desirable, excessive volatility can have an adverse
impact on price discovery, export performance, sustainability of current account
balance, and balance sheets. In the context of upgrading Indian foreign exchange market
to international standards, a well- developed foreign exchange derivative market (both
OTC as well as Exchange-traded) is imperative.
With a view to enable entities to manage volatility in the currency market, RBI on April
20, 2007 issued comprehensive guidelines on the usage of foreign currency forwards,
swaps and options in the OTC market. At the same time, RBI also set up an Internal
Working Group to explore the advantages of introducing currency futures. The Report
of the Internal Working Group of RBI submitted in April 2008, recommended the
introduction of Exchange Traded Currency Futures.
Currently, India is a USD 34 billion OTC market, where all the major currencies like
USD, EURO, YEN, Pound, Swiss Franc etc. are traded. With the help of electronic
trading and efficient risk management systems, Exchange Traded Currency Futures will
bring in more transparency and efficiency in price discovery, eliminate counterparty
credit risk, provide access to all types of market 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. Source :-( Report of the RBI-SEBI
standing technical committee on exchange traded currency futures) 2008.
CURRENCY DERIVATIVE PRODUCTS
Derivative contracts have several variants. The most common variants are forwards,
futures, options and swaps. We take a brief look at various derivatives contracts that
have come to be used.
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.
FUTURE :
Swap is private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolio of
forward contracts.
The currency swap entails swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than
those in the opposite direction. There are a various types of currency swaps like
as fixed-to-fixed currency swap, floating to floating swap, fixed to floating
currency swap.
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.
The foreign exchange spot market trades in different currencies for both spot and
forward delivery. Generally they do not have specific location, and mostly take
place primarily by means of telecommunications both within and between countries.
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.
For example,
Direct Indirect
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,
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.
In foreign exchange markets, the base currency is the first currency in a currency
pair. The second currency is called as the terms currency. Exchange rates are quoted
in per unit of the base currency. That is the expression Dollar-Rupee, 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.
Exchange rates are constantly changing, which means that the value of one currency
in terms of the other is constantly in flux. Changes in rates are expressed as
strengthening or weakening of one currency vis-à-vis the second currency.
With a view to enable entities to manage volatility in the currency market, RBI on
April 20, 2007 issued comprehensive guidelines on the usage of foreign currency
forwards, swaps and options in the OTC market. At the same time, RBI also set up an
Internal Working Group to explore the advantages of introducing currency futures.
The Report of the Internal Working Group of RBI submitted in April 2008,
recommended the introduction of exchange traded currency futures. Exchange traded
futures as compared to OTC forwards serve the same economic purpose, yet differ in
fundamental ways. An individual entering into a forward contract agrees to transact at
a forward price on a future date. On the maturity date, the obligation of the individual
equals the forward price at which the contract was executed. Except on the maturity
date, no money changes hands. On the other hand, in the case of an exchange traded
futures contract, mark to market obligations is settled on a daily basis. Since the
profits or losses in the futures market are collected / paid on a daily basis, the scope
for building up of mark to market losses in the books of various participants gets
limited.
Further, in an Exchange traded scenario where the market lot is fixed at a much lesser
size than the OTC market, equitable opportunity is provided to all classes of investors
whether large or small to 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.
Source :-( Report of the RBI-SEBI standing technical committee on exchange
traded currency futures) 2008.
Futures markets were designed to solve the problems that exist in forward markets. 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. But unlike forward contracts, the futures contracts
are standardized and exchange traded. To facilitate liquidity in the futures contracts, the
exchange specifies certain standard features of the contract. A futures contract is
standardized contract with standard underlying instrument, a standard quantity and quality
of the underlying instrument that can be delivered, (or which can be used for reference
purposes in settlement) and a standard timing of such settlement. A futures contract may
be offset prior to maturity by entering into an equal and opposite transaction.
Location of settlement
The rationale for introducing currency futures in the Indian context has been outlined
in the Report of the Internal Working Group on Currency Futures (Reserve Bank of
India, April 2008) as follows;
The rationale for establishing the currency futures market is manifold. Both residents and
non-residents 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 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 TERMINOLOGY
SPOT PRICE :
The price at which an asset trades in the spot market. The transaction in which
securities and foreign exchange get traded for immediate delivery. Since the
exchange of securities and cash is virtually immediate, the term, cash market, has
also been used to refer to spot dealing. In the case of USDINR, spot value is T +
2.
FUTURE PRICE :
The price at which the future contract traded in the future market.
CONTRACT CYCLE :
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.
The last business day of the month will be termed the value date /final settlement
date of each contract. The last business day would be taken to the same as that
for inter bank settlements in Mumbai. The rules for inter bank settlements,
including those for ‗known holidays‘ and would be those as laid down by Foreign
Exchange Dealers Association of India (FEDAI).
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 :
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 :
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 :
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.
Hedging:
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 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.
Speculation: Bearish, sell futures
Let us understand how this works. Typically futures move correspondingly with
the underlying, as long as there is sufficient liquidity in the market. If the
underlying price rises, so will the futures price. If the underlying price falls, so
will the futures price. Now take the case of the trader who expects to see a fall
in the price of USD-INR. He sells one two-month contract of futures on USD
say at Rs. 42.20 (each contact for USD 1000). He pays a small margin on the
same. Two months later, when the futures contract expires, USD-INR rate let us
say is Rs.42. On the day of expiration, the spot and the futures price converges.
He has made a clean profit of 20 paise per dollar. For the one contract that he
sold, this works out to be Rs.2000.
Arbitrage:
Like other future trading, the future currencies are also traded at organized
exchanges. The following diagram shows how operation take place on currency
future market:
TRADER TRADER
( BUYER ) ( SELLER )
Informs
CLEARING
HOUSE
It has been observed that in most futures markets, actual physical delivery of the
underlying assets is very rare and hardly it ranges from 1 percent to 5 percent. Most
often buyers and sellers offset their original position prior to delivery date by taking an
opposite positions. This is because most of futures contracts in different products are
predominantly speculative instruments. For example, X purchases American Dollar
futures and Y sells it. It leads to two contracts, first, X party and clearing house and
second Y party and clearing house. Assume next day X sells same contract to Z, then X
is out of the picture and the clearing house is seller to Z and buyer from Y, and hence,
this process is goes on.
REGULATORY FRAMEWORK FOR CURRENCY FUTURES
With a view to enable entities to manage volatility in the currency market, RBI on April
20, 2007 issued comprehensive guidelines on the usage of foreign currency forwards,
swaps and options in the OTC market. At the same time, RBI also set up an Internal
Working Group to explore the advantages of introducing currency futures. The Report
of the Internal Working Group of RBI submitted in April 2008, recommended the
introduction of exchange traded currency futures. With the expected benefits of
exchange traded currency futures, it was decided in a joint meeting of RBI and SEBI on
February 28, 2008, that an RBI-SEBI Standing Technical Committee on Exchange
Traded Currency and Interest Rate Derivatives would be constituted. To begin with, the
Committee would evolve norms and oversee the implementation of Exchange traded
currency futures. The Terms of Reference to the Committee was as under:
2. To suggest the eligibility norms for existing and new Exchanges for Currency
and Interest Rate Futures trading.
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;
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.
PRODUCT DEFINITIONS OF CURRENCY FUTURE ON
NSE/BSE
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.
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.
A payoff is the likely profit/loss that would accrue to a market participant with
change in the price of the underlying asset. This is generally depicted in the
form of payoff diagrams which show the price of the underlying asset on the X-
axis and the profits/losses on the Y-axis. Futures contracts have linear payoffs.
In simple words, it means that the losses as well as profits for the buyer and the
seller of a futures contract are unlimited. Options do not have linear payoffs.
Their pay offs are non-linear. These linear payoffs are fascinating as they can be
combined with options and the underlying to generate various complex payoffs.
However, currently only payoffs of futures are discussed as exchange traded
foreign currency options are not permitted in India.
The figure shows the profits/losses for a long futures position. The
investor bought futures when the USD was at Rs.43.19. If the price goes
up, his futures position starts making profit. If the price falls, his futures
position starts showing losses.
P
R
O
F
I
T
43.19
0
USD
D
L
O
S
S
Payoff for seller of futures: Short futures
The payoff for a person who sells a futures contract is similar to the payoff for a
person who shorts an asset. He has a potentially unlimited upside as well as a
potentially unlimited downside. Take the case of a speculator who sells a two
month currency futures contract when the USD stands at say Rs.43.19. The
underlying asset in this case is the currency, USD. When the value of dollar
moves down, i.e. when rupee appreciates, the short futures position starts 25
making profits, and when the dollar appreciates, i.e. when rupee depreciates, it
starts making losses. The Figure below shows the payoff diagram for the seller
of a futures contract.
43.19
0
USD
D
L
O
S
S
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
The relationship between F and S then could be given as
F Se^(r rf )T - =
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.
It is noted that corporate profits are exposed to exchange rate risk in many
situation. For example, if a trader is exporting or importing any particular
product from other countries then he is exposed to foreign exchange risk.
Similarly, if the firm is borrowing or lending or investing for short or long
period from foreign countries, in all these situations, the firm‘s 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
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) =111500.Rs.
Another important decision in this respect is to decide hedging ratio HR. The
value of the futures position should be taken to match as closely as possible the
value of the cash market position. As we know that in the futures markets due to
their standardization, exact match will generally not be possible but hedge ratio
should be as close to unity as possible. We may define the hedge ratio HR as
follows:
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 it‘s also a very help full in Arbitraging.
Larger exporter and importer has continued to deal in the OTC counter
even exchange traded currency future is available in markets because,
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.
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- 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.
BIBLIOGRAPHY
Websites:
www.sebi.gov.in
www.rbi.org.in
www.frost.com
www.wikipedia.com
www.economywatch.com
www.bseindia.com
www.nseindia.com