Neeraj Mishra

nmishra@nse.co.in
Some pointers to the task ahead
 60 Questions
 2 hours
 100 Marks
 25% negative for wrong answer (eg 4 Marks/ 1 negative)

 2 hrs = 120 minutes; i.e. approx 2 minutes per question

 Approx 1.5 marks per question
 Better marks for problem solving
 More focus on Trading, Clearing & strategies
 Use elimination technique / don’t reply if absolutely unsure
Chapter 1 Introduction to Currency Markets
• Spot : Immediate delivery but standard convention is T+2 days
(an exception is USDCAD which has T+1)
• Types of Spot
• Value Cash : Trade day / Same day
• Value Tom : Trade date + 1 (tomorrow)
• Spot : Trade date + 2

• Forward / Outright Forward = anytime greater than Spot

• Any rate other than Spot rate is based/referenced on Spot Rate

• Base Currency / Term Currency

• USD INR
• Base/Denominator Term / Numerator

• Quotation is for BASE CURRENCY always

• How much Term Currency is required to buy 1 Base Currency
• How much Term Currency can you buy with 1 Base currency
Chapter 1 Introduction to Currency Markets…..

• Strengthening Weakening
• Appreciation Depreciation
• Costlier Cheaper
• For 2 parts of a currency pair they go opposite

• 45.0000 USD INR

• 47.0000 Strong/appreciate Weak/depreciate
• 42.0000 Weak/depreciate Strong/appreciate

• Swaps:
• Simultaneous purchase / sale of currency
• Facilitate funding in currency other than the one you have
• Each party gets to use a foreign currency for a specific time
• Liquidity in one currency is converted into another for a period of time
• International Monetary Fund has a currency – SDR Special Drawing Rights
• US Dollar Index – Designed to show movement against major currencies Euro, GBP, Yen & CAD
• Currency rates can impact:
• Consumer prices
• Investment decision
• Interest rates
• Economic growth
• Location of industry
– US Dollar is the most traded currency
– It is used as :
– Investment currency : capital markets
– Reserve currency : Central Banks
– Transaction Currency : International commodity markets
– Invoice currency : contracts
– Intervention currency : Monetary authority intervention
– Vehicle currency : to trade two illiquid currencies (Euro has emerged)
• Want to convert INR to Pesos
• Sell INR for USD & the Buy Pesos for the USD
• Two transactions, but better control and liquid
• Less number of currencies to maintain and research
• Reduces number of exchange rates to be maintained
• Eg: 10 currencies 9 pairs / 45 pairs
• Reason for USD role as Vehicle currency – Bretton Woods par value system

• Second major currency : Euro

• Third major currency : Yen
• British pound GBP : Only until WWII, also known as Cable
• Swiss Franc : Does not belong to EMU / G7 countries
• Learn to read the currency table

• Factors affecting exchange rate : interest rates, inflation & GDP

• Indicators of strong economy result in appreciation of currency against others
Chapter 2: Foreign Exchange Derivatives

• Every derivative product has to have a ‘Bases’ / ‘Underlying’

• Price of any derivative is driven by the ‘Spot price’ of the underlying
• SCRA 1956 defines derivative
• Derivatives are securities under SCRA and hence governed by SCRA i.e. SEBI
• Derivatives also defined in Sec 45U(a) of RBI Act
• Under RBI Act derivatives include instruments on Foreign Exchange

• Derivative products emerged as hedge against commodity prices

• Commodity linked derivatives were most prominent for almost 300 yrs
• Financial derivatives in spot light post 1970
• Financial derivatives became prominent (2/3 of all transactions ) by 1990
• Types of Derivative Products:
• Forwards: Customized contract
• Futures : forward contract that is standardized and traded on an exchange
• Options :
• Warrants : long dated option contracts traded in OTC
• LEAPS : Long dated options traded on exchange
Market players:
• Hedgers-to lower or eliminate risk
• Speculators-bet on future movement with leverage
• Arbitrageurs-mispricing/discrepancy in prices
Key economic functions:
Prices of derivative converge with prices of underlying at expiration
Derivatives help in discovery of future prices
Derivatives help in transferring RISK
Derivatives help in increasing volumes in underlying market

Forward contracts brought buyer and seller to the market

Forwards still carried ‘Credit Risk’
Hence Futures contracts were introduced on Exchanges
CME & CBOT the largest exchanges. Now merged to form CME group.
• Derivatives traded on Exchange are called Exchange Traded Derivatives
• Privately negotiated derivatives are called OTC Derivatives (Over The Counter)
• Out of the two, Exchange Traded Derivatives have rigid structure
• OTC markets have the following feature:
• Management of counter party / credit risk is not centralised
• No formal limits, positions, leveraging , margining etc
• No formal rules for risk sharing
• No rules for market stability and integrity
• No formal regulators generally

• Problems in OTC:
• Dynamic exposure
• Information asymetry
• High concentration of activity with small number of institution

• Rapid asset price change / counterparty credit failures pose systemic risk
Chapter 3: Exchange Traded Currency Futures

Currency Futures:
• Standardised contract
• Traded on exchange
• Contract to buy/sell certain qty of underlying
• Underlying is an exchange rate between 2 currencies
• At a certain future date
• At a certain decided price
• Locking a certain exchange rate in case of currency futures
• Settlement can be cash or delivery
• Always routed thru the Exchange
• Linear product

Tick Size : MINIMUM trading increment allowed

Tick size movement : 47.0025 – 47.0050 – 47.0075
Value of tick size = tick size * contract size
Rs 2.5 = Rs 0.0025 * 1000
Bought 5 contracts and price moved 4 ticks = Profit /loss is 5 * 4 * 2.5 = Rs 50
Future Terminology:
• Spot price : spot market price / the price for T+2 day settlement
• Future price : price of futures contract
• Contract cycle : 12 monthly contracts
• Value date/ Final settlement date : date of final settlement ( last business day of month)
• Expiry date : last trading day (two business days prior to value date)
• Contract Size : 1000 USD in case of USD INR
• Basis : Futures price – Spot price. Normally positive. i.e. Futures price is generally HIGHER than spot
• Cost of carry : spot price + storage cost + interest cost – earning from asset.
• Initial Margin :
• Marking to Market (MTM) : Adjustment to margin a/c at day end based on daily settlement price

Why Currency Futures:

To overcome problems in Forward Market
Contracts are standardized for underlying, quantity, timing of settlement, location of settlement, units of price
Improves liquidity

Advantage: price transparancy, no counterparty risk, easy reach, better price discovery, lower transaction cost
• CME created first ever FX futures in 1972
• FX derivatives could emerge due to the abondonment of Bretton Woods agreement

Interest Rate Parity:

• Price of future is dependent on spot rate & difference in interest rate in both currencies

• If interest rate in US is 1%
• Interest rate in India is 6%
• USD INR rate today is 50.0000
• What will be USD INR rate one year future price

• Calculation based on bringing USD on loan in India and investing. Price of one year future should not leave
any arbitrage opportunity

• Always use Continuous componding formula F = S * e ^( (r-p) *t)

• 50 * e ^ (.06-.01) * 1
• 50 * 1.05 = 52.5634
 by heart e = 2.7182
 first find out the value of what ever is raised to the power of e separately
 type 2.7182
 click x^y
 type the value derived above
 the result should be multiplied by spot price
Chapter 4 : Strategies using Currency Futures

• Hedgers look to manage / transfer risk

• Speculators look to take risk
• Both are required for a healthy liquid market
• Speculation is not similar to manipulation
• Manipulator pushes prices in reverse of market equilibrium
Long Future Position :
• Buying while expecting price to rise
• Buying without underlying position is speculative long

Short Future Position:

• Selling while expecting price to fall
• Selling without underlying position is speculative short

Hedging:
Taking opposite positions in spot & futures market to reduce risk OR lock prices
Hedger has an Overall Portfolio (OP) of atleast 2 positions
1 underlying position
2 Hedging position with counter effect of 1 position
• Value of OP = Underlying position + Hedging Position
• In case of perfect hedge OP will never change with change in FX rate

Type of FX hedge using futures:

Long Hedge = short in underlying FX & long in Futures
Short Hedge = Long in underlying FX & short in Futures

Proper size of Hedge:

Basic approach (Equal Hedge) = exporter sold goods worth USD 10000. Hedges by selling 10 USD contract
i.e. size of underlying position = size of hedging position
Modern approach (Optimal Hedge) = yields the highest level of utility to hedger
= perfect hedge

Spreads : difference between two futures contracts

Reasons: int rate diff, liquidity in banking sys, monetary policy decisions & inflation
Intra currency spread: same currency diff expiry
Inter currency spread : diff currency pair same expiry
Expect diff to go up buy spread ( buy far month sell near month) and vice versa
Arbitrage : locking profit on basis of dicrepancy between two markets (OTC vs Futures)
Chapter 5 : Trading

• Underlying : rate of USD / INR

• Contract size: 1000 USD
• Tick size : Rs 0.0025
• Price Bands : not applicable
• 12 monthly contracts max 1 year
• Expiry / last trading day : 2 days before last day of month
• Settlement days : daily MTM T+1 final settlement T+2
• Settlement price : daily MTM closing price of future contract; final settlement at RBI ref rate on last trading
day
• Settlement method : cash settled
• Market time : 9 to 5 pm

• Base price : on first day its theoretical future price

• : on other days it’s the daily settlement price
• Closing Price : Last half hour weighted average price for the contract AND If not traded at all or not
traded in half hour then THEORETICAL price

• OHLL : Open, High, Low & LTP is continuously disseminated

Entities:
• Trading Member (TM)
• Members of recognized stock exchange
• Trade on own behalf (proprietary) or for Client including Participant
• Exchange assigns TM ID to each member
• Can have more than one user, each user has unique ID
• Members responsible for control over all user ids
• Clearing Member (CM)
• Member of the clearing corporation
• Manage risk and confirm Participant trades
• Trading Cum Clearing Member (TCM)
• Can trade as well as clear self and other members trades
• Professional Clearing Member (PCM)
• No right to trade only clearing function
• Participants
• Type of client like a financial institution
• Trade through multiple TM but clear through single CM
• Trading through a TWS (trader workstation Screen)
TYPES OF ORDERS:
Time Condition:
• Day order = valid for the day, canceled at day end by system if not traded
• Immediate Or Cancel (IOC) = For immediate matching only, or else canceled, partial match allowed,
remaining qty cancelled
Price Condition:
• Market price = price not specified best price is assigned
• Limit Price = A specified price . Trade cannot take at a price worse than this. This the price referred after
hitting stop loss
• Stop-Loss = for conditional release of order based on price reached / breached
Stop loss buy trigger price should be less than limit price
Stop loss sell trigger price should be greater than limit price
Other Condition:
• PRO means order is for members own a/c
• CLI means order is on behalf of client
Price Limit circuit filter:
• No daily price bands. To prevent erroneous orders operating range of 3% (first 6 months) and 5% (next 6
months)
• Orders beyond operating range go into price freeze
Mark to Market:
• Online real time calculation
• Maximum 75% of total deposit allowed to be lost
• Warning given at 60%, 75% and 90% of breaching this limit
• On utilizing the 75% limit member is suspended
Position Limit:
• To avoid huge built up of positions
• Monitored at day end
• Monitored at both client level and member level
• Violation of limits used for further surveillance
• CM accountable for TM violation
• TM accountable for Client violation
Limits:
• Client level = 10 million USD or 6% of all open positions whichever is higher
• Exchange disseminates warning when 3% crossed for any client
• Non Bank Member = 50 Million USD or 15%
• Bank Member = 100 million USD or 15%
• Clearing member = no separate limits
Surveillance System
Rules, regulations and bye-laws
Chapter 6: Clearing, Settlement & Risk
Management
• Clearing Corporation (CC) undertakes clearing & settlement
• Acts as legal counter party to all trades
• This is called NOVATION
• Guarantees financial settlement

Clearing & Settlement includes:

1. Clearing
2. Settlement
3. Risk Management

Clearing Entities:
Clearing Members = TCM and PCM clear trades. For each additional TM under them they have to bring
additional deposit
Clearing Banks = Used for Funds settlement
Each member required to open an account with Clearing Bank
Clearing Mechanism

• Means working out open positions and obligations of PCM / TCM

• The calculated position is used for exposure and daily margin calculation
Position of CM
Sum of open position of all TM under him
Sum of open position of all Participants under him

Position of TM
Net proprietary position PLUS sum of each client position

Position of Clients
Sum of net position in each contract (either long / Short)
Example: Open Position (Contracts)

TM clearing Proprietary Client 1 Client 2 Open position

through CM Trades

XYZ Buy 40 Buy 30 Buy 40 +60

Sell 20 Sell 10 Sell 20
+20 +20 +20

FRX Buy 20 Buy 80 Buy 30 +20

Sell 30 Sell 60 Sell 70 -50
-10 +20 -40
Total +20 +40 +20 +80
-10 -40 -50
Settlement Mechanism

MTM
Daily end of day for all open positions
Trade price MINUS Days settlement price
Previous settlement price MINUS Days settlement price ( if not traded today)

CMs who have made loss pay MTM which in turn is passed on to CMs who profit
CM responsible to collect from TM
TM responsible to collect MTM from Clients
MTM payin payout is done on T+1 day

After MTM calculation open positions reset to settlement price for next day

Type of activity Bought / Sold Today’s sett price MTM

Position brought 1000 * 40 (yesterdays 43 1000*3

forward sett price

Bought 2000 * 40 43 1000 * 2

Sold 1000 * 42
Open position from 1000 * 40 43 1000 * 3
above
Final Settlement of futures
Done on last trading day / expiry day of the contract
Done for all CMs for all open positions
Done on T+2 basis

Risk Management
•Financial soundness of members (capital, net worth, security deposit etc)
•Upfront margin for all open positions
•VAR based SPAN margin (Standard Portfolio Analysis of Risk)
•MTM done for all open positions and collected in cash on T+1 basis
•Online position monitoring
•Generation of warning when certain levels breached
•CM can set limits for TM thru terminals provided to them
•If margin limit violated trading facility is withdrawn
•Before disablement member can take action to reduce position or bring deposit
•Settlement guarantee fund for this segment
Margin Requirement

•Initial security deposit used for trading exposure

•For additional exposure additional deposit required
•Surplus with exchange is not returned (returned only on written request in 3 days)

Initial Margin
•Based on worst case basis to cover 99% VAR over one day

Portfolio Based Margin

•SPAN based
•Computed at 5 times during day - begin day, 11, 12:30, 2 and end of day

Calendar Spread Margin

•Rs 250 PLUS 1/3 of far month value
•Calendar spread margin benefit only till expiry of near month
•Eg JULY-AUGUST spread
ELM (extreme loss margin)
1% of MTM value

Liquid Networth
Liquid networth MINUS Initial & ELM should be atleast 50 lacs at all times

Liquid Assets
Maintained separately for CF

MTM
Collected on T+1 before start of trading next day
If not collected, initial margin is hiked up to cover risk

Margin collection
Compulsory to collect all margins from clients and report to exchange
Stringent penalty for not collecting
Inspection of members to ensure collection
Safeguard Clients Money
CC segregates the margin deposited by CMs for own a/c and client a/c
Clients money held in trust for use of client only

UCC (Unique Client Code)

Each member required to provide a UCC to each client that is unique