WHAT IS CURRENCY…????

It represents the value of an economy and its prospective at present with comparison of another economy.

For Example:

USD/INR pair represents$ 1 = Rs.45

This pair means one dollar if we purchase/sell we have to give/take 45 rupees for it.

Similarly, EURINR, GBPINR, JPYINR will be defined.

Appreciation and depreciation of currency

USDINR is appreciatingEarlier 1 USD = Rs.46 but now 1 USD = Rs.45.50

Explanation:

Earlier we have to give Rs.46.00 for one dollar now we are giving Rs.45.50 per unit of dollar. We have to pay half a rupee less that means Indian economy is better then US economy and the value of its currency is going up. This termed as rupee is appreciating and dollar is depreciating.

And the pair USDINR is said to be depreciating.

Largest Asset ClassMajor currencies: Dollar, Euro, Yen, British Pound,

Swiss Franc Average turnover is over US$ 4 trillion (daily)Forex derivatives accounts for 40% of ADTVMain trading centers are London, NY, Tokyo &

Singapore High volumes low margin game with extreme

Liquidity24 hours tradingRange of factor impacting exchange rates Participants

Introduction

Forex Market: 24 Hrs a day – 7 days a week

24 Hrs Market (IST)

INDIAN FOREX MARKET

OTC EXCHANGE TRADED

OPTIONS

SPOT

USEMCX-SX NSE

FUTURES

FORWARDS

SWAPS

Large banks Central BanksGovernmentMultinationals & Commercial CompaniesHedge FundsInstitutionsRetail Forex Brokers Speculators

Participants

Basic Definitions simplified

Tom: One business day after deal date (T+1)

Spot: Buying a different currency for immediate delivery (T+2)

Forward: Contract between counterparties to exchange currency on any day after spot (T+3 or later)

Base currency: In the forex market it is the first currency in any currency pair

Quote or Term Currency: In the Forex markets, is the second currency in any pair also called the ‘Pip’ currency.

Eg: USD/INR rate equals 62. (One dollar is worth CHF 1.1323)

Definations (continued)

Bid Price Price at which the market is prepared to buy a

specific currency pair in the Forex market and you can sell the base currency (on the left side of the quotation)

(eg: in the quote USD/INR 54.1525/1550, the bid price is 54.1525. One can sell one 1 USD for 54.1525 INR)

Ask (or offer)Price Price at which the market is prepared to sell a

specific currency pair in the Forex market and you can buy the base currency (on the right side of the quotation)

(eg: in the quote USD/INR 54.1525/1550, the ask price is 54.1550. One can buy one 1 USD for 54.1550 INR)

Basic Definitions simplified

Global Currency Composition

Daily Averages in billions of US dollar and per cent

%share

US dollar/euro

US dollar/yen

US dollar/sterling

US dollar/Australian dollar

US dollar/Swiss franc

US dollar/Canadian dollar

US dollar/Swedish Krona

US dollar/other

Euro/yen

Euro/sterling

Euro/Swiss franc

Euro/other

Other Currency pairs

All currency pairs

27

13

12

6

5

4

2

19

2

2

2

4

4

100

Market Turnover By Currency Pair

Factors Affecting USDINR

ExchangeRate

RBIIntervention

Performance ofEquity Market

PolicyDecisions

Performance ofOther AsianCurrencies

PoliticalFactors

CapitalFlows

FundamentalFactors

UncertainEvents

Interest RatesChange in interest rates by Reserve Bank of India Interest rates change by Federal Reserve (USA) Interest rates change by European Commercial BankExpectation of change in interest rates

Factors Affecting Currency Market

Interest rates are positively correlated with a strong currency When interest rates increase in a country, its currency strengthens

against other currencies

Inflows of Foreign FundsStrong economic fundamentals attract funds into the

countryPolitical stability and clear economic direction Country specific ratings based on economic indicatorsReverse is also true

Factors Affecting Currency Market

Foreign funds inflows are positively correlated with a strong currency When funds enter the country, they create a demand for the local

currency (read Rupee) resulting in the currency strengthening

2. Foreign Currency Derivatives

“Currency Derivatives’’

Swaps Options Forwards Futures

Debt, Forex , Stock & Commodity markets

• What are Derivatives?

• Markets?

What is traded on a Currency exchange?

In a Nut Shell: Manage Risk

• Transfer Risk• Price Discovery• Integration of Markets • Increase Savings in the long run• Speculative trading in a controlled environment

Why do we require Currency Derivatives?

Forwards: Customized contracts between two parties where settlement takes place on a pre determined negotiated date price in the future

Futures: Standardized agreement between two parties to buy or sell currency at a certain time in the future at a pre determined price.

Options: Calls & PutsOptions are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a

given quantity of the underlying asset, at a given price on or before a given future date.

Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given

Derivatives: Basic Definitions

Forward Vs. Futures

Forward Contracts OTCCounterparty riskTerms changeablePoor liquidityFew PlayersNo MarginsRelationshipSkill to Structure

Future Contracts• Exchange Traded• Exchange assumes risk• Terms defined by Exchange• High Liquidity• Many Players• Margins• Price Transparency• Standard Product

3. Exchange Traded Currency Futures

Futures contract is a standardized contract, to buy or sell a certain underlying asset or an instrument at a certain date in the future, at a predetermined price

Futures price: price at which a contract trades in the futures market

Currency futures are a linear product

Settlement date is the last business day of the month

Futures Terminology

Expiry date is the date specified in the contract and will be two business days prior to final settlement date

Contract Specifications are details on currency futures contracts as stipulated by RBI-SEBI standing technical committee report on exchange traded currency futures

Initial margin is the amount to be deposited in the margin account.

Mark- to-Market is the daily adjustment made to the margin account based of the futures closing price.

Futures Terminology

Contract Specification Snapshot

Underlying USD / INR

Trading Hours 9:00 AM to 5:00 PM

Size of Contract Minimum Lot Size is US$ 1,000

Price Quotation In INR (Tick Size – INR 0.0025)

Tenor of Contract Maximum of 12 Months

Available Contracts Monthly

Settlement Mechanism In INR

Settlement Reference Rate RBI USD/INR Reference Rate

Final Settlement Date2 days beforeLast working day of month, except Saturday.

Note: The above product specification is as per the RBI-SEBI Standing Technical Committee Report on Exchange Traded Currency Futures

Eliminates risk caused by fluctuation in exchange rates

Liquidity to the participant where an existing contract can be offset prior to maturity by entering into an equal and opposite transaction

Aids Business Planning Hedging using futures reduces volatility of returns Hedgers could be:-

Corporates, Producers, Intermediaries in Spot Markets, Merchandisers, Traders, Importers & Exporters etc.

Rationale behind Currency Futures

4. Strategies Using Futures

What is meant by Hedging?

Hedging means taking a position in the future market that is opposite to position in the physical market with a view to reduce risk associated with unpredictable price change

A long futures hedge is appropriate when you know you will buy an asset in the future and want to lock in the price

A short futures hedge is appropriate when you know you will sell an asset in the future & want to lock in the price

Types of Hedges

The profit (loss) in the cash position is offset by equivalent loss (profit) in the futures position

Appreciation and Depreciation of Currency

Event Importer Exporter

Appreciation of USD Loses Money Gains Money

Depreciation of INR Loses Money Gains Money

Event Importer Exporter

Depreciation of USD Gains Money Loses Money

Appreciation of INR Gains Money Loses Money

USDINR 45

USDINR 50

USDINR 40

USDINR 45

Scenario 1

Scenario 2

TransactionAn exporter who has executed an export order and money is

to be received on 31 Dec 13, say USD 500,000.

Spot USD/INR was as 54.20 when contract was executed.

RiskRupee will appreciate and export will realize USD 500,000 at

a rate lower than 54.20

Hedge StrategyShort (Sell) 500 contracts of each expiry 31 Dec 13.

Using Futures to Hedge Currency Risk

Payoff of Hedge vis-à-vis the transaction: Hypothetical Example

Spot is at 54.20 when the exporter buys future and

USDINR Dec futures at 54.80

Short (Sell) 500 USDINR futures contracts expiry Dec 2013.

On Expiry Date – 31st Dec

Spot on Expiry

P/L on Exchange P/L on Physical

54.50 (INR 1,50,000) INR 1,50,000

53.90 INR 1,50,000 (INR 1,50,000)

So if rupee moves either way corporate is hedged against currency fluctuation.

TransactionOn 1st April, 2013 a student enrolled for CMT-USA October

2013 test and he needs to make his payment of USD 1000 on 15th September, 2013.

Spot USD/INR was at 54.20 when he got enrolled.

RiskUSD may strengthen over next 6 months causing the

enrolment to cost more

Hedge StrategyLong (Buys)1 USDINR Futures contract

Using Futures to Hedge Currency Risk

On April 1, 2013, an Indian Copper Exporter enters into a contract to Export 1000 MT of Copper with payment to be received in US Dollar (USD) on July 1, 2013.

Hedger (Copper Exporter)

The price of copper has been fixed at USD 7200/MT at the prevailing exchange rate of 1 USD = INR 54.76

The Cost of One Tonne of copper in INR is Rs. 394272 (7200*54.76).

The exporter has a risk of Weakening USD over next three months having negative implication on his operating margins hence profitability and long-term sustainability……

COPPER EXPORTER

Is Long on USD 7200000 in the Spot marketShort (Sell) 7200 USDINR futures contracts

Buys USDINR futures contracts to square-off transaction

Sell USD to meet export requirement in the spot market

Time t1

Time t2

Hed

ge P

eri

od

If not hedged and INR weakens, the exporter makes a profit and when INR strengthen, he will make a loss.

Risk Management Process…using currency futures…

Hedger – Practical Implication

DateSpot Market Futures Market

USD-INR July USD Contract

1-April-13 54.76 54.95

1-July-13 58.53 58.72

Market Entry Date Market Price Exit Date Market Price Profit / Loss

Spot1-Apr-13

54.76 (L)1-Jul-13

58.53 (S) 27144000

Futures 54.95 (S) 58.72 (L) -27144000

The Loss in Futures Market is set off by Profit in Spot Market.

By Hedging, we have locked-in the price i.e. Selling price in spot market Rs. 306216000 + loss from Futures market Rs. (27144000) = Rs. 279072000

Price of Copper = Rs. 7200/MT

Exported Qty. = 1000 MTNo Basis Risk : Perfect Hedge situation exists

SPREADS

• What is a Spread?Difference in price of two futures contractsA spread involves buying one futures contract in one month and simultaneously selling another futures contract of a different month.

• Participants: Investors / Traders

• Objective:To earn profit from existing spread between near month futures contract and far month futures contract.

Interest Rate Differentials Liquidity in the banking system Monetary policy decisions Inflation

Intra-Currency Pair Spread Inter-Currency Pair Spread

Normal Market: When the price of the far month futures contract is higher than the near month one, then it is referred to as “normal market”.

Inverted Market: If the price of the far month futures contract is lower than the near month one, then it is referred to as “inverted market”.

What influences spreads?

Involves buying a contract on one exchange at one price and simultaneously selling an identical contract on another exchange at a higher price.

Inter-market arbitrage is possible only when there are price differences between two exchanges.

Arbitrage

Price difference between currency futures traded on different exchanges results in arbitrage positions

E.g. On 2 Feb 2009, following is the USDINR Oct futures contract prices

Exchange A USD/INR 49.0750Exchange B USD/INR 49.0275

Buy on Exchange B and simultaneously sell on Exchange A

Hold until maturity. Final settlement of both contracts at same price of RBI reference rate

Inter Market Arbitrage

5. Trading

Automated screen-based trading on TWS

National reach

Order driven trading system

Transparent, Objective and Fair system of order matching

Identity of the trader undisclosed

Daily Turnover limits for Buy and Sell for each User linked to deposit

Flexibility in placing orders

Complete Online Market Information

Square-off facility

Market Operations: Trading features

Tenors of Contracts: Period for which the contract is available for trading also called trading cycle of the contract

Final Settlement Rate: is the Reserve Bank Reference rate on the date of expiry.

Expiry Date: Contracts expire on last working day (except Saturday) of the contract month. The last day for the trading of the contract shall be two days prior to the final settlement

Terms

Day 1. Purchase: One contract of $1000 (Launch of new contract)

a) @ say 51.75 X1000 X (1.75%+1%) = Rs.1423.125 (margin blocked)

(Initial+ELM)

Day 2. Exchange rate weakens a) @ say 51.95 X 1000 X (1%+2.6%) = Rs.1870..200

(margin ) (ELM+SPAN)

= 447.075 (further margin blocked)

b) M2M = 51.95 - 51.75 X 1000 = Rs.200 Payout

Margin Calculation

Extreme Loss Margin is calculated at 1% on M2M value of Gross Open Position

7. Regulatory Framework

Acts

RBI-SEBI standing technical committee on exchange traded currency and interest rate derivatives Provides comprehensive guidelines on the usage of foreign

currency forwards, swaps and options in the OTC market Recommends the introduction of exchange traded currency

futures Constituted a technical committees on Exchange Traded

Currency and Interest Rate Derivatives

Foreign Exchange Management Act, 1999 - Provisions Provided different guidelines and notifications for Currency

Trading under RBI’s regulation in India.Provides the Currency Contract Specifications with limits

and regulations to be followed

The Foreign Exchange Management Act (FEMA) is a 1999 Indian law "to consolidate and amend the law relating to foreign exchange with the objective of facilitating external trade and payments and for promoting the orderly development and maintenance of foreign exchange market in India". It was passed in the winter session of Parliament in 1999, replacing the Foreign Exchange Regulation Act (FERA). This act seeks to make offenses related to foreign exchange civil offenses. It extends to the whole of India.,[1] replacing FERA, which had become incompatible with the pro-liberalisation policies of the Government of India. It enabled a new foreign exchange management regime consistent with the emerging framework of the World Trade Organisation (WTO). It is another matter that the enactment of FEMA also brought with it the Prevention of Money Laundering Act of 2002, which came into effect from 1 July 2005.

8. Accounting

Accounting in case of default Amount not paid is adjusted against margin (Debit m2m-currency

futures account and credit currency futures account) Losses on the contract will be recognised on the profit & loss

account.

Disclosure Requirements AS32

Taxation: Income or loss carried out on recognised exchanges is not

taxed as speculative income or loss. Thus loss can be set off against any other income during the year (or subsequent assessment year- can be carried fwd upto 8 years)

Accounting

Thank you