(pawan) currency derivatives part=2

7/29/2019 (Pawan) Currency Derivatives Part=2

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TABLE OF CONTENTS

CHAPTER NUMBER TOPIC PAGE NUMBER

CHAPTER NO.1 Introduction

CHAPTER NO.2 Objectives of the study

CHAPTER NO.3 Literature review & problem

formulation

i. History and Developmentof Currency Derivative

ii. Brief overview of foreignexchange market.

iii. Rationale for IntroducingCurrency Futures

CHAPTER NO.4 Research methodology

CHAPTER NO.5 Analysis & Interpretation

CHAPTER NO.6 Key findings

CHAPTER NO.7 Suggestion

CHAPTER NO.8 Limitation of the study

CHAPTER NO.9 Annexture

Bibliography


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INTRODUCTION

Each country has its own currency through which both national and international transactions are

performed. All the international business transactions involve an exchange of one currency for

another.

The foreign exchange markets of a country provide the mechanism of exchanging different currencies

with one and another, and thus, facilitating transfer of purchasing power from one country to

another .

With the multiple growths of international trade and finance all over the world, trading in

foreign currencies has grown tremendously over the past several decades.Since the exchange rates are continuously changing, so the firms are exposed to the risk of exchange

rate movements. As a result the assets or liability or cash flows of a firm which are denominated in

foreign currencies undergo a change in value over a period of time due to variation in exchange rates.

This variability in value of assets or liabilities or cash flows is referred to exchange rate risk.

Since the fixed exchange rate system has been fallen in the early

1970s, specifically in developed countries, the currency risk has become substantial for many

business fir ms that was the reason behind development of currency derivatives.

Each country has its own currency through which both national and international transactions areperformed. All the international business transactions involve an exchange of one currency for

another.

For example,

If any Indian firm borrows funds from international financial market in US dollars for short or long

term then at maturity the same would be refunded in particular agreed currency along with accrued

interest on borrowed money. It means that the borrowed foreign currency brought in the country will

be converted into Indian currency, and when borrowed fund are paid to the lender then the homecurrency will be converted into foreign lenders currency. Thus, the currency units of a country

involve an exchange of one currency for another. 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


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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.


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OBJECTIVES OF STUDY

The primary objective of the study is first to gain some practical knowledge regarding the functioning

of Currency Derivatives and how are they traded in the market. Also it is necessary to understand there

primary functions and knowledge about various future derivatives instruments.

The other objectives were:

To study the Importance of Currency Derivatives. To study the role of working of future and options market. To study the process and functions of Currency Derivatives .To explore the methodology and

types of Derivatives provided in India.

To study the purpose, process, principle, functions of the Currency Derivatives. To study the different types of methods/techniques used to evaluate them. To study the level of evaluations. know the challenges which are faced in present market scenario.


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Literature review and problem formulation

INTRODUCTION TO FINANCIAL DERIVATIVES

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.

Alan Greenspan, Former Chairman

US Federal Reserve Bank

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.

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 theprice 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 etc.

A very simple example of derivatives is curd, which is derivative of milk. The price of curddepends upon the price of milk which in turn depends upon the demand and supply of milk.

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


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Stock Index Value : NSE Nifty Currency : Exchange Rate

TYPES OF FINANCIAL DERIVATIVES

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 :


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DERIVATIVES

Financials Commodities

Basics Complex

1. Forwards 1. Swaps

2. Futures 2.Exotics (Non STD)

3. Options

4. Warrants and Convertibles

One form of classification of derivative instruments is between commodity derivatives and financialderivatives. 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, forwardcontracts, 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 Over The Counter

Commodity Futures Forward Contracts

Financial Futures Swaps

Options (stock and index)Stock Index Future


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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.

A major difference between the two is that ofcounterparty 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.

DERIVATIVES INTRODUCTION IN INDIA

The first step towards introduction of derivatives trading in India was the promulgation of theSecurities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in

securities. SEBI set up a 24member 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 inoptions 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.

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 marketplacefor FX trading. Traders of CME FX futures are a diverse group that includes multinational


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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.

Source: - (NCFM-Currency future Module)

UTILITY OF CURRENCY DERIVATIVES

Currency-based derivatives are used by exporters invoicing receivables in foreign currency, willing to

protect their earnings from the foreign currency depreciation by locking the currency conversion rateat a high level. Their use by importers hedging foreign currency payables is effective when the

payment currency is expected to appreciate and the importers would like to guarantee a lower

conversion rate. Investors in foreign currency denominated securities would like to secure strong

foreign earnings by obtaining the right to sell foreign currency at a high conversion rate, thus

defending their revenue from the foreign currency depreciation. Multinational companies use currency

derivatives being engaged in direct investment overseas. They want to guarantee the rate of purchasing

foreign currency for various payments related to the installation of a foreign branch or subsidiary, or to

a joint venture with a foreign partner.

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 futurecurrency conversion rate at a high level. A similar foreign currency forward selling contract is


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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,

If any Indian firm borrows funds from international financial market in US dollars for

short or long term then at maturity the same would be refunded in particular agreed currency along

with accrued interest on borrowed money. It means that the borrowed foreign currency brought in

the country will be converted into Indian currency, and when borrowed fund are paid to the lender

then the home currency will be converted into foreign lenders currency. Thus, the currency units

of a country involve an exchange of one currency for another.

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 currenciesundergo a change in value over a period of time due to variation in exchange rates.


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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.

INTRODUCTION TO CURRENCY FUTURE

A futures contract is a standardized contract, traded on an exchange, to buy or sell a certain

underlying asset or an instrument at a certain date in the future, at a specified price. When the

underlying asset is a commodity, e.g. Oil or Wheat, the contract is termed a commodity futures

contract

. When the underlying is an exchange rate, the contract is termed a

currency futurescontract

. In other words, it is a contract to exchange one currency for another currency at a

specified date and a specified rate in the future.

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 sellerand 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.


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Purchase price: Rs .42.2500

Price increases by one tick: +Rs. 00.0025

New price: Rs .42.2525

Purchase price: Rs .42.2500Price decreases by one tick: Rs. 00.0025

New price: Rs.42. 2475

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: 42.260042.2500

Step 2: 4 ticks * 5 contracts = 20 pointsStep 3: 20 points * Rupees 2.5 per tick = Rupees 50

BRIEF OVERVIEW OF FOREIGN EXCHANGE MARKET

OVERVIEW OF THE FOREIGN EXCHANGE MARKET IN INDIA

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 theOTC market. At the same time, RBI also set up an Internal Working Group to explore the advantages


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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.

Subsequently, RBI and SEBI jointly constituted a Standing Technical Committee to analyze the

Currency Forward and Future market around the world and lay down the guidelines to introduce

Exchange Traded Currency Futures in the Indian market. The Committee submitted itsreporton May

29, 2008. FurtherRBIandSEBIalso issued circulars in this regard on August 06, 2008.

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
http://www.bseindia.com/deri/Downloads/CDX/rbirep_290508.pdfhttp://www.bseindia.com/deri/Downloads/CDX/rbirep_290508.pdfhttp://www.bseindia.com/deri/Downloads/CDX/rbirep_290508.pdfhttp://www.bseindia.com/deri/Downloads/CDX/rbi_circular060808.pdfhttp://www.bseindia.com/deri/Downloads/CDX/rbi_circular060808.pdfhttp://www.bseindia.com/deri/Downloads/CDX/rbi_circular060808.pdfhttp://www.bseindia.com/deri/Downloads/CDX/sebi_060808.pdfhttp://www.bseindia.com/deri/Downloads/CDX/sebi_060808.pdfhttp://www.bseindia.com/deri/Downloads/CDX/sebi_060808.pdfhttp://www.bseindia.com/deri/Downloads/CDX/sebi_060808.pdfhttp://www.bseindia.com/deri/Downloads/CDX/rbi_circular060808.pdfhttp://www.bseindia.com/deri/Downloads/CDX/rbirep_290508.pdf


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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.

A forward contract is customized contract between two entities, where settlement takes place

on a specific date in the future at todays pre-agreed price. The exchange rate is fixed at the

time the contract is entered into. This is known as forward exchange rate or simply forward

rate.

FUTURE :A currency futures contract provides a simultaneous right and obligation to buy and sell a

particular currency at a specified future date, a specified price and a standard quantity. In

another word, a future contract is an agreement between two parties to buy or sell an asset at a

certain time in the future at a certain price. Future contracts are special types of forward

contracts in the sense that they are standardized exchange-traded contracts.

SWAP :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.

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 :


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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 warrantsand are generally traded OTC.

FOREIGN EXCHANGE SPOT (CASH) MARKET

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.

It consists of a network of foreign dealers which are oftenly banks, financial institutions, largeconcerns, etc. The large banks usually make markets in different currencies.

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.


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FOREIGN EXCHANGE QUOTATIONS

Foreign exchange quotations can be confusing because currencies are quoted in terms of other

currencies. It means exchange rate is relative price.

For example,

If one US dollar is worth of Rs. 45 in Indian rupees then it implies that 45 Indian rupees will buy

one dollar of USA, or that one rupee is worth of 0.022 US dollar which is simply reciprocal of the

former dollar exchange rate.

EXCHANGE RATE

Direct Indirect

The number of units of domestic The number of unit of foreignCurrency stated against one unit currency per unit of domestic

of foreign currency. currency.

Re/$ = 45.7250 ( or ) Re 1 = $ 0.02187

$1 = Rs. 45.7250

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,


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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.

Base Currency/ Terms Currency:

In foreign exchange markets, the base currency is the first currency in a currency pair. The secondcurrency 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--vis the second currency.

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 DollarRupee 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.

NEED FOR EXCHANGE TRADED CURRENCY FUTURES


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 RBIsubmitted in April 2008, recommended the introduction of exchange traded currency futures .


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Exchange traded futures as compared to OTC forwards serve the same economicpurpose, yet differ

in fundamental ways. An individual entering into a forwardcontract agrees to transact at a forward

price on a future date. On the maturitydate, the obligation of the individual equals the forward price

at which thecontract was executed. Except on the maturity date, no money changes hands. Onthe

other hand, in the case of an exchange traded futures contract, mark to marketobligations is settled

on a daily basis. Since the profits or losses in the futuresmarket are collected / paid on a daily basis,

the scope for building up of mark tomarket losses in the books of various participants gets limited.

The counterparty risk in a futures contract is further eliminated by the presence of a clearing

corporation, which by assuming counterparty guarantee eliminates credit risk.

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.

RATIONALE FOR INTRODUCING CURRENCY FUTURE

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.

The standardized items in a futures contract are:

Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change


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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 withor without drift, while real exchange rates over long run are mean reverting. As such, it is possible that

over a longrun, 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.


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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.

VALUE DATE / FINAL SETTELMENT DATE :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).


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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 isknown 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)


22/45

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 amargin call and is expected to top up the margin account to the initial margin level before

trading commences on the next day.

USES OF CURRENCY FUTURES

Hedging: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 atRs.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


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(Rs.44,000 + Rs.250)/1000, while spot rate on that date was Rs.44.0000. The entity was able

to hedge its exposure.

Speculation: Bullish, buy futuresTake the case of a speculator who has a view on the direction of the market. He would like to

trade based on this view. He expects that the USD-INR rate presently at Rs.42, is to go up in

the next two-three months. How can he trade based on this belief? In case he can buy dollars

and hold it, by investing the necessary capital, he can profit if say the Rupee depreciates to

Rs.42.50. Assuming he buys USD 10000, it would require an investment of Rs.4,20,000. If

the exchange rate moves as he expected in the next three months, then he shall make a profit

of around Rs.10000. This works out to an annual return of around 4.76%. It may please be

noted that the cost of funds invested is not considered in computing this return.

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

Futures can be used by a speculator who believes that an underlying is over-valued and is likely

to see a fall in price. How can he trade based on his opinion? In the absence of a deferral

product, there wasn 't much he could do to profit from his opinion. Today all he needs to do is

sell the 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:


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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 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 riskless profit.

TRADING PROCESS AND SETTLEMENT PROCESS

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:


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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


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 Committeewas as under:

TRADER

( BUYER )

TRADER

( SELLER )

MEMBER

( BROKER )

MEMBER

( BROKER )

CLEARING

HOUSE

Purchase order Sales order

Transaction on the floor (Exchange)

Informs


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1. To coordinate the regulatory roles of RBI and SEBI in regard to trading of Currency andInterest Rate Futures on the Exchanges.

2. To suggest the eligibility norms for existing and new Exchanges for Currency and Interest RateFutures 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.

COMPARISION OF FORWARD AND FUTURES

CURRENCY CONTRACT

BASIS FORWARD FUTURES

Size Structured as per requirement

of the parties

Standardized

Delivery

date

Tailored on individual needs Standardized

Method of

transaction

Established by the bank or

broker through electronic

media

Open auction among buyers and seller on the

floor of recognized exchange.

Participants Banks, brokers, forex dealers,

multinational companies,

institutional investors,

arbitrageurs, traders, etc.

Banks, brokers, multinational companies,

institutional investors, small traders,

speculators, arbitrageurs, etc.

Margins None as such, but

compensating bank balanced

may be required

Margin deposit required

Maturity Tailored to needs: from one

week to 10 years

Standardized

Settlement Actual delivery or offset with

cash settlement. No separate

clearing house

Daily settlement to the market and variation

margin requirements

Market

place

Over the telephone worldwide

and computer networks

At recognized exchange floor with worldwide

communications


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Accessibility Limited to large customers

banks, institutions, etc.

Open to any one who is in need of hedging

facilities or has risk capital to speculate

Delivery More than 90 percent settled

by actual delivery

Actual delivery has very less even below one

percent

Secured Risk is high being less secured Highly secured through margin deposit.

RESEARCH METHODOLOGY:

TYPE OF RESEARCHIn 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.

SOURCE OF DATA COLLECTION


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Secondary data were used such as various books, report submitted by RBI/SEBI

committee and NCFM/BCFM modules.

OBJECTIVES OF THE STUDYThe basic idea behind undertaking Currency Derivatives project 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 practical considerations and ways of considering currency future price.

To analyze different currency derivatives products.

SCOPE OF PROPOSED STUDY:

Currency-based derivatives are used by exporters invoicing receivables in foreign currency, willing to

protect their earnings from the foreign currency depreciation by locking the currency conversion rate

at a high level. Their use by importers hedging foreign currency payables is effective when the

payment currency is expected to appreciate and the importers would like to guarantee a lowerconversion rate. Investors in foreign currency denominated securities would like to secure strong

foreign earnings by obtaining the right to sell foreign currency at a high conversion rate, thus

defending their revenue from the foreign currency depreciation. Multinational companies use currency

derivatives being engaged in direct investment overseas. They want to guarantee the rate of purchasing

foreign currency for various payments related to the installation of a foreign branch or subsidiary, or to

a joint venture with a foreign partner.

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 theirpurchasers are mostly large business firms and investment institutions, although the banks may require


29/45

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.

DATA COLLECTION

Data collection is a term used to describe a process of preparing and

collecting business data - for example as part of a process improvement or

similar project. Data collection usually takes place early on in an improvement

project, and is often formalized through a data collection Plan which often

contains the following activity.

1. Pre collection activityAgree goals, target data, definitions, methods

2. Collectiondata collection

3. Present Findingsusually involves some form of sorting analysis and/or presentation

There are two methods of data collection which are discussed below:

DATA COLLECTION


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Primary Data Secondary Data

(Data collection techniques)

Questionnaire Interview External Internet Intrenal

Source source

PRIMARY DATA

In primary data collection, you collect the data yourself using methods such as

interviews and questionnaires. The key point here is that the data you collect is

unique to you and your research and, until you publish, no one else has access

to it.

I have tried to collect the data using methods such as interviews and

questionnaires. The key point here is that the data collected is unique and

research and, no one else has access to it. It is done to get the real scenario and

to get the original data of present.

DATA COLLECTION TECHNIQUE

Questionnaire:

Questionnaire are a popular means of collecting data, but are difficult to design and often require many

rewrites before an acceptable questionnaire is produced. The features included in questionnaire are:

Theme and covering letter Instruction for completion


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Types of questions Length

Interview:

This technique is primarily used to gain an understanding of the underlying

reasons and motivations for peoples attitudes, preferences or behavior. The

interview was done by asking a general question. I encourage the respondent to

talk freely. I have used an unstructured format, the subsequent direction of the

interview being determined by the respondents initial reply, and come to know

what is its initial problem is.

SAMPLING METHODOLOGY

Sampling technique:

Initially, a rough draft was prepared keeping in mind the objective of the

research. A pilot study was done in order to know the accuracy of the

questionnaire. The final questionnaire was arrived only after certain important

changes were done. Thus my sampling came out to be judgmental and

continent.


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Sampling Unit:

The respondents who were asked to fill out questionnaires are the sampling

units.

Sampling Size: 20

SECONDARY DATA

All methods of data collection can supply quantitative data (numbers, statistics

or financial) or qualitative data (usually words or text). Quantitative data may

often be presented in tabular or graphical form. Secondary data is data that has

already been collected by someone else for a different purpose to yours.

Need of using secondary data

1. Data is of use in the collection of primary data.

2. They are one of the cheapest and easiest means of access to information.

3. Secondary data may actually provided enough information to resolve the

Problem being investigated.

4. Secondary data can be a valuable source of new ideas that can be explored later through primary

research.

Limitation of secondary data

1. May be outdated.

2. No control over data collection.

3. May not be reported in the required form.


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4. May not be reported in the required form.

5. May not be very accurate.

6. Collection for some other purpose.

ANALYSIS

INTEREST RATE PARITY PRINCIPLE

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 isa 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;

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.


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PRODUCT DEFINITIONS OF CURRENCY FUTURE ON NSE/BSE

Underlying

Initially, currency futures contracts on US DollarIndian Rupee (US$-INR) would be

permitted.

Trading Hours

The trading on currency futures would be available from 9 a.m. to 5 p.m.

Size of the contract

The minimum contract size of the currency futures contract at the time of introduction

would be US$ 1000. The contract size would be periodically aligned to ensure that the size

of the contract remains close to the minimum size.

Quotation

The currency futures contract would be quoted in rupee terms. However, the outstanding

positions would be in dollar terms.

Tenor of the contract

The currency futures contract shall have a maximum maturity of 12 months.

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.

Final settlement day

The currency futures contract would expire on the last working day (excluding Saturdays) of

the month. The last working day would be taken to be the same as that for Interbank

Settlements in Mumbai. The rules for Interbank Settlements, including those for known

holidays and subsequently declared holiday would be those as laid down by FEDAI.


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35

The contract specification in a tabular form is as under:

Underlying Rate of exchange between one USD and

INR

Trading Hours(Monday to Friday)

09:00 a.m. to 05:00 p.m.

Contract Size USD 1000

Tick Size 0.25 paisa or INR 0.0025

Trading Period Maximum expiration period of 12 months

Contract Months 12 near calendar months

Final Settlement date/

Value date

Last working day of the month (subject to

Holiday calendars)

Last Trading Day Two working days prior to Final SettlementDate

Settlement Cash settled

Final Settlement Price The reference rate fixed by RBI two

working days prior to the final settlement

date will be used for final settlement

CURRENCY FUTURES PAYOFFS

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.

Payoff for buyer of futures: Long futures

The payoff for a person who buys a futures contract is similar to the payoff for a person who

holds an asset. He has a potentially unlimited upside as well as a potentially unlimited


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36

downside. Take the case of a speculator who buys 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 up, i.e. when Rupee depreciates, the long futures

position starts making profits, and when the dollar depreciates, i.e. when rupee appreciates,

it starts making losses. Figure 4.1 shows the payoff diagram for the buyer of a futures

contract.

Payoff for buyer of future:

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.

PROFIT

LOSS

USD

0

43.19


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37

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.

Payoff for seller of future:

The figure shows the profits/losses for a short futures position. The investor sold futureswhen the USD was at 43.19. If the price goes down, his futures position starts making

profit. If the price rises, his futures position starts showing losses

PROF

IT

LOSS

USD

0

43.19


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38

PRICING FUTURES COST OF CARRY MODEL

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 yearsE=2.71828

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 beF= 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.

HEDGING WITH CURENCY FUTURES

Exchange rates are quite volatile and unpredictable, it is possible that anticipated profit in

foreign investment may be eliminated, rather even may incur loss. Thus, in order to hedge

this foreign currency risk, the traders oftenly use the currency futures. For example, a long

hedge (I.e.., buying currency futures contracts) will protect against a rise in a foreign

currency value whereas a short hedge (i.e., selling currency futures contracts) will protect

against a decline in a foreign currencys value.


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39

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 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

The choice of underlying currencyThe first important decision in this respect is deciding the currency in which futures

contracts are to be initiated. For example, an Indian manufacturer wants to purchase some

raw materials from Germany then he would like future in German mark since his exposure

in straight forward in mark against home currency (Indian rupee). Assume that there is no

such future (between rupee and mark) available in the market then the trader would choose

among other currencies for the hedging in futures. Which contract should he choose?

Probably he has only one option rupee with dollar. This is called cross hedge.

Choice of the maturity of the contract

The second important decision in hedging through currency futures is selecting the currency

which matures nearest to the need of that currency. For example, suppose Indian importerimport raw material of 100000 USD on 1st November 2008. And he will have to pay 100000

USD on 1st February 2009. And he predicts that the value of USD will increase against

Indian rupees nearest to due date of that payment. Importer predicts that the value of USD

will increase more than 51.0000.

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

Order Book

ContractBest

Buy Qty

Best

Buy Price

Best

Sell Price

Best

Sell QtyLTP Volume

Open

Interest

USDINR 261108 464 49.8550 49.8575 712 49.8550 58506 43785

USDINR 291208 189 49.6925 49.7000 612 49.7300 176453 111830
http://www.nseindia.com/marketinfo/fxTracker/fxTracker.jsp?filetype=4&HistDate=25112008http://www.nseindia.com/marketinfo/fxTracker/fxTracker.jsp?filetype=4&HistDate=25112008http://www.nseindia.com/marketinfo/fxTracker/fxTracker.jsp?filetype=4&HistDate=25112008http://www.nseindia.com/marketinfo/fxTracker/fxTracker.jsp?filetype=4&HistDate=25112008http://www.nseindia.com/marketinfo/fxTracker/fxTracker.jsp?filetype=4&HistDate=25112008http://www.nseindia.com/marketinfo/fxTracker/fxTracker.jsp?filetype=4&HistDate=25112008


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40

USDINR 280109 1 49.8850 49.9250 2 49.9450 5598 16809

USDINR 250209 100 50.1000 50.2275 1 50.1925 3771 6367

USDINR 270309 100 49.9225 50.5000 5 49.9125 311 892

USDINR 280409 1 50.0000 51.0000 5 50.5000 - 278

USDINR 270509 - - 51.0000 5 47.1000 - 506

USDINR 260609 25 49.0000 - - 50.0000 - 116

USDINR 290709 1 48.0875 - - 49.1500 - 44

USDINR 270809 2 48.1625 50.5000 1 50.3000 6 2215

USDINR 280909 1 48.2375 - - 51.2000 - 79

USDINR 281009 1 48.3100 53.1900 2 50.9900 - 2

USDINR 261109 1 48.3825 - - 50.9275 - -

Volume As On 26-NOV-2008 17:00:00 Hours

IST

No. of Contracts

244645

Archives

As On 26-Nov-2008 12:00:00 Hours IST

Underlying RBI reference rate

USDINR 49.8500

Rules, Byelaws & Regulations

Membership

Circulars

List of Holidays

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.
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Choice of the number of contracts (hedging ratio)

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, VFis the value of the futures position and Vc is the value of the cash position.

Suppose value of contract dated 28

th

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 outstandard 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 higherauthority 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


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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 evenexchange traded currency future is available in markets because,

There is a limit of USD 100 million on open interest applicable to trading memberwho 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 Currencyfuture, at this time if any person wants to use other instrument of currency

derivatives in this case he has to use OTC.

SUGGESTIONS

Currency Future need to change some restriction it imposed such as cut off limitof 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 isavailable 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 theredemand 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.


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In India the regulatory of Financial and Securities market (SEBI) has Ban onother 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.

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 futurecontract 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.

LIMITATION OF THE STUDY


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The limitations of the study were

The analysis was purely based on the secondary data. So, any error in the secondarydata might also affect the study undertaken.

The currency future is new concept and topic related book was not available inlibrary and market.

The study is based only on secondary & primary data so lack of keen observations and interactions were also the limiting factors in the proper conclusion

of the study


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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)

Websites:www.sebi.gov.in

www.rbi.org.in

www.frost.com

www.wikipedia.com

www.economywatch.com

www.bseindia.com

www.nseindia.com
http://www.sebi.gov.in/http://www.sebi.gov.in/http://www.rbi.org.in/http://www.rbi.org.in/http://www.frost.com/http://www.frost.com/http://www.wikipedia.com/http://www.wikipedia.com/http://www.economywatch.com/http://www.economywatch.com/http://www.bseindia.com/http://www.bseindia.com/http://www.nseindia.com/http://www.nseindia.com/http://www.nseindia.com/http://www.bseindia.com/http://www.economywatch.com/http://www.wikipedia.com/http://www.frost.com/http://www.rbi.org.in/http://www.sebi.gov.in/

(pawan) currency derivatives part=2

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