Currency Derivatives at Religare

8/12/2019 Currency Derivatives at Religare

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CHAPTER

No.

CONTENTS P No.1 INTRODUCTION

Introduction to currency derivatives

Objectives

Scope

Research Methodology

Source of Data

Limitation

Hypothesis

2

2 Review of Literature 14

3 Company Profile 18

4 Theoretical Framework 27

5 Brief Overview of Foreign Exchange Market 39

6 Analysis 54

7 Finding, Suggestions and conclusions 75

8 Bibliography 79


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Chapter 1


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INTRODUCTION OF CURRENCY DERIVATIVES

The current currency rate mechanism has evolved over thousands of years of the

world community trying with various mechanism of facilitating the trade of goods and

services. Initially, the trading of goods and services was by barter system where in goods

were exchanged for each other. For example, a farmer would exchange wheat grown on his

farmland with cotton with another farmer. Such system had its difficulties primarily because

of non-divisibility of certain goods, cost in transporting such goods for trading and difficulty

in valuing of services. For example, how does a dairy farmer exchange his cattle for few liters

of edible oil or one kilogram of salt? The farmer has no way to divide the cattle! Similarly,

suppose wheat is grown in one part of a country and sugar isgrown in another part of the

country, the farmer has to travel long distances every time he has to exchange wheat for

sugar. Therefore the need to have a common medium of exchange resulted in the innovationof money

With time, countries started trading across borders as they realized that everything

cannot be produced in each country or cost of production of certain goods is cheaper in

certain countries than others. The growth in international trade resulted in evolution of

foreign exchange (FX) i.e., value of one currency of one country versus value of currency of

other country. Each country has its own brand alongside its flag. When money is branded it

is called currency. Whenever there is a cross-border trade, there is need to exchange one


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brand of money for another, and this exchange of two currencies is called foreign exchange

or simply forex (FX).

The introduction of currency derivatives in India is a landmark decision which is

likely to be a boon for importers, exporters and companies with foreign exchange exposure.

These derivative products have a wide range with their special features suiting to the needs

and requirements of the individuals. As currency derivative is new to India, it is time to have

a broad understanding of them which are mostly couched in jargons and technical terms.

Thus the very subject raises a kind of aversion for the common people. The currency

derivatives are contracts just like any other derivatives viz., Stock, Index etc. Unlike the

stock, the underlying in this case is currencies. The value of the currencies determine the

values of the currency derivatives.

As it is universally accepted that market risks are ones which can not eliminated in

absolute terms. But their management is perfectly possible. The currency derivatives are

efficient tools for management of risks in money and forex markets. The need to protect the

exposure against unforeseen and unpredictable movement in currency and interest rates has

led to the emergence of these kinds of derivatives. Thus external borrowings or receivables or

payments in foreign currencies come within the purview of management under it .As we all

know the exporters and importers incur huge obligations in terms of foreign currencies and

they can guard their interest by buying appropriate product

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 exchangerates.


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OBJECTIVES OF THE STUDY:-

The 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 THE STUDY:-

Globalization of the financial market has led to a manifold increase in investment.

New markets have been opened; new instruments have been developed; and new services

have been launched. Besides, a number of opportunities and challenges have also been

thrown open.


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Online currency trading is new as compared to equity market in India. Mainly three

exchanges are involved in online commodities trading MCX, NSE and ise-india. Hence, the

scope of Currency market is very wide in the market.

RESEARCH METHODOLOGY-

In this project Descriptive research methodologies were use.

The research methodology adopted for carrying out the study was at the

first stage theoretical study is attempted and at the second stage observed online trading on

NSE/BSE.

SOURCE OF DATA COLLECTION:-

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

RBI/SEBI committee and NCFM/BCFM modules.

LIMITATION OF THE STUDY:-

The analysis was purely based on the secondary data. So, any error in the

secondary data might also affect the study undertaken.

The currency future is new concept and topic related book was not available in

library and market.

HYPOTHESIS:-

It has been said in the past that derivatives are k indof a side show, where the

main event takes place in the money and capital markets. One could attend the side show

without taking part in the main event and vice- versa. With respect to derivative and

money/capital markets, that is simply not true todey. Derivatives are so widely used that even

if one has no intension of using them, it is important to understand how they are used by

others and what effects, positive and negative; they could have on money and capital


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markets.

..Peter L. Bernstien

The futures market holds a great importance in the economy and, therefore, it becomes

imperative that we analyse this important market and seek answers to a few basic questions.

The main theme of the study is to assess the progress of the currency futures in India with a

compact view over the volatility of the currency futures. In order to study the growth of the

currency futures, the number of contracts traded and open interest at NSE and MCX have

been inclusively compared. A correlation between the two was calculated and the result

depicted that they have a significant relationship with a correlation cofficient of 0.83 in case

of NSE. A plot of that correlation is shown in Figure 1.

Attempt has also been made to check whether the daily returns of the NSE and MCX

on currency futures are normally distributed and the data have been used for the

Kolmogorov- Smirnov Test to test the hypothesis that the returns are normally distributed.

Kolmogorov- Smirnov Test is a non-parametric test and it is used to determine whether the

distribution is homogeneous. With the measure of skewness and kurtosis it has been found

that the returns are normally distributed and, thus, the null hypothesis is accepted.

The hypothesis tested in the study is as follows:

H0: The returns of the currency futures are normally distributed.

H1: The returns of the currency futures are not normally distributed

FIGURE 1: PLOTTED GRAPH OF CORRELATION BETWEEN OPEN INTEREST

AND CONTRACTS TRADED AT NSE:-


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III.QUANTITATIVE ANALYSIS :-

The growth of the currency futures in India has been assessed by measuring the growth in

two variables which are open interestand contracts traded. A correlation between the two

was calculated and the result depicted that they have a significant relationship with a

correlation cofficient of 0.83 in case of NSE

TABLE 2: CORRELATION BETWEEN OPEN INTEREST AND CONTRACTS

TRADED IN NSE:-

Linear Correlation

Number of points = 320

Correlation coefficient (r) = 0.8324

95% confidence interval: 0.7953 to 0.863

Coefficient of determination (r squared) = 0.6928

Test: Is r significantly different than zero?

The two-tailed P value is < 0.0001, considered extremely significant.

The growth of the open interest and contracts traded are explained below

Open interestis the total number of outstanding contracts that are held by the market

Participants at the end of the day. It is also considered as the number of futures contracts that

have not yet been exercised, expired or fulfilled by delivery. It is often used to confirm the

trends and trends reversals for futures markets. It measures the flow of money into the futures

market. A seller and a buyer forms one contract and hence in order to determine the total

open interest in the market we need to know either the total of buyers or the sellers and not


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the sum of both. the open interest position that is reported each day represents the increase or

decrease in the number of contracts for that day. An increasing open interest means that the

new money is flowing in the market .Marketplace and the present trend will continue. If the

open interest is declining it implies that the market is liquidating and the prevailing price

trend is coming to an end. The leveling off of open interest following a sustained price

advance is often an early warning of the end to an up trending or bull market. The

interpretations which can made on the basis of the open interest may be shown with the help

of the following table

Price Open Interest Interpretation

Rising Rising Market is Strong

Rising Falling Market is weakening

Falling Rising Market is Weak

Falling Falling Market is Strengthening

I. Figure 2 shows the daily movement in the open interest of currency futures in both NSE

and MCX. It depicts that the open interest in both NSE and MCX have been increasing with a

steady speed since the currency futures are been traded. The open interest in the NSE was

406200 on 31st Dec. 2009 as compared to 16332 on 28th Aug. 2008 and that on MCX it was

425451 on 31stDec. 2009 as compared to 17331 on 7th Oct. 2008. It can be seen that in terms

of the open interest, the growth of the MCX is more as compared to the NSE .

FIGURE 2

The trend as depicted by figure 1 it is found that the growth of open interest in both

NSE and MCX was down during March 2009 to August 2009 which is the indicator that it


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was affected by the global recession experienced by the Indian economy. Figure 3, which

shows the open interest at the end of each month, also depicts that there was a fall in the open

Interest during the period of January-July 2009. Hence, it can be said that this slackening in

trade was due to the global recession. However, the market has recovered itself and a good

growth is being experienced

FIGURE 3

II. CONTRACTS TRADED:-

The number of contracts traded on a stock exchange shows the total volume of contracts

traded. An increase in the number of contracts traded on an stock exchange expresses the

growth of trade in that particular stock exchange for a particular currency future. The number

contracts traded in the NSE increased to 1444150 contracts on 31st Dec. 2009 from 65798

contracts on 28th Aug. 2008, and from 59952 contracts on 7th Oct. 2008 to 1556411

contracts on 31st Dec. 2009 in the MCX. Figure 4 clearly depicts the growing trend in the

daily volumes traded in both NSE and MCX. It can also be noticed over here that the number

of contracts traded in MCX have been more than that traded in the NSE.


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FIGURE 4

III. MONTHLY TURNOVER

The monthly turnover of both the stock exchanges (NSE and MCX) have also

experienced an upward trend in the year 2009 with a total of Rs. 48395 crore in Jan. 2009 and

Rs. 319195 crore in Nov. 2009. Figure 5 depicts the clear picture of the currently moving

trend in both the stock exchanges. This too says that the currency futures trading at MCX is

growing faster than that at NSE.

NORMALITY IN THE DAILY CHANGES IN VALUE OF RUPEE

The distribution of the changes in the value of Rupee is not symmetric as the skewness is not

mzero in any case. Presence of positive skewness in Dec. 2008, Feb. 2009, Mar. 2009, Apr.

2009, June 2009, July 2009, Aug. 2009, Sept. 2009, Nov. 2009 and Dec. 2009 means that the

distribution has a right tail and the negative skewness in rest of the months means that the

distribution has a left tail. In case of kurtosis, it can be concluded that the distribution was

normal only during May 2009 and during the rest of the period it was not normally

distributed. A detailed statistic is given in the Table 1.


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TABLE 1: DESCRIPTIVE STATISTICS OF DAILY CHANGES IN THE VALUE OF

RUPEE (MONTH-WISE)

Period No. of Obs. Mean S.D. Min Max Skewness Kurtosis

Sept. 08 20 0.1575 0.3774 -0.92 0.69 -1.28 2.32Oct. 08 15 0.1433 0.4404 -0.58 0.73 -0.2846 -1.18

Nov. 08 17 0.0518 0.6189 -1.44 1.22 -0.3942 1.04

Dec. 08 20 -0.082 0.5413 -1.1 1.1 0.4118 0.24

Jan. 09 19 0.0153 0.2841 -0.52 0.43 -0.2313 -1.15

Feb. 09 16 0.105 0.2712 -0.21 0.69 1.0553 0.14

Mar. 09 18 -0.0444 0.3574 -0.63 0.54 0.008 -0.17

Apr. 09 15 -0.0053 0.3327 -0.62 0.53 0.0068 -0.67

May. 09 19 -0.1258 0.4296 -1.38 0.49 -1.2914 3.04

Jun. 09 21 0.042 0.2734 -0.38 0.53 0.0373 -0.82

Jul. 09 22 0.0032 0.2793 -0.56 0.71 0.464 0.91

Aug. 09 19 0.0532 0.2055 -0.33 0.41 0.0656 -0.37

Sept. 09 18 -0.0383 0.185 -0.39 0.33 0.2875 -0.38

Oct. 09 17 -0.0394 0.3477 -0.56 0.4 -0.1591 -1.71

Nov. 09 19 -0.0295 0.2227 -0.41 0.54 0.4711 1.15

Dec. 09 20 0.0115 0.1108 -0.2 0.23 0.0388 -0.06

Contrary to the statistical results based on skewness and kurtosis, the Kolmogorov-Smirnov

test says that the distribution is normal in every case. The detailed results are given in the

Table 2

Dec

. 09

Nov.

09

Oct.

09

Sep

t.

09

Aug.

09

Jul.

09

Jun.

09

M

ay

09

Ap

r.0

9

Mar

. 09

Feb

. 09

Ja

n.

09

De

c.

08

No

v.

08

Oc

t.

08

Sep

t.

08

N 20 19 17 18 19 22 21 19 15 18 16 19 20 17 15 20

Normal

mean

Parameters

a,,b

.011

5

-

.0295

-.0394 -

.038

3

.0532 .003

2

.041

9

-

.12

58

-

.00

53

-

.044

4

.105

0

.01

53

-

.08

20

.051

8

.14

33

.157

5

Std.Deviation

.11080

.22270

.34773 .18497

.20548

.27929

.27336

.42964

.33273

.35741

.27124

.28408

.54129

.61891

.44042

.37741


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Most

Extreme

Differences

Absolute

.111 .133 .184 .186 .108 .112 .133 .17

6

.11

2

.106 .213 .13

3

.17

6

.132

.14

2

.163

Positive .111 .133 .159 .186 .108 .112 .133 .08

7

.11

2

.106 .213 .13

3

.17

6

.122

.10

4

.093

Negative -.089 -.130

.184

-.121 -.076 -

.071

-

.130

-

.17

6

-

.09

4

-

.088

-

.123

-

.12

1

-

.07

2

-

.132

-

.14

2

-

.163

Kolmogoro

v-Smirnov

Z

.494 .578 .758 .790 .472 .527 .608 .76

8

.43

6

.451 .853 .58

2

.78

9

.544

.55

2

.730

a. Test distribution is Normal.

b. Calculated from data

CONCLUSIONS AND SUGGESTIONS

The Indian currency futures market has experienced an impressive growth since its

introduction. The upward trend of the volumes and open interest for currency futures in both

NSE and MCX explains the whole story in detail. The growth was only the reason for the

introduction of three other currency futures in January this year. In the coming future it is

expected that the market participants will find some more currency futures introduced into

the market. Currently on 26 th March, 2010 the SEBI allowed the United Stock Exchange of

India to launch currency futures. It became the fourth currency future exchange after NSE,

BSE a nd MCX. The two exchanges (NSE and MCX) are currently clocking an average dailyturnover of over Rs 20,000 crore in currency products while it was just Rs 2,400 crore in

January last year. It can be thus concluded that the currency futures market will get more

success in the coming future and the economy and the risk hedgers will definitely be

benefited from this trade. The correlation test also explained that the relationship between the

open interest and traded volumes is very much significant and that the change in the value of

currency is normally distributed thus illustrating that the risk is minimum in the currency

futures contracts. The risk involved is comparatively low in this case and currency futures has

proved to be a good tool for hedging the risk involved in the currency of a country (currency


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risk). It is hoped that the currency futures market will develop faster and it will be a good

choice for all the market participants in the near future and it will find its way in the Indian

economy.

Chapter 2


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Literature Review:-

The introduction of currency futures markets enable the traders to transact in

large volumes at much lower transaction costs relative to the cash market. This results in an


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increase in order flow to futures markets, reasons of which are unresolved on both theoretical

and on empirical front. A future market has two contrasting effects:

If the speculators observe a noisy but informative signal, the hedgers react to the noise in

the speculative trades, producing an increase in volatility.

The futures market improves risk sharing and therefore reduces price volatility. Opponents

of speculative trading activity have generally argued that increased trading in futures leads to

unnecessary price volatility in the underlying cash markets. Some researchers suggest that the

participation of speculative traders in the systems that allow high degrees of leverage lowers

the quality of the information in the market, e.g. Figlewski (1981) and Stein (1987). Cox

(1976), among others, notes that uninformed traders could play a stabilizing role in the cash

markets. Others question the role of future markets as representative of an institutional

alternative for accurate price forecasting,e.g. Martin and Garcia (1981). In contrast, models

developed by Danthine (1978 )argue that the futures markets improve market depth and

reduce volatility because the cost to informed traders of responding to mispricing is reduced.

Froot and Perold (1991) extend Kyles (1985) model to show that market depth is increased

by more rapid dissemination of market-wide information and the presence of market makers

in the futures market in addition to the cash market. Ross (1989) assumes that there exists an

economy that is devoid of arbitrage and proceeds to provide a condition under which the

noarbitrage situation will be sustained. It implies that the variance of the price change will be

equal to the rate of information flow. The implication of this is that the volatility of the asset

price will increase as the rate of information flow increases.

Thus, if futures increase the flow of information, then in the absence of

arbitrage opportunity, the volatility of the spot price must change. It has also been suggested

that the futures markets have become an important medium of price discovery in cash

markets, e.g. Schwarz and Laatsch (1991). Questions pertaining to the impact of derivative

trading activity on cash market volatility have been empirically addressed in two ways.First,

researchers have attempted to establish the impact of derivatives trading on cash markets by

comparing cash market volatilities during the pre and post-futures trading eras. The majority

of studies on this area suggests that speculative (derivatives) markets either add to the

stability, or do not impact the volatility of cash markets e.g. Simpson and Ireland (1985),

Edward (1988), Skinner (1989). Second, researchers have examined the relationship between


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speculative (derivative) trading activity and cash markets by directly evaluating the impact

of futures trading activity on the behavior of cash market e.g. Samanta (2007).

Edward (1988) and Bessembinder and Seguin (1992) provide evidence that

futures trading activity improves the stability in equity indices. In case of currency futures the

study of the relationship between futures trading and the variability of the underlying cash

market is complicated by the nature of exchange rate movements. The exchange rates move

like random walk but the changes do not, e.g. Meese and Rogoff (1983) and Manasanton

(1986). Under these conditions, the applicability of traditional volatility measures, such as the

absolute change in prices, provides inconsistence estimates in the study of the trading-activity

versus exchange rate-volatility relationship. A financial time series like this can not be

modeled in the normal way. To model such time series, time varying volatility models is

required. Engel (1982) first time proposed to incorporate time varying nature of volatility

using ARCH process. The work of Engle (1982) was made better by Bollerslev (1986), who

incorporated GARCH models to overcome some of the lacunas of ARCH models like

overfitting and breach of non-negativity constraints. Many researchers have found GARCH

family of models outperforming other models.

Different researchers used different markets and different methods to

communicate the same thing of applicability of GARCH family of models for modeling

conditional volatility.On US-based data the studies are Akgiray (1989), Pagan and Schwert

(1980), Brails Ford and Faff (1996) and Brooks (1998). On Europe based data the study is

Corhay and Rad (1994). On Asian Countries based data the study is Andersen and

Bollserslev (1998). All the researchers have found that GARCH family of models provide

more accurate forecast of volatility of returns of the financial assets. Out of three special

features of financial time series data (leptokurtic distribution, volatility clustering and

leverage effect) the leptokurtic and volatility clustering nature of the financial return data has

been captured by GARCH models but asymmetric behavior has not been captured. To solve

the issue Nelson (1991), Zakoian (1994) and GJR (1993) proposed EGARCH, TARCH and

GJR models respectively which can capture these tendencies of asymmetric nature of

financial data (Engle and Victor 1993) too.

Chapter 3 :-


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2. COMPANY PROFILE

Religare is an emerging markets financial services group with a presence

across Asia, Africa, Middle East, Europe, and the Americas. In India, Religares largestmarket, the group offers a wide array of products and services including broking, insurance,

asset management, lending solutions, investment banking and wealth management. With

10,000-plus employees across multiple geographies, Religare serves over a million clients,

including corporate and institutions, high net worth families and individuals, and retail

investors.

RELIGARE Securities Ltd. (RSL) is a wholly owned subsidiary of

RELIGARE Financial Services Ltd. (RFSL), a Company promoted by the late Dr. Parvinder

Singh, Ex-CMD of Ranbaxy Laboratories Ltd.

The primary focus of Religare Securities Ltd. is to cater to services in Capital

Market Operations to Institutional Investors. The Company is a member of the National

Stock Exchange (NSE) and OTCEI. The growing list of financial institutions with whom

RSL is empanelled as approved Broker is a reflection of the high levels of services

maintained by the Company.

As on date the Company is empanelled with UTI, IDBI, IFCI, SBI, BOI-MF,

Punjab National Bank, PNB-MF, Oriental Insurance, GIC, UTI-Offshore, ICICI Can bank

MF, Punjab & Sind Bank, Pioneer ITI, SUN F&C, IDBI Principal, Prudential ICICI, ING

Baring and J M Mutual Fund.

RELIGARE was founded with the vision of providing integrated financial care

driven by the relationship of trust. The bouquet of services offered by RELIGARE includes

Broking (Stocks and Commodities), Depository Participant Service, Advisory on Mutual

Fund Investments and Portfolio Management Services.

RELIGARE is a pioneer in the concept of partnership to reach multiple

locations in order to effectively service its large base of individual clients. Besides the reach

of Industry :Finance - General


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BSE Code :532915

Book Closure :11/08/2010

Group :Religare

NSE Code : RELIGARE

Market Cap :Rs. 6,897.44 Cr.

ISIN No :INE621H01010

Market Lot :1

Face Value :Rs. 10.00

RELIGARE, the clients of the company greatly benefit by its strong research

capability, which encompasses fundamentals as well as technical knowledge.

GROUP :

RELIGARE in recent years has expanded its reach in health care and financial

services wherein it has multiple specialty hospital and labs which provide health care services

and multiple financial services such as secondary market equity services, portfolio

management services, depository services etc.

RELIGARE financial services group comprises of Religare Securities

Limited, RELIGARE Comdex Limited and RELIGARE Finvest Limited which provide

services in Equity, Commodity and Financial Services business & Religare Insurance

Advisory Ltd.

RELIGARE SECURITIES LIMITED:-

1. Member of National Stock Exchange of India and Bombay Stock

Exchange of India.

2. Depository Participant with National Securities Depository

Limited (NSDL) and Central Depository Services Limited(CDSL).

3. A SEBI approved Portfolio Manager.


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RSL provides platform to all segments of the investor to leverage the immense

opportunity offered by equity investing in India either on their own or through managed

funds in Portfolio Management.

The ARN No. of the Religare Securities Ltd. is 33764. The ARN No. is required by to

be available with the broker who deals on behalf of investors or sell the mutual funds of the

different companies present in the market.

Currency Broking:

Religare Securities Limited (RSL), the broking arm of REL, offers a comprehensive

range of services which include equity broking and currency futures and options broking.

Exchange-driven currency trading has shown remarkable growth over the past few years. It is

the basis for cross-border diversification and business deals. It is our strong belief that a

valuable broking franchise is one that has a very high level of client retention and can provide

differentiated services based on client needs.

At Religare, we enable our clients to seize investment opportunities in the currency market by

facilitating futures and options trades in four currency pairs:

US$-Indian Rupee

Euro-Indian Rupee

Pound Sterling-Indian Rupee

Japanese Yen-Indian Rupee


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Religare Enterprises Limited

Religare Securities Limited

Equity Broking

Online Investment Portal

Portfolio Management Services

Depository Services

Religare Commodities Limited

Commodity Broking

Religare Capital Markets Limited

Investment Banking

Proposed Institutional Broking

Religare Realty Limited

In house Real Estate Management Company

Religare Hichens Harrison**

Corporate Broking

Institutional Broking

Religare Finvest Limited

Lending and Distribution business

Proposed Custodial business

Religare Insurance Broking Limited

Life Insurance

General Insurance

Reinsurance

Religare Arts Initiative Limited

Business of Art

Gallery launched - arts-i

Religare Venture Capital Limited

Private Equity and Investment Manager

Religare Asset Management*

Derivatives Sales

Corporate finance


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MISSION:-

To be India's first Multinational providing complete financial services solution

across the globe

VISION:-

Providing integrated financial care driven by the relationship of trust and

confidence.

PRODUCTS:

Products Subscription

fees

Enrolment

Deposit

R-ALLY NIL NIL

R-ALLY Lite (Browser Based) NIL Rs. 5,000

R-ALLY Pro (Application Based) Rs. 1,800 NIL

Trading in Equities with Religare truly empowers you for your

investment needs. We ensure you have a superlative trading experience through -

A highly process driven, diligent approach

Powerful Research & Analytics and

One of the "best-in-class" dealing roomsFurther, Religare also has one of the largest

retail networks. Now, you can walk into any of our branches and connect to our

highly skilled and dedicated relationship managers to get the best services.


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The Religare Edge :-

Pan India footprint

Powerful research and analytics supported by a pool of highly skilled research

analysts

Ethical business practices

Offline/Online delivery models

Single window for all investment needs through your unique CRN.

BROKERAGE :-

INTRADAY:- 3 paisa (.3%) (NEGOTIABLE)

DELIVERY :- 30 paisa (.03%) (NEGOTIABLE)

SERVICES:-

Arts

Initiative

Investment

Wealth

Personal

Insurance

Mutual

Fund

Commodity

Equity

REL


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Organization Structure of Religare Securities:


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Competitions of Religare :-

There are several financial security companies playing their roles in Indian equity market.

But Religare faces competitions from these few companies.

ICICI Direct.com

Share Khan (SSKI)

Kotak Securities.com

India Bulls

HDFC Securities

5paisa.com

Motital Oswal

IL&FS

Karvy


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Chapter 4

Theoritical framework of


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About Financial Derivatives:-

DEFINITION OF FINANCIAL DERIVATIVES:-

A word formed by derivation. It means, this word has been arisen by derivation.

Something derived; it means that some things have to be derived or arisen out of the

underlying variables. A financial derivative is an indeed derived from the financial

market.

Derivatives are financial contracts whose value/price is independent on the behavior

of the price of one or more basic underlying assets. These contracts are legally

binding agreements, made on the trading screen of stock exchanges, to buy or sell an

asset in future. These assets can be a share, index, interest rate, bond, rupee dollar

exchange rate, sugar, crude oil, soybeans, cotton, coffee and what you have.

A very simple example of derivatives is curd, which is derivative of milk. The price

of curd depends upon the price of milk which in turn depends upon the demand and

supply of milk.

The Underlying Securities for Derivatives are :

Commodities: Castor seed, Grain, Pepper, Potatoes, etc.

Precious Metal : Gold, Silver

Short Term Debt Securities : Treasury Bills

Interest Rates Common shares/stock

Stock Index Value : NSE Nifty

Currency : Exchange Rate.


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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 :

DERIVATIVES

Financials Commodities

Basics Complex

1. Forwards 1. Swaps

2. Futures 2.Exotics (Non STD)

3. Options

4. Warrants and Convertibles


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One form of classification of derivative instruments is between commodity derivatives and

financial derivatives. The basic difference between these is the nature of the underlying

instrument or assets. In commodity derivatives, the underlying instrument is commodity

which may be wheat, cotton, pepper, sugar, jute, turmeric, corn, crude oil, natural gas,

gold, silver and so on. In financial derivative, the underlying instrument may be treasury

bills, stocks, bonds, foreign exchange, stock index, cost of living index etc. It is to be

noted that financial derivative is fairly standard and there are no quality issues whereas in

commodity derivative, the quality may be the underlying matters. Another way of

classifying the financial derivatives is into basic and complex. In this, forward contracts,

futures contracts and option contracts have been included in the basic derivatives whereas

swaps and other complex derivatives are taken into complex category because they are

built up from either forwards/futures or options contracts, or both. In fact, such derivatives

are effectively derivatives of derivatives.

Derivatives are traded at organized exchanges and in the Over The Counter ( OTC

) market :

Derivatives Trading Forum

Organized Exchanges Over The Counter

Commodity Futures Forward Contracts

Financial Futures Swaps

Options (stock and index)

Stock Index Future

Derivatives traded at exchanges are standardized contracts having standard delivery

dates and trading units. OTC derivatives are customized contracts that enable the parties

to select the trading units and delivery dates to suit their requirements.


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A major difference between the two is that of counterpar ty r iskthe 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 the Securities Laws (Amendment) Ordinance, 1995, which withdrew the

prohibition on options in securities. SEBI set up a 24 member committee under the

chairmanship of Dr. L.C. Gupta on November 18, 1996 to develop appropriate regulatory

framework for derivatives trading in India, submitted its report on March 17, 1998. The

committee recommended that the derivatives should be declared as securities so that

regulatory framework applicable to trading of securities could also govern trading of

derivatives.

To begin with, SEBI approved trading in index futures contracts based on S&P

CNX Nifty and BSE-30 (Sensex) index. The trading in index options commenced in June

2001 and the trading in options on individual securities commenced in July 2001. Futures

contracts on individual stocks were launched in November 2001.


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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 marketplace for FX trading. Traders of CME

FX futures are a diverse group that includes multinational corporations, hedge funds,

commercial banks, investment banks, financial managers, commodity trading advisors

(CTAs), proprietary trading firms; currency overlay managers and individual investors. They

trade in order to transact business, hedge against unfavorable changes in currency rates, or to

speculate on rate fluctuations.

Source: - (NCFM-Currency future Module)


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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 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 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 future currency conversion rate at a high level. A similar foreign currency


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forward selling contract is obtained by investors in foreign currency denominated bonds (or

other securities) who want to take advantage of higher foreign that domestic interest rates on

government or corporate bonds and the foreign currency forward premium. They hedge

against the foreign currency depreciation below the forward selling rate which would ruin

their return from foreign financial investment. Investment in foreign securities induced by

higher foreign interest rates and accompanied by the forward selling of the foreign currency

income is called a covered interest arbitrage.

Source :-( Recent Development in I nternational Curr ency Deri vative Market by Lucjan T.

Orlowski)

Exchanges Trading in Currency Derivatives

MCX Stock Exchange Ltd. (MCXSX):-

MCX Stock Exchange Ltd. (MCXSX) commenced operations in the currency derivatives

segment on 7th October, 2008, within the regulatory framework of Securities & Exchange

Board of India (SEBI) and Reserve Bank of India (RBI). The all-India electronictrading

platform of MCX-SX offers participants the benefits of high liquidity, trade transparency,

easy online accessibility and counterparty guarantee through MCXSX Clearing

Corporation Ltd. (MCX-SX CCL), established on the lines of global clearing corporations.

MCX-SX has emerged as the first exchange in India to provide currency futures rates on a

real-time basis through mobile across all service providers, to publish a primer on currency

futures trade for guidance of interested participants and to launch websites in various

regional languages. MCXSX has also signed MOUs with varioustrade associations across

India. For more information please visitwww.mcx-sx.com.

National Stock Exchange (NSE)

National Stock Exchange (NSE) commenced operations in 1994 and provides a nationwide

electronic trading platform for various types of securities for investors under one roof. These

instruments are available for trading under different segments: Wholesale Debt Market

Segment; Capital Market Segment, Futures and Options Segment and Currency Derivatives
http://www.mcx-sx.com/http://www.mcx-sx.com/http://www.mcx-sx.com/http://www.mcx-sx.com/


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Segment. Derivatives trading at NSE commenced in the year 2000, and the product

base includes trading in futures and options on S&P CNX Nifty Index, CNX IT Index, Bank

Nifty Index, CNX Nifty Junior Index, CNX 100 Index, Nifty Midcap 50 Index, S&P CNX

Index; futures and options on around 200 single stocks; and currency futures on the USDINR

contracts presently. NSEs trading presence is now in over 1,500 cities across India. NSE

ranks 3rd in the world, in terms of number of transactions executed on a stock exchange; 2nd

in the world, in terms of the number of contracts traded in Single Stock Futures; 3rd in the

world, in terms of number of contracts traded, in Stock Index Futures; and 2nd in Asia, in

terms of number of contracts traded, in equity derivatives instrument. For more information

please visit www.nseindia.com.

United Stock Exchange (USE)

United Stock Exchange (USE), Indias newest stock exchange, represents the

commitment of all 21 Indian public sector banks, respected private banks and corporate

houses to build an institution that is on its way to becoming an enduring symbol of Indias

modern financial markets. USE also boasts of Bombay Stock Exchange, as a strategic

partner. As Asias oldest stock exchange, BSE lends decades of unparalleled expertise in

exchange technology, clearing & settlement, regulatory structure and governance.

Leveraging the collective experience of its founding partners, USE has developed a

trustworthy and state of the art exchange platform that provides a truly world class trading

experience. For more information please visit www.useindia.com


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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 purchasingpower from one country to another.

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

trading in foreign currencies has grown tremendously over the past several decades. Since

the exchange rates are continuously changing, so the firms are exposed to the risk of

exchange rate movements. As a result the assets or liability or cash flows of a firm which

are denominated in foreign currencies undergo a change in value over a period of time due

to variation in exchange rates.

This variability in the value of assets or liabilities or cash flows is referred to

exchange rate risk. Since the fixed exchange rate system has been fallen in the early 1970s,

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

business firms. As a result, these firms are increasingly turning to various risk hedging

products like foreign currency futures, foreign currency forwards, foreign currency options,

and foreign currency swaps.


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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 seller and buyer. All settlements however, unlike in the case of OTC markets, go

through the exchange.

Currency futures are a linear product, and calculating profits or losses on Currency

Futures will be similar to calculating profits or losses on Index futures. In determining

profits and losses in futures trading, it is essential to know both the contract size (thenumber 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.

Purchase price: Rs .42.2500

Price increases by one tick: +Rs. 00.0025

New price: Rs .42.2525

Purchase price: Rs .42.2500

Price decreases by one tick: Rs. 00.0025

New price: Rs.42. 2475


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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 points

Step 3: 20 points * Rupees 2.5 per tick = Rupees 50


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Chapter 5

BRIEF OVERVIEW OF FOREIGN

EXCHANGE MARKET


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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 foreign market in various ways, it led to

extensive fluctuations of exchange rate. This issue has attracted a great deal of concern from

policy-makers and investors. While some flexibility in foreign exchange markets and

exchange rate determination is desirable, excessive volatility can have an adverse impact on

price discovery, export performance, sustainability of current account balance, and balance

sheets. In the context of upgrading Indian foreign exchange market to international standards,

a well- developed foreign exchange derivative market (both OTC as well as Exchange-

traded) is imperative.

With a view to enable entities to manage volatility in the currency market, RBI on

April 20, 2007 issued comprehensive guidelines on the usage of foreign currency forwards,

swaps and options in the OTC market. At the same time, RBI also set up an Internal Working

Group to explore the advantages of introducing currency futures. The Report of the Internal

Working Group of RBI submitted in April 2008, recommended the introduction of Exchange

Traded Currency Futures.

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 itsreport on May 29, 2008. FurtherRBI andSEBI also 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
http://www.bseindia.com/deri/Downloads/CDX/rbirep_290508.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/rbi_circular060808.pdfhttp://www.bseindia.com/deri/Downloads/CDX/rbirep_290508.pdf


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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 techn ical committee on exchange traded

currency futures) 2008.

CURRENCY DERIVATIVE PRODUCTS:-

Derivative contracts have several variants. The most common variants are

forwards, futures, options and swaps. We take a brief look at various derivatives contracts

that have come to be used.

FORWARD :

The basic objective of a forward market in any underlying asset is to fix a price for a

contract to be carried through on the future agreed date and is intended to free both the

purchaser and the seller from any risk of loss which might incur due to fluctuations in the

price of underlying asset.

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.


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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 :

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, large concerns,

etc. The large banks usually make markets in different currencies.


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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.

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 foreign

Currency 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


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There are two ways of quoting exchange rates: the direct and indirect.

Most countries use the direct method. In global foreign exchange market, two rates are

quoted by the dealer: one rate for buying (bid rate), and another for selling (ask or

offered rate) for a currency. This is a unique feature of this market. It should be noted

that where the bank sells dollars against rupees, one can say that rupees against dollar. In

order to separate buying and selling rate, a small dash or oblique line is drawn after the

dash.

For example-

If US dollar is quoted in the market as Rs 46.3500/3550, it means that the

forex dealer is ready to purchase the dollar at Rs 46.3500 and ready to sell at Rs 46.3550.The difference between the buying and selling rates is called spread It is important to note

that selling rate is always higher than the buying rate. Traders, usually large banks, deal in

two way prices, both buying and selling, are called market makers.

Base Currency/ Terms Currency:

In foreign exchange markets, the base currency is the first currency in a currency pair. The

second currency is called as the terms currency. Exchange rates are quoted in per unit of thebase 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

appreciati on or depreciationof 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.


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NEED FOR EXCHANGE TRADED CURRENCY FUTURES:-

With a view to enable entities to manage volatility in the currency market, RBI on

April 20, 2007 issued comprehensive guidelines on the usage of foreign currency forwards,

swaps and options in the OTC market. At the same time, RBI also set up an Internal Working

Group to explore the advantages of introducing currency futures. The Report of the Internal

Working Group of RBI submitted in April 2008, recommended the introduction of exchange

traded currency futures. 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. On the 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 to market 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 techn ical commi ttee on exchange traded

currency futu res) 2008.


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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

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 unchangedfrom 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.


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Currency futures enable them to hedge these risks. Nominal exchange rates are often

random walks with or without drift, while real exchange rates over long run are mean reverting.

As such, it is possible that over a long run, the incentive to hedge currency risk may not be

large. However, financial planning horizon is much smaller than the long-run, which is

typically inter-generational in the context of exchange rates. As such, there is a strong need to

hedge currency risk and this need has grown manifold with fast growth in cross-border trade

and investments flows. The argument for hedging currency risks appear to be natural in case of

assets, and applies equally to trade in goods and services, which results in income flows with

leads and lags and get converted into different currencies at the market rates. Empirically,

changes in exchange rate are found to have very low correlations with foreign equity and bond

returns. This in theory should lower portfolio risk. Therefore, sometimes argument is advanced

against the need for hedging currency risks. But there is strong empirical evidence to suggest

that hedging reduces the volatility of returns and indeed considering the episodic nature of

currency returns, there are strong arguments to use instruments to hedge currency risks.


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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, and 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).

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.


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BASIS :

In the context of financial futures, basis can be defined as the futures price minus the

spot price. There will be a different basis for each delivery month for each contract.

In a normal market, basis will be positive. This reflects that futures prices normally

exceed spot prices.

COST OF CARRY :

The relationship between futures prices and spot prices can be

summarized in terms of what is known as the cost of carry. This measures the storage

cost plus the interest that is paid to finance or carry the asset till delivery less the

income earned on the asset. For equity derivatives carry cost is the rate of interest.

INITIAL MARGIN :

When the position is opened, the member has to deposit the margin with

the clearing house as per the rate fixed by the exchange which may vary asset to asset.

Or in another words, the amount that must be deposited in the margin account at the

time a future contract is first entered into is known as initial margin.

MARKING TO MARKET :

At the end of trading session, all the outstanding contracts are reprised at

the settlement price of that session. It means that all the futures contracts are daily

settled, and profit and loss is determined on each transaction. This procedure, called

marking to market, requires that funds charge every day. The funds are added or

subtracted from a mandatory margin (initial margin) that traders are required to

maintain the balance in the account. Due to this adjustment, futures contract is also

called as daily reconnected forwards.


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MAINTENANCE MARGIN :

Members account are debited or credited on a daily basis. In turn

customers account are also required to be maintained at a certain level, usually about

75 percent of the initial margin, is called the maintenance margin. This is somewhat

lower than the initial margin.

This is set to ensure that the balance in the margin account

never becomes negative. If the balance in the margin account falls below the maintenance

margin, the investor receives a margin call and is expected to top up the margin account to

the initial margin level before trading commences on the next day.

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:

It has been observed that in most futures markets, actual physical delivery of the underlying

assets is very rare and hardly has it ranged from 1 percent to 5 percent. Most often buyers and

TRADER

(BUYER)

TRADER

(SELLER)

MEMBER

(BROKER)

MEMBER

(BROKER)

CLEARING

HOUSE

Purchase order Sales order

Transaction on the floor (Exchange)

Informs


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sellers offset their original position prior to delivery date by taking an opposite positions.

This is because most of futures contracts in different products are predominantly speculative

instruments. For example, X purchases American Dollar futures and Y sells it. It leads to two

contracts, first, X party and clearing house and second Y party and clearing house. Assume

next day X sells same contract to Z, then X is out of the picture and the clearing house is

seller to Z and buyer from Y, and hence, this process is goes on.

REGULATORY FRAMEWORK FOR CURRENCY FUTURES:-

With a view to enable entities to manage volatility in the currency market, RBI on April 20,

2007 issued comprehensive guidelines on the usage of foreign currency forwards, swaps and

options in the OTC market. At the same time, RBI also set up an Internal Working Group toexplore the advantages of introducing currency futures. The Report of the Internal Working

Group of RBI submitted in April 2008, recommended the introduction of exchange traded

currency futures. With the expected benefits of exchange traded currency futures, it was

decided in a joint meeting of RBI and SEBI on February 28, 2008, that an RBI-SEBI

Standing Technical Committee on Exchange Traded Currency and Interest Rate Derivatives

would be constituted. To begin with, the Committee would evolve norms and oversee the

implementation of Exchange traded currency futures. The Terms of Reference to the

Committee was as under:

1. To coordinate the regulatory roles of RBI and SEBI in regard to trading of Currency

and Interest Rate Futures on the Exchanges.

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

Interest Rate Futures trading.

3. To suggest eligibility criteria for the members of such exchanges.

4. To review product design, margin requirements and other risk mitigation measures on

an ongoing basis.

5. To suggest surveillance mechanism and dissemination of market information.

6. To consider microstructure issues, in the overall interest of financial stability.


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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

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.

A currency future, also known as FX future, is a futures contract to exchange one currency

for another at a specified date in the future at a price (exchange rate) that is fixed on the

purchase date. On NSE the price of a future contract is in terms of INR per unit of other


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currency e.g. US Dollars. Currency future contracts allow investors to hedge against foreign

exchange risk. Currency Derivatives are available on four currency pairs viz. US Dollars

(USD), Euro (EUR), Great Britain Pound (GBP) and Japanese Yen (JPY). Currency options

are currently available on US Dollars.

Clearing & Settlement - Currency Derivatives National Securities Clearing

Corporation Limited (NSCCL) is the clearing and settlement agency for all deals executed on

the Currency Derivatives segment. NSCCL acts as legal counter-party to all deals on NSE's

Currency Derivatives segment and guarantees settlement. A Clearing Member (CM) of

NSCCL has the responsibility of clearing and settlement of all deals executed by Trading

Members (TM) on NSE, who clear and settle such deals through them.

Futures vs. Forwards:-

Currency Futures Forwards

Type of Contracts Standardized Customized

Price transparencyHigh, Real time rate Low, Over the phone

Accessibility Online / Offline modes Offline/ OTC

Underlying exposure Not Required Required

Margin

Requirement

3.00% Non standardized may vary from 8-12

%

MTM Settlement Daily Settled NA

Settlement Net settled in INR

(Cash)

Physical Settlement


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Chapter :


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Concept of interest rate parity:-

Let us assume that risk free interest rate for one year deposit in India is 7% andin USA it is 3%. You as smart trader/ investor will raise money from USA and deploy it in

India and try to capture the arbitrage of 4%. You could continue to do so and make this

transaction as a non ending money making machine. Life is not that simple! And such

arbitrages do not exist for very long.

We will carry out the above transaction through an example to explain the concept of

interest rate parity and derivation of future prices which ensure that arbitrage does not exist

Assumptions:

1. Spot exchange rate of USDINR is 50 (S)

2. One year future rate for USDINR is F

3. Risk free interest rate for one year in USA is 3% (RUSD)

4. Risk free interest rate for one year in India is 7% (R INR)

5. Money can be transferred easily from one country into another without anyrestriction of

amount, without any taxes etc

You decide to borrow one USD from USA for one year, bring it to India, convert it in

INR and deposit for one year in India. After one year, you return the money back to USA.On

start of this transaction, you borrow 1 USD in US at the rate of 3% and agree to return 1.03

USD after one year (including interest of 3 cents). This 1 USD is converted into INR at the

prevailing spot rate of 50. You deposit the resulting INR 50 for one year at interest rate of

7%. At the end of one year, you receive INR 3.5 (7% of 50) as interest on your deposit and

also get back your principal of INR 50 i.e., you receive a total of INR 53.5. You need to use

these proceeds to repay the loan taken in USA.

Two important things to think before we proceed:

The loan taken in USA was in USD and currently you have INR. Therefore you

need to convert INR into USD

What exchange rate do you use to convert INR into USD?


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At the beginning of the transaction, you would lock the conversion rate of INR into

US Dusing one year future price of USDINR. To ensure that the transaction does not result

into any risk free profit, the money which you receive in India after one year should be equal

to the loan amount that you have to pay in USA. We will convert the above argument into a

formula:

S(1+R INR)= F(1+R USD)

Or, F/S = (1+R INR)/(1+RUSD)

Another way to illustrate the concept is to think that the INR 53.5 received after one year in

India should be equal to USD 1.03 when converted using one year future exchange rate.

Therefore,

F/ 50 = (1+.07) / (1+.03)

F= 51.9417

Approximately, F is equal to the interest rate difference between two currencies i.e.,

F = S + (R INR- R USD)*S

This concept of difference between future exchange rate and spot exchange rate being

approximately equal to the difference in domestic and foreign interest rate is called theInterest rate parity. Alternative way to explain, interest rate parity says that the spotprice

and futures price of a currency pair incorporates any interest rate differentials between the

two currencies assuming there are no transaction costs or taxes. A more accurate formula for

calculating, the arbitrage-free forward price is as follows.

F = S(1 + RQCPeriod) / (1 + RBCPeriod)

Where

F = forward price

S = spot price

R BC = interest rate on base currency

R QC = interest rate on quoting currency

Period = forward period in years

For a quick estimate of forward premium, following formula mentioned above for USDINR

currency pair could be used. The formula is generalized for other currency pairand is given

below:


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F = S + (S(RQCRBC)Period)

In above example, if USD interest rate were to go up and INR interest rate were to remain at

7%, the one year future price of USDINR would decline as the interest rate difference

between the two currencies has narrowed and vice versa. Traders use expectation on change

in interest rate to initiate long/ short positions in currency futures. Everything else remaining

the same, if USD interest rate is expected to go up (say from 2.5% to 3.0%) and INR interest

rate are expected to remain constant say at 7%; a trader would initiate a short position in

USDINR futures market.

Illustration:

Suppose 6 month interest rate in India is 5% (or 10% per annum) and in USA are 1% (2%

per annum). The current USDINR spot rate is 50. What is the likely 6 month USDINR

futures price? As explained above, as per interest rate parity, future rate is equal to the

interest rate differential between two currency pairs. Therefore approximately 6 month future

rate would be:

Spot + 6 month interest difference = 50 + 4% of 50

= 50 + 2 = 52

The exact rate could be calculated using the formula mentioned above and the answer comes

to 51.98.

51.98 = 50 x (1+0.1/12 x 6) / (1+0.02/12 x 6)

Concept of premium and discount

Therefore one year future price of USDINR pair is 51.94 when spot price is 50. It means that

INR is at discount to USD and USD is at premium to INR. Intuitively to understand why INRis called at discount to USD, think that to buy same 1 USD you had to pay INR 50 and you

have to pay 51.94 after one year i.e., you have to pay more INR to buy same 1 USD. And

therefore future value of INR is at discount to USD. Therefore in any currency pair, future

value of a currency with high interest rate is at a discount (in relation to spot price) to the

currency with low interest rate.


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PRODUCT DEFINITIONS OF CURRENCY FUTURE ON NSE/BSE:

Underlying

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

permitted.

Trading Hours

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

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.


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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.

The contract specification in a tabular form is as under:

Underlying Rate of exchange between one USD and

Trading Hours 09:00 a.m. to

Documents

Currency Derivatives at Religare