Currency Derivatives Project -- Lavnish

A Project on ANALYTICAL STUDY ON CURRENCY DERIVATIVES IN

INDIA

(Submitted in partial fulfillment of the requirement of Master of Business Administration, Distance Education

Guru Jambheshwar University of Science & Technology , Hisar

Research Supervisor: Submitted by : Lavnish jaitly Mr. Nikhil Kulshrestha Enrolment No.08061148429 (Associate Prof.) Specialization :- FINANCE NSB

Session 2008-10 Directorate of Distance Education

Guru Jambheshwar University of Science & Technology Hisar (India)

[Project report on Currency Derivatives] IBMR-Ahmedabad Page 1

CERTIFICATE

This is to certify that MR LAVNISH JAITLY, Enrolment No. 08061148429 has preceded under by supervision her Research Project Report on “ANALYTICAL STUDY ON CURRENCY DERIVATIVE IN INDIA” in the specialization area “FINANCE.”

The work embodied in this report is original and is of the standard expected of an MBA student and has not been submitted in part or full to this or any other university for the award of any degree or diploma. She has completed all requirements of guidelines for Research Project Report and the work is fit for evaluation.


DECLARATION

This is to certify that the project Report entitled “ANALYTICAL STUDY ON CURRENCY DERIVATIVE IN INDIA” is an original work and has not been submitted is part or full to this or any other university/institution the award of any degree or diploma.

Signature of candidate-

NAME: Lavnish JaitlyENROLMENT NO.: 08061148429SPECILIZATION: FINANCESESSION: 2008-2010

TABLE OF CONTENTS


1) Introduction

2) Objectives of the study

3) Literature review & problem formulationi) History and Development of Currency Derivative ii) Brief overview of foreign exchange market.iii) Rationale for Introducing Currency Futures

4) Research methodology

5) Analysis & Interpretation

6) Key findings

7) Suggestion

8) Limitation of the study

9) Annexture

10)Biblioagraphy

INTRODUCTION


Each country has its own currency through which both national and

international transactions are performed. All the inter national

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 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

lender’s 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 currencies undergo a change in value over a period of time


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.


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.


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 derivatives…These instruments

enhances the ability to differentiate risk and allocate it to those investors most able and

willing to take it- a process that has undoubtedly improved national productivity growth and

standards of livings.”

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 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


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

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.

A major difference between the two is that of counterparty risk—the risk of default by

either party. With the exchange traded derivatives, the risk is controlled by exchanges

through clearing house which act as a contractual intermediary and impose margin

requirement. In contrast, OTC derivatives signify greater vulnerability.

DERIVATIVES INTRODUCTION IN INDIA[Project report on Currency Derivatives] IBMR-Ahmedabad Page 11

The first step towards introduction of derivatives trading in India was the promulgation of

the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on

options in securities. SEBI set up a 24 – member committee under the chairmanship of

Dr. L.C. Gupta on November 18, 1996 to develop appropriate regulatory framework for

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

recommended that the derivatives should be declared as ‘securities’ so that regulatory

framework applicable to trading of ‘securities’ could also govern trading of derivatives.

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

and BSE-30 (Sensex) index. The trading in index options commenced in June 2001 and

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

on individual stocks were launched in November 2001.

HISTORY OF CURRENCY DERIVATIVES

Currency futures were first created at the Chicago Mercantile Exchange (CME) in 1972.The

contracts were created under the guidance and leadership of Leo Melamed, CME Chairman

Emeritus. The FX contract capitalized on the U.S. abandonment of the Bretton Woods

agreement, which had fixed world exchange rates to a gold standard after World War II. The

abandonment of the Bretton Woods agreement resulted in currency values being allowed to

float, increasing the risk of doing business. By creating another type of market in which

futures could be traded, CME currency futures extended the reach of risk management

beyond commodities, which were the main derivative contracts traded at CME until then. The

concept of currency futures at CME was revolutionary, and gained credibility through

endorsement of Nobel-prize-winning economist Milton Friedman.

Today, CME offers 41 individual FX futures and 31 options contracts on 19 currencies, all of

which trade electronically on the exchange’s 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)

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 forward selling

contract is obtained by investors in foreign currency denominated bonds (or other securities)

who want to take advantage of higher foreign that domestic interest rates on government or

corporate bonds and the foreign currency forward premium. They hedge against the foreign

currency depreciation below the forward selling rate which would ruin their return from foreign

financial investment. Investment in foreign securities induced by higher foreign interest rates

and accompanied by the forward selling of the foreign currency income is called a covered

interest arbitrage.

Source :-( Recent Development in International Currency Derivative Market by Lucjan

T. Orlowski)


INTRODUCTION TO CURRENCY DERIVATIVES

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

transactions are performed. All the international business transactions involve an

exchange of one currency for another.

For example,

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

lender’s 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 currencies undergo a change in value over a period of time


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 futures contract”. 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 (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.

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

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: 42.2600 – 42.2500

Step 2: 4 ticks * 5 contracts = 20 points

Step 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 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 its report on May 29, 2008. Further RBI and SEBI also issued circulars in this

regard on August 06, 2008.


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

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

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

Currently, India is a USD 34 billion OTC market, where all the major currencies like USD,

EURO, YEN, Pound, Swiss Franc etc. are traded. With the help of electronic trading and

efficient risk management systems, Exchange Traded Currency Futures will bring in more

transparency and efficiency in price discovery, eliminate counterparty credit risk, provide

access to all types of market participants, offer standardized products and provide

transparent trading platform. Banks are also allowed to become members of this segment on

the Exchange, thereby providing them with a new opportunity.

Source :-( Report of the RBI-SEBI standing technical committee on exchange traded

currency futures) 2008.

CURRENCY DERIVATIVE PRODUCTS

Derivative contracts have several variants. The most common variants are forwards,

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

have come to be used.


FORWARD :

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

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

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

in the price of underlying asset.

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

takes place on a specific date in the future at today’s 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 :

Currency option is a financial instrument that give the option holder a right and not the

obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit

for a specified time period ( until the expiration date ). In other words, a foreign

currency option is a contract for future delivery of a specified currency in exchange for

another in which buyer of the option has to right to buy (call) or sell (put) a particular

currency at an agreed price for or within specified period. The seller of the option gets

the premium from the buyer of the option for the obligation undertaken in the contract.

Options generally have lives of up to one year, the majority of options traded on

options exchanges having a maximum maturity of nine months. Longer dated options

are called warrants and are generally traded OTC.

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.


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

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 the base currency. That is the expression Dollar-Rupee, tells you that the Dollar is

being quoted in terms of the Rupee. The Dollar is the base currency and the Rupee is the

terms currency.

Exchange rates are constantly changing, which means that the value of one currency in

terms of the other is constantly in flux. Changes in rates are expressed as strengthening

or weakening of one currency vis-à-vis the second currency.

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 Dollar – Rupee 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



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

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

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

exchange traded currency futures. Exchange traded futures as compared to OTC forwards

serve the same economic purpose, yet differ in fundamental ways. An individual entering

into a forward contract agrees to transact at a forward price on a future date. On the

maturity date, the obligation of the individual equals the forward price at which the contract

was executed. Except on the maturity date, no money changes hands. On the other hand,

in the case of an exchange traded futures contract, mark to market obligations is settled on

a daily basis. Since the profits or losses in the futures market are collected / paid on a daily

basis, the scope for building up of mark to market losses in the books of various

participants gets limited.

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

· Location of settlement


The rationale for introducing currency futures in the Indian context has been outlined in the

Report of the Internal Working Group on Currency Futures (Reserve Bank of India, April 2008)

as follows;

The rationale for establishing the currency futures market is manifold. Both residents and non-

residents purchase domestic currency assets. If the exchange rate remains unchanged from

the time of purchase of the asset to its sale, no gains and losses are made out of currency

exposures. But if domestic currency depreciates (appreciates) against the foreign currency, the

exposure would result in gain (loss) for residents purchasing foreign assets and loss (gain) for

non residents purchasing domestic assets. In this backdrop, unpredicted movements in

exchange rates expose investors to currency risks.

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

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

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

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

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

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

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

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

leads and lags and

get converted into different currencies at the market rates. Empirically, changes in exchange

rate are found to have very low correlations with foreign equity and bond returns. This in theory

should lower portfolio risk. Therefore, sometimes argument is advanced against the need for

hedging currency risks. But there is strong empirical evidence to suggest that hedging reduces

the volatility of returns and indeed considering the episodic nature of currency returns, there

are strong arguments to use instruments to hedge currency risks.


FUTURE TERMINOLOGY

SPOT PRICE :

The price at which an asset trades in the spot market. The transaction in which

securities and foreign exchange get traded for immediate delivery. Since the

exchange of securities and cash is virtually immediate, the term, cash market, has

also been used to refer to spot dealing. In the case of USDINR, spot value is T + 2.


FUTURE PRICE :

The price at which the future contract traded in the future market.

CONTRACT CYCLE :

The period over which a contract trades. The currency future contracts in Indian

market have one month, two month, three month up to twelve month expiry cycles. In

NSE/BSE will have 12 contracts outstanding at any given point in time.

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.


BASIS :

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

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

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

exceed spot prices.

COST OF CARRY :

The relationship between futures prices and spot prices can be summarized in terms

of what is known as the cost of carry. This measures the storage cost plus the interest

that is paid to finance or ‘carry’ the asset till delivery less the income earned on the

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

INITIAL MARGIN :

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

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

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

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

MARKING TO MARKET :

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

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

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

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

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


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

called as daily reconnected forwards.

MAINTENANCE MARGIN :

Member’s 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.

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 at Rs.44.2500. Entity A shall do the following:

Sell one August contract today. The value of the contract is Rs.44,250.

Let us assume the RBI reference rate on August 27, 2008 is Rs.44.0000. The entity

shall sell on August 27, 2008, USD 1000 in the spot market and get Rs. 44,000. The

futures contract will settle at Rs.44.0000 (final settlement price = RBI reference

rate).

The return from the futures transaction would be Rs. 250, i.e. (Rs. 44,250 – Rs.

44,000). As may be observed, the effective rate for the remittance received by the

entity A is Rs.44. 2500 (Rs.44,000 + Rs.250)/1000, while spot rate on that date was

Rs.44.0000. The entity was able to hedge its exposure.

Speculation: Bullish, buy futures

Take 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:

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 risk less 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:


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


TRADER( BUYER )

TRADER( SELLER )

MEMBER( BROKER )

MEMBER( BROKER )

CLEARINGHOUSE

Purchase order Sales order

Transaction on the floor (Exchange)

Informs



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

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

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

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

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

Technical Committee on Exchange Traded Currency and Interest Rate Derivatives would be

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

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

Committee was as under:

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.

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.


RESEARCH METHODOLOGY:

TYPE OF RESEARCH

In this project Descriptive research methodologies were use.

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

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

NSE/BSE.


SOURCE OF DATA COLLECTION

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

RBI/SEBI committee and NCFM/BCFM modules.

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 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 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 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 activity – Agree goals, target data, definitions, methods

2. Collection – data collection

3. Present Findings – usually involves some form of sorting analysis and/or presentation

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


DATA COLLECTION

Primary Data Secondary Data(Data collection techniques)

Questionnaire Interview External Internet Intrenal Source source

PRIMARY DATAIn 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· Types of questions· Length

Interview:

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

reasons and motivations for people’s 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 respondent’s 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.

Sampling Unit:

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

units.

Sampling Size: 20SECONDARY 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.

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 is a function of the spot rate and the interest rate

differential between the two currencies, adjusted for time. In the case of fully convertible

currencies, having no restrictions on borrowing or lending of either currency the forward

rate can be calculated as follows;

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.


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 contrac t

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.

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 Settlement

DateSettlement Cash settled

48

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 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.

49

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.

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

PROFIT

LOSS

USDD

0

43.19

50

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

futures when 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

PROFIT

LOSS

USDD

0

43.19

51

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 years

E=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 be

F = 44 * e^(0.10-0.07 )*1=45.34

52

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 currency’s

value.

It is noted that corporate profits are exposed to exchange rate risk in many situation.

For example, if a trader is exporting or importing any particular product from other

countries then he is exposed to foreign exchange risk. Similarly, if the firm is

borrowing or lending or investing for short or long period from foreign countries, in

all these situations, the firm’s profit will be affected by change in foreign exchange

rates. In all these situations, the firm can take long or short position in futures

currency market as per requirement.

The general rule for determining whether a long or short futures position will hedge

a potential foreign exchange loss is:

Loss from appreciating in Indian rupee= Short hedge

Loss form depreciating in Indian rupee= Long hedge

53

The choice of underlying currency

The 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 importer import 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

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

54

http://www.nseindia.com/marketinfo/fxTracker/fxTracker.jsp?filetype=4&HistDate=25112008








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 ISTUnderlying 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.

Choice of the number of contracts (hedging ratio)

55











Another important decision in this respect is to decide hedging ratio HR. The value

of the futures position should be taken to match as closely as possible the value of

the cash market position. As we know that in the futures markets due to their

standardization, exact match will generally not be possible but hedge ratio should

be as close to unity as possible. We may define the hedge ratio HR as follows:

HR= VF / Vc

Where, VF is the value of the futures position and Vc is the value of the cash

position.

Suppose value of contract dated 28th January 2009 is 49.8850.

And spot value is 49.8500.

HR=49.8850/49.8500=1.001.

FINDINGS

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Cost of carry model and Interest rate parity model are useful tools to find out

standard future price and also useful for comparing standard with actual

future price. And it’s also a very help full in Arbitraging.

New concept of Exchange traded currency future trading is regulated by

higher authority 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 trading. And also time reduced in Clearing and

Settlement process up to T+1 day’s basis.

Larger exporter and importer has continued to deal in the OTC counter even

exchange traded currency future is available in markets because,

There is a limit of USD 100 million on open interest applicable to trading

member who 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

Currency future, at this time if any person wants to use other instrument of

currency derivatives in this case he has to use OTC.

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SUGGESTIONS

Currency Future need to change some restriction it imposed such as cut

off limit of 5 million USD, Ban on NRI’s and FII’s and Mutual Funds from

Participating.

Now in exchange traded currency future segment only one pair USD-INR

is available to trade so there is also one more demand by the exporters

and importers to introduce another pair in currency trading. Like POUND-

INR, CAD-INR etc.

In OTC there is no limit for trader to buy or short Currency futures so

there demand 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.

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

on other Currency Derivatives except Currency Futures, so this restriction

seem unreasonable to exporters and importers. And according to Indian

financial growth now it’s become necessary to introducing other currency

derivatives in Exchange traded currency derivative segment.

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CONCLUSIONS

By far the most significant event in finance during the past decade has been the

extraordinary development and expansion of financial derivatives…These

instruments enhances the ability to differentiate risk and allocate it to those

investors most able and willing to take it- a process that has undoubtedly improved

national productivity growth and standards of livings.

The currency future gives the safe and standardized contract to its investors and

individuals who are aware about the forex market or predict the movement of

exchange rate so they will get the right platform for the trading in currency future.

Because of exchange traded future contract and its standardized nature gives

counter party risk minimized.

Initially only NSE had the permission but now BSE and MCX has also started

currency future. It is shows that how currency future covers ground in the compare

of other available derivatives instruments. Not only big businessmen and exporter

and importers use this but individual who are interested and having knowledge

about forex market they can also invest in currency future.

Exchange between USD-INR markets in India is very big and these exchange

traded contract will give more awareness in market and attract the investors.

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LIMITATION OF THE STUDY

The limitations of the study were

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.

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

60

ANNEXURE

QUESTIONNAIRE

1) What do you understand by training?a) Learningb) Enhancement of knowledge, skill and aptitudec) Sharing informationd) All of above

2) Training is must for enhancing productivity and performance.a) Completely agreeb) Partially agreec) Disagreed) Unsure

3) (i) Have you attended any training programme in the last 01 year?a) Yesb) No

(ii) If yes ,which module of soft skill development training?a) Personality and positive attitudeb) Business communicationc) Team building and leadershipd) Stress management and work-life balancee) Business etiquettes and corporate groomingf) All of aboveg) If any other please specify ___________________________

4) (i) After the training ,have you given feedback of it?

61

a) Yesb) No

(ii) If yes, through which method?(can select more than one)a) Questionnaireb) Interviewc) Supplement testd) If any other please specify _______________

5) Which method of post training feedback according to you is more appropriate?a) Observationb) Questionnairec) Interviewsd) Self diariese) Supplement test

6) (i) Do you think that the feedback can evaluate the training effectiveness?a) Yesb) No

(ii) If yes, how can the post training feedbacks can help the participants?(can select more than one)a) Improve job performanceb) An aid to future planningc) Motivate to do betterd) All of the abovee) None

7) Post training evaluation focus on result rather than on the effort expended in conducting training.a) Completely agreeb) Partially agree

62

c) Disagreed) Unsure

8) What should be the ideal time to evaluate the training?a) Immediate after trainingb) After 15 daysc) After 1 monthd) Cant say

9) Should the post training evaluation procedure reviewed and revised periodically?a) Yesb) Noc) Cant say10) Is the whole feedback exercise after the training worth the time, money and effort?a) Yesb) Noc) Cant say

11) The post training feedbacks can be used :a) To identify the effectiveness and valuation of the training programmeb) To identify the ROI( return on investment)c) To identify the need of retrainingd) To provide the points to improve the traininge) All of above

12) Any suggestion for improving the post training feedback procedure exists in Sahara India Pariwar?

BIBLIOGRAPHY

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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

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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/

Documents

Currency Derivatives Project -- Lavnish