Currency-Hand Book (1)

7/28/2019 Currency-Hand Book (1)

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CURRENCY DERIVATIVES

HAND BOOK


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1. Introduction to Currency Markets


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Introduction

Largest Asset Class

Major currencies: Dollar, Euro, Yen, British Pound, Swiss Franc

Average turnover is over US$ 4 trillion (daily)

Forex derivatives accounts for 40% of ADTV

Main trading centers are London, NY, Tokyo & Singapore

High volumes low margin game with extreme Liquidity 24 hours trading

Range of factor impacting exchange rates

Participants


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Forex Market: 24 a day7 days a week24 Hrs Market (IST)


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INDIAN FOREX MARKET

OTC EXCHANGE TRADED

OPTIONS

SPOT

MCX-SXNSE USE

FUTURES

FORWARDS

SWAPS


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Participants

Large banks

Central Banks

Government

Multinationals & Commercial Companies

Hedge Funds Institutions

Retail Forex Brokers

Speculators


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Basic Definitions simplified

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

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

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

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

Quote or Term Currency: In the Forex markets, is the second currency in any pairalso called the Pip currency.

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


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Basic Definitions simplified

Bid Price

Price at which the market is prepared to buy a specific currency pair in the Forexmarket and you can sell the base currency (on the left side of the quotation)

(eg: in the quote GBP/USD 2.0483/84, the bid price is 2.0483. One can sell one GBP

for 2.0483 USD)Ask (or offer)Price

Price at which the market is prepared to sell a specific currency pair in the Forexmarket and you can buy the base currency (on the right side of the quotation)

(eg: in the quote EUR/USD 1.4692/94, the ask price is 1.4694. One can buy one

Euro for 1.4694 USD)


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Global Currency Composition

Daily Averages in billions of US dollar and per cent

2001 2004 2007

Amount %share Amount %share Amount %share

US dollar/euro

US dollar/yen

US dollar/sterling

US dollar/Australian dollarUS dollar/Swiss franc

US dollar/Canadian dollar

US dollar/Swedish Krona

US dollar/other

Euro/yen

Euro/sterling

Euro/Swiss franc

Euro/other

Other Currency pairs

All currency pairs

354

231

125

4757

50

195

30

24

12

21

26

1,173

30

20

11

45

4

17

3

2

1

2

2

100

503

298

248

9878

71

295

51

43

26

39

42

1,794

28

17

14

54

4

16

3

2

1

2

2

100

840

397

361

175143

115

56

572

70

64

54

112

122

3,081

27

13

12

6

5

4

2

19

2

2

2

4

4

100

Market Turnover By Currency Pair


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Factors Affecting USDINR

ExchangeRate

RBIIntervention

Performance ofEquity Market

PolicyDecisions

Performance ofOther AsianCurrencies

PoliticalFactors

CapitalFlows

FundamentalFactors

UncertainEvents


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Factors Affecting Currency Market

Interest Rates Change in interest rates by Reserve Bank of India

Interest rates change by Federal Reserve (USA)

Interest rates change by European Commercial Bank

Expectation of change in interest rates

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

against other currencies


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Factors Affecting Currency Market

Inflows of Foreign Funds

Strong economic fundamentals attract funds into the country

Political stability and clear economic direction

Country specific ratings based on economic indicators

Reverse is also true

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

currency (read Rupee) resulting in the currency strengthening


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2. Foreign Currency Derivatives


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Futures & Options

Markets-Debt, Forex & Stocks

What is traded on a Currency exchange?


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In a Nut Shell: Manage Risk

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

Why do we require Currency Derivatives?


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Derivatives: Basic Definitions

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

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

Options: Calls & Puts

Warrants: Long dated options

LEAPS: Long Term Equity Anticipation Securities (options with upto 3 years maturity

SWAPS: Agreement between two parties to exchange cash flows in the future accordingto a pre-arranged method


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Forward Vs. Futures

Forward Contracts OTC

Counterparty risk

Terms changeable

Poor liquidity

Few Players

No Margins Relationship

Skill to Structure

Future Contracts

Exchange Traded

Exchange assumes risk

Terms defined by Exchange

High Liquidity

Many Players Margins

Price Transparency

Standard Product


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3. Exchange Traded Currency Futures


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Futures Terminology

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

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

Currency futures are a linear product

Settlement date is the last business day of the month


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Futures Terminology

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

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

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

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


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Contract Specification Snapshot

Underlying USD / INR

Trading Hours 9:00 AM to 5:00 PM

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

Price Quotation In INR (Tick Size INR 0.0025)

Tenor of Contract Maximum of 12 Months

Available Contracts Monthly

Settlement Mechanism In INR

Settlement Reference Rate RBI USD/INR Reference Rate

Final Settlement Date Last working day of month, except Saturday.

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


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Rationale behind Currency Futures

Eliminates risk caused by fluctuation in exchange rates

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

Aids Business Planning

Hedging using futures reduces volatility of returns

Hedgers could be:-Corporates, Producers, Intermediaries in Spot Markets, Merchandisers,Traders, Importers & Exporters etc.


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Pricing of Currency Futures

The spot and interest rate differential impact future price perception

Following are three commonly used formulas

a) Term: Base Formula

b) Spot forward r&p Formula

c) Continuous Compounding Formula

Continuous Compounding Formula is preferred

All three methods give very close results


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Continuous Compounding Formula

F = S0e (rd-rf)T

Where,

F = Future PriceS

0

= Spot Price

rd = Domestic Rate of Interest

rf = Interest Rate in the foreign country

T = Tenure


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What is meant by Hedging?

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

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

want to lock in the price

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

Types of Hedges

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


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Appreciation and Depreciation of Currency

Event Importer Exporter

Appreciation of USD Loses Money Gains Money

Depreciation of INR Loses Money Gains Money

Event Importer Exporter

Depreciation of USD Gains Money Loses Money

Appreciation of INR Gains Money Loses Money

USDINR 53

USDINR 55

USDINR 50

USDINR 53

Scenario 1

Scenario 2


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Using Futures to Hedge Currency Risk

Transaction

An exporter who has executed an export order and money is to be received on 31 May13, say USD 500,000.

Spot USD/INR was as 54.80 when contract was executed.

RiskRupee will appreciate and export will realize USD 500,000 at a rate lower than 54.80

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


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

Spot is at 54.80 when the exporter Sell future and

USDINR Dec futures at 55.10

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

On Expiry Date 31st

May

Spot on Expiry P/L on Exchange P/L on Physical

55.50 (INR 2,00,000) INR 3,50,000

54.50 INR 3,00,000 (INR 1,50,000)

So if rupee moves either way corporate is hedged against currencyfluctuation.


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Using Futures to Hedge Currency Risk

Transaction

On 1st April, 2013 a student enrolled for CMT-USA October 2013 test and he needs tomake his payment of USD 1000 on 15th September, 2013.

Spot USD/INR was at 53.26 when he got enrolled.

RiskUSD may strengthen over next 6 months causing the enrolment to cost more

Hedge StrategyLong (Buys)1 USDINR Futures contract


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Hedger (Copper Exporter)

On April 1, 2013, an Indian Copper Exporter enters into a contract to Export 1000 MT

of Copper with payment to be received in US Dollar (USD) on July 1, 2013.

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

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

The exporter has a risk of Weakening USD over next three months having negative

implication on his operating margins hence profitability and long-term sustainability


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COPPER EXPORTER

Is Long on USD 7200000 in theSpot market

Short (Sell) 7200 USDINR

futures contracts

Buys USDINR futures contractsto square-off transaction

Sell USD to meet exportrequirement in the spot market

Time t1

Time t2

HedgePeriod

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

Risk Management Processusing currency futures


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Hedger Practical Implication

DateSpot Market Futures Market

USD-INR July USD Contract

1-April-13 54.76 54.95

1-July-13 56.53 56.72

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

Spot1-Apr-13

54.76 (L) 3942720001-Jul-13

56.53 (S) 407016000 12744000

Futures 54.95 (S) 395640000 56.72 (L) 408384000 -12744000

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

By Hedging, we have locked-in the price i.e. Selling price in spot market Rs. 40701600 + lossfrom Futures market Rs. (-12744000)= Rs. 394272000

Price of Copper = Rs. 7200/MT

Exported Qty. = 1000 MT

No Basis Risk : PerfectHedge situation exists


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SPREADS

What is a Spread?

Difference in price of two futures contractsA spread involves buying one futures contract in one month and simultaneouslyselling another futures contract of a different month.

Participants: Investors / Traders

Objective:

To earn profit from existing spread between near month futures contract and farmonth futures contract.


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What influences spreads?

Interest Rate Differentials Liquidity in the banking system Monetary policy decisions Inflation Intra-Currency Pair Spread Inter-Currency Pair Spread

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

Inverted Market: If the price of the far month futures contract is lower thanthe near month one, then it is referred to as invertedmarket.


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Arbitrage

Involves buying a contract on one exchange at one price andsimultaneously selling an identical contract on another exchangeat a higher price.

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

I M k A bi


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Inter Market Arbitrage

Price difference between currency futures traded on different exchanges results in

arbitrage positions

E.g. On 2 Feb 2013, following is the USDINR Oct futures contract prices

NSE USD/INR 56.0750MCX-SX USD/INR 56.0275

Buy on MCX-SX and simultaneously sell on NSE

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


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5. Trading


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Market Operations: Trading features

Automated screen-based trading on TWS

National reach

Order driven trading system

Transparent, Objective and Fair system of order matching

Identity of the trader undisclosed

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

Flexibility in placing orders

Complete Online Market Information

Square-off facility


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Terms

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

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

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


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Types of order

Price conditions

Limit Order :- specifying the price at which the trade shouldbe executed

Market Order:-To be executed at prevailing price. For suchorders, the trading system determines the price.

Stop loss Order:- Remains in the system inactive/abeyance

mode and is activated only on trigger of a threshold price,defined by member.


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Time Conditions

Day Order

Available for execution during the Trading Day until executed or cancelled

Unexecuted Day orders get cancelled at EOD

Good Till Cancelled (GTC)

Available for execution till expiry of the contract or till it is cancelled,whichever is earlier

Types of order


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Trading Parameters

Open Price: On the first day is the theoretical futures price & on subsequent tradingdays will be daily settlement price

Close Price:

System generated at the end of the day

Close price is the weighted average price of all trades executed during last 30

minutes in a given contract.

If less than 5 trades during last 30 minutes, then last 10 trades executed during a

trading day

If less than 5 trades during the day, then all trades.

If no trade is executed, last closing price.

l h d S


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Players In the Trading System

Trading Member

Clearing Member

Trading-cum-Clearing Member

Professional Clearing Member

Participants


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6. Clearing Settlement and Risk Management


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Risk Management Tools

Price Circuit filter (Price Range)

Pre-defined in the Contract Specifications

Computed on the previous days Close Price

+/-3% & +/-5%

Position Limits

Margins

Mark-to-Market

Above all- Financial soundness of members

Open Position


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Open Position

SEBI has specified Position Limits for Clients, TM and Clearing Member :

1. At Client level Gross Open Position of client across all contracts cannot exceed 6% oftotal open interest or 10 million USD whichever is higher

2. At Trading Member level Gross Open Position of the Trading Member across allcontracts should not exceed 15% of the total open interest or 50 million USDwhichever is higher.

3. At Clearing Member level No separate position limit prescribed. However shouldensured that all trading position are within above mentioned limits

Margins


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Margins

Type of Margin Description

Initial Margin Subject to a minimum of 1.75 % on the first day of currency futures

trading and 1% thereafter. Initial Margin shall be deducted from LiquidNet worth on an online, real-time basis

Extreme Loss Margin Computed at 1% on the mark to market value of the Gross Open

Position. Extreme loss margin shall be deducted from the liquid assets of

the Clearing Member.

The SPAN based methodology is adopted

o The client-wise margins would be grossed across various clients

at Trading/Clearing member level

o Proprietary positions of the Trading/ Clearing Member treated asthat of a client

Real Time alerts for margin utilization beyond specified percentages

(60%, 75%, 90%)

l l


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Margin Calculation

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

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

(Initial+ELM)

Day 2. Exchange rate weakens

a) @ say 51.95 X 1000 X (1%+2.6%) = Rs.1870..200 (margin )

(ELM+SPAN)

= 447.075 (further margin blocked)

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

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

M gi C l l ti


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Margin Calculation

Day 3. Exchange rate strengthens

a) @ say 51.25 X 1000 X (1%+2.4%) = Rs.1742.500 (margin)

(ELM+SPAN)

= 127.7 (margin released)

b) M2M = 51.25 - 51.95 X 1000 = Rs.700 Payin

Day 4. Square up open position ie. sell one contract

@ say 52.00 51.25 X 1000 =750 payout + 1742.5 margin released

Calendar Spread Margins


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Calendar Spread Margins

Calendar Spread Margins are only Rs. 250 per lot + (20% of ELM of far

month contract )

Far month contract of $1000 @ Rs.50 = Rs 50000

ELM = 1% = 500

20% of ELM = 100 (note 33.33% instead of 20%)

Spread Margin = 100+250 = Rs. 350

Surveillance System


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Surveillance System

Large Open interest, cost of carry and volatility monitored

Monitor closing prices

Capture and process client level details

Automatically generates alerts highlighting material aberrations

Inspections

Builds database based on trading information

The Exchange as the first level regulator has an online surveillance capabilitythat monitors prices, positions & volumes in real time so as

to deter market manipulation


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Online Monitoring

Price Volatility (RPF file captures the information on periodic basis)

Daily Price Range ( DPR )

Margin Utilization by Members

Marked-to-Market of Members

Maximum Allowable Open Position

Clearing Mechanism


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Clearing Mechanism

Undertaken by Clearing Corporation which undertakes clearing & settlement of alltrades executed in currency derivatives

Clearing members & Clearing banks

Clearing mechanism:

Working out open positions & obligations of TM and CM (aggregating)

Proprietary positions on net basis

Client position by summing buy & sell position

Daily margins generated

Example: Open Position (contracts)


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Example: Open Position (contracts)

TM clearingthrough CM

ProprietaryTrades

Client 1 Client 2 Open Position

XYZ Buy 40

Sell 20

Buy 30

Sell 10

Buy 40

Sell 20

Long 110

Short 50

FRX Buy 20

Sell 30

Buy 80

Sell 60

Buy 30

Sell 70

Short 160

Long 130

Total Long 40

Short 50

Long 110

Short 70

Short 90

Long 70

Net Long 30


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7. Regulatory Framework

A t


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Acts

RBI-SEBI standing technical committee on exchange traded currency and

interest rate derivatives

Provides comprehensive guidelines on the usage of foreign currency forwards,swaps and options in the OTC market

Recommends the introduction of exchange traded currency futures Constituted a technical committees on Exchange Traded Currency and Interest

Rate Derivatives

Foreign Exchange Management Act, 1999 - Provisions

Provided different guidelines and notifications for Currency Trading under RBIsregulation in India.

Provides the Currency Contract Specifications with limits and regulations to befollowed

Regulatory Framework for Exchanges


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Regulatory Framework for Exchanges

Recognized Stock exchanges by SEBI having national reach are allowed to set-upCurrency Futures Segment. Following guidelines are to be fulfilled:

1. The trading should take place through an online screen-based trading system, whichalso has a disaster recovery site.

2. Clearing of currency derivatives should be done by an independent ClearingCorporation.

3. The exchange must have an online surveillance capability which monitors positions,prices and volumes in real time so as to deter market manipulation.

4. The exchange shall have a balance sheet net worth of at least Rs. 100 crores.5. Information about trades, quantities, and quotes should be disseminated by the

exchange in real time to at least two information vending networks6. The exchange should have arbitration and investor grievances redressal mechanism7. The exchange should have adequate inspection capability.

A recognized stock exchange where other securities are also being traded may set upa separate currency futures segment in the following manner:

1. The trading and the order driven platform of currency futures should be separate fromthe trading platforms of the other segments.

2. The membership of the currency futures segment should be separate from themembership of the other segments.


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A Clearing Corporation can function only after obtaining SEBI approval. Its

conditions are as follows:

The Clearing Corporation should be a company incorporated under theCompanies Act, 1956 and should be distinct from the exchange.

The Clearing Corporation must perform full novation.

The Clearing Corporation should enforce the stipulated margin requirements,mark to market settlement, electronic funds transfer, etc.

A separate settlement guarantee fund should be created and maintained.

Regulatory Framework for Clearing Corporations

Eligibility Criteria's for members


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Members in Currency Derivatives segment are required to seek separate

registration from SEBI

Following Entities are eligible to apply:

Individuals

Partnership Firms registered under the Indian Partnership Act, 1932;

Corporations, Companies or Institutions or subsidiaries of such Corporations,Companies or Institutions set up for providing financial services;

Such other person as may be permitted under the Securities Contracts(Regulation) Rules 1957

Eligibility Criteria s for members

Eligibility Criteria's for Banks


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Eligibility Criteria s for Banks

AD Category - I bankauthorized by the Reserve Bank of India under FEMA Act, 1999 arepermitted to become trading and clearing members of the currency futures market, subjectto fulfilling the following minimum prudential requirements:

a) Minimum net worth of Rs. 500 crores.b) Minimum CRAR of 10 per cent.c) Net NPA should not exceed 3 per cent.d) Made net profit for last 3 years.

Banks are required to lay down detailed guidelines with the approval of their Boards fortrading and clearing in currency futures contracts & management of risks.

Urban Co-operative banks or State Co-operative banks who cannot fulfill aboverequirements, can participate in the currency futures market only as clients, subject to

approval from the respective regulatory Departments of the Reserve Bank.

Eligibilit Criteria's for Corporate


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Eligibility Criteria's for Corporate

A company shall be eligible to be a member: such company is formed in compliance with the provisions of Section 12 of the said Act

it undertakes to comply with financial requirements and norms as may be specified by

the SEBI for the registration of such company

the directors of such company are not disqualified for being members of a stockexchange under the Securities Contracts (Regulation) Rules, 1957 and the directors ofthe company had not held the offices of the directors in any company which had been amember of the stock exchange and had been declared defaulter or expelled by theexchange.


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8. Accounting

Accounting


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Accounting

Accounting at Inception of contract

Initial margin will reflect in Current Assets as currency futures account

Bank guarantees & securities lodged will be disclosed in notes to accounts

Accounting at time of daily settlement

Daily credit/debit will reflect in bank account and double entry will be M2Mmargin currency futures account

If client pays lump sum for the purpose of margin/M2M, a separate account tobe debited Deposit for M2M Margin account

At year end the balance in Deposit for M2M Margin account will be reflected incurrent assets.

Accounting for Open Position

Based on valuation on the balance sheet date, profit & loss affected (As30)

Accounting


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Accounting

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

account and credit currency futures account)

Losses on the contract will be recognised on the profit & loss account.

Disclosure Requirements AS32

Taxation:

Income or loss carried out on recognised exchanges is not taxed as speculativeincome or loss. Thus loss can be set off against any other income during theyear (or subsequent assessment year- can be carried forward upto 8 years)


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9. Code of Conduct

Code of Conduct


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Code of Conduct

Brokers

integrity

Exercise of skill & care

Manipulation (for person gain, rumors, deceptive txn)

Malpractices- (False entries/excessively speculative)

Compliance with Statutory requirements -(Govt/SEBI/SE) Breach of Trust (disclose discuss client information)

Not encourage transactions for sole purpose of brokerage

Fairness to client

Protect client interest

Comply with his obligations in completing settlement of transactions

Advertisement & Publicity (unless permitted by exchange)

Code of Conduct


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Code of Conduct

Trading Members

Adequate disclosure in his dealings with clients

No trading member will guarantee against a loss

Observe high standards of commercial honor

Adherence to Trading practices

Act honestly and fairly

Employ resources effectively for performance of business activity Ensue that the fiduciary and other obligations imposed on them and staff by

statutory acts, rules & regulations is complied with.

Responsible for all actions originating through-trading member id & user id

Client is responsibility of the trading member-must ensure compliance

No discretionary powers in the constituents account unless written authorization

given by client Will not disclose name and beneficial identity of a constituent except to currency

derivative segment of the exchange

Code of Conduct


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Code of Conduct

Grievance Redresses Mechanism for Investors

Exchange has a dedicated department to handle grievance Investor to submit in a prescribed compliant form along with supporting to

substantiate claim Exchange scrutinizes the complaint and issues a complaint number and gives an

acknowledgement to the aggrieved

Exchange tries to resolve the matter If differences persist then exchange holds meetings with the parties at exchange

premises Party at fault is enlightened on the correct position on the matter SEBI has instructed exchanges to have arbitration committees which are governed

by exchange by-laws Parties to arbitration are required to select the arbitrator from a panel of

arbitrators Arbitration award is binding on both parties Aggrieved party can within 15 days file an appeal to the arbitration tribunal Final award is enforceable as if it were the decree of the court


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UPDATES WILL CONTINUE

Documents

Currency-Hand Book (1)