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 financial environment today has more risks than earlier. Successful business firms are those that

are able to manage these risks effectively. Due to changes in the macroeconomic structures and

increasing internationalization of businesses, there has been a dramatic increase in the volatility of

economic variables such as interest rates, exchange rates, commodity prices etc. Firms that monitor

their risks carefully and manage their risks with judicious policies enjoy a more stable business than

those who are unable to identify and manage their risks. There are many risks which are influenced

by factors external to the business and therefore suitable mechanisms to manage and reduce such

risks need to be adopted. One of the modern day solutions to manage financial risks is ‘hedging’

which can be done through derivatives.

In finance, a derivative is a financial instrument whose value depends on other, more basic,

underlying variables. Such a variable is called an "underlying" and can be a traded asset, for

example, a stock or commodity, but can also be something which is impossible to trade, such as the

temperature (in the case of weather derivatives), unemployment rate, or any kind of (economical)

index. A derivative is essentially a contract whose payoff depends on the behavior of some

benchmark. The most common derivatives are futures, options, and swaps.

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

DERIVATIVES INTRODUCTION IN INDIA

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

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

securities. SEBI set up a 24 – member committee under the chairmanship of Dr. L.C. Gupta on

November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India,

submitted its report on March 17, 1998. The committee recommended that the derivatives should be

declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’ could also

govern trading of derivatives. To begin with, SEBI approved trading in index futures contracts based

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

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

on individual stocks were launched in November 2001.

CURRENCY DERIVATIVES

INTRODUCTION 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 due to variation in exchange rates.

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

Since the fixed exchange rate system has been fallen in the early 1970s, specifically in developed

countries, the currency risk has become substantial for many business firms.

As a result, these firms are increasingly turning to various risk hedging products like foreign

currency futures, foreign currency forwards, foreign currency options, and foreign currency swaps.

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.

Currency future derivatives in India

A RBI-SEBI Standing Technical Committee was set up to evolve norms and oversee implementation

of Exchange Traded Currency and Interest Rate derivatives. To begin with, the Committee as looked

at Exchange Traded Currency Derivatives and submitted a report on Exchange Traded Currency

Futures (―Report‖). This report was submitted on May 29, 2008.

The report laid down the framework for the launch of Exchange Traded Currency Future in terms of

the eligibility norms for existing and new Exchanges and their Clearing Corporations/Houses,

eligibility criteria for members of such Exchanges/Clearing Corporations/Houses, product design,

risk management measures, surveillance mechanism and other related issues.

The Currency Future in India was first time traded at NSE on August 29, 2008. Thereafter BSE and

MCX were subsequently allowed to deal in currency future from October 1, 2008 and October 31,

2008.

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 policymakers 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 welldeveloped 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.

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.e

INDIAN FOREIGN EXCHANGE MARKETS – PARTICIPANTS

NCY futures market –

Introduction to Currency Markets

How and why does the demand and supply of a currency increase and decrease?

There are several reasons. A rise in export earnings of a country increases foreign exchange supply.

A rise in imports increases demand. These are the objective reasons, but there are many subjective

reasons too. Some of the subjective reasons are: directional viewpoints of market participants,

expectations of national economic performance, confidence in a country’s economy and so on.

EXCHANGE RATE

Foreign exchange rate is the value of a foreign currency relative to domestic currency. T he

exchange of currencies is done in the foreign exchange market, which is one of the biggest financial

markets. The participants of the market are banks, corporations, exporters, importers etc. A foreign

exchange contract typically states the currency pair, the amount of the contract, the agreed rate of

exchange etc.

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.

A foreign exchange deal is always done in currency pairs, for example, US Dollar – Indian Rupee

contract (USD – INR); British Pound – INR (GBP - INR), Japanese Yen – U.S. Dollar (JPYUSD),

U.S. Dollar – Swiss Franc (USD-CHF) etc. Some of the liquid currencies in the world are USD,

JPY, EURO, GBP, and CHF and some of the liquid currency contracts are on USD-JPY, USD-

EURO, EURO-JPY, USD-GBP, and USD-CHF. The prevailing exchange rates are usually depicted

in a currency table like the one given below:

Base Currency/ Terms Currency:

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

The second currency is referred to as the ‘counter/terms/quote’ currency. The exchange rate tells the

worth of the base currency in terms of the terms currency, i.e. for a buyer, how much of the terms

currency must be paid to obtain one unit of the base 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, a USD-INR rate of

Rs. 48.0530 implies that Rs. 48.0530 must be paid to obtain one US Dollar. Foreign exchange prices

are highly volatile and fluctuate on a real time basis. In foreign exchange contracts, the price

fluctuation is expressed as appreciation/depreciation or the strengthening/weakening of a currency

relative to the other. A change of USD-INR rate from Rs. 48 to Rs. 48.50 implies that USD has

strengthened/ appreciated and the INR has weakened/depreciated, since a buyer of USD will now

have to pay more INR to buy 1 USD than before.

Fixed Exchange Rate Regime and Floating Exchange Rate Regime

There are mainly two methods employed by governments to determine the value of domestic

currency vis-à-vis other currencies : fixed and floating exchange rate.

Fixed exchange rate regime:

Fixed exchange rate, also known as a pegged exchange rate, is when a currency's value is maintained

at a fixed ratio to the value of another currency or to a basket of currencies or to any other measure

of value e.g. gold. In order to maintain a fixed exchange rate, a government participates in the open

currency market. When the value of currency rises beyond the permissible limits, the government

sells the currency in the open market, thereby increasing its supply and reducing value. Similarly,

when the currency value falls beyond certain limit, the government buys it from the open market,

resulting in an increase in its demand and value.

Another method of maintaining a fixed exchange rate is by making it illegal to trade currency at any

other rate. However, this is difficult to enforce and often leads to a black market in foreign currency.

Floating exchange rate regime:

Unlike the fixed rate, a floating exchange rate is determined by a market mechanism through supply

and demand for the currency. A floating rate is often termed "self-correcting", as any fluctuation in

the value caused by differences in supply and demand will automatically be corrected by the market.

For example, if demand for a currency is low, its value will decrease, thus making imported goods

more expensive and exports relatively cheaper. The countries buying these export goods will

demand the domestic currency in order to make payments, and the demand for domestic currency

will increase. This will again lead to appreciation in the value of the currency. Therefore, floating

exchange rate is self correcting, requiring no government intervention. However, usually in cases of

extreme appreciation or depreciation of the currency, the country’s Central Bank intervenes to

stabilize the currency. Thus, the exchange rate regimes of floating currencies are more technically

called a managed float.

Factors Affecting Exchange Rates

There are various factors affecting the exchange rate of a currency. They can be classified as

fundamental factors, technical factors, political factors and speculative factors.

A country’s currency exchange rate is typically affected by the supply and demand for the country’s

currency in the international foreign exchange market. The demand and supply dynamics is

principally influenced by factors like interest rates, inflation, and trade balance and economic &

political scenarios in the country. The level of confidence in the economy of a particular country also

influences the currency of that country

Fundamental factors:

The fundamental factors are basic economic policies followed by the government in relation to

inflation, balance of payment position, unemployment, capacity utilization, trends in import and

export, etc. Normally, other things remaining constant the currencies of the countries that follow

sound economic policies will always be stronger. Similarly, countries having balance of payment

surplus will enjoy a favorable exchange rate. Conversely, for countries facing balance of payment

deficit, the exchange rate will be adverse.

Technical factors:

Interest rates: Rising interest rates in a country may lead to inflow of hot money in the

country, thereby raising demand for the domestic currency. This in turn causes appreciation in the

value of the domestic currency.

Inflation rate: High inflation rate in a country reduces the relative competitiveness of the

export sector of that country. Lower exports result in a reduction in demand of the domestic currency

and therefore the currency depreciates.

Exchange rate policy and Central Bank interventions: Exchange rate policy of the country is

the most important factor influencing determination of exchange rates. For example, a country may

decide to follow a fixed or flexible exchange rate regime, and based on this, exchange rate

movements may be less/more frequent. Further, governments sometimes participate in foreign

exchange market through its Central bank in order to control the demand or supply of domestic

currency.

Political factors:

Political stability also influences the exchange rates. Exchange rates are susceptible to political

instability and can be very volatile during times of political crises.

Speculation:

Speculative activities by traders worldwide also affect exchange rate movements. For example, if

speculators think that the currency of a country is over valued and will devalue in near future, they

will pull out their money from that country resulting in reduced demand for that currency and

depreciating its value.

APPRECIATION AND DEPRECIATION OF INDIAN RUPPEES

The Rupee depreciated against the Dollar, with the close price of USDINR for May 2011 moving

from `44.5450 to `45.2425 during the period, experiencing an intraday high of `45.4875 and a low of

`44.4750.

The Rupee appreciated against the EURO, with the close price of EURINR for May 2011 moving

from `66.0825 to `65.0725 during the period, experiencing an intraday high of `66.7075 and a low of

`63.3625.

QUOTES

In currency markets, the rates are generally quoted in terms of USD. The price of a currency in terms

of another currency is called ‘quote’. A quote where USD is the base currency is referred to as a

‘direct quote’ (e.g. 1 USD – INR 48.5000) while a quote where USD is referred to as the terms

currency is an ‘indirect quote’ (e.g. 1 INR = 0.021 USD).

USD is the most widely traded currency and is often used as the vehicle currency. Use of vehicle

currency helps the market in reduction in number of quotes at any point of time, since exchange rate

between any two currencies can be determined through the USD quote for those currencies. This is

possible since a quote for any currency against the USD is readily available.

Any quote not against the USD is referred to as ‘cross’ since the rate is calculated via the USD.

For example, the cross quote for EUR-GBP can be arrived through EUR-USD quote * USD-GBP

quote (i.e. 1.406 * 0.606 = 0.852). Therefore, availability of USD quote for all currencies can help in

determining the exchange rate for any pair of currency by using the cross-rate.

TICK-SIZE

Tick size refers to the minimum price differential at which traders can enter bids and offers. For

example, the Currency Futures contracts traded at the NSE have a tick size of Rs. 0.0025. So, if the

prevailing futures price is Rs. 48.5000, the minimum permissible price movement can cause the new

price to be either Rs. 48.4975 or Rs. 48.5025. Tick value refers to the amount of money that is made

or lost in a contract with each price movement.

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. 52.2500. One tick move on this contract will translate

to Rs. 52.2475 or Rs. 52.2525 depending on the direction of market movement.

Purchase price: Rs. 52.2500

Price increases by one tick: + Rs. 00.0025

New price: Rs. 52.2525

Purchase price: Rs. 52.2500

Price decreases by one tick: Rs. 00.0025

New price: Rs. 52.2475

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 ticks, she makes Rupees 50.

Step 1: 52.2600 – 52.2500

Step 2: 4 ticks * 5 contracts = 20 points

Step 3: 20 points * Rs. 2.5 per tick = Rs. 50

(Note: please note the above examples do not include transaction fees and any other fees,

which are essential for calculating final profit and loss)

SPREADS

Spreads or the dealer’s margin is the difference between bid price (the price at which a dealer is

willing to buy a foreign currency) and ask price (the price at which a dealer is willing to sell a

foreign currency). the quote for bid will be lower than ask, which means the amount to be paid in

counter currency to acquire a base currency will be higher than the amount of counter currency that

one can receive by selling a base currency. For example, a bid-ask quote for USDINR of Rs.

47.5000 – Rs. 47.8000 means that the dealer is willing to buy USD by paying Rs. 47.5000 and sell

USD at a price of Rs. 47.8000. The spread or the profit of the dealer in this case is Rs. 0.30.

SPOT TRANSACTION AND FORWARD TRANSACTION

The spot market transaction does not imply immediate exchange of currency, rather the

settlement (exchange of currency) takes place on a value date, which is usually two business days

after the trade date. The price at which the deal takes place is known as the spot rate (also known as

benchmark price). The two-day settlement period allows the parties to confirm the transaction and

arrange payment to each other.

A forward transaction is a currency transaction wherein the actual settlement date is at a

specified future date, which is more than two working days after the deal date. The date of

settlement and the rate of exchange (called forward rate) is specified in the contract. The difference

between spot rate and forward rate is called “forward margin”.

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 Contracts

Forward contracts are agreements to exchange currencies at an agreed rate on a specified

future date. The actual settlement date is more than two working days after the deal date. The agreed

rate is called forward rate and the difference between the spot rate and the forward rate is called as

forward margin. Forward contracts are bilateral contracts (privately negotiated), traded outside a

regulated stock exchange and suffer from counter -party risks and liquidity risks. Counter Party risk

means that one party in the contract may default on fulfilling its obligations thereby causing loss to

the other party.

Futures Contracts

Futures contracts are also agreements to buy or sell an asset for a certain price at a future

time. Unlike forward contracts, which are traded in the over -the-counter market with no standard

contract size or standard delivery arrangements, futures contracts are exchange traded and are more

standardized. They are standardized in terms of contract sizes, trading parameters, settlement

procedures and are traded on a regulated exchange. The contract size is fixed and is referred to as lot

size.

Since futures contracts are traded through exchanges, the settlement of the contract is

guaranteed by the exchange or a clearing corporation and hence there is no counter party risk.

Exchanges guarantee the execution by holding an amount as security from both the parties. This

amount is called as Margin money. Futures contracts provide the flexibility of closing out the

contract prior to the maturity by squaring off the transaction in the market. Table 3.1 draws a

comparison between a forward contract and a futures contract.

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,

Banks, brokers, multinational

companies, institutional

investors, small traders,

arbitrageurs, traders, etc. 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

Risk Counter-Party risk is present

since no guarantee is provided

Exchange provides the

guarantee of settlement and

hence no counter party risk.

Trading Informal Over-the-Counter

market; Private contract

between parties

Traded on an exchange

Secured Risk is high being less

Secured

Highly secured through margin

deposit.

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.

Option:

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) MARKETThe 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 often 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.

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 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 0future. 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.

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 the tick value is. 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.

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

RATIONALE FOR INTRODUCING CURRENCY FUTURE

With the help of electronic trading and efficient risk management systems, Exchange traded currency

future has helped to get transparency and efficiency in price discovery, elimination of counterparty credit

risk, access to all types of market participants, standardized products and transparent trading platform.

Banks are also allowed to become members of this segment on the Exchange and this provides them new

opportunity in this market segment.

PRICING FUTURES

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, 2011, 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, 2011, expiring on June 9, 2011 is : the

answer will be Rs.46.7908 per dollar. Then, this theoretical price is compared with the quoted

futures price on January 10, 2011 and the relationship is observed.

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

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.

STRATEGIES USING CURRENCY FUTURESFutures contracts act as hedging tools and help in protecting the risks associated with

uncertainties in exchange rates. Anyone who is anticipating a future cash outflow (payment of

money) in a foreign currency, can lock-in the exchange rate for the future date by entering into a

futures contract. For example, let us take the example of an oil-importing firm - ABC Co. The

company is expected to make future payments of USD 100000 after 3 months in USD for payment

against oil imports. Suppose the current 3 -month futures rate is Rs. 45, then ABC Co. has two

alternatives:

OPTION A: ABC Co. does nothing and decides to pay the money by converting the INR to USD.

If the spot rate after three months is Rs. 47, the ABC Co. will have to pay INR 47, 00,000 to buy

USD 100000. Alternatively, if the spot price is Rs. 43.0000, ABC Co. will have to pay only INR

43, 00,000 to buy USD 100000. The point is that ABC Co. is not sure of its future liability and is

subject to risk of exchange rate fluctuations.

OPTION B: ABC Co. can alternatively enter into a futures contract to buy 1,00,000 USD at Rs. 45

and lock in the future cash outflow in terms of INR. In this case, whatever may be the prevailing

spot market price after three months the company’s liability is locked in at INR 45,00,000. In other

words, the company is protected against adverse movement in the exchange rates.

This is known as hedging and currency futures contracts are generally used by hedgers to

reduce any known risks relating to the exchange rate.

In a currency futures contract, the party taking a long (buy) position agrees to buy the base

currency at the future rate by paying the terms currency. The party with a short (sell) position agrees

to sell the base currency and receive the terms currency at the pre-specified exchange rate. When the

base currency appreciates and the spot rate at maturity date (S) becomes more than the strike rate in

the futures contract (K), the ‘long’ party who is going to buy the base currency at the strike rate

makes a profit. The party with the ‘long’ position can buy the USD at a lower rate and sell in the

market where the exchange rate is higher thereby making a profit.

The party with a ‘short’ position loses since it has to sell the base currency at a price lower

than the prevailing spot rate. When the base currency depreciates and falls below the strike rate

(K), the ‘long’ party loses and a ‘short’ position gains. This is depicted in Figure 4-1 as a pay-off

diagram. In the pay-off diagram the profits are illustrative above the horizontal line and the losses

below. The movement in the exchange rate is given on the horizontal line. The straight line

(diagonal) indicates the pay-off for a buyer of USDINR contract. This pay-off is also called as a

‘linear pay-off’.

An exposure in the currency futures market without any exposure (actual or expected) in the spot

market becomes a speculative transaction. However, the role of speculators cannot be undermined in

the futures market. They play an active role in the derivatives market and help in providing liquidity

to the market. In this chapter, we will discuss the various positions that can be taken in a futures

market. We will also discuss the relevance of each position to different market players.

Figure4.1: Payoff from an USD-INR Futures Contract (Base Currency – USD)

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 nonlinear.

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.

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 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.

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’ often 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

Hedging in currency market can be done through two positions, viz. Short Hedge and Long

Hedge. They are explained as under:

Short-Hedge

A short hedge involves taking a short position in the futures market. In a currency market,

short hedge is taken by someone who already owns the base currency or is expecting a future receipt

of the base currency. An example where this strategy can be used:

An exporter, who is expecting a receipt of USD in the future, will try to fix the conversion

rate by holding a short position in the USD-INR contract. Box 4.1 explains the pay-off from a short

hedge strategy through an example.

Long Hedge

A long hedge involves holding a long position in the futures market. A Long position holder

agrees to buy the base currency at the expiry date by paying the agreed exchange rate. This strategy

is used by those who will need to acquire base currency in the future to pay any liability in the

future. An example where this strategy can be used:

An importer who has to make payment for his imports in USD will take a long position in

USDINR contracts and fix the rate at which he can buy USD in future by paying INR. Box 4.2

explains the pay-off from a long hedge strategy in currency market.

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 2010. And he will have to pay 100000 USD on 1st

February 2011. 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 FROM NSE SITE (REFER CURRENCY PROJECT

1)

Choice of the number of contracts (hedging ratio)

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

position should be taken to match as closely as possible the value of the cash market position. As we

know that in the futures markets due to their standardization, exact match will generally not be

possible but hedge ratio should be as close to unity as possible. We may define the hedge ratio HR as

follows:

HR= VF / Vc

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

Suppose value of contract dated 28th January 2011 is 49.8850.

And spot value is 49.8500.

HR=49.8850/49.8500=1.001.

SPECULATION IN CURRENCY FUTURES

Futures contracts can also be used by speculators who anticipate that the spot price in the

future will be different from the prevailing futures price. For speculators, who anticipate a

strengthening of the base currency will hold a long position in the currency contracts, in order to

profit when the exchange rates move up as per the expectation. A speculator who anticipates a

weakening of the base currency in terms of the terms currency, will hold a short position in the

futures contract so that he can make a profit when the exchange rate moves down. Speculators prefer

taking positions in the futures market to the spot market because of the low investment required in

case of futures market. In futures market, the parties are required to pay just the margin money

upfront, but in case of spot market, the parties have to invest the full amount, as they have to

purchase the foreign currency.

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 mispricing 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.

NEED FOR EXCHANGE TRADED CURRENCY

FUTURESCurrency futures are needed if your business is influenced by fluctuations in currency exchange

rates. If you are in India and are importing something, you have done the costing of your imports on

the basis of a certain exchange rate between the Indian Rupee and the relevant foreign currency. By

the time you actually import, the value of the Indian Rupee may have gone down and you may lose

out on your income in terms of Indian Rupees by paying higher. On the contrary, if you are

exporting something and the value of the Indian Rupee has gone up, you earn less in terms of

Rupees than you had anticipated. Currency futures help you hedge against these exchange rate risks.

Currency futures benefits to investors as :

Importers/Exporters may have some obligations in Forex market, trading in Currency Futures

will help them hedge their positions. Similarly, any investor can trade in Currency Futures with

or with no obligations.

The counter-party risk is eliminated as the clearing corporation guarantees the trades.

By ensuring that the best price is available to all categories of market participants, transactions

are executed on a price time priority.

In Currency Futures, mark to market obligations are settled on a daily basis, unlike a forward

contract, which is an agreement to transact at a forward price on a future date and no money

changes hands except on the maturity date.

EXCHANGES ENGAGED IN CURRENCY FUTURE IN INDIA

NSE- Started in Aug,2008

MCX-SX-Started in October,2008

BSE- Started in October,2008

USE-Will start on 31st Aug,2010

AVAILABLE CURRENCY FUTURES IN INDIA

US Dollar - Rupee Currency Futures Contract

Euro - Rupee Currency Futures Contract-It was introduced on 29th Jan, 2010

British Pound - Rupee Currency Futures Contract-It was introduced on 29th Jan, 2010

Yen - Rupee Currency Futures Contract-It was introduced on 29th Jan, 2010

FUTURE TERMINOLOGY SPOT PRICE :

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

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

virtually immediate, the term, cash market, has also been used to refer to spot dealing. In the case of

USDINR, spot value is T + 2.

FUTURE PRICE :

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

CONTRACT CYCLE :

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

one month, two month, and three month up to twelve month expiry cycles. In NSE/BSE will have 12

contracts outstanding at any given point in time.

VALUE DATE / FINAL SETTELMENT DATE :

The last business day of the month will be termed the value date /final settlement date of

each contract. The last business day would be taken to the same as that for inter bank settlements in

Mumbai. The rules for inter bank settlements, including those for ‘known holidays’ and would be

those as laid down by Foreign Exchange Dealers Association of India (FEDAI).

EXPIRY DATE :

It is the date specified in the futures contract. This is the last day on which the contract will be

traded, at the end of which it will cease to exist. The last trading day will be two business days prior

to the value date / final settlement date.

CONTRACT SIZE :

The amount of asset that has to be delivered under one contract. Also called as lot size. In case of

USDINR it is USD 1000.

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.

TRADING PROCESS AND SETTLEMENT PROCESS

What is currency trading?

While trade is international, currencies are national. As international transactions are settled in

global currencies, usually they are brought/sold for one another and this constitutes ‘currency

trading’.

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.

TRADING PARAMETERS

Base Price

Base price of the USD/INR Futures Contracts on the first day shall be the theoretical futures

price. The base price of the Contracts on subsequent trading days will be the daily settlement price of

the USD/INR futures contracts.

Closing Price

The closing price for a futures contract is currently calculated as the last half an hour

weighted average price of the contract. In case a futures contract is not traded on a day, or not traded

during the last half hour, a 'theoretical settlement price' is computed as may be decided by the

relevant authority from time to time.

Dissemination of Open, High, Low, and

Last-Traded Prices

During a trading session, the Exchange continuously disseminates open, high, low, and last-

traded prices through its trading system on real time basis.

TENORS OF FUTURES CONTRACT

The tenor of a contract means the period when the contract will be available for futures

trading, i.e. the period between the start of trading and the day it expires. This period is also known

as the “trading cycle” of the contract. The currency future contract will be available for trading with

a maximum maturity of 12 months.

Expiry Date

All contracts expire on the last working day (excluding Saturdays) of the contract months.

The last day for the trading of the contract shall be two working days prior to the final settlement.

Final Settlement Rate

Final Settlement rate would be the Reserve Bank (RBI) Reference rate for the date of expiry.

TYPES OF ORDERS

The system allows the trading members to enter orders with various conditions attached to

them as per their requirements.

These conditions are broadly divided into the following categories:

Time conditions

Price conditions

Other conditions

Several combinations of the above are allowed thereby providing enormous flexibility to the users.

The order types and conditions are summarized below.

• Time conditions

- Day order: A day order, as the name suggests is an order which is valid for the day on which it is

entered. If the order is not executed during the day, the system cancels the order automatically at the

end of the day.

- Immediate or Cancel (IOC): An IOC order allows the user to buy or sell a contract as soon as the

order is released into the system, failing which the order is cancelled from the system. Partial match

is possible for the order, and the unmatched portion of the order is cancelled immediately.

• Price condition

- Market price: Market orders are orders for which no price is specified at the time the order is

entered (i.e. price is market price). For such orders, the trading system determines the price.

- Limit price: An order to a broker to buy a specified quantity of a security at or below a specified

price, or to sell it at or above a specified price (called the limit price). This ensures that a person will

never pay more for the futures contract than whatever price is set as his/her limit. It is also the price

of orders after triggering from stop-loss book.

Stop-loss: This facility allows the user to release an order into the system, after the market price of

the security reaches or crosses a threshold price e.g. if for stop-loss buy order, the trigger is Rs.

42.0025, the limit price is Rs. 42.2575 , then this order is released into the system once the market

price reaches or exceeds Rs. 42.0025. This order is added to the regular lot book with time of

triggering as the time stamp, as a limit order of Rs. 42.2575. be less than the limit price and for the

stop-loss sell order, the trigger price has to be greater than the limit price.

• Other conditions

- Pro: Pro means that the orders are entered on the trading member's own account.

- Cli: Cli means that the trading member enters the orders on behalf of a client.

In exchange traded derivative contracts, the Clearing Corporation acts as a central counterparty to all

trades and performs full notations. The risk to the clearing corporation can only be taken care of

through a stringent margining framework. Also, since derivatives are leveraged instruments, margins

also act as a cost and discourage excessive speculation. A robust risk management system should

therefore, not only impose margins on the members of the clearing corporation but also enforce

collection of margins from the clients.

Price Limit Circuit Filter

There shall be no daily price bands applicable for Currency Futures contracts. However in order to

prevent erroneous order entry by members, operating ranges will be kept at +/-3% of the base price

for contracts with tenure upto 6 months and +/-5% for contracts with tenure greater than 6 months.

In respect of orders which have come under price freeze, the members would be required to confirm

to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On

such confirmation, the Exchange may take appropriate action.

REGULATORY FRAMEWORK FOR CURRENCY

FUTURESWith 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. 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.

PRODUCT DEFINITIONS OF CURRENCY

FUTURE ON NSE/BSE

Underlying

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

Trading Hours

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

Size of the contract

The minimum contract size of the currency futures contract at the time of introduction would be US$

1000. The contract size would be periodically aligned to ensure that the size of the contract remains

close to the minimum size.

Quotation

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

would be in dollar terms.

Tenor of the contract

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

Available contracts

All monthly maturities from 1 to 12 months would be made available.

Settlement mechanism

The currency futures contract shall be settled in cash in Indian Rupee.

Settlement price

The settlement price would be the Reserve Bank Reference Rate on the date of expiry. The

methodology of computation and dissemination of the Reference Rate may be publicly disclosed by

RBI.

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:

PRICE WATCH AS ON 7 JULY 2011 ON NSE

MCX Stock Exchange (MCX-SX), India’s new stock exchange, commenced operations in

the Currency Derivatives Segment on October 7, 2008 under the regulatory framework of Securities

& Exchange Board of India (SEBI) and Reserve Bank of India (RBI). The Exchange is recognized

by SEBI under Section 4 of Securities Contracts (Regulation) Act, 1956.

A new generation stock exchange, MCX-SX offers a world-class electronic platform for

trading in currency futures contracts and is currently the market leader in this segment. Within a year

of inception, MCX-SX has achieved a stupendous growth in average daily turnover and open

interest. The average daily turnover increased from Rs 355 crore during its first month of operations

to Rs 18,359 crore in March 2011. In line with global best practices and regulatory requirements,

clearing and settlement is conducted through a separate Clearing Corporation MCX-SX Clearing

Corporation Ltd. (MCX-SX CCL). MCX-SX currently witnesses participation from 555 towns and

cities across India and has a strong member base of 734. MCX-SX believes in the philosophy of

‘Systematic Development of Markets through Information, Innovation, Education and

Research.’ The Exchange endeavours to ensure continuous innovation and to introduce various new

products under the extant regulatory framework. The Exchange is in readiness to commence Equity

segment and Equity Futures & Options segment besides other products such as Interest Rate Futures,

SME segment securities, Index Funds and Exchange Traded Funds etc, on receiving regulatory

approvals.

CURRENCY FUTURES MARKET - A PERSPECTIVE

Globalization and integration of financial markets, coupled with progressive increase of

cross-border flow of capital, have transformed the dynamics of Indian financial markets. This has

increased the need for dynamic currency risk management. The steady rise in India’s foreign trade

along with liberalization in foreign exchange regime has led to large inflow of foreign currency into

the system in the form of FDI and FII investments.

In order to provide a liquid, transparent and vibrant market for foreign exchange rate risk

management, Securities & Exchange Board of India (SEBI) and Reserve Bank of India (RBI) have

allowed trading in currency futures on stock exchanges for the first time in India, initially based on

the USDINR exchange rate and subsequently on three other currency pairs – EURINR, GBPINR and

JPYINR. The USDINR futures contract is already being traded on MCX-SX with more than US$ 2

billion average daily turnover. This would give Indian businesses another tool for hedging their

foreign exchange risk effectively and efficiently at transparent rates on an electronic trading

platform. The primary purpose of exchange-traded currency derivatives is to provide a mechanism

for price risk management and consequently provide price curve of expected future prices to enable

the industry to protect its foreign currency exposure. The need for such instruments increases with

increase of foreign exchange volatility.

Does the national economy of India need currency futures?

Every business exposed to foreign exchange risk needs to have a facility to hedge against such risk.

Exchange-traded currency futures, as on MCX-SX, are a superior tool for such hedging because of

greater transparency, liquidity, counterparty guarantee and accessibility. Since the economy is made

up of businesses of all sizes, anything that is good for business is also good for the national

economy.

Participants of a currency futures market

A host of benefits are available to a wide range of financial market participants, including hedgers

(exporters, importers, corporate and Banks), investors and arbitrageurs on MCX-SX.

Hedgers: A high-liquidity platform for hedging against the effects of unfavourable

fluctuations in the foreign exchange markets is available on exchange. Banks, importers, exporters

and corporate houses hedge on MCX-SX.

Investors: All those interested in taking a view on appreciation (or depreciation) of exchange

rate in the long and short term can participate in the MCX-SX currency futures. For example, if one

expects depreciation of the Indian Rupee against the US dollar, then he can hold on long (buy)

position in USDINR contract for returns. Contrarily, he can sell the contract if he sees appreciation

of the Indian Rupee.

Arbitrageurs: Arbitrageurs get the opportunity of trading in currency futures by

simultaneous purchase and sale in two different markets, taking advantage of price differential

between the markets.

Product Specifications - JPYINR

Symbol JPYINR

Instrument Type FUTCUR

Unit of trading 1 (1 unit denotes 100000 YEN)

Underlying JPY

Quotation/Price Quote Rs per 100 YEN

Tick size 0.25 paise or INR 0.0025

Trading hours Monday to Friday - 9:00 a.m. to 5:00 p.m.

Contract trading cycle 12 month trading cycle.

Settlement price Exchange rate published by the Reserve Bank in its

Press Release captioned RBI Reference Rate for

US$ and Euro.

Last trading day Two working days prior to the last business day of the expiry

month at 12 noon.

Final settlement day Last working day (excluding Saturdays) of the expiry month.

The last working day will be the same as that for Interbank

Settlements in Mumbai.

Base price Theoretical price on the 1st day of the contract. On all other

days, DSP of the contract

Price operating range Tenure upto 6 months: +/-3 % of base price

Tenure greater than 6 months: +/- 5% of base price

Position limits

Clients Higher of 6% of total open interest or

JPY 200 million

Trading Members Higher of 15% of the total open interest or

JPY 1000 million

Banks Higher of 15% of the total open interest or

JPY 2000 million

Minimum initial

margin

4.50% on first day & 2.30% thereafter

Extreme loss margin 0.7% of MTM value of gross open positions.

Calendar spreads Rs. 600 for a spread of 1 month; Rs 1000 for a spread of 2

months and Rs 1500 for a spread of 3 months or more

Settlement Daily settlement : T + 1

Final settlement : T + 2

Mode of settlement Cash settled in Indian Rupees

Daily settlement price

(DSP)

DSP shall be calculated on the basis of the last half an hour

weighted average price of such contract or such other price as

may be decided by the relevant authority from time to time.

Final settlement price

(FSP)

Exchange rate published by the Reserve Bank in its Press

Release captioned RBI Reference Rate for US$ and Euro.

Product Specifications - EURINR

Symbol EURINR

Instrument Type FUTCUR

Unit of trading 1 (1 unit denotes 1000 EURO)

Underlying EURO

Quotation/Price Quote Rs. per EUR

Tick size 0.25 paise or INR 0.0025

Trading hours Monday to Friday - 9:00 a.m. to 5:00 p.m.

Contract trading cycle 12 month trading cycle.

Settlement price RBI Reference Rate on the date of expiry.

Last trading day Two working days prior to the last

business day of the expiry month at 12

noon.

Final settlement day Last working day (excluding Saturdays)

of the expiry month. The last working day

will be the same as that for Interbank

Settlements in Mumbai.

Base price Theoretical price on the 1st day of the

contract. On all other days, DSP of the

contract

Price operating range Tenure upto 6 months: +/-3 % of base

price Tenure greater than 6 months: +/-

5% of base price

Position limits

Clients Higher of 6% of total open interest or

EUR 5 million

Trading Members Higher of 15% of the total open interest

or EUR 25 million

Banks Higher of 15% of the total open interest

or EUR 50 million

Minimum initial margin 2.8% on First day & 2% thereafter

Extreme loss margin 0.3% of MTM value of gross open

positions

Calendar spreads Rs.700/- for a spread of 1 month, 1000/-

for a spread of 2 months, Rs.1500/- for a

spread of 3 months or more

Settlement Daily settlement : T + 1

Final settlement : T + 2

Mode of settlement Cash settled in Indian Rupees

Daily settlement price

(DSP)

DSP shall be calculated on the basis of

the last half an hour weighted average

price of such contract or such other price

as may be decided by the relevant

authority from time to time.

Final settlement price

(FSP)

RBI reference rate

Product Specifications – GBPINR

Symbol GBPINR

Instrument Type FUTCUR

Unit of trading 1 (1 unit denotes 1000 POUND

STERLING))

Underlying POUND STERLING

Quotation/Price Quote Rs. per GBP

Tick size 0.25 paise or INR 0.0025

Trading hours Monday to Friday - 9:00 a.m. to 5:00 p.m.

Contract trading cycle 12 month trading cycle.

Settlement price Exchange rate published by the Reserve

Bank in its Press Release captioned RBI

Reference Rate for US$ and Euro.

Last trading day Two working days prior to the last

business day of the expiry month at 12

noon.

Final settlement day Last working day (excluding Saturdays)

of the expiry month. The last working day

will be the same as that for Interbank

Settlements in Mumbai.

Base price Theoretical price on the 1st day of the

contract. On all other days, DSP of the

contract

Price operating range Tenure upto 6 months: +/-3 % of base

price

Tenure greater than 6 months: +/- 5% of

base price

Position limits

Clients Higher of 6% of total open interest or

GBP 5 million

Trading Members Higher of 15% of the total open interest

or GBP 25 million

Banks Higher of 15% of the total open interest

or GBP 50 million

Minimum initial margin 3.2% on first day & 2% thereafter

Extreme loss margin 0.5% of MTM value of gross open

positions.

Calendar spreads Rs.1500/- for a spread of 1 month, 1800/-

for a spread of 2 months, Rs.2000/- for a

spread of 3 months or more

Settlement Daily settlement : T + 1

Final settlement : T + 2

Mode of settlement Cash settled in Indian Rupees

Daily settlement price

(DSP) DSP shall be calculated on the basis of

the last half an hour weighted average

price of such contract or such other price

as may be decided by the relevant

authority from time to time.

Final settlement price

(FSP) Exchange rate published by the Reserve

Bank in its Press Release captioned RBI

Reference Rate for US$ and Euro.

Product Specifications – USDINR

Symbol USDINR

Instrument Type FUTCUR

Unit of trading 1(1 unit denotes 1000 USD)STERLING))

Underlying The exchange rate in Indian Rupees for a

US Dollar

Quotation/Price Quote Rs. per GBP

Tick size 0.25 paise or INR 0.0025

Trading hours Monday to Friday - 9:00 a.m. to 5:00 p.m.

Contract trading cycle 12 month trading cycle.

Settlement price Exchange rate published by the Reserve Bank in

its Press Release captioned RBI Reference Rate

for US$ and Euro.

Last trading day Two working days prior to the last business day

of the expiry month at 12 noon.

Final settlement day Last working day (excluding Saturdays) of the

expiry month. The last working day will be the

same as that for Interbank Settlements in

Mumbai.

Base price Theoretical price on the 1st day of the contract.

On all other days, DSP of the contract

Price operating range Tenure upto 6 months: +/-3 % of base price

Tenure greater than 6 months: +/- 5% of base

price

Position limits

Clients Higher of 6% of total open interest or

USD 10 million

Trading Members Higher of 15% of the total open interest or USD

50 million

Banks Higher of 15% of the total open interest or USD

100 million

Minimum initial margin 1.75% on first day & 1% thereafter

Extreme loss margin 1% of MTM value of gross open position.

Calendar spreads Rs. 400/- for a spread of 1 month, Rs. 500/- for

a spread of 2 months, Rs. 800/- for a spread of 3

months & Rs. 1000/- for a spread of 4 months or

more

Settlement Daily settlement : T + 1

Final settlement : T + 2

Mode of settlement Cash settled in Indian Rupees

Daily settlement price

(DSP) DSP shall be calculated on the basis of the last

half an hour weighted average price of such

contract or such other price as may be decided

by the relevant authority from time to time.

Final settlement price

(FSP) RBI reference rate

USDINR

PRICE

VOLUME

OPEN

INTEREST

During

May

2011,

the

market share of the Exchange stood at 41.18% in the Currency Futures market. The average traded

daily turnover in MCX-SX was `17,023.07 crores with average daily contracts of 3,695,791.

Geo -Insights

Globally, recovery is expected to sustain in 2011 even as it is projected to moderate marginally from

its 2010 pace due to the phasing out of the fiscal stimulus. However new risks have emerged with

challenges like rising oil and other commodity prices, inflationary pressures in some emerging

economies and after effects of tragic earthquake in Japan.

Turning to the domestic macroeconomic situation as reported by RBI in its Monetary Policy

Statement for 2011-12, the Indian economy is estimated to have grown by 8.6% last year. The index

of industrial production (IIP), which grew by 10.7% during the first half of last year, moderated

subsequently, bringing down the overall growth for April 2010 - February 2011 to 7.8%. Particularly

significant were the slowdown in capital goods production and investment spending. Going forward,

high oil and other commodity prices and the impact of the Reserve Bank’s anti-inflationary

monetary stance will moderate growth. Based on the assumption of a normal monsoon, and crude oil

prices averaging US$110 a barrel over the full year 2011-12, the baseline projection of real GDP

growth for 2011-12, for policy purposes, is around 8%.

Can currency futures help small traders?

Yes. The minimum size of the USDINR futures contract is USD 1,000. Similarly EURINR future

contract is EURO 1000, GBPINR future contract is GBP 1000 and JPYINR future contract is YEN

1,00,000. These are well within the reach of most small traders.

All transactions on the Exchange are anonymous and are executed on a price time priority ensuring

that the best price is available to all categories of market participants irrespective of their size. As the

profits or losses in the futures market are also paid / collected on a daily basis, the scope of

accumulation of losses for participants gets limited.

What are the terms and conditions set by RBI for Banks to participate in exchange traded fx

futures?

RBI has allowed Banks to participate in currency futures market.

The AD Category I Banks which fulfill stipulated prudential requirements are eligible to become a

clearing member and / or trading member of the currency derivatives segment of MCX-SX.

AD Category I Banks which are urban co-operative banks or state co-operative banks can participate

in the currency futures market only as a client, subject to approval thereof, from the respective

regulatory department of RBI.

Which are the global exchanges that provide trading in currency futures?

Internationally, exchanges such as Chicago Mercantile Exchange (CME), Johannesburg Stock

Exchange, Euronext.liffe, BM&FBOVESPA and Tokyo Financial Exchange provide trading in

currency futures.

Why should one trade in Indian exchanges as compared to international exchanges?

Indian currency futures enable individuals and companies in India to hedge and trade their Indian

Rupee risk. Most international exchanges offer contracts denominated in other currencies.

Trends in Currency Future in India

Currency futures trading started in India on August 29, 2008 on National Stock Exchange. This was

the first time currency derivatives got listed on an exchange in India. Till this time, the currency

futures trading took place over the counter and were unorganized. With the entry of the National

Stock Exchange in the picture, currency trading became more organized with the NSE acting as a

counter party to all the transactions. Soon after the BSE and MCX also marked their entry into the

currency derivatives market.

Volumes on currency futures exchanges (mainly NSE and MCX) have consistently increased since

the start of trading. Combined daily volumes on the most active currency futures bourses — MCX

Stock Exchange (MCX-SX) and the National Stock Exchange (NSE) —The BSE has failed to

generate enough interest in this segment and the volumes remain abysmally low on the exchange.

Although volatility has ensured that volumes surged after the launch, trading has been concentrated

on front-month contracts as majority of users are traders, small exporters and brokers/banks. (Refer

history currency)

BENEFITS OF CURRENCY TRADING IN INDIA

Easy Accessibility - Small investors would get an easy access to currency futures trading on the

popular exchanges

Easy Affordability - Margins are very low and the contract size is very small.

Low Transaction Cost - As opposed to the high pay-out of commissions in overseas forex

trading, currency futures carries low costs for investors

Transparency - It is possible for you to verify trade details on NSE if you have a doubt that the

broker has tried to cheat you.

Counter-party default risk - All the trades done on the recognized exchanges are guaranteed by

the clearing corporations and hence it eliminates the risks associated with counter party default.

NSCCL (National Securities Clearing Corporation Limited) carries out all the notation, clearing

and settlement process of currency futures trading

Standardized Contracts - Exchange Traded currency futures are standardized in respect of lot

size ($1000) and maturity (12 monthly contracts). Retail investors with their limited resources

would find it tremendously beneficial to take positions in standardised USD INR futures

contracts.

Moreover, the currency futures market is used by some companies for hedging. These

companies either purchase currency futures for their future payables, or sell the futures on

currencies for their future receipts.

Speculators may also buy or sell futures on a foreign currency as a protection against the

strengthening or weakening of the US dollar. So, speculators may be able to earn profit from the

rise or fall of these exchange rates.

OPPORTUNITIES

Introduction of Options trading

FII participation could be allowed.

NRI participation could be allowed which would add to more volumes and liquidity.

Positions larger than $5 million could be allowed - a tiny limit when compared with the size of

exposure that is found in a trillion dollar economy.

FINDINGS

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.

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 POUNDINR, 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.

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.

Currency Futures – the road ahead

Standardised rules for lot sizes and trading, framed by the Reserve Bank of India, means exchanges

and brokers have to rely on better technology and back-end support to attract clients. Currency futures

today are offered only for rupeedollar contracts for longer periods (12 contracts) than the existing

forward contracts (3 contracts – 3 months, 6

monthsand 12 months). MCX-SX will launch 11 currency trading websites in regional languages

(having launched 5 so far – in Hindi, Marathi, Gujarati, Tamil and Malayalam).

Liberalisation in terms of changes in the contract size, variable lot sizes and extended trading

hours could help encourage larger participation. The rupee futures have a contract size of

$1,000. The position limit for a client is higher of 6% of the total open interest or $ 5 million.

For the trading member it is higher of 15% of the total open interest or $25 million. If the

trading member is a bank it is higher of 15% of the total open interest or $ 100 million.

Hence till the total open interest rises, a participant cannot increase his open interest beyond

present proportion/limits.

Foreign institutional investors are excluded from the market and their inclusion as participants

can help in stepping up volumes significantly.

SEBI has approved a fourth exchange, promoted by a clutch of public and private sector

banks, to commence trading in rupee-dollar futures. United Stock Exchange of India,

expected to come on line in February 2009, is the fourth currency futures bourse after

National Stock Exchange, MCX-SX and BSE. The new stock exchange has been promoted

by key PSU lenders such as Bank of India, Bank of Baroda, Canara Bank, Andhra Bank,

Allahabad Bank, Indian Overseas Bank and Oriental Bank of Commerce, Union Bank of

India and United Bank of India jointly with MMTC that together will hold minimum 49% in

the bourse. Other shareholders include Standard Chartered Bank, Federal Bank, Tata

Consultancy Services and STCI, who will jointly own 25% and national-level brokers with

20% stake.