currency futures

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A Project report On Price risk management using currency futures for Greenback Forex Services Ltd. In partial fulfillment of the requirements of Masters of Management Studies conducted by University of Mumbai through Rizvi Institute of Management Studies and Research under the guidance of Prof. Vishal Singhi

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trends of currency futures in india

Transcript of currency futures

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A

Project report

On

Price risk management using currency futures

for

Greenback Forex Services Ltd.

In partial fulfillment of the requirements of

Masters of Management Studies

conducted by

University of Mumbai

through

Rizvi Institute of Management Studies and Research

under the guidance of

Prof. Vishal Singhi

Submitted by

Kaynat Chainwala

MMS

Batch: 2011 – 2013

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CERTIFICATE

This is to certify that Ms. Kaynat Chainwala, a student of Rizvi Management Institute, of MMS

III bearing Roll No. 32 and specializing in Finance has successfully completed the project titled

“Price risk management using currency futures”

under the guidance of Prof. Vishal Singhi in partial fulfillment of the requirement of Masters of

Management Studies by Rizvi Management Institutes for the academic year 2011 – 2013.

_______________

Prof. Vishal Singhi

Project Guide

_______________ ______________

Prof. Umar Farooq Dr. Kalim Khan

Academic Coordinator Director

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ACKNOWLEDGEMENT

I would like to express my sincere gratitude towards thanking the following people:

Prof. Vishal Singhi, Internal Mentor, for supporting & guiding me through my summer

internship project.

I thank Dr. Kalim Khan, Director, Rizvi Institute of Management studies & Research, Mumbai,

for providing me the opportunity to have such a good experience of an internship project.

Finally, I am highly thankful to my parents, friends and my entire family, who have supported

me in this venture.

Kaynat Chainwala

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Executive summary

The Indian rupee, that has weakened almost 25 per cent against the US dollar since the beginning

of the year 2012 is likely to remain volatile for some more time to come mainly due to

uncertainty in the domestic and global economic outlook. The partially convertible rupee got

battered in the month of June; 2012 and hit a record low of 56.80 against the dollar which was

almost 12 per cent down from the year's high of 50.57 recorded in March, 2012.

The rising oil import bill, increasing trade deficit, inflation, interest rates, capital outflows, slow

pace of Euro crisis which led to the recent depreciation of the Rupee especially post August 2011

have serious implications. The industry would be inhibited to go for capex due to cost escalations

as a result of import-led inflation, implied cost of borrowing in foreign currency. Exports will

become more competitive and demand should also benefit from a gradual, albeit very slow,

improvement in the global scenario. Simultaneously, the import bill of manufacturers will, or is

already rising. However, over time a realistic exchange rate should lend stability and

sustainability to economic performance.

The time has come for companies to use hedging as a well-planned ingredient and not continue

to use it as a short term strategic measure for risk management. Unlike the economic crisis of

2008 when oil prices crashed to aggravate the situation, the current volatility owed itself to

increasing demand for foreign exchange fuelled by domestic demand - for both internal like

import of gold and exports and the reluctance of the Reserve Bank of India to stem the runaway

depreciation of the rupee.

"Risk management has assumed underlined importance for the companies.”Risk

management strategies for hedging foreign exchange, interest rate and commodity price risks

have assumed an imperative adjunct of corporate strategy, more so in a globalised economic

structure.

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TABLE OF CONTENTS:

RESEARCH OBJECTIVE 1

CURRENCY MARKETS

Current Status 2

Overview 5

Factors that affect currency rates 8

CURRENCY/FOREX RISK MANAGEMENT

Currency risks 10

FOREX Risk Management- Process and Necessity 13

Hedging Strategies 14

Derivatives Instruments traded in India 15

Business Growth in Currency Derivatives in India 20

CURRENCY FUTURES

Introduction 21

Rationale 23

Market players 26

Major exchanges 29

NSE

MCX-SX

USE

Trading and volumes 31

Major contracts traded on the exchange 32

Futures terminology 33

Product specification 35

Pricing futures

Cost of carry model 37

Hedging with currency futures 38

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Currency futures payoffs 42

MANAGING CURRENCY RISK USING FUTURES

Using Purchasing Power Parity (PPP) 44

Using Interest Rate Parity (IRP) 45

Quantitative analysis

Open interest and volumes of contracts traded 46

Correlation between OI and volumes traded 47

Returns for the past year 48

Historical volatility 49

Research work 50

CONCLUSION 51

BIBLIOGRAPHY 52

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RESEARCH OBJECTIVE

The main objective of this study is to study risks and hedging techniques used to manage them.

A significant number of firms hedge their risk exposures, with wide variations in which risks get

hedged and the tools used for hedging. A significant number of firms hedge against risks, some

risks seem to be hedged more often than others.

In this report, we will look at the most widely hedged risks – Exchange rate risk.

The most widely hedged risk is Exchange rate risk because it not only affects the multinational

companies but also the domestic companies since their revenue are dependent on inputs from

foreign markets.

Derivatives have been used to manage risk for a very long time, but they were available only to a

few firms and at high cost, since they had to be customized for each user. The development of

options and futures markets in the 1970s and 1980s allowed for the standardization of derivative

products, thus allowing access to even individuals who wanted to hedge against specific risk.

The range of risks that are covered by derivatives grows each year, and there are very few

market-wide risks that you cannot hedge today using options or futures.

The introduction of currency futures in India has passed a journey of almost four years and many

changes have been implemented in the trading system in this regard. Currency futures have

significantly gained importance all over the world since the first currency futures contract was

traded in the year 1972. The futures market holds a great importance in the economy and,

therefore, it becomes imperative that we analyse this important market and seek answers to a few

basic questions. The main theme of this paper is to assess the speed in which the growth of

currency futures in India has accelerated. It also aims at examining the volatility of the currency

futures. In order to study the growth of the currency futures, the number of contracts traded and

open interest at NSE has been inclusively compared.

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“If you don’t invest in risk management, it doesn’t matter what business you’re in, it’s a risky

business.”

INDIAN CURRENCY MARKETS

CURRENT SCENARIO:

When India remained largely unaffected by the US sub-prime crisis of 2007-08 that snowballed

into a global financial crisis, it was praised for not being exposed to complex debt instruments.

That was perhaps a good thing then.

But four years later, the scenario has changed. Now, India is more integrated with the global

economy. Besides, the interest rate outlook has turned more volatile.

The rupee crossed historic 56.40 levels recently against the dollar and depreciated against other

major currencies. The volatility in rupee movements is only set to increase on account of a host

of external and domestic forces.

The importance of currency risk management — adopting new hedging methods and moving

beyond forward contracts — has increased in this scenario. Bungling on currency risk

management can adversely affect profits, sales, cost, revenue and competitiveness of companies

involved in international business

HEDGING ERRORS

Indian companies mainly use forward contract derivatives from their banks to hedge currency

exchange risk. Exchange-traded currency futures and options are yet to become popular, in spite

of the fact that these were introduced by RBI and SEBI to provide a transparent hedging system,

especially to small and medium scale units.

Indian companies went in for over-the-counter derivatives, duly encouraged by banks, only to

have their fingers burnt when the rupee rates moved against them.Such structures were

developed for speculation rather than for hedging, and now have been banned by RBI.

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Another area where currency risk has been mismanaged is foreign currency loans. Companies

have taken huge cheap dollar loans, which have turned expensive with steep depreciation of the

rupee.

PROSPECTS AHEAD

Foreign currency exposures must be divided into monthly, quarterly, half-yearly and yearly

basis. Short-term exposures up to, say, one month may be fully covered with forward contract

derivatives, and after that the strategy of partial hedging may be used to deal with volatility in the

dollar-rupee rate.

The concept of stop loss, to follow market trends for hedging, should now be used seriously.

Option and futures exchange traded derivatives, which have transparency and offsetting

characteristics, may be used when rupee volatility against the dollar increases.

Such flexibilities are not available in the case of hedging by forward contracts. Futures can also

be used to correct the forward contract hedge at low cost and effort. Importers may remain

hedged using forward derivatives contract for short and medium-term committed exposures.

Hedging with forex derivatives may create situations for marked-to-market losses. Indian

corporates should give serious attention to operational hedging techniques, especially for very

long term exposures in foreign currencies. 

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GLOBAL SITUATION

Global and local macro economic factors, and risk avoidance by forex dealers, have created a

huge demand for the dollar. The global factors that have led to a strong dollar worldwide are: the

Euro debt crisis; financial uncertainty in France and Germany, the flagship Euro zone

economies; downgrading of Japan due to its high levels of debt; high oil and commodity prices;

and overall negative global sentiments. Added to these are local factors, such as a negative trade

deficit, high inflation, indifferent FII/FDI investments, growth slowdown, burgeoning fiscal

deficit, ratings downgrade, and paralysis in policymaking — all of which have led to rupee

depreciation against the dollar. But present trend of the declining rupee can be converted into big

opportunity, particularly by expanding exports in new international markets. Currency risk

management will play a crucial role in translating this potential into reality.

The rupee will not appreciate in any significant way, unless our current account achieves surplus

position. The rupee-dollar exchange rates are a critical factor in exports, imports, international

loans, foreign remittances, tourism and overseas education. The depreciating rupee poses major

challenges for importers and those servicing unhedged foreign currency loans. Future business

decisions will be influenced by the external value of the rupee against major currencies,

including the dollar.

Contrary to what is generally believed, even dollar depreciation can hurt exporters because

foreign buyers, especially in Europe and the US, exert pressure on Indian exporters to cut prices.

What's more, export-oriented large companies may have hedged their short, medium and long-

term exposures at, say, 48-50 to a dollar, when the rupee was below 45.

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Overview of CURRENCY MARKETS :

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

border flow of capital, have transformed the dynamics of the 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 inflows 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 being traded on MCX-SX with more than US $3.05 billion

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

exchange risks 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.

Participants in Currency Markets:

The forex market is an OTC market without any centralized clearing house. It consists of two

tiers.

• The interbank or wholesale market,

• Client or retail market

4 broad categories of participants operate within these two tiers i.e. the participants in the foreign

exchange market comprise;

(i)Corporate

(ii)Commercial banks

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(iii)Exchange brokers

(iv)Central banks

Corporates: The business houses, international investors, and multinational corporations may

operate in the market to meet their genuine trade or investment requirements. They

may also buy or sell currencies with a view to speculate or trade in currencies to the extent

permitted by the exchange control regulations. They operate by placing orders with the

commercial banks. The deals between banks and their clients form the retail segment of foreign

exchange market.

Commercial Banks: are the major players in the market. They buy and sell currencies for their

clients. They may also operate on their own. When a bank enters a market to correct excess or

sale or purchase position in a foreign currency arising from its various deals with its customers, it

is said to do a cover operation. Such transactions constitute hardly 5% of the total transactions

done by a large bank. A major portion of the volume is accounted buy trading in currencies

indulged by the bank to gain from exchange movements. For transactions involving large

volumes, banks may deal directly among themselves. For smaller transactions, the intermediation

of foreign exchange brokers may be sought.

Exchange brokers: facilitate deal between banks. In the absence of exchange brokers, banks

have to contact each other for quotes. If there are 150 banks at a centre, for obtaining the best

quote for a single currency, a dealer may have to contact 149 banks. Exchange brokers ensure

that the most favorable quotation is obtained and at low cost in terms of time and money. The

bank may leave with the broker the limit up to which and the rate at which it wishes to buy or

sell the foreign currency concerned. From the intends from other banks, the broker will be able to

match the requirements of both. The names of the counter parties are revealed to the banks only

when the deal is acceptable to them. Till then anonymity is maintained. Exchange brokers tend to

specialize in certain exotic currencies, but they also handle all major currencies.

Central banks: most all central bank and treasuries participate in the forex market. Central banks

play very important role in foreign exchange market. However, these banks do not undertake

significant volume of trading. Each central bank has official/unofficial target of the forex rate

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for its home currency. If the actual price deviates from the target rate, the central banks intervene

in the market to set a tone. E.g. FeD, ECB, RBI...

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Factors that affect currency rates:

Numerous factors determine exchange rates, and all are related to the trading relationship

between two countries.Exchange rates are relative, and are expressed as a comparison of

the currencies of two countries. The following are some of the principal determinants of the

exchange rate between two countries.

1. Differentials in Inflation

As a general rule, a country with a consistently lower inflation rate exhibit a rising currency

value, as its purchasing power increases relative to other currencies. During the last half of the

twentieth century, the countries with low inflation included Japan, Germany and Switzerland,

while the U.S. and Canada achieved low inflation only later. Those countries with higher

inflation typically see depreciation in their currency in relation to the currencies of their trading

partners. This is also usually accompanied by higher interest rates.

2. Differentials in Interest Rates

Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest

rates, central banks exert influence over both inflation and exchange rates, and changing interest

rates impact inflation and currency values. Higher interest rates offer lenders in an economy a

higher return relative to other countries. Therefore, higher interest rates attract foreign capital

and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if

inflation in the country is much higher than in others, or if additional factors serve to drive the

currency down. The opposite relationship exists for decreasing interest rates - that is, lower

interest rates tend to decrease exchange rates.

3. Current-Account Deficit

The current account is the balance of trade between a country and its trading partners, reflecting

all payments between countries for goods, services, interest and dividends. A deficit in the

current account shows the country is spending more on foreign trade than it is earning, and that it

is borrowing capital from foreign sources to make up the deficit. In other words, the country

requires more foreign currency than it receives through sales of exports, and it supplies more of

its own currency than foreigners demand for its products. The excess demand for foreign

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currency lowers the country's exchange rate until domestic goods and services are cheap enough

for foreigners, and foreign assets are too expensive to generate sales for domestic interests.

4. Public Debt

Countries will engage in large-scale deficit financing to pay for public sector projects and

governmental funding. While such activity stimulates the domestic economy, nations with large

public deficits and debts are less attractive to foreign investors. A large debt encourages

inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper

real dollars in the future. In the worst case scenario, a government may print money to pay part

of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a

government is not able to service its deficit through domestic means (selling domestic bonds,

increasing the money supply), then it must increase the supply of securities for sale to foreigners,

thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they

believe the country risks defaulting on its obligations. Foreigners will be less willing to own

securities denominated in that currency if the risk of default is great.

5. Terms of Trade

A ratio comparing export prices to import prices, the terms of trade is related to current accounts

and the balance of payments. If the price of a country's exports rises by a greater rate than that of

its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater

demand for the country's exports. This, in turn, results in rising revenues from exports, which

provides increased demand for the country's currency (and an increase in the currency's value). If

the price of exports rises by a smaller rate than that of its imports, the currency's value will

decrease in relation to its trading partners.

6. Political Stability and Economic Performance

Foreign investors inevitably seek out stable countries with strong economic performance in

which to invest their capital. A country with such positive attributes will draw investment funds

away from other countries perceived to have more political and economic risk. Political turmoil,

for example, can cause a loss of confidence in a currency and a movement of capital to the

currencies of more stable countries. 

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CURRENCY /FOREX RISK MANAGEMENT

Currency risks:

“The impact that unexpected exchange rates changes have on the value of the corporation.”

Currency risk is very important to a corporation as it can have a major impact on its cash flows,

assets and liabilities, net profit and ultimately its stock market value. Assuming the corporation

has accepted that currency risk needs to be managed specifically and separately, it has three

initial priorities:

1. Define what kinds of currency risk the corporation is exposed to

2. Define a corporate Treasury strategy to deal with these currency risks

3. Define what financial instruments it allows itself to use for this purpose

Currency risk is simple in concept, but complex in reality. At its most basic, it is the possible

gain or loss resulting from an exchange rate move. It can affect the value of a corporation

directly as a result of an unhedged exposure or more indirectly. Different types of currency risk

can also offset each other. For instance, take a US citizen who owns stock in a German auto

manufacturer and exporter to the US. If the Euro falls against the US dollar, the US dollar value

of the Euro-denominated stock falls individual sees the US dollar value of their holding decline.

However, the German auto exporter should in fact benefit from a weaker Euro as this makes the

company’s exports to the US cheaper, allowing them the choice of either maintaining US prices

to maintain margin or cutting them further to boost market share. Sooner or later, the stock

market will realize this and mark up the stock price of the auto exporter. Thus, the stock owner

may lose on the currency translation, but gain on the higher stock price. This is of course a very

simple example and life unfortunately is rarely that simple. The first step in successfully

managing currency risk is to acknowledge that such risk actually exists and that it has to be

managed in the general interest of the corporation and the corporation’s shareholders. Indeed, at

its best, prudent currency hedging can be defined as the elimination of speculation. The real

speculation is in fact not managing currency risk. 

The next step, however, is slightly more complex and that is to identify the nature and extent of

the currency risk or exposure. It should be noted that the emphasis here is for the most part on

non-financial corporations, on manufacturers and service providers rather than on banks or other

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types of financial institutions. Non-financial corporation’s generally having only a small amount

of their total assets in the form of receivables and other types of transaction. Most of their assets

are made up of inventory, buildings, equipment and other forms of tangible “real” assets. In

order to measure the effect of exchange rate moves on a corporation, one first has to define the

type and then the amount of risk involved, or the “value at risk” (VaR). There are three main

types of currency risk that a multinational corporation is exposed to and has to manage.

Kinds of Foreign Exchange Exposure

Types of Currency Risk 

1. Transaction risk (receivables, dividends, etc.)

2. Translation risk (balance sheet)

3. Economic risk (present value of future operating cash flows)

Transaction Risk:

Transaction currency risk is essentially cash flow risk and relates to any transaction, such as

receivables, payables or dividends. The most common type of transaction risk relates to export

or import contracts. When there is an exchange rate move involving the currencies of such a

contract, this represents a direct transactional currency risk to the corporation. This is the most

basic type of currency risk that a corporation faces.

Translation Risk: 

Translation risk is slightly more complex and is the result of the consolidation of parent company

and foreign subsidiary financial statements. This consolidation means that exchange rate impact

on the balance sheet of the foreign subsidiaries is transmitted or  translated to the parent

company’s balance.

Translation risk is thus balance sheet currency risk. While most large multinational corporations

actively manage their transaction currency risk, many are less aware of the potential dangers of

translation risk. The actual translation process in consolidating financial statements is done either

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at the average exchange rate of the period or at the exchange rate at the period end, depending on

the specific accounting regulations affecting the parent company. As a direct result, the

consolidated results will vary as either the average or the end-of-period exchange rate varies.

Thus, all foreign currency-denominated profit is exposed to translation currency risk as exchange

rates vary. In addition, the foreign currency value of foreign subsidiaries is also consolidated on

the parent company’s balance sheet, and that value will vary accordingly. Translation risk for a

foreign subsidiary is usually measured by the net assets (assets less liabilities) that are exposed to

potential exchange rate moves. 

Economic Risk:

The translation of foreign subsidiaries concerns the consolidated group balance sheet. However,

this does not affect the real “economic” value or exposure of the subsidiary. Economic risk

focuses on how exchange rate moves change the real economic value of the corporation,

focusing on the present value of future operating cash flows and how this changes in line with

exchange rate changes. More specifically, the economic risk of a corporation reflects the effect

of exchange rate changes on items such as export and domestic sales, and the cost of domestic

and imported inputs. As with translation risk, calculating economic risk is complex, but clearly

necessary to be able to assess how exchange rate changes can affect the present value of foreign

subsidiaries. Economic risk is usually applied to the present value of future operating cash flows

of a corporation’s foreign subsidiaries. However, it can also be applied to the parent company’s

operations and how the present value of those change in line with exchange rate changes.

Summarizing this part, transaction risk deals with the effect of exchange rate moves on

transactional exposure such as accounts receivable/payable or dividends. Translation risk focuses

on how exchange rate moves can affect foreign subsidiary valuation and therefore the valuation

of the consolidated group balance sheet. Finally, economic risk deals with the effect of exchange

rate changes to the present value of future operating cash flows, focusing on the “currency

of determination” of revenues and operating expenses.

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Foreign Exchange Risk Management: Process & Necessity

Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on account of

sudden/unanticipated changes in exchange rates, quantified in terms of exposures. Exposure is

defined as a contracted, projected or contingent cash flow whose magnitude is not certain at the

moment and depends on the value of the foreign exchange rates. The process of identifying risks

faced by the firm and implementing the process of protection from these risks by financial or

operational hedging is defined as foreign exchange risk management.

Necessity of managing foreign exchange risk

A key assumption in the concept of foreign exchange risk is that exchange rate changes are not

predictable and that this is determined by how efficient the markets for foreign exchange are.

Research in the area of efficiency of foreign exchange markets has thus far been able to establish

only a weak form of the efficient market hypothesis conclusively which implies that successive

changes in exchange rates cannot be predicted by analyzing the historical sequence of exchange

rates.

However, when the efficient markets theory is applied to the foreign exchange market under

floating exchange rates there is some evidence to suggest that the present prices properly reflect

all available information.This implies that exchange rates react to new information in an

immediate and unbiased fashion, so that no one party can make a profit by this information and

in any case, information on direction of the rates arrives randomly so exchange rates also

fluctuate randomly. It implies that foreign exchange risk management cannot be done away with

by employing resources to predict exchange rate changes.

Some firms feel hedging techniques are speculative or do not fall in their area of expertise and

hence do not venture into hedging practices. Other firms are unaware of being exposed to foreign

exchange risks. There are a set of firms who only hedge some of their risks, while others are

aware of the various risks they face, but are unaware of the methods to guard the firm against the

risk. There is yet another set of companies who believe shareholder value cannot be increased by

hedging the firm’s foreign exchange risks as shareholders can themselves individually hedge

themselves against the same using instruments like forward contracts available in the market or

diversify such risks out by manipulating their portfolio.

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Hedging Strategies/ Instruments:

A derivative is a financial contract whose value is derived from the value of some other financial

asset, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an

index of prices. The main role of derivatives is that they reallocate risk among financial market

participants, help to make financial markets more complete. This section outlines the hedging

strategies using derivatives with foreign exchange being the only risk assumed.

Derivatives market in India:

Derivatives markets have been in existence in India in some form or other for a long time. In the

area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and,

by the early 1900s India had one of the world’s largest futures industries. In 1952 the

government banned cash settlement and options trading and derivatives trading shifted to

informal forwards markets. In recent years, government policy has changed, allowing for an

increased role for market-based pricing and less suspicion of derivatives trading. The ban on

futures trading of many commodities was lifted starting in the early 2000s, and national

electronic commodity exchanges were created.

In the equity markets, a system of trading called “badla” involving some elements of forwards

trading had been in existence for decades. However, the system led to a number of undesirable

practices and it was prohibited off and on till the Securities and Exchange Board of India (SEBI)

banned it for good in 2001. A series of reforms of the stock market between 1993 and 1996

paved the way for the development of exchange-traded equity derivatives markets in India. In

1993, the government created the NSE in collaboration with state-owned financial institutions.

NSE improved the efficiency and transparency of the stock markets by offering a fully

automated screen-based trading system and real-time price dissemination. In 1995, a prohibition

on trading options was lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-

traded derivatives. The report of the L. C. Gupta Committee, set up by SEBI, recommended a

phased introduction of derivative products, and bi-level regulation (i.e., self-regulation by

exchanges with SEBI providing a supervisory and advisory role). Another report, by the J. R.

Varma Committee in 1998, worked out various operational details such as the margining

systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R) A, was amended

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so that derivatives could be declared “securities.” This allowed the regulatory framework for

trading securities to be extended to derivatives. The Act considers derivatives to be legal and

valid, but only if they are traded on exchanges. Finally, a 30-year ban on forward trading was

also lifted in 1999.

The economic liberalization of the early nineties facilitated the introduction of derivatives based

on interest rates and foreign exchange. A system of market-determined exchange rates was

adopted by India in March 1993. In August 1994, the rupee was made fully convertible on

current account. These reforms allowed increased integration between domestic and international

markets, and created a need to manage currency risk. The easing of various restrictions on the

free movement of interest rates resulted in the need to manage interest rate risk.

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Derivatives Instruments Traded in India:

In the exchange-traded market, the biggest success story has been derivatives on equity products.

Index futures were introduced in June 2000, followed by index options in June 2001, and options

and futures on individual securities in July 2001 and November 2001, respectively.

Derivatives on stock indexes and individual stocks have grown rapidly since inception. In

particular, single stock futures have become equally popular to the index futures. In fact, NSE

has the highest volume (i.e. number of contracts traded) in the single stock futures globally,

enabling it to highest rank holder among world exchanges at point of time. While single stock

options were less popular than stock futures, they have witnessed a high growth rate since

starting of 2011 after they were changed to European style. On the other hand, index options are

hugely popular than index futures. Now a days, index options turnover share the 2/3rd of the

total F&O turnover. NSE launched interest rate futures in 2009 on 10 Year Notional Coupon-

bearing Govt. of India Security & the recently introduced (2011) 91-day Govt. of India T-Bill;

but in contrast to equity derivatives, there has been little trading in them. This particular segment

is still in its nascent stage.

Regulators permitted the exchanges to launch currency derivatives contracts to start with

USDINR currency pair in 2nd half of 2008. Later on three more currency pairs EURINR,

GBPINR & JPYINR is allowed in Feb. 2010. Currency options contracts were launched on Oct.

29th 2010 on USDINR only & so far now this is the only option contract available in the

segment. Since its launch forex derivatives have seen continuous activity & rising trading

volumes than interest rate derivatives and any other segments.

Exchange-traded commodity derivatives have been allowed for trading only since April 2003.

The number of commodities eligible for futures trading is 109 by 2011 on 21 recognized

exchanges. Of all the commodities, bullion contracts shares 40.75%, most of the total turnover.

Among all exchanges, MCX enjoys the biggest share of turnover of more than 82% of the total

traded value.

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Price risk management using currency futures

A Derivative is a financial product that is derived out of the value of an underlying asset.

Derivatives are very popular and are widely used financial instruments.

Derivative products can be classified into the following main types:

1. Forwards

2. Futures

3.Options

4. Swaps

Out of these Futures & Options are actively traded on organized stock exchanges whereas

Forwards are traded in OTC Exchanges.

Forwards Contract: 

A forward contract is the simplest of the Derivative products. It is a mutual agreement between

two parties, in which the buyer agrees to buy a quantity of an asset at a specific price from the

seller at a future date. The Price of the contract does not change before delivery. These types of

contracts are binding, which means both the buyer and seller must stay committed to the

contract. This means they are bound to deliver or take delivery of the product on which the

forward contract was agreed upon. Forwards contracts are very useful in hedging.

Important Characteristics of Forwards Contracts: 

1.They are Over the counter (OTC) contracts

2. Both the buyer and seller are bound by the contractual terms

3. The Price remains fixed

Limitations of Forwards contracts: 

1. Lack of centralized trading. Any two individuals can enter into a forwards contract

2. Lack of Liquidity

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Price risk management using currency futures

3. Counterparty risk - The case wherein either the buyer or seller does not honor his end of the

contract.

Futures Contract: 

A futures contract is an agreement to buy or sell an asset at a certain time in the future at a

specific price. The Contractual terms of the futures contracts are very clear. The Futures market

was designed to solve the shortcomings in the forwards contracts. Unlike forwards, futures are

traded in organized exchanges. They also use a clearing house that provides the necessary

protection to both the buyer and the seller. The price of the futures contract can change prior to

delivery. Hence, both participants must settle daily price changes as per the contract values.

An Example of a futures contract would be an agreement to 100 tonnes of Steel at Rs. 10000/-

per tonne at some date say in December 2008. If no interim payments are made and if the price

of Steel moves violently, a considerable credit risk could build up. To avoid this margin system

is used by the exchanges. As per the margin system, both parties must deposit a small sum with

the exchange. This amount will be a small percentage of the total contract. This amount is called

the initial margin. As the steel value changes, the contract value also changes. If the contract

value changes, the margin must be topped up by an amount corresponding to the change in price

of steel. The margin money is the property of the person who deposits it and would be returned

to them if the contract gets cancelled/completed.

Characteristics of Futures contract: 

1. They are traded in organized exchanges

2. Credit risk is eliminated with the margin system. Both parties deposit a portion of the contract

with the clearing house.

3. Both the buyer and seller are bound by the contract terms and are expected to honor their end

of the contract.

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Price risk management using currency futures

Options Contract:

An options contract is nothing but the right to buy or sell something at a specified price within a

period of time. The feature of the options contract for a buyer is that, the buyer has the right to

buy, but he may choose to buy or may even choose to cancel the contract. Hence the buyer’s

maximum loss is only the initial amount that was paid to gain the rights. Unlike buyers, the

options contracts for sellers are an obligation. If a seller enters into an agreement, he has to

deliver the asset on the specified date and the price agreed upon.Thus the loss for a seller could

bemuchworse.

The right to buy is called a "CALL" option while the right to sell is called a "PUT" option.

Please note that an option is only a right to do something. It is not an obligation to carry out the

action. For a buyer it is only a right and not an obligation, but for a seller it is an obligation.

For Example, you want to buy Gold. You form an options contract with a Gold merchant to buy

1000 grams of Gold at the rate of say Rs. 1000/- per gram of gold on December 1st 2008. The

total value of the contract would sum up to 10, 00, 000/- (10 lacs). As part of getting into the

contract you make an initial payment of say 2% of the contract value to the merchant. You make

a payment of Rs. 20 thousand (Rs. 20,000/-) and the contract gets formed. Now you are the

buyer and the merchant is the seller.

Swaps:

A Swap is an agreement between two parties to exchange future cash flows according to a

predefined formula. These streams of cash flow are called the "Legs" of the swap. Usually, when

the swap contract is formed at least one of these series of cash flows is determined by a random

or uncertain value like interest rate or equity price etc.Most swap contracts are traded OTC

which are tailor made for the counterparties. Some are also traded in organized exchanges. The

four generic types of swaps are:

1.Interest rate swaps

2. Currency swaps

3. Equity swaps

4. Commodity swaps

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Price risk management using currency futures

Business Growth in Currency Derivatives Segment:

Year Currency Futures Currency Options Total Averag

e Daily

Turnov

er 

(  cr.)

No. of

contracts

Turnover 

(  cr.)

No. of

contracts

Notional

Turnover 

(  cr.)

No. of

contract

s

Turnov

er 

(  cr.)

2012-

2013

12,55,98,

771

6,84,576.48 4,19,22,048 2,28,021.21 16,75,20,

819

9,12,59

7.69

3,04,19

9.2

2011-

2012

70,13,71,

974

33,78,488.9

2

27,19,72,15

8

12,96,500.9

8

97,33,44,

132

46,74,9

89.9

3,89,58

2.5

2010-

2011

71,21,81,

928

32,79,002.1

3

3,74,20,147 1,70,785.59 74,96,02,

075

34,49,7

87.7

2,87,48

2.3

2009-

2010

37,86,06,

983

17,82,608.0

4

- - 37,86,06,

983

17,82,6

08.0

1,48,55

0.6

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Price risk management using currency futures

Currency Futures

A Powerful tool to manage currency risk:

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 and delivery date. Both parties of the futures contract must

fulfill their obligations on the settlement date.

Internationally, 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

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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 paisa or 0.0025

Rupee. 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: 52.2500 Purchase price: 52.2500

Price increases by 1 tick: .0025 Price decreases by 1tick: .0025

New price: 52.2525 New price: 52.2475

The value of one tick on each contract is Rupees 2.50 (1000X 0.0025). So if a trader buys

5contracts and the price moves up by 4 ticks, he makes Rupees 50.00.

Step 1: 52.2600 – 52.2500

Step 2: 4 ticks * 5 contracts = 20 points

Step 3: 20 points * Rupees 2.5 per tick = Rupees 50.00

Introduction of currency futures in India:

Important dates of Currency Futures Market:

1972:- First trading of Currency Futures in Chicago Mercantile Exchange.

June 7, 2007:- First trading of Rupee Futures in Dubai gold and commodities exchange.

Nov, 2007:- Internal working group of RBI submitted its recommendation for currency

Futures trading in Exchanges.

April, 2008:- Raghuram Rajan committee report on Financial sector reforms has also

suggested to start currency Futures trading.

May 29, 2008:-Standing committee of RBI and SEBI submitted its report on currency

Futures trading in Exchanges.

August 06, 2008:- Circular Issued for currency Futures trading in stock exchanges.

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Price risk management using currency futures

August 07, 2008:- Joint panel of RBI and SEBI have decided to introduce currency

Futures trading in stock exchanges.

August 14, 2008:- Application invited from traders for membership

August 27, 2008:- Mock trading conducted under the guidance of FEDAI and NSE at

04.30-05.30 PM

August 29, 2008:- Actual trading kicked off at NSE

October 1, 2008:- Trading kicked off at BSE

October 7,2008:- Trading started at MCX

Rationale for introducing Currency Futures:

Futures markets were designed to solve the problems that exist in forward markets. A futures

contract is an agreement between two parties to buy or sell an asset at a certain time in the future

at a certain price. But unlike forward contracts, the futures contracts are standardized and

exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain

standard features of the contract. A futures contract is standardized contract with standard

underlying instrument, a standard quantity and quality of the underlying instrument that can be

delivered, (or which can be used for reference purposes in settlement) and a standard timing of

such settlement. A futures contract may be offset prior to maturity by entering into an equal and

opposite transaction.

The standardized items in a futures contract are:

• Quantity of the underlying

• Quality of the underlying

• The date and the month of delivery

• The units of price quotation and minimum price change

• Location of settlement

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Price risk management using currency futures

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

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

as follows:

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

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

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

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

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

residents purchasing domestic assets.

In this backdrop, unpredicted movements in exchange rates expose investors to currency risks.

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

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

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

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

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

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

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

equally to trade in goods and services, which results in income flows with leads and lags and get

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

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

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

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

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

strong arguments to use instruments to hedge currency risks.

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Price risk management using currency futures

Due to internationalization of Indian economy, exchange rate changes of rupee against USD are

exposing our corporate sector to a formidable business risk. Rupee touching the historic low

level of Rs 57.09 against USD caused adverse damage to companies having imports and foreign

currency loans. Unpredictable cycles of depreciation and appreciation resulted in additional risk

factors to already very risky international business.

Due to global economic uncertainties, rupee touched 52 level in 2009 but recovered to 44 per

USD. Now bearish sentiments are more powerful and chances of such recovery in short term are

not bright. To meet challenges of rupee’s sudden and steep depreciation, innovative currency risk

hedging strategies have to be developed in consonance to the hedging policies of the company.

More dynamism has to be shown to meet the challenges of unpredictable exchange rate

fluctuations. Indian companies now have to track USD/ INR rates seriously because more than

85% of our exports and imports are invoiced in USD, further, majority of foreign currency

borrowing were also raised in USD.

ECB/FCCB EXPOSURE:

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Indian corporates raised huge dollar denominated funds under ECB / FCCB schemes of RBI due

to rupee appreciation and availability of loans at cheap LIBOR rates for USD in 2011. During

such period, Indian companies mobilized huge USD funds to meet their requirements for capital

intensive imports, investment in infrastructure, refinancing high cost existing foreign currency

loans, overseas acquisition etc. via automatic and approval route as per RBI guidelines.

Foreign borrowing constitutes high percentage (40% to 90%) of loan portfolio of big companies.

Domestic loans became expensive due to RBI monetary policy. Companies raised funds costing

interest of 5%p.a to 7%p.a and converted to rupee equivalent when market rate of USD were at

the 44 – 45 per dollar. At that level, nobody forecasted that the exchange rates would fall to

56.09 in such a short span of time. Majority of borrowers either did not hedge or partially

hedged. Such situation has created huge burden of repayment of principal and interest on

borrowing which are due for payment in the upcoming months. In majority of cases foreign

currency loans will prove to be bad choice for Indian companies resulting in poor results next yr.

Market players:

Hedgers

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.

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Price risk management using currency futures

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.

Speculators

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, hecan 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.

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Price risk management using currency futures

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.

Arbitrageurs

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.

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Price risk management using currency futures

One of the methods of arbitrage with regard to USD-INR could be a trading strategy between

forwards and futures market. As we discussed earlier, the futures price and forward prices are

arrived at using the principle of cost of carry. Such of those entities who can trade both

forwards and futures shall be able to identify any mis-pricing between forwards and futures. If

one of them is priced higher, the same shall be sold while simultaneously buying the other

which is priced lower. If the tenor of both the contracts is same, since both forwards and

futures shall be settled at the same RBI reference rate, the transaction shall result in a risk less

profit.

Major exchanges:

In India the Forex future currency trade can be carried out through recognized stock markets –

Bombay Stock Exchange, National Stock Exchange and Multi Commodity Exchange. National

Stock Exchange has started Forex future currency trading from August 29, 2008. NSE is the first

exchange in India to have obtained an in principle approval from Security and Exchange Board

of India to set up currency derivatives segment. BSE is the third exchange in India to have

obtained an in principle approval from Security and Exchange Board of India after NSE and

MCX.

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Price risk management using currency futures

In brief the history of Trading in Currency Future contracts in India can be traced back to the

year 2008 when various stock exchanges started trading in currency futures on the following

dates:

National Stock Exchange started its operation on August 29, 2008

Multi Commodity Exchange started its operation on October 7, 2008

United Stock Exchange launched its operations on September 20, 2010.

(MCX got the approval from SEBI before BSE but it could start trading in Currency future after

BSE) This shows that trading in currency futures in India is not very old rather it is at the stage

of infancy.

NSE: All the trades done at NSE are cleared and settled by National Security Clearing

Corporation. NSCCL is a separate and independent entity. The following data shows the

increasing trade of currency futures at NSE

MCX: MCX-SX started live operations on October 7, 2008 by launching monthly

contracts in the USDINR currency pair under the regulatory framework of Securities and

Exchange Board of India (SEBI), and Reserve Bank of India (RBI). Consequently, the

stock exchange expanded its currency derivatives offerings to Euro-Indian Rupee

(EURINR), Pound Sterling-Indian Rupee (GBPINR) and Japanese Yen-Indian Rupee

(JPYINR). The currency futures trading will be through MCX Stock Exchange, the new

company that MCX has recently floated. Presently all future contracts on MCX-SX are

cash settled. There will be no physical contracts. All trade on MCX-SX takes place on its

nationwide electronic trading platform that can be accessed from dedicated terminals at

locations of the members of the exchange. All participants on the MCXSX trading

platform have to participate only through trading members of the Exchange. Participants

have to open a trading account and deposit stipulated cash/collaterals with the trading

member. MCX-SX stands in as the counterparty for each transaction; so participants need

not worry about default. In the event of a default, MCX-SX will step in and fulfills the

obligations of the defaulting party, and then proceed to recover dues and penalties from

them.

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Those who entered either by buying (long) or selling (short) a futures contract can close their

contract obligations through squaring-off their positions at any time during the life of that

contract by taking opposite position in the same contract. A long (buy) position holder has to

short (sell) the contract to square off his/her position or vice versa. The participants will be

relieved of their contract obligations to the extent they square off their positions. All contracts

that remain open at expiry are settled in Indian rupees in cash at the reference rate specified by

RBI.

USE: The United Stock Exchange of India (USE) is the fourth pan India exchange to be

launched for trading financial instruments specifically currency futures and currency

options. USE has Bombay Stock Exchange as a strategic partner. USE represents the

commitment of ALL 21 Indian public sector banks, private banks and corporate houses to

build an institution of standing. USE launched its operations on 20 Sept 2010. USE began

operations in the future contracts in each of the following currency pairs:

United States Dollar-Indian Rupee (USD-INR)

Euro-Indian Rupee (EUR-INR)

Pound Sterling-Indian Rupee (GBP-INR)

Japanese Yen-Indian Rupee (JPY-INR)

There would be 12 contracts i.e. one for each of the next 12 months in each of the above

currency pair. Outright contracts as well as calendar spread contracts are available in each pair

for trading.

Trading and volumes:

Exchange-trading of the rupee, in India, started in 2010. At a point in time, turnover in exchange-

traded currency futures did seem to have overtaken the OTC forward market. The USD-INR

futures contract on MCX-SX, NSE, and USE with a contract size of USD 1000 occupied the

first three ranks for volume in the world in 2010 and 2011. The USD-INR options contract on the

NSE ranked fourth while the EUR-INR futures on the NSE also featured in the top 20 forex

futures contracts in the world.

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Price risk management using currency futures

Volumes have also seen a rising trend here in India which shows the increased participation in

this new emerging asset class. Combined volumes in currency futures have increased at a CAGR

of 132% from 2009 to 2011 in NSECDS and MCX-SX exchanges after it opened up for trading

on Indian bourses in 2008. Depth has increased in all currency futures pairs as well

MCX-SX, whose application for a full-fledged stock exchange was recently approved by SEBI,

currently offers trading in only currency futures.

It has witnessed a steady and significant growth in currency futures turnover and open interest

and continued to maintain its leadership in currency futures with a market share of 43.57 per cent

in the last fiscal (FY11-12).

The average daily turnover has increased from Rs 324.78 crore during its first month of

operations to Rs 13,530.47 crore at the end of July 2012.

Major Contracts traded on the exchange:

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Price risk management using currency futures

Futures terminology:

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Price risk management using currency futures

Some of the common terms used in the context of currency futures market are given below:

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 is 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 SETTLEMENT 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 100

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.

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Price risk management using currency futures

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.

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.

Product Specifications:

Symbol USDINR

Instrument Type FUTCUR

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Price risk management using currency futures

Unit of trading 1 (1 unit denotes 1000 USD)

Underlying USD

Quotation/PriceQuote Rs. per USD

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.

Last trading dayTwo working days prior to the last business day of the expiry month at

12:15pm.

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 priceTheoretical price on the 1st day of the contract. On all other days, DSP

of the contract.

Price operating rangeTenure up to 6 months Tenure greater than 6 months

+/-3 % of base price +/- 5% of base price

Position limits

Clients Trading Members Banks

Higher of 6% of

total open interest

or USD 10 million

Higher of 15% of the

total open interest or

USD 50 million

Higher of 15% of the

total open interest or

USD 100 million

Minimum initial

margin1.75% 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

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Price risk management using currency futures

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

Pricing FUTURES   –   Cost   of Carry Model

Pricing of futures contract is very simple. Using the cost-of-carry logic, we calculate the

fair value of a futures contract. Every time the observed price deviates from the fair value,

arbitragers would enter into trades to capture the arbitrage profit. This in turn would push the

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Price risk management using currency futures

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. 56.0775.

From the equation above the one year forward exchange rate should be

F = 56.0775 * e^(0.10-0.07 )*1=57.78

It may be noted from the above equation, if foreign interest rate is greater than the domestic rate

i.e. rf > r, then F shall be less than S. The value of F shall decrease further as time T increase. If

the foreign interest is lower than the domestic rate, i.e. rf < r, then value of F shall be greater than

S. The value of F shall increase further as time T increases.

HEDGING WITH CURRENCY FUTURES

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

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

currency risk, the traders’ oftenly use the currency futures. For example, a long hedge (I.e..,

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Price risk management using currency futures

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

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. 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 september 2012. And he will have to pay 100000 USD on

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Price risk management using currency futures

1st December2012. 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 58.0000.

What he will do to protect against depreciating Indian rupee? Spot value of 1 USD is 55.66.

Solution:He should buy ten contract of USDINR 28102012 at the rate of 56.0775. Value of the

contract is (56.0775*1000*100) =5607750. (Value of currency future per USD*contract size*No

of contract).

For that he has to pay 5% margin on 5607750 i.e.he will have to pay Rs.280387.5 at present.

And suppose on settlement day the spot price of USD is 58.0000. On settlement date payoff of

importer will be (58.0000-56.0775) =1.9225 per USD. And (1.9225*100000) =192250.Rs.

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 2009 is 56.0775

And spot value is 55.66

HR=56.0775/55.66=1.007

Hedging against Indian Rupee appreciation

Let’s assume an Indian IT exporter receives an export order worth EUR100,000 from a European

telecom major with the delivery date being in three months. At the time of placing the contract,

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Price risk management using currency futures

the Euro is worth 64.05 Indian Rupees in the Spot market, while a Futures contract for an expiry

date that matches the order payment date is trading at INR64. This puts the value of the order,

when placed, at INR6,405,000. However, if the domestic exchange rate appreciates significantly

(to INR63.20) by the time the order is paid for (which is one month after the delivery date), the

firm will receive only INR6,320,000 rather than INR6,405,000.

To insure against such losses, the firm can, at the time it receives the order, enter into 100 Euro

Futures contracts of EUR1,000 each to sell at INR64 per Euro, which involves contracting to sell

a foreign Currency on expiry date at the agreed exchange rate. If on the payment date the

exchange rate is INR63.20, the exporter will receive only INR6,320,000 on selling the Euro in

the Spot market, but gains INR80,000 (ie 64 - 63.20 * 100 * 1,000) in the Futures market.

Overall, the firm receives INR6,400,000 and protects itself against the sharp appreciation of the

domestic Currency against the Euro.

In the short term, firms can make gains or losses from hedging. The basic purpose of hedging is

to protect against excessive losses. Firms also tend to benefit from knowing exactly how much

they will receive from the export deals and can avoid the uncertainty associated with future

exchange rate movements.

Hedging against Indian Rupee depreciation

An organic chemicals dealer in India places an import order worth EUR100,000 with a German

manufacturer. Let’s assume the current Spot rate of the Euro is INR64.05 and at this rate the

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Price risk management using currency futures

value of the order is INR 6,405,000. The importer is worried about the sharp depreciation of the

Indian Rupee against the Euro during the months until the payment is due. So, the importer buys

100 Euro Futures contracts (EUR1, 000 each) at INR64 per Euro. At expiry, the Rupee has

depreciated to INR65 and the importer has to pay INR6,500,000, gaining INR100,000 (ie

INR65-64 * 100 * 1,000) from the Futures market and the resulting outflow would be only

INR6,400,000.

In the short term, firms can make gains or losses from hedging. The basic purpose of hedging is

to protect against excessive losses. Firms also tend to benefit from knowing exactly how much

they will pay for the import order and avoid the uncertainty associated with future exchange rate

movements.

CURRENCY FUTURES PAYOFFS

A payoff is the likely profit/loss that would accrue to a market participant with change in the

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PROFIT

LOSS

USDD

0

56.07

Price risk management using currency futures

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

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.53.19. 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.

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PROfFIT

LOSS

USDD

0

56.07

Price risk management using currency futures

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.56.07. 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.56.07. 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

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Price risk management using currency futures

when the USD was at 56.07. If the price goes down, his futures position starts making

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

Managing currency risk through currency Futures:

Understanding currency risk

Case: (When firm has foreign currency payable in future)

ABC, an Indian company, imports machinery from US firm for $ 5 million. Due date for

payment is January 22, 2011. Present exchange rate is Rs. 47/$ (as on January 22, 2010)

Inflation in India = 6%

Inflation in US= 1%

Interest rate in India = 8%

Interest rate in US= .5%

Situation: - ABC company needs to pay $ 5 million on January 22, 2011. Since the payment will

be made in future and exchange rate does not remain constant, there is uncertainty with the

actual cash outflow. USD may appreciate or depreciate in future. If USD appreciates cash

outflow in terms of rupee will me more which leads to risk.

Risk: Volatility of exchange rate (especially when USD appreciates)

Problem 1: How to eliminate the risk.

Problem 2: How to forecast the forward rate

Solution 1: In this situation, ABC needs to go long hedge by buying currency futures for $ 5

million for 1 year. Since contract size for USD future is $1000, number of contract will be

5000000/1000=5000 to get perfect hedge.

Solution 2: There two basic methods to calculate spot and future exchange rate.

(a) Purchasing power parity (PPP)

(b) Interest rate parity (IRP)

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Determination of Exchange rate as per Purchasing Power Parity:-

PPP theory follows law of one price, which states that the price of identical goods should be

same all over the world. Exchange rate of currency is being adjusted if the inflation rate is

different in two countries.

Absolute form of PPP

Case 2: Suppose 1 kg apple costs $5 in USA and Rs 220 in India, then as per this theory the

exchange rate will be 220/5 = Rs 44/$

Relative form of PPP

According to this theory, exchange rate is determined by the inflation of one country over

inflation of another country. It states that the percentage change in the exchange rate should

equal the percentage in the ratio of the price indices of the two countries.

Spot exchange rate at time t = value of country A’ currency in terms of country B at the

beginning of the period * (Inflation rate of country A/ Inflation rate of country B)^t

Determination of Exchange rate as per Interest Rate Parity

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;

As per this IRP, interest rate difference between two countries is equal to the percentage

difference between the forward exchange rate and the spot exchange rate.

Forward exchange rate for settlement at period N= Current spot exchange rate*(1+domestic

country interest rate)/ (1+foreign country interest rate)

Here the Spot rate is $1 = Rs. 47

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Interest rate in India = 8%

Interest rate in US= .5%

One year forward rate for $ will be 47*(1.08/1.005) ^1=50.51

Therefore, the country with a higher interest rate would have a lower forward exchange rate.

Quantitative Analysis:

i)Open Interest and Volume of Contracts Traded

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

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

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

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

A sellor and a buyer forms one contract and hence in order to determine the total open interest in

the market we need to know either the total of buyers or the sellors and not the sum of both.the

open interest position that is reported each day represents the increase or decrease in the number

of contracts for that day. An increasing open interest means that the new money is flowing in the

marketplace and the present trend will continue. If the open interest is declining it implies that

the market is liquidating and the prevailing price trend is coming to an end. The leveling off of

open interest following a sustained price advance is often an early warning of the end to an

uptrending or bull market.

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

of the following table:

Price Open Interest Interpretation

Rising Rising Market is Strong

Rising Falling Market is weakening

Falling Rising Market is Weak

Falling Falling Market is Strengthening

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

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Price risk management using currency futures

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

trade in that particular stock exchange for a particular currency future.

Correlation between open interest and no. of contracts traded at NSE and

MCX-SX:

 26-A

ug-11

12-Sep-11

29-Sep-11

16-Oct-

11

2-Nov-1

1

19-Nov-1

1

6-Dec-

11

23-Dec-

11

9-Jan-12

26-Jan-12

12-Feb-12

29-Feb-12

17-Mar-

12

3-Apr-1

2

20-Apr-1

2

7-May

-12

24-May

-12

10-Jun-12

27-Jun-12

14-Jul-1

2

31-Jul-1

20

1000000

2000000

3000000

4000000

5000000

6000000

7000000

Open Interesttotal vol

 

Null hypothesis: no significant correlation between open interest and contracts traded

Alternate hypothesis: significant correlation between open interest and contracts traded

Inference: A linear correlation is found

Alternate hypothesis is accepted with extreme significance

No. of points: 230

Contract considered: 29 august 2012

Correlation coefficient: 0.8984

In order to understand Growth trajectory of the currency futures, open interest and no. of

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Price risk management using currency futures

contracts traded at NSE and MCX-SX have been compared, explained and statistically

supported. A correlation between the two was calculated and result depicted that they have a

significant relationship with correlation coefficient of 0.8984 which concludes growth in both the

variables.

ii) Returns for past 1 year on major exchanges

-0.03

-0.02

-0.01

0

0.01

0.02

0.03

0.04

Returns for 2011-12

returns on mcx sxreturns on nse

Returns on $-rupee contracts haven’t been that great in the last 1 year, more or less the same on

both the leading currency futures exchanges.

Returns on MCX SX -0.00069%

Returns on NSE -0.00071%

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(iii) Historical volatility

Sep

'11

Oct

'11

Oct

'11

Nov

'11

Nov

'11

Dec '

11De

c '11

Jan

'12

Jan

'12

Feb

'12

Feb

'12

Feb

'12

Mar

'12

Mar

'12

April

'12

April

'12

May

'12

May

'12

June

'12

June

'12

July

'12

July

'12

July

'12 44.00

46.00

48.00

50.00

52.00

54.00

56.00

58.00

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

Annualized Volatility 2011-12

closing price

90 day Hvol

20 day Hvol

closin

g pr

ice

Annualized historical volatility in 2003- 3.4

Annualized historical volatility in 2008- 6.5

Annualized historical volatility in 2012- 9.2( as shown in the graph)

Over the years, there has been a trend increase in Dollar-Rupee volatility, measured by the

percentage movement in a month. The Rupee used to fluctuate an average of 1% (or 45 paise)

earlier, but the monthly fluctuation is now averaging 5% (about 225-250 paise). Moreover, the

volatility is likely to remain above 3% (135-150 paise) in the future.

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Price risk management using currency futures

The main reason behind the structural increase in volatility is the growth of India's Current

Account, including exports and imports of both goods and services, and India's Capital Account,

which is witness to a high degree of volatility in portfolio investment flows. This has led to a

huge increase in the daily turnover in the Dollar-Rupee market, to such an extent that it is now

increasingly difficult for the RBI to contain the volatility on a daily basis. As the economy

continues to grow and open up, it is unlikely that forex volatility is going to decrease.

Research work:

I have taken the case of an exporter who is expecting payment of $100000 every month starting

from January 2011.In this piece of work I have taken 30 paise as the threshold i.e. if the currency

movement breaches 30 paise mark in a day I will cover that contract that day itself. Here I have

taken 2 case scenarios to see the difference in returns due to proportion covered under hedging.

1. if 50 % of the contract is covered undered futures and 50% is managed actively.

2. If 25% of the contract is covered undered futures and 75% is managed actively.

Here I have taken different time frames to see the impact of currency fluctuations on the

exporters income. If the exporter starts receiving payment from January 2011 or march 2011 or

june 2011 then the probable returns he may receive are given in the following table:

When 25 % is hedged When 50 % is hedged

Jan 2011 0.40% 1.77%

March 2011 4.28% 1.26%

June 2011 3.13% 3.28%

This table shows that Hedging is a very crucial strategy for both importers and exporters but it is

very important on the part of trader as well that he is actively involved to make gains which are

offset by losses due to hedging, thereby getting higher returns. It even throws light on the fact

that putting a portion aside for active management gives higher returns than fully hedged but

then the investor has to monitor the market on a daily basis.

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Price risk management using currency futures

Having said that hedging is important for preventing losses rather than making gains, which is its

very definition. So for a trader who is involoved active foreign trade, hedging comes to be of

great help.

Conclusion:

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

The upward trend of the volumes and open interest for currency futures in NSE explains the

whole story in detail. The growth of USD-INR currency futures since August 2008 led to the

introduction of three other currency futures in January 2010. The GBP-INR, JPY-INR and the

USD-INR currency futures have recorded a growth and thus confirmed that the introduction of

currency futures have been a good step taken by the Government.

The correlation between the open interest and the contracts traded has been the maximum in this

case. It is +0.87 thus signifying the growth of the USD-INR currency futures.

Although currency futures has reduced volatility asymmetric and have led to enhancement in the

quality of transactions and information , the fact that the currency market just plus 4 years old

does to some extent cloud the conclusion as volatility has increased substantially in 2011-12 to

June 2012 period due to global crises and rising CAD(Current Account Deficit) in India.

The growth of currency futures in India and the volatility pattern in the Indian exchange market

has proved the influence of currency futures as a hedging instrument in India. Although currency

futures has reduced volatility and has led to enhancement in the quality and speed of market

transactions, the fact that the currency futures market just 4 plus years old does to some extent

cloud the conclusion as volatility has increased substantially in 2011-12 to June 2012 period due

to various global issues (Eurozone crisis) and domestic issues such as rising Current Account

Deficit (CAD).

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Bibliography

Books:

FUTURES, OPTIONS AND OTHER DERIVATIVES by JOHN. C. HULL

Articles:

The introduction of currency derivatives on exchanges has provided investors new asset class to

dabble with – Nirmal Bang

Currency futures – taxes, levy and liquidity –Mint

NCFM – Currency Future Module

Currency futures traded on the NSE- Dharen Kumar Pandey

Websites:

www.nseindia.com

www.mcx-sx.com

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