Atharva school of business

PROF. MANISHA SANGHAVI

Derivatives and risk management

Currency derivatives- Futures and options

Group members

• Harshang V. Bhatt 06• Gaurav Chhabria 11• Alkesh S. Desai

18• Viral Parikh

21• Purvi Doshi 24• Nirav K. Dhruve

25• Mansi Kothari 48• Akash Shah 71• Meghana Kapadia 42

• Rinku Jain 37

INTRODUCTION TO CURRENCY MARKETS

Akash shah

BASIC FOREIGN EXCHANGE DEFINITIONS

• Spot: Foreign exchange spot trading is buying one currency with a different currency for immediate delivery. The standard settlement convention for Foreign Exchange Spot trades is T+2 days, i.e., two business days from the date of trade. An exception is the USD/CAD (USD–Canadian Dollars) currency pair which settles T+1.

• Forward Outright: A foreign exchange forward is a contract between two counterparties to exchange one currency for another on any day after spot.

• The duration of the trade can be a few days, months or years.

Base Currency / Terms Currency• In foreign exchange markets, the base

currency is the first currency in a currency pair. The second currency is called as the terms currency.

• Eg. The expression US Dollar–Rupee, tells you that the US Dollar is being quoted in terms of the Rupee. The US Dollar is the base currency and the Rupee is the terms currency.

• Exchange rates are constantly changing, which means that the value of one currency in terms of the other is constantly in flux. Changes in rates are expressed as strengthening or weakening of one currency vis-à-vis the other currency.

CONTD…

• Changes are also expressed as appreciation or depreciation of one currency in terms of the other currency.

• Eg. If US Dollar–Rupee moved from 43.00 to 43.25, the US Dollar has appreciated and the Rupee has depreciated.

SWAPS

• A foreign exchange swap is a simultaneous purchase and sale, or sale and purchase, of identical amounts of one currency for another with two different value dates.

• Foreign Exchange Swaps are commonly used as a way to facilitate funding in the cases where funds are available in a different currency than the one needed.

EXCHANGE RATE MECHANISM

• Foreign Exchange - The exchange rate is a price - the number of units of one nation’s currency that must be surrendered in order to acquire one unit of another nation’s currency.

• A foreign exchange transaction is still a shift of funds or short-term financial claims from one country and currency to another. Thus, within India, any money denominated in any currency other than the Indian Rupees (INR) is, broadly speaking, “foreign exchange.

Contd…

• Foreign Exchange can be cash, funds available on credit cards and debit cards, travellers’ cheques, bank deposits, or other short-term claims.

• Foreign currencies are usually needed for payments across national borders.

• The exchange rate is a price - the number of units of one nation’s currency that must be surrendered in order to acquire one unit of another nation’s currency.

Contd….

• The participants in the foreign exchange market are thus a heterogeneous group.

• The various investors, hedgers, and speculators may be focused on any time period, from a few minutes to several years.

• The exchange rate important price in an open economy, influencing consumer prices, investment decisions, interest rates, economic growth, the location of industry, and much more.

MAJOR CURRENCIES OF THE WORLD

• The US Dollar is by far the most widely traded currency.

• The market practice is to trade each of the two currencies against a common third currency as a vehicle, rather than to trade the two currencies directly against each other.

• The vehicle currency used most often is the US Dollar, although very recently euro also has become an important vehicle currency.

• Thus, a trader who wants to shift funds from one currency to another, say from Indian Rupees to Philippine Pesos, will probably sell INR for US Dollars and then sell the US Dollars for Pesos.

• The US Dollar took on a major vehicle currency role with the introduction of the Bretton Woods par value system, in which most nations met their IMF exchange rate obligations by buying and selling US Dollars.

OTHER MAJOR CURRENCIES

• The Euro: Like the US Dollar, the Euro has a strong international presence and over the years has emerged as a premier currency, second only to the US Dollar.

• The Japanese Yen : The Japanese Yen is the third most traded currency in the world. It has a much smaller international presence than the US Dollar or the Euro. The Yen is very liquid around the world, practically around the clock.

• The British Pound: Until the end of World War II, the Pound was the currency of reference. The nickname Cable is derived from the telegrams used to update the GBP/USD rates across the Atlantic. The currency is heavily traded against the Euro and the US Dollar.

• The Swiss Franc : The Swiss Franc is the only currency of a major European country that belongs neither to the European Monetary Union nor to the G-7 countries.

CURRENCY TABLE.

Harshang Bhatt

Overview of Currency Markets

• 24-hour market• Business is heavy• Each nation’s market has its own

infrastructure• Cross-border foreign exchange trading

Introduction of Currency Derivatives

• Introduced in Chicago, 1972.• Chicago Mercantile Exchange.• Guided by Leo Melamed.• Abolishment of Bretton-woods agreement.

ECONOMIC VARIABLES IMPACTING EXCHANGE RATE MOVEMENTS

• GDP.• Inflation rate.• Interest rate.• Economic variables.

Currency Derivatives in India

• Launched on 29th August 2008 on NSE.

• Launched on 7th October 2008 on MCX-SX.

• Launched on 14th October 2008 on BSE.

• Current Daily average turnover is Rs. 4500 crore, on each NSE & MCX-SX. ( last year the figure was only Rs. 300 crore).

• July 6th 2009, was the most active day, to hit the total turnover of Rs. 11,600 crore from 24 lakh contracts.

Currency futures Mansi Kothari

CURRENCY FUTURES

• 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.

• 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.

• For example:

TERMINOLOGY

• Spot price• Future price• Contract cycle• Value date• Expiry date• Contract size• Basis• Cost of carry• Initial margin• Marking to market

RATIONALE BEHIND CURRENCY FUTURES

• Hedging of risk

• Price transparency

• Economy wide perspective.

INTEREST RATE PARITY AND PRICING OF CURRENCY

FUTURES

RINKU JAIN

Interest Rate Parity• Interest rate parity is a non-arbitrage condition

• If the returns are different, an arbitrage transaction could, in theory, produce a risk-free return.

DERIVATION OF FUTURE RATE FROM SPOT RATE

• The price of future can be derived by following:

Term : Base Formula

Spot-Forward r& p Formula

Continuous Compounding Formula

Term: Base Formula

• Forward = Spot + Points

Points =Spot 1 + terms i * days basis _ 1

1 + base i * days basis

i = rate of interestbasis = day count basis(Most currencies use a 360-day basis, except the pound sterling and a few others, which use a 365-day year.)

Spot-Forward r& p Formula

• F(0,T) = (1+ r)T/ (1+p)T

CONTINUOUS COMPOUNDING FORMULA• F(0,T) =(r-p)T

SPECULATION IN FUTURE MARKET

• Speculators play a vital role in the futures markets.

• Assist Hedgers

• Speculation is not similar to manipulation.

Long Position In Future Market

• Long position in a currency futures contract without any exposure in the cash market is called a speculative position.

• If the exchange rate strengthens Profit • If the exchange rate weakens Loss

Long Position In Future

Observation: The trader has effectively analysed the market conditions and has taken a right call by going long on futures and thus has made a gain of Rs. 1,880.

SHORT POSITION IN FUTURES

• Short position in a currency futures contract without any exposure in the cash market is called a speculative transaction.

If the exchange rate weakens Profit If the exchange rate strengthens Loss

Observation: The trader has effectively analysed the market conditions and has taken a right call by going short on futures andthus has made a gain of Rs. 362.50 per contract with small investment (a margin of 3%, which comes to Rs. 1270.80) in a span of 6 days.

Trading Alkesh.S.Desai

TRADING– USD INR Currency Derivatives

Underlying Rate of exchange between one USD and INRContract Size USD 1000Tick Size Re. 0.0025Price Bands Trading Cycle .Expiry DayLast Trading Day Settlement Basis.Settlement Price.SettlementFinal Settlement PriceFinal settlement date.

TRADING PARAMETERS

• Base Price• Closing Price• Dissemination of Open, High,

Low, and Last-Traded Prices

TENORS OF FUTURES CONTRACT• Expiry Date• Final Settlement Rate

ENTITIES IN THE TRADING SYSTEM• Trading Members (TM)• Clearing Members (CM)• Trading-cum-Clearing Member (TCM)• Professional Clearing Members (PCM)• Participants

TYPES OF ORDERS

• Time conditions Day order Immediate or Cancel

(IOC)• Price conditionMarket priceLimit priceStop-loss

• Other conditionsProCli• Price Limit Circuit Filter

MARK-to-MARKET

POSITION LIMITS

Surveillance System

Rules, regulations and bye laws of Exchange

Purvi and Meghna

HEDGING USING CURRENCY FUTURESA hedger has an Overall Portfolio (OP)composed of (at least) 2 positions:

1. Underlying position2. Hedging position with negative correlation with

underlying position

Types of FX Hedgers using Futures• Long hedge

• Short hedge

The proper size of the Hedging position

• Basic Approach: Equal hedge

• Modern Approach: Optimal hedge

Long Futures Hedge Exposed to the Risk of Strengthening USD

Short Futures Hedge Exposed to the Risk of Weakening USD

TRADING SPREADS USING CURRENCY FUTURESSpread movement is based on following

factors:• Interest Rate Differentials• Liquidity in Banking System• Monetary Policy Decisions (Repo,

Reverse Repo and CRR)• Inflation

• Intra-Currency Pair Spread

• Inter-Currency Pair Spread

• Example

ARBITRAGE

• Arbitrage means locking in a profit by simultaneously entering into transactions in two or more markets. If the relation between forward prices and futures prices differs, it gives rise to arbitrage opportunities.

• Difference in the equilibrium prices determined by the demand and supply at two different markets also gives opportunities to arbitrage.

• Example – Let’s say the spot rate for USD/INR is quoted @ Rs. 44.325 and one month forward is quoted at 3 paisa premium to spot @ 44.3550 while at the same time one month currency futures is trading @ Rs.44.4625. An active arbitrager realizes that there is an arbitrage opportunity as the one month futures price is more than the one month forward price.

Futures trading

Clearing , settlement and risk management

Nirav K. Dhruve

Clearing entities

• Clearing members• Clearing banks

Clearing mechanism

• It involves working out open position and obligations of CM

• This position is considered for exposure and daily margin purposes

• The open positions of Clearing Members (CMs) are arrived at by aggregating the open positions of all the TMs and all custodial participants clearing through him, in contracts in which they have traded.

• TMs are required to identify the orders, whether its proprietary or client based

Determinant of open position of a clearing member

Settlement mechanism

• Settlement of futures contract

1) Mark to market settlement P/L are computed as the difference

between trade price and day’s settlement price during that day which are not squared up

The previous day;s settlement price and today’s settlement price if the contract is b/f

Buy/sell price of the contract if it is squared up

Contd…

2) Final settlement:

On the last trading day of the futures contracts, after the close of trading hours, the Clearing Corporation marks all positions of a CM to the final settlement price and the resulting profit/loss is settled in cash

Settlement price of a future contract• Daily settlement price on a trading day

is the closing price of the respective futures contracts on such day

• Last half an hour weighted average price of the contract

• The final settlement price is the RBI reference rate for the last trading day of the futures contract

• All open positions will be mark to market on the final settlement price

Risk management measures

• The financial soundness• Initial margin• Open positions are MOM

based• Members positions are based

on • Separate settlement

guarantee funds are created

Margin requirements

• Initial margin • Portfolio based margin• Real time computation• Calendar spread margins• Extreme loss margin• Liquid net worth• MOM settlement

Currency OptionsGaurav Chhabria

Over the counter Options Market Used mainly by Multinational

companies and large commercial international banks.

Options are frequently written for U.S dollars against Pound Sterling, Deusche Marks, Swiss francs, Canadian Dollar, Euro,etc.

Maturity ranges from 2 to 6 months.

Divided into subparts: Retail Market and Wholesale Market

Limitations faced

Market is relatively illiquid because of its tailor made nature

Contracts are not standardized because of which there is lack of secondary market operators.

Counter party risk Mispricing

Exchange-traded currency options First trading commenced in 1982 by

Philadelphia Stock Exchange(PHLX). In June 1987, Currency Exchange

Warrants (CEW) were introduced on American Stock Exchange (AMEX) with long maturity exceeding 1 year.

In February 1988, CEWs traded in AMEX had foreign currency put options with 5 years to expiration.

Basics of Currency Options

Call Option: Option to buy foreign currency

Sell Option: Option to sell foreign currency

Price element

Exercise or Strike Price: Rate at which foreign currency can be bought and sold

Premium: Which is the cost or price of the option itself

Underlying or Actual Spot exchange rate: Rate in the currency market exists on exercise date.

Types

American Options: Can be exercised at any time between the writing date and expiration date.

European Option: Can only be exercised at the expiration date and not before this date. Mostly popular in Switzerland and Germany.

Viral Parikh

Determinants of the currency option value

Changes in forward rate Changes in spot rate Time to Maturity Impact of changing volatility Changes in interest rate differential Alternative option strike price

Changes in Forward Rate (Sensitivity)

• The standard foreign currency is priced around the forward rate.

• It gives an idea how the future rate will move because the forward rate is determined after considering the interest rate differential of both the currencies

• Forward rate also provides information to the trader to manage the position

Spot Rate Changes (Delta)

• It has direct impact on the time value of the option

• As long as the option has time remaining the option will posses the time value element

• The sensitivity of the option premium to a small change in the spot exchange is called as delta

For Example

• The change in the spot rate is $1.70 to $1.72 and also assume that option premium changes from $0.038/£ to $0.032/£

Delta=ΔPremium = 0.038-0.032= 0.60 Δspot rate 1.72-1.76

Time To Maturity(Theta)

• Longer the period to maturity the greater will be the option value.

• This relation is referred as Theta.• Rule of thumb is trader will normally find

longer maturity options better value, giving the trader to alter an option position without suffering Time value deteriotion.

Theta = Δ Premium Δ Time

Impact of changing volatility (Lambda)

• Volatility in the context of option may be defined as The standard deviation of daily percentage changes in the underlying exchange rate.

• If exchange rate volatility increases then risk in option increases.

• It will result in increase in option premium.

Example

• Option has annual volatility of 10.5%, soDaily volatility = Annual volatility/√365. = 10.5/19.105

= 0.55%.Lambda = Δpremium

Δvolatility.Thumb rule- Traders who believe volatility will

fall, will sell options and buy-back for a profit after volatility falls and cause option premium to fall.

Changes in interest rate differentials. (Rho and Phi)

• The expected change in option premium from a small change in domestic interest rate is called Rho

• The expected change in option premium from a small change in Foreign interest rate is called Phi

formula

RHO = Δ Premium Δ Re interest rate

PHI= Δ Premium Δ Foreign interest rate

Rule of thumb- A trader who is purchasing a call option on foreign currency should do so before the domestic interest rate rises.

Alternative strike price and option premiums

• The most important thing in option valuation is the availability of alternative strike price In the market and finally selecting the same.

• How to choose?• This is determined by exercising

various strike prices and respective option premium at each strike price. The option which has more option premium will be selected and then finally a final strike price will be selected.

Options trading

THANK YOU, VERY MUCH