GROWTH OF CURRENCY FUTURES MARKET IN INDIA : A REALITY CHECK

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ANUJ KHERA NMP24- 06DINESH NMP24-13JAGDISHWARA REDDY .S NMP24-14PARWAZ ALAM KHAN NMP24-19ANIL KUMAR BHARDWAJ NMP24-29

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A transferable futures contract that specifies the price at which a specified currency can be bought or sold at a future date.

Currency future contracts allow investors to hedge against foreign exchange risk.

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Provide an additional tool for hedging currency risk. Further development of domestic foreign exchange

market. Permit trades other than hedges with a view to moving

gradually towards fuller capital account convertibility Provide a platform to retail segment of the market to

ensure broad based Participation based on equal treatment Efficient method of credit risk transfer through the

Exchange Create a market to facilitate large volume transactions to

go through on an anonymous basis without distorting the levels.

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Main implications of currency futures market for monetary and exchange rate policies arise from the following:

Risks of possible dollarization of the economy Risks of possible increased volatility in the

exchange rate

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

International Monetary Market (IMM) launched trading in seven currency futures on May 16, 1972.

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Currency futures trading was started in Mumbai August 29, 2008.

With over 300 trading members including 11 banks registered in this segment, the first day saw a very lively counter, with nearly 70,000 contracts being traded.

The first trade on the NSE was by East India Securities Ltd

Amongst the banks, HDFC Bank carried out the first trade. The largest trade was by Standard Chartered Bank constituting 15,000 contracts. Banks contributed 40 percent of the total gross volume.

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Currency futures can be traded between Indian rupees and US dollar (US$ -- INR)

The trading of Indian currency futures can be done between 9 am to 5 pm

The minimum size of currency futures is US$ 1000 periodically the value of the contract can be changed by RBI and SEBI

The currency future can have maximum validity of 12 months

The currency futures contract can be settled in cash

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There are 3 trade exchange that trades in currency futures

National Stock Exchange (NSE)

Bombay Stock Exchange (BSE)

Multi-Commodity Exchange (MCX)

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According to market analysts, introduction of currency futures in the Indian market will give companies

Greater flexibility in hedging their underlying currency exposure and will bring in more liquidity into the market as currency future or

Forex derivative contract will enable a person, a bank or an institution to buy or sell a particular currency against the other on a specified future date, and at a price specified in the contract.

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Futures contracts, mirroring the underlying assets

Forex Bonds Interest rates Index Stocks Commodities Others –

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Transparency and efficient price discovery. The market brings together

divergent categories of buyers and sellers. Elimination of counterparty credit risk. Access to all types of market participants. Standardized products. Transparent trading platform

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Standardization – it is not possible to obtain a perfect hedge in terms of amount and timing.

Cost –forwards have no upfront cost, while margining requirements may effectively drive the cost of hedging in futures up.

Small lots- not possible to hedge small exposures generally.

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The principle objective of the Foreign Exchange Regulation Act (FERA) is to prevent the outflow of Indian currency. The objective of the act is as follows.

• To regulate dealings in foreign exchange and securities• To regulate the transaction indirectly affecting foreign exchange• To regulate import and export of currency and bullion• To regulate employment of foreign nationals• To regulate foreign companies• To regulate acquisition, holding etc of immovable property in

India by non-residents

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The FEMA act extends to the whole of India. The main provision of the Act are as follows:

Section 3: Dealing in Foreign Exchange Section 4 Holding of foreign Exchange Section 5 Current account Transaction Section 6 : Capital account Transaction Section 7: Export of Goods and Services Section 8 : Relisation of Repatriation and Foreign

Exchange Section 9: Exemption from Resalisation and Repatriation

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The term ‘derivative’ is defined in section 45U (a) of the RBI Act to mean ” an instrument, to be settled at a future date, whose value is derived from change in interest rate, foreign exchange rate, credit rating or credit index, price of securities (also called “underlying”), or a combination of more than one of them and includes interest rate ,swaps, forward rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign currency options, foreign currency-rupee options or such other instruments as may be specified by the Bank from time to time”.

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Section 45 the Act provides that ‘notwithstanding anything contained in the Securities Contracts (Regulation) Act, 1956 (42 of 1956), or any other law for the time being in force, transactions in such derivatives, as may be specified by the Bank from time to time, shall be valid, if at least one of the parties to the transaction is the Bank, a scheduled bank, or such other agency falling under the regulatory purview of the Bank under the Act, the Banking Regulation Act, 1949 (10 of 1949), the Foreign Exchange Management Act, 1999 (42 of 1999), or any other Act or instrument having the force of law, as may be specified by the Bank from time to time.” V (1)

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Section 45 W deals with the power of the Reserve Bank to regulate transactions in derivatives. The Reserve Bank is empowered by section 45 W to give directions ‘to all agencies or any of them, dealing in securities, money market instruments, foreign exchange, derivatives, or other instruments of like nature as the Bank may specify from time to time’ and also to call for any information, statement or other particulars from such agencies or cause an inspection of such agencies to be made.

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Section 3:- no person can deal in or transfer foreign exchange or foreign security to any person without general or special permission granted by the Reserve Bank. Sale or drawal of foreign exchange to or from an authorized person is subject to the reasonable restrictions imposed by the Central Government in consultation with the Reserve Bank

Section 7:- prohibit, restrict or regulate capital account transactions section 10:- authorize any person to deal in foreign exchange or

foreign securities, etc The Reserve Bank is competent to permit any person to

trade in foreign exchange by way of spot, forward or futures in exercise of its powers under the FEMA.

FEMA also provides the Reserve Bank with overriding jurisdiction over development and management of foreign exchange markets. Therefore, the Reserve Bank may specify currency futures as an added instrument.

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under regulation 4 of FEMA 25 in Schedule I, rules for domestic foreign exchange market are covered

under regulation 5 of FEMA 25 in Schedule II:-the

permission to a person resident outside India to enter into a foreign exchange derivative contract is covered

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Derivatives in India: A Chronology

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Data and Quantitative Analysis- currency futures

trading turnover stood at 10,62,087 crore ($239.3 billion) and averaged at50 576 crore ($11.4 billion) per day in July 2011.

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Data and Quantitative Analysis- currency futures

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Data and Quantitative Analysis- currency futures

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Data and Quantitative Analysis- currency futures

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Data and Quantitative Analysis- currency futures

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Data and Quantitative Analysis- currency futures

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Unhedged FX Asset Return = Expected FX Asset Return + Currency Surprise

Data and Quantitative Analysis- currency futures

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Private Banks

Financial Institutions

Others

Public Sector Banks

Foreign Banks

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Most widely traded currency – Dollar

Investment currency in capital markets Reserve currency of Central Banks Transaction currency in many commodity markets Invoice currency for many contracts

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Participants Central Banks Commercial Banks Hedge Funds Commercial companies Investment management firms Retail FX brokers INDIVIDUALS

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Main Instruments Spot Outright forwards Swaps Interest Rate Swaps Currency Swaps

OTC Currency Options Exchange Traded Currency Futures

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Supply and Demand Forces Dollar against major currencies like Euro, Pound, Yen Global Asian Stock markets Indian Stock markets Economic factors

Government budget deficits Interest rates Inflation Fiscal and Monetary Policy

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Market activity

Hedging Banks Importers & Exporters Corporate

Trading/ Speculation View on appreciation or depreciation of USD/INR

Arbitrage Inter market (OTC forwards and NSE - futures) Inter exchange ( NSE and MCX-SX, NSE and DGCX)

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OTC Market

Interbank Market - Average daily turnover in Global FX market- over $3.5 trillion

Forward Contracts Customized Contracts

High Spreads Access restricted to participants with underlying positions Physical Settlement Low Accessibility Counterparty Risk

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A new and better alternative for trading FX

USD/ INR cash settled futures market at NSE Access to all Indians Transparent online trading platform No requirement for underlying position Low Margins Anonymous order matching facility Robust settlement systems with counterparty guarantee Low Bid – Offer Spreads

• Euro, Yen and Sterling v/s Rupee futures to be added soon to the Currency Derivatives Segment (RBI has already given permission)

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Expectation that dollar will strengthen against the rupee Buy 10 November futures @ 46.60

◦ Cash outflow of margin @ 5 % - Rs 23,300

Book Potential Profit / Loss Sell November futures @ 46.75 to book profit of – Rs 1,500 on an

investment of Rs 23,300

What if my view is completely wrong ?◦ Sell futures @ 46.30 and book a loss of – Rs 3000

Stop Loss Trigger at a movement of 10 paise per $ against the view – to prevent excess losses

RETURN of 6.43 % INTRA-DAY

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Hedge the FX exposure

◦ Exporter : IT, Electronics & Hardware, Jewelery, Auto Ancillaries, Textiles, Chemicals, Food & Beverages

◦ Importer : Oil and Gas , Gems and Jewelery◦ Investors : Institutions investing abroad◦ Borrowers : ECB's and FCCB's◦ Individuals : Students studying abroad

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Hedging Example - Importer

• If an Oil Importer wants to import Crude Oil, worth $1 million on June 3, 2009 with delivery and payment dates being three months ahead, in Sept 2009.

Spot Rate on 3rd June 09 INR 46.74 per USD

Amt payable as on 3rd June 09 Rs 4,67,40,000 (46.74 * 1000000)

Buy 3 month futures contract

Futures Price = Spot + Cost of Carry USD 47.05 (46.74+0.31)

Futures Price in INR Rs 4,70,50,000

Spot Rate on 3rd September 09 INR 49.20 per USD

If not hedged payment would Rs 4,92,00,000

Saving due to hedging Rs 21,50,000

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Hedging Example – Exporter

• Exporter earning USD 1,000,000 for DEC 09, expecting remittance on 25 DEC 2009

Spot Rate on 30th OCT 09 INR 47.02 per dollar

Sell 1000 USDINR contracts DEC 09

Futures Price = Spot+ Cost of Carry INR 47.20 per USD (47.02+0.18)

Futures Price in INR Rs 4,72,00,000

Spot Rate on 28 DEC 09 INR 46.50 per USD

If not hedged receipt would be Rs 4,65,00,000

Saving due to hedging Rs 7,00,000

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Costs

Deposit

Upfront Margin – 5% of the contract amount

Charges

Brokerage – 0.04 % of the contract value

Government Taxes and Duty Service Tax – 10 % of Brokerage STT (only on sell) – Nil ( as of now) Transaction Tax – Nil ( as of now) Stamp Duty – 0.002 %

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Margins / collaterals To be deposited pre – trade Released once trade is unwound or the contract

matures Forms of collaterals (*)

Cash Bank guarantees Fixed deposits, GOI bonds Approved equities / mutual fund units

( * )- Check with Head office

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Providing collaterals

Cash through CIM (debited from clearing bank account) FD and BG from approved banks GOI bonds through National Securities Clearing

Corporation Ltd (NSCCL) Approved securities

Releasing collaterals

Cash – next day in the bank a/c, FD and BG same day Approved securities to custodians on same day

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The market should be efficient with widespread awareness amongst various market players. It is most important that the contract size should be kept at such a level that it facilitates

price discovery as well as trading, particularly for retail segment of market. While attracting liquidity through product innovation is a feature of the competitive market in the

initial phase, a standardized product across various exchanges would invite greater participation and add to the liquidity of currency future markets.

If FIIs have to be allowed in currency future trading, there should than be a cap on their open interest position in currency future. The positive aspects of the entry of these securities will be that they will bring in huge volumes and liquidity into the market.

The contract should be settled on the last working day of the following month and settlement price should be the RBI reference rate on the last trading day.

The exchange rate should be determined by the market forces, there should be a substantial intervention by the RBI.

There can be two types of members in this trading such as- Hedger and Speculators. The responsibility of fixing of margin for these categories may be left to the exchange. Having a dedicated exchange for currency future may be preferred approach since it would

ensure a clean regulatory and supervisory structure.

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Thank you