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Workbook for

NISM-Series-I
Currency Derivatives Certification Examination
(NISM-Series-I: CD Examination)
National Institute of Securities Markets
This workbook has been developed to assist candidates in preparing for the Natio
nal Institute of Securities
Markets (NISM) NISM-Series-I: Currency Derivatives Certification Examination (NI
SM-Series-I: CD
Examination).
Workbook Version: May 2010
Published by:
National Institute of Securities Markets
© National Institute of Securities Markets, 2009
Plot 82, Sector 17, Vashi, Navi Mumbai - 400705, India.
All rights reserved. Reproduction of this publication in any form without prior
permission of the publishers is
strictly prohibited.
Disclaimer
The contents of this publication do not necessarily constitute or imply its endo
rsement, recommendation, or
favoring by the National Institute of Securities Market (NISM) or the Securities
and Exchange Board of India
(SEBI). This publication is meant for general reading and educational purpose on
ly. It is not meant to serve
as guide for investment. The views and opinions and statements of authors or pub
lishers expressed herein
do not constitute a personal recommendation or suggestion for any specific need
of an Individual. It shall
not be used for advertising or product endorsement purposes.
The statements/explanations/concepts are of general nature and may not have take
n into account the
particular objective/move/aim/need/circumstances of individual user/reader/organ
ization/institute. Thus
NISM and SEBI do not assume any responsibility for any wrong move or action take
n based on the
information available in this publication.
Therefore before acting on or following the steps suggested on any theme or befo
re following any
recommendation given in this publication user/reader should consider/seek profes
sional advice.
The publication contains information, statements, opinions, statistics and mater
ials that have been obtained
from sources believed to be reliable and the publishers of this title have made
best efforts to avoid any
errors. However, publishers of this material offer no guarantees and warranties
of any kind to the
readers/users of the information contained in this publication.
Since the work and research is still going on in all these knowledge streams, NI
SM and SEBI do not
warrant the totality and absolute accuracy, adequacy or completeness of this inf
ormation and material and
expressly disclaim any liability for errors or omissions in this information and
material herein. NISM and
SEBI do not accept any legal liability what so ever based on any information con
tained herein.
While the NISM Certification examination will be largely based on material in th
is workbook, NISM does not
guarantee that all questions in the examination will be from material covered he
rein.
About NISM
In pursuance of the announcement made by the Finance Minister in his Budget Spee
ch in February 2005,
Securities and Exchange Board of India (SEBI) has established the National Insti
tute of Securities Markets
(NISM) in Mumbai.
SEBI, by establishing NISM, has articulated the desire expressed by the Indian g
overnment to promote
securities market education and research.
Towards accomplishing the desire of Government of India and vision of SEBI, NISM
has launched an effort to
deliver financial and securities education at various levels and across various
segments in India and abroad.
To implement its objectives, NISM has established six distinct schools to cater
the educational needs of
various constituencies such as investor, issuers, intermediaries, regulatory sta
ff, policy makers, academia and
future professionals of securities markets.
NISM brings out various publications on securities markets with a view to enhanc
e knowledge levels of
participants in the securities industry.
NISM is mandated to implement certification examinations for professionals emplo
yed in various segments of
the Indian securities markets.
Acknowledgement
This workbook has been developed by NISM in close cooperation with the Examinati
on Committee for NISMSeries-
I: Currency Derivatives Certification Examination (NISM-Series-I: CD Examination
) consisting of
representatives of Securities and Exchange Board of India (SEBI), Bombay Stock E
xchange (BSE), National
Stock Exchange (NSE), MCX Stock Exchange (MCX-SX) and Foreign Exchange Dealers A
ssociation of India
(FEDAI). NISM gratefully acknowledges the contribution of all committee members.
Parts of the content of this workbook have been provided by BSE, NSE and MCX-SX.
NISM is grateful for their
contribution.
About the NISM-Series-I: Currency Derivatives Certification Examination (NISM-Se
ries-I: CD
Examination)
The examination seeks to create a common minimum knowledge benchmark for persons
working in the
currency derivative segment, in order to enable a better understanding of curren
cy markets and exchange
traded currency future products, better quality investor service, operational pr
ocess efficiency and risk controls.
Examination Objectives
On successful completion of the examination the candidate should:
• Know the basics of currency markets and specifically Exchange Traded Currency Fu
tures markets.
• Understand the trading, clearing and settlement mechanisms related to Exchange T
raded Currency
Futures markets and basic investment strategies that use currency futures produc
ts.
• Know the regulatory environment in which the Exchange Traded Currency Futures ma
rkets operate in
India.
Assessment Structure
The NISM-Series-I: Currency Derivatives Certification Examination (NISM-Series-I
: CD Examination) will be of
100 marks, will have 60 questions, and should be completed in 2 hours. There wil
l be negative marking of 25%
of the marks assigned to a question. The passing score for the examination is 60
%.
How to register and take the examination
To find out more and register for the examination please visit www.nism.ac.in
Table of Contents
CHAPTER 1 INTRODUCTION TO CURRENCY MARKETS 7
1.1 BASIC FOREIGN EXCHANGE DEFINITIONS 7
1.2 EXCHANGE RATE MECHANISM 7
1.3 MAJOR CURRENCIES OF THE WORLD 9
1.4 OVERVIEW OF INTERNATIONAL CURRENCY MARKETS 10
1.5 ECONOMIC VARIABLES IMPACTING EXCHANGE RATE MOVEMENTS 11
CHAPTER 2 FOREIGN EXCHANGE DERIVATIVES 13
2.1 DERIVATIVES – DEFINITION 13
2.2 DERIVATIVE PRODUCTS 13
2.3 GROWTH DRIVERS OF DERIVATIVES 14
2.4 MARKET PLAYERS 14
2.5 KEY ECONOMIC FUNCTION OF DERIVATIVES 15
2.6 EXCHANGE-TRADED vs. OVER –THE- COUNTER DERIVATIVES 16
CHAPTER 3 EXCHANGE TRADED CURRENCY FUTURES 19
3.1 CURRENCY FUTURES -DEFINITION 19
3.2 FUTURES TERMINOLOGY 20
3.3 RATIONALE BEHIND CURRENCY FUTURES 20
3.4 DISTINCTION BETWEEN FUTURES AND FORWARD CONTRACTS 22
3.5 INTEREST RATE PARITY AND PRICING OF CURRENCY FUTURES 23
CHAPTER 4 STRATEGIES USING CURRENCY FUTURES 27
4.1 SPECULATION IN FUTURES MARKETS 27
4.2 LONG POSITION IN FUTURES 27
4.3 SHORT POSITION IN FUTURES 28
4.4 HEDGING USING CURRENCY FUTURES 29
4.5 TRADING SPREADS USING CURRENCY FUTURES 38
4.6 ARBITRAGE 38
CHAPTER 5 TRADING 41
5.1 CURRENCY FUTURES CONTRACT SPECIFICATION 41
5.2 TRADING PARAMETERS 41
5.3 TENORS OF FUTURES CONTRACT 42
5.4 TRADER WORKSTATION SCREEN (TWS) 42
5.5 ENTITIES IN THE TRADING SYSTEM 42
5.6 TYPES OF ORDERS 43
5.7 MARK-to-MARKET 44
5.8 POSITION LIMITS 44
CHAPTER 6 CLEARING, SETTLEMENT AND RISK MANAGEMENT 47
6.1 CLEARING ENTITIES 47
6.2 CLEARING MECHANISM 47
6.3 SETTLEMENT MECHANISM 49
6.4 RISK MANAGEMENT MEASURES 51
6.5 MARGIN REQUIREMENTS 52
CHAPTER 7 REGULATORY FRAMEWORK FOR CURRENCY DERIVATIVES 55
7.1 SECURITIES CONTRACTS (REGULATION) ACT, 1956 [SC(R)A] 55
7.2 SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992 56
7.3 RBI-SEBI STANDING TECHNICAL COMMITTEE ON EXCHANGE TRADED
CURRENCY AND INTEREST RATE DERIVATIVES 56
7.4 FOREIGN EXCHANGE MANAGEMENT ACT, 1999 - PROVISIONS 57
7.5 REGULATORY FRAMEWORK FOR EXCHANGES 59
7.6 REGULATORY FRAMEWORK FOR CLEARING CORPORATIONS 60
7.7 GOVERNING COUNCIL OF THE EXCHANGE AND CLEARING CORPORATION 60
7.8 ELIGIBILITY CRITERIA FOR MEMBERS 60
CHAPTER 8 ACCOUNTING AND TAXATION 65
8.1 ACCOUNTING 65
8.2 TAXATION OF DERIVATIVE TRANSACTION IN SECURITIES 68
CHAPTER 9 CODES OF CONDUCT AND INVESTOR PROTECTION MEASURES 69
9.1 ADHERENCE TO SEBI CODES OF CONDUCT FOR BROKERS/ SUB-BROKERS 69
9.2 ADHERENCE TO CODES OF CONDUCT SPECIFIC TO ETCF SEGMENT 73
9.3 GRIEVANCE REDRESSAL MECHANISM FOR INVESTORS 75
APPENDIX A SAFEGUARDS FOR INVESTORS 79
APPENDIX B SAMPLE QUESTIONS 83
APPENDIX C EXCHANGES TRADING IN CURRENCY FUTURES 91
LIST OF ABBREVATIONS 93
7
CHAPTER 1 INTRODUCTION TO CURRENCY MARKETS
1.1 BASIC FOREIGN EXCHANGE DEFINITIONS
Spot: Foreign exchange spot trading is buying one currency with a different curr
ency 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) currenc
y pair which settles T+1.
Rates for days other than spot are always calculated with reference to spot rate
.
Forward Outright: A foreign exchange forward is a contract between two counterpa
rties to exchange one
currency for another on any day after spot. In this transaction, money does not
actually change hands until
some agreed upon future date. The duration of the trade can be a few days, month
s or years. For most major
currencies, three business days or more after deal date would constitute a forwa
rd transaction.
Settlement date / Value Date Definition
Value Cash Trade Date Same day as deal date
Value Tom (Tomorrow) Trade Date + 1 1 business day after deal date
Spot Trade Date + 2 2 business days after deal date*
Forward Outright Trade Date + 3 or any later date 3 business days or more after
deal date,
always longer than Spot
* USD/CAD is the exception
Base Currency / Terms Currency: In foreign exchange markets, the base currency i
s the first currency in a
currency pair. The second currency is called as the terms currency. Exchange rat
es are quoted in per unit of
the base currency. Eg. The expression US Dollar–Rupee, tells you that the US Dolla
r is being quoted in terms
of the Rupee. The US Dollar is the base currency and the Rupee is the terms curr
ency.
Exchange rates are constantly changing, which means that the value of one curren
cy 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. Changes are also expressed as appreciation or depreciation of on
e currency in terms of the
other currency. Whenever the base currency buys more of the terms currency, the
base currency has
strengthened / appreciated and the terms currency has weakened / depreciated. Eg
. If US Dollar–Rupee
moved from 43.00 to 43.25, the US Dollar has appreciated and the Rupee has depre
ciated.
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 Exch
ange 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. Effectively, each party to the deal is given the use of an amount of for
eign currency for a specific time.
The Forward Rate is derived by adjusting the Spot rate for the interest rate dif
ferential of the two currencies for
the period between the Spot and the Forward date. Liquidity in one currency is c
onverted into another currency
for a period of time.
1.2 EXCHANGE RATE MECHANISM
“Foreign Exchange” refers to money denominated in the currency of another nation or
a group of nations. Any
person who exchanges money denominated in his own nation’s currency for money deno
minated in another
nation’s currency acquires foreign exchange.
8
This holds true whether the amount of the transaction is equal to a few rupees o
r to billions of rupees; whether
the person involved is a tourist cashing a travellers’ cheque or an investor excha
nging hundreds of millions of
rupees for the acquisition of a foreign company; and whether the form of money b
eing acquired is foreign
currency notes, foreign currency-denominated bank deposits, or other short-term
claims denominated in
foreign 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 o
ther than the Indian Rupees
(INR) is, broadly speaking, “foreign exchange.” Foreign Exchange can be cash, funds
available on credit cards
and debit cards, travellers’ cheques, bank deposits, or other short-term claims. I
t is still “foreign exchange” if it
is a short-term negotiable financial claim denominated in a currency other than
INR.
Almost every nation has its own national currency or monetary unit - Rupee, US D
ollar, Peso etc.- used for
making and receiving payments within its own borders. But foreign currencies are
usually needed for payments
across national borders. Thus, in any nation whose residents conduct business ab
road or engage in financial
transactions with persons in other countries, there must be a mechanism for prov
iding access to foreign
currencies, so that payments can be made in a form acceptable to foreigners. In
other words, there is need for
“foreign exchange” transactions—exchange of one currency for another.
The exchange rate is a price - the number of units of one nation’s currency that m
ust be surrendered in order
to acquire one unit of another nation’s currency. There are scores of “exchange rate
s” for INR and other
currencies, say US Dollar. In the spot market, there is an exchange rate for eve
ry other national currency
traded in that market, as well as for various composite currencies or constructe
d monetary units such as the
Euro or the International Monetary Fund’s “SDR”. There are also various “trade-weighted” o
r “effective” rates
designed to show a currency’s movements against an average of various other curren
cies (for eg US Dollar
index, which is a weighted index against world major currencies like Euro, Pound
Sterling, Yen, and Canadian
Dollar). Apart from the spot rates, there are additional exchange rates for othe
r delivery dates in the forward
markets.
The market price is determined by the interaction of buyers and sellers in that
market, and a market exchange
rate between two currencies is determined by the interaction of the official and
private participants in the
foreign exchange rate market. For a currency with an exchange rate that is fixed
, or set by the monetary
authorities, the central bank or another official body is a participant in the m
arket, standing ready to buy or sell
the currency as necessary to maintain the authorized pegged rate or range. But i
n countries like the United
States, which follows a complete free floating regime, the authorities are not k
nown to intervene in the foreign
exchange market on a continuous basis to influence the exchange rate. The market
participation is made up of
individuals, non-financial firms, banks, official bodies, and other private inst
itutions from all over the world that
are buying and selling US Dollars at that particular time.
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 t
o several years. But,
whatever is the constitution of participants, and whether their motive is invest
ing, hedging, speculating,
arbitraging, paying for imports, or seeking to influence the rate, they are all
part of the aggregate demand for
and supply of the currencies involved, and they all play a role in determining t
he market price at that instant.
Given the diverse views, interests, and time frames of the participants, predict
ing the future course of
exchange rates is a particularly complex and uncertain exercise. At the same tim
e, since the exchange rate
influences such a vast array of participants and business decisions, it is a per
vasive and singularly important
price in an open economy, influencing consumer prices, investment decisions, int
erest rates, economic growth,
the location of industry, and much more. The role of the foreign exchange market
in the determination of that
price is critically important.
9
1.3 MAJOR CURRENCIES OF THE WORLD
The US Dollar is by far the most widely traded currency. In part, the widespread
use of the US Dollar reflects
its substantial international role as “investment” currency in many capital markets,
“reserve” currency held by
many central banks, “transaction” currency in many international commodity markets, “i
nvoice” currency in
many contracts, and “intervention” currency employed by monetary authorities in mark
et operations to
influence their own exchange rates.
In addition, the widespread trading of the US Dollar reflects its use as a “vehicl
e” currency in foreign exchange
transactions, a use that reinforces its international role in trade and finance.
For most pairs of currencies, the
market practice is to trade each of the two currencies against a common third cu
rrency as a vehicle, rather
than to trade the two currencies directly against each other. The vehicle curren
cy used most often is the US
Dollar, although very recently euro also has become an important vehicle currenc
y.
Thus, a trader who wants to shift funds from one currency to another, say from I
ndian Rupees to Philippine
Pesos, will probably sell INR for US Dollars and then sell the US Dollars for Pe
sos. Although this approach
results in two transactions rather than one, it may be the preferred way, since
the US Dollar/INR market and
the US Dollar/Philippine Peso market are much more active and liquid and have mu
ch better information than a
bilateral market for the two currencies directly against each other. By using th
e US Dollar or some other
currency as a vehicle, banks and other foreign exchange market participants can
limit more of their working
balances to the vehicle currency, rather than holding and managing many currenci
es, and can concentrate
their research and information sources on the vehicle currency.
Use of a vehicle currency greatly reduces the number of exchange rates that must
be dealt with in a
multilateral system. In a system of 10 currencies, if one currency is selected a
s the vehicle currency and used
for all transactions, there would be a total of nine currency pairs or exchange
rates to be dealt with (i.e. one
exchange rate for the vehicle currency against each of the others), whereas if n
o vehicle currency were used,
there would be 45 exchange rates to be dealt with. In a system of 100 currencies
with no vehicle currencies,
potentially there would be 4,950 currency pairs or exchange rates [the formula i
s: n(n-1)/2]. Thus, using a
vehicle currency can yield the advantages of fewer, larger, and more liquid mark
ets with fewer currency
balances, reduced informational needs, and simpler operations.
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 to
maintain a par value relationship for their own currency against the US Dollar.
The US Dollar was a convenient
vehicle because of its central role in the exchange rate system and its widespre
ad use as a reserve currency.
The US Dollar’s vehicle currency role was also due to the presence of large and li
quid US Dollar money and
other financial markets, and, in time, the Euro-US Dollar markets, where the US
Dollars needed for (or
resulting from) foreign exchange transactions could conveniently be borrowed (or
placed).
Other Major Currencies include:
The Euro
Like the US Dollar, the Euro has a strong international presence and over the ye
ars 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 s
maller international presence
than the US Dollar or the Euro. The Yen is very liquid around the world, practic
ally around the clock.
10
The British Pound
Until the end of World War II, the Pound was the currency of reference. The nick
name 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, but it has a spotty presence against other currencie
s. The two-year bout with the
Exchange Rate Mechanism, between 1990 and 1992, had a soothing effect on the Bri
tish Pound, as it
generally had to follow the Deutsche Mark s fluctuations, but the crisis conditi
ons that precipitated the pound s
withdrawal from the Exchange Rate Mechanism had a psychological effect on the cu
rrency.
The Swiss Franc
The Swiss Franc is the only currency of a major European country that belongs ne
ither to the European
Monetary Union nor to the G-7 countries. Although the Swiss economy is relativel
y small, the Swiss Franc is
one of the major currencies, closely resembling the strength and quality of the
Swiss economy and finance.
Switzerland has a very close economic relationship with Germany, and thus to the
Euro zone.
Typically, it is believed that the Swiss Franc is a stable currency. Actually, f
rom a foreign exchange point of
view, the Swiss Franc closely resembles the patterns of the Euro, but lacks its
liquidity.
Currency Table
The Currency Table is a a user-friendly table that provides information on curre
ncy movements.
USD EUR GBP JPY
USD 1 0.7468 0.6627 99.19
EUR 1.339 1 0.8869 132.66
GBP 1.509 1.1275 1 149.53
JPY 0.0101 0.0075 0.0067 1
1.4 OVERVIEW OF INTERNATIONAL CURRENCY MARKETS
During the past quarter century, the concept of a 24-hour market has become a re
ality. Somewhere on the
planet, financial centres are open for business; banks and other institutions ar
e trading the US Dollar and other
currencies every hour of the day and night, except on weekends. In financial cen
tres around the world,
business hours overlap; as some centres close, others open and begin to trade. T
he foreign exchange market
follows the sun around the earth.
Business is heavy when both the US markets and the major European markets are op
en -that is, when it is
morning in New York and afternoon in London. In the New York market, nearly two-
thirds of the day’s activity
typically takes place in the morning hours. Activity normally becomes very slow
in New York in the mid-to late
afternoon, after European markets have closed and before the Tokyo, Hong Kong, a
nd Singapore markets
have opened.
Given this uneven flow of business around the clock, market participants often w
ill respond less aggressively to
an exchange rate development that occurs at a relatively inactive time of day, a
nd will wait to see whether the
development is confirmed when the major markets open. Some institutions pay litt
le attention to developments
in less active markets. Nonetheless, the 24-hour market does provide a continuou
s “real-time” market
11
assessment of the ebb and flow of influences and attitudes with respect to the t
raded currencies, and an
opportunity for a quick judgment of unexpected events. With many traders carryin
g pocket monitors, it has
become relatively easy to stay in touch with market developments at all times.
The market consists of a limited number of major dealer institutions that are pa
rticularly active in foreign
exchange, trading with customers and (more often) with each other. Most of these
institutions, but not all, are
commercial banks and investment banks. These institutions are geographically dis
persed, located in numerous
financial centres around the world. Wherever they are located, these institution
s are in close communication
with each other; linked to each other through telephones, computers, and other e
lectronic means.
Each nation’s market has its own infrastructure. For foreign exchange market opera
tions as well as for other
connected matters, each country enforces its own laws, banking regulations, acco
unting rules, taxation and
operates its own payment and settlement systems. Thus, even in a global foreign
exchange market with
currencies traded on essentially the same terms simultaneously in many financial
centres, there are different
national financial systems and infrastructures through which transactions are ex
ecuted, and within which
currencies are held.
With access to all of the foreign exchange markets generally open to participant
s from all countries, and with
vast amounts of market information transmitted simultaneously and almost instant
ly to dealers throughout the
world, there is an enormous amount of cross-border foreign exchange trading amon
g dealers as well as
between dealers and their customers.
At any moment, the exchange rates of major currencies tend to be virtually ident
ical in all the financial centres
where there is active trading. Rarely are there such substantial price differenc
es among major centres as to
provide major opportunities for arbitrage. In pricing, the various financial cen
tres that are open for business and
active at any one time are effectively integrated into a single market.
1.5 ECONOMIC VARIABLES IMPACTING EXCHANGE RATE MOVEMENTS
Various economic variables impact the movement in exchange rates. Interest rates
, inflation figures, GDP are
the main variables; however other economic indicators that provide direction reg
arding the state of the
economy also have a significant impact on the movement of a currency. These woul
d include employment
reports, balance of payment figures, manufacturing indices, consumer prices and
retail sales amongst others.
Indicators which suggest that the economy is strengthening are positively correl
ated with a strong currency and
would result in the currency strengthening and vice versa.
Currency trader should be aware of government policies and the central bank stan
ce as indicated by them from
time to time, either by policy action or market intervention. Government structu
res its policies in a manner such
that its long term objectives on employment and growth are met. In trying to ach
ieve these objectives, it
sometimes has to work around the economic variables and hence policy directives
and the economic variables
are entwined and have an impact on exchange rate movements.
For instance, if the government wants to stimulate growth, one of the measures i
t could take would be cutting
interest rates and if such a measure is seen to bear expected results then the m
arket would react positively
and its impact would also be seen in the strengthening of the home currency. Inf
lation and interest rates are
opposites. In order to reduce inflation, which reduces the purchasing power of m
oney, often the policy of high
interest rate is followed but such a policy hinders growth therefore a policy to
balance inflation and interest
rates is considered ideal and the perception of the success of such a policy by
the participants in the foreign
exchange market will impact the movement and direction of the currency.
This page has
been left blank
intentionally
13
CHAPTER 2 FOREIGN EXCHANGE DERIVATIVES
2.1 DERIVATIVES - DEFINITION
Derivative is a product whose value is derived from the value of one or more bas
ic variables, called bases
(underlying asset, index, or reference rate), in a contractual manner. The under
lying asset can be equity,
foreign exchange, commodity or any other asset. For example, wheat farmers may w
ish to sell their harvest at
a future date to eliminate the risk of a change in prices by that date. Such a t
ransaction is an example of a
derivative. The price of this derivative is driven by the spot price of wheat wh
ich is the "underlying".
In the Indian context the Securities Contracts (Regulation) Act, 1956 [SC(R)A] d
efines "derivative" to include-
1. A security derived from a debt instrument, share, loan whether secured or uns
ecured, risk instrument
or contract for differences or any other form of security.
2. A contract which derives its value from the prices, or index of prices, of un
derlying securities.
Derivatives are securities under the SC(R)A and hence the trading of derivatives
is governed by the regulatory
framework under the SC(R)A.
The term derivative has also been defined in section 45U(a) of the RBI act as fo
llows:
An instrument, to be settled at a future date, whose value is derived from chang
e in interest rate, foreign
exchange rate, credit rating or credit index, price of securities (also called “un
derlying”), 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 o
ptions or such other
instruments as may be specified by the Bank from time to time.
Derivative products initially emerged as hedging devices against fluctuations in
commodity prices, and
commodity-linked derivatives remained the sole form of such products for almost
three hundred years.
Financial derivatives came into spotlight in the post-1970 period due to growing
instability in the financial
markets. However, since their emergence, these products have become very popular
and by 1990s, they
accounted for about two-thirds of total transactions in derivative products. In
recent years, the market for
financial derivatives has grown tremendously in terms of variety of instruments
available, their complexity and
also turnover.
Box 2.1: Emergence of financial derivative products
2.2 DERIVATIVE PRODUCTS
Derivative contracts have several variants. The most common variants are forward
s, futures, options and
swaps. We take a brief look at various derivatives contracts that have come to b
e used.
Forwards: A forward contract is a customized contract between two parties, where
settlement takes place on a
specific date in the future at today s pre-agreed price.
Futures: A futures contract is an agreement between two parties to buy or sell a
n asset at a certain time in the
future at a certain price. Futures contracts are special types of forward contra
cts in the sense that they are
standardized and are generally traded on an exchange.
Options: Options are of two types - calls and puts. Calls give the buyer the rig
ht but not the obligation to buy a
given quantity of the underlying asset, at a given price on or before a given fu
ture date. Puts give the buyer the
right, but not the obligation to sell a given quantity of the underlying asset a
t a given price on or before a given
date.
14
Warrants: Options generally have tenors of upto one year; the majority of option
s traded on options
exchanges have a maximum maturity of nine months. Longer-dated options are calle
d warrants and are
generally traded over-the-counter (OTC).
LEAPS: The acronym LEAPS means Long Term Equity Anticipation Securities. These a
re options having a
maturity of upto three years.
Baskets: Basket options are options on portfolios of underlying assets. The unde
rlying asset is usually a
moving average of a basket of assets. Equity index option is a form of basket op
tion.
Swaps: Swaps are agreements between two parties to exchange cash flows in the fu
ture according to a
prearranged formula. They can be regarded as portfolios of forward contracts. Th
e two commonly used swaps
are:
• Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in
the same currency.
• Currency swaps: These entail swapping both principal and interest between the pa
rties, with the cash
flows in one direction being in a different currency than those in the opposite
direction.
Swaptions: Swaptions are options to buy or sell a swap that will become operativ
e at the expiry of the
options. Thus a swaption is an option on a forward swap. Rather than have calls
and puts, the swaptions
market has receiver swaptions and payer swaptions. A receiver swaption is an opt
ion to receive fixed and pay
floating. A payer swaption is an option to pay fixed and receive floating.
2.3 GROWTH DRIVERS OF DERIVATIVES
Over the last three decades, the derivatives market has seen a phenomenal growth
. A large variety of
derivative contracts have been launched at exchanges across the world. Some of t
he factors driving the growth
of financial derivatives are:
1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the international fi
nancial markets,
3. Marked improvement in communication facilities and sharp decline in their cos
ts,
4. Development of more sophisticated risk management tools, providing a wider ch
oice of risk
management strategies, and
5. Innovations in the derivatives markets, which optimally combine the risks and
returns over a large
number of financial assets, leading to higher returns, reduced risk and lower tr
ansactions costs as
compared to individual financial assets.
2.4 MARKET PLAYERS
The following three broad categories of participants - hedgers, speculators, and
arbitrageurs - trade in the
derivatives market. Hedgers face risk associated with the price of an asset and
they use futures or options
markets to reduce or eliminate this risk. Speculators wish to bet on future move
ments in the price of an asset.
Futures and options contracts can give them an extra leverage; that is, they can
increase both the potential
gains and potential losses in a speculative venture. Arbitrageurs are in busines
s to take advantage of a
15
discrepancy between prices in two different markets. If, for example, they see t
he futures price of an asset
getting out of line with the cash price, they will take offsetting positions in
the two markets to lock in a profit.
2.5 KEY ECONOMIC FUNCTION OF DERIVATIVES
Despite the fear and criticism with which the derivative markets are commonly lo
oked at, these markets
perform a number of economic functions.
1. Prices in an organized derivatives market reflect the perception of market pa
rticipants about the future and
lead the prices of underlying to the perceived future level. The prices of deriv
atives converge with the
prices of the underlying at the expiration of the derivative contract. Thus deri
vatives help in discovery of
future prices.
2. The derivatives market helps to transfer risks from those who have them but m
ay not like them to those
who have an appetite for risks.
3. Derivatives, due to their inherent nature, are linked to the underlying cash
markets. With the introduction of
derivatives, the underlying market witnesses higher trading volumes because of p
articipation by more
players who would not otherwise participate for lack of an arrangement to transf
er risk.
4. Speculative trades shift to a more controlled environment of derivatives mark
et. In the absence of an
organized derivatives market, speculators trade in the underlying cash markets.
Margining, monitoring and
surveillance of the activities of various participants become extremely difficul
t in these types of mixed
markets.
Early forward contracts in the US addressed merchants concerns about ensuring t
hat there were buyers and
sellers for commodities. However credit risk" remained a serious problem. To de
al with this problem, a group
of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The pri
mary intention of the
CBOT was to provide a centralized location known in advance for buyers and selle
rs to negotiate forward
contracts. In 1865, the CBOT went one step further and listed the first exchang
e traded" derivatives contract in
the US, these contracts were called futures contracts". In 1919, Chicago Butter
and Egg Board, a spin-off of
CBOT, was reorganized to allow futures trading. Its name was changed to Chicago
Mercantile Exchange
(CME). The CBOT and the CME were, until recently the two largest organized futur
es exchanges, which have
merged to become the “CME Group”.
The first stock index futures contract was traded at Kansas City Board of Trade.
Currently the most popular
stock index futures contract in the world is based on S&P 500 index, traded on C
hicago Mercantile Exchange.
During the mid eighties, financial futures became the most active derivative ins
truments generating volumes
many times more than the commodity futures. Index futures, futures on T-bills an
d Euro-Dollar futures are the
three most popular futures contracts traded today. Other popular international e
xchanges that trade derivatives
are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in
France, Eurex etc.
Box 2.2: History of derivatives markets
5. An important incidental benefit that flows from derivatives trading is that i
t acts as a catalyst for new
entrepreneurial activity. The derivatives have a history of attracting many brig
ht, creative, well-educated
people with an entrepreneurial attitude. They often energize others to create ne
w businesses, new
products and new employment opportunities, the benefits of which are immense.
In a nut shell, derivatives markets help increase savings and investment in the
long run. Transfer of risk
enables market participants to expand their volume of activity.
16
2.6 EXCHANGE-TRADED VS. OVER –THE- COUNTER DERIVATIVES
Derivatives have probably been around for as long as people have been trading wi
th one another. Forward
contracting dates back at least to the 12th century, and may well have been arou
nd before then. Merchants
entered into contracts with one another for future delivery of specified amount
of commodities at specified
price. A primary motivation for pre-arranging a buyer or seller for a stock of c
ommodities in early forward
contracts was to lessen the possibility that large swings would inhibit marketin
g the commodity after a harvest.
As the name suggests, derivatives that trade on an exchange are called exchange
traded derivatives, whereas
privately negotiated derivative contracts are called OTC derivatives.
The OTC derivatives markets have witnessed rather sharp growth over the last few
years which have
accompanied the modernization of commercial and investment banking and globalisa
tion of financial activities.
The recent developments in information technology have contributed to a great ex
tent to these developments.
While both exchange-traded and OTC derivative contracts offer many benefits, the
former have rigid structures
compared to the latter.
The OTC derivatives markets have the following features compared to exchange-tra
ded derivatives:
1) The management of counter-party (credit) risk is decentralized and located wi
thin individual institutions,
2) There are no formal centralized limits on individual positions, leverage, or
margining; limits are determined
as credit lines by each of the counterparties entering into these contracts
3) There are no formal rules for risk and burden-sharing,
4) There are no formal rules or mechanisms for ensuring market stability and int
egrity, and for safeguarding the
collective interests of market participants, and
5) Although OTC contracts are affected indirectly by national legal systems, ban
king supervision and market
surveillance, they are generally not regulated by a regulatory authority.
Some of the features of OTC derivatives markets embody risks to financial market
stability. The following
features of OTC derivatives markets can give rise to instability in institutions
, markets, and the international
financial system:
(i) the dynamic nature of gross credit exposures;
(ii) information asymmetries;
(iii) the effects of OTC derivative activities on available aggregate credit;
(iv) the high concentration of OTC derivative activities in major institutions;
and
(v) the central role of OTC derivatives markets in the global financial system.
Instability arises when shocks, such as counter-party credit events and sharp mo
vements in asset prices that
underlie derivative contracts occur, which significantly alter the perceptions o
f current and potential future
credit exposures. When asset prices change rapidly, the size and configuration o
f counter-party exposures can
become unsustainably large and provoke a rapid unwinding of positions.
There has been some progress in addressing these risks and perceptions. However,
the progress has been
limited in implementing reforms in risk management, including counter-party, liq
uidity and operational risks,
and OTC derivatives markets continue to pose a threat to international financial
stability. The problem is more
17
acute as heavy reliance on OTC derivatives creates the possibility of systemic f
inancial events, which fall
outside the more formal clearing corporation structures.
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19
CHAPTER 3 EXCHANGE TRADED CURRENCY FUTURES
3.1 CURRENCY FUTURES -DEFINITION
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 future
s contract”. In other words,
it is a contract to exchange one currency for another currency at a specified da
te and a specified rate in the
future. Therefore, the buyer and the seller lock themselves into an exchange rat
e for a specific value and
delivery date. Both parties of the futures contract must fulfill their obligatio
ns on the settlement date.
Internationally, currency futures can be cash settled or settled by delivering t
he respective obligation of the
seller and buyer. All settlements, however, unlike in the case of OTC markets, g
o through the exchange.
Currency futures are a linear product, and calculating profits or losses on Curr
ency Futures will be similar to
calculating profits or losses on Index futures. In determining profits and losse
s in futures trading, it is essential
to know both the contract size (the number of currency units being traded) and a
lso what the “tick” value is.
A tick is the minimum trading increment or price differential at which traders a
re able to enter bids and offers.
Tick values differ for different currency pairs and different underlyings. For e
.g. in the case of the USD-INR
currency futures contract the tick size shall be 0.25 paise 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.
42.2500. One tick move on this contract will translate to Rs.42.2475 or Rs.42.25
25 depending on the direction
of market movement.
Purchase price: Rs.42.2500
Price increases by one tick: +Rs.00.0025
New price: Rs.42.2525
Purchase price: Rs.42.2500
Price decreases by one tick: –Rs.00.0025
New price: Rs.42.2475
The value of one tick on each contract is Rupees 2.50 (1000X 0.0025). So if a tr
ader buys 5 contracts and the
price moves up by 4 ticks, he makes Rupees 50.00
Step 1: 42.2600 – 42.2500
Step 2: 4 ticks * 5 contracts = 20 points
Step 3: 20 points * Rupees 2.5 per tick = Rupees 50.00
(Note: The above examples do not include transaction fees and any other fees, wh
ich are essential for
calculating final profit and loss)
20
3.2 FUTURES TERMINOLOGY
• Spot price: The price at which an asset trades in the spot market. In the case o
f USD/INR, spot
value is T + 2.
• Futures price: The price at which the futures contract trades in the futures mar
ket.
• Contract cycle: The period over which a contract trades. The currency futures co
ntracts on the SEBI
recognized exchanges have one-month, two-month, and three-month up to twelve-mon
th expiry
cycles. Hence, these exchanges will have 12 contracts outstanding at any given p
oint in time.
• Value Date/Final Settlement Date: The last business day of the month will be ter
med the Value date
/ Final Settlement date of each contract. The last business day would be taken t
o the same as that for
Inter-bank Settlements in Mumbai. The rules for Inter-bank Settlements, includin
g those for ‘known
holidays’ and ‘subsequently declared holiday’ would be those as laid down by Foreign E
xchange
Dealers’ Association of India (FEDAI).
• Expiry date: It is the date specified in the futures contract. All contracts exp
ire on the last working day
(excluding Saturdays) of the contract months. The last day for the trading of th
e contract shall be two
working days prior to the final settlement date or value date.
• Contract size: The amount of asset that has to be delivered under one contract.
Also called as lot
size. In the case of USD/INR it is USD 1000; EUR/INR it is EUR 1000; GBP/INR it
is GBP 1000 and
in case of JPY/INR it is JPY 100,000. ( Ref. RBI Circular: RBI/2009-10/290, date
d 19th January, by
which RBI has allowed trade in EUR/INR, JPY/INR and GBP/INR pairs.)1
• 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 p
rices.
• Cost of carry: The relationship between futures prices and spot prices can be su
mmarized in terms
of what is known as the cost of carry. This measures (in commodity markets) 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: The amount that must be deposited in the margin account at the t
ime a futures
contract is first entered into is known as initial margin.
• Marking-to-market: In the futures market, at the end of each trading day, the ma
rgin account is
adjusted to reflect the investor s gain or loss depending upon the futures closi
ng price. This is called
marking-to-market.
3.3 RATIONALE BEHIND CURRENCY FUTURES
Futures markets were designed to address certain 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 th
e future at a certain price. But
unlike forward contracts, the futures contracts are standardized and exchange tr
aded. To facilitate liquidity in
the futures contracts, the exchange specifies certain standard features of the c
ontract. A futures contract is
standardized contract with standard underlying instrument, a standard quantity o
f the underlying instrument
1 In this book, we will discuss the concepts taking USD/INR as an example.
21
that can be delivered, (or which can be used for reference purposes in settlemen
t) 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
• The date and the month of delivery
• The units of price quotation and minimum price change
• Location of settlement
The rationale for introducing currency futures in the Indian context has been ou
tlined in the Report of the
Internal Working Group on Currency Futures (Reserve Bank of India, April 2008) a
s follows;
“The rationale for establishing the currency futures market is manifold. Both resi
dents and non-residents
purchase domestic currency assets. If the exchange rate remains unchanged from t
he time of purchase of the
asset to its sale, no gains and losses are made out of currency exposures. But i
f domestic currency
depreciates (appreciates) against the foreign currency, the exposure would resul
t 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. Curr
ency futures enable them
to hedge these risks. Nominal exchange rates are often random walks with or with
out drift, while real
exchange rates over long run are mean reverting. As such, it is possible that ov
er a long – run, the incentive to
hedge currency risk may not be large. However, financial planning horizon is muc
h smaller than the long-run,
which is typically inter-generational in the context of exchange rates. Per se,
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 co
nverted 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 s
trong empirical evidence to
suggest that hedging reduces the volatility of returns and indeed considering th
e episodic nature of currency
returns, there are strong arguments to use instruments to hedge currency risks.
Currency risks could be hedged mainly through forwards, futures, swaps and optio
ns. Each of these
instruments has its role in managing the currency risk. The main advantage of cu
rrency futures over its closest
substitute product, viz. forwards which are traded over the counter lies in pric
e transparency, elimination of
counterparty credit risk and greater reach in terms of easy accessibility to all
. Currency futures are expected to
bring about better price discovery and also possibly lower transaction costs. Ap
art from pure hedgers,
currency futures also invite arbitrageurs, speculators and those traders who may
take a bet on exchange rate
movements without an underlying or an economic exposure as a motivation for trad
ing.
From an economy-wide perspective, currency futures contribute to hedging of risk
s and help traders and
investors in undertaking their economic activity. There is a large body of empir
ical evidence which suggests
that exchange rate volatility has an adverse impact on foreign trade. Since ther
e are first order gains from
trade which contribute to output growth and consumer welfare, currency futures c
an potentially have an
important impact on real economy. Gains from international risk sharing through
trade in assets could be of
relatively smaller magnitude than gains from trade. However, in a dynamic settin
g these investments could still
significantly impact capital formation in an economy and as such currency future
s could be seen as a facilitator
in promoting investment and aggregate demand in the economy, thus promoting grow
th”.
22
The Chicago Mercantile Exchange (CME) created FX futures, the first ever financi
al futures contracts, in 1972.
The contracts were created under the guidance and leadership of Leo Melamed, CME
Chairman Emeritus. The
FX contract capitalized on the U.S. abandonment of the Bretton Woods agreement,
which had fixed world
exchange rates to a gold standard after World War II. The abandonment of the Bre
tton Woods agreement
resulted in currency values being allowed to float, increasing the risk of doing
business. By creating another
type of market in which futures could be traded, CME currency futures extended t
he reach of risk management
beyond commodities, which were the main derivative contracts traded at CME until
then. The concept of
currency futures at CME was revolutionary, and gained credibility through endors
ement of Nobel-prize-winning
economist Milton Friedman.
Today, CME offers 41 individual FX futures and 31 options contracts on 19 curren
cies, all of which trade
electronically on the exchange’s CME Globex platform. It is the largest regulated
marketplace for FX trading.
Traders of CME FX futures are a diverse group that includes multinational corpor
ations, hedge funds,
commercial banks, investment banks, financial managers, commodity trading adviso
rs (CTAs), proprietary
trading firms, currency overlay managers and individual investors. They trade in
order to transact business,
hedge against unfavourable changes in currency rates, or to speculate on rate fl
uctuations.
Box 3.1: Emergence and growth of FX futures
3.4 DISTINCTION BETWEEN FUTURES AND FORWARD CONTRACTS
Forward contracts are often confused with futures contracts. The confusion is pr
imarily because both serve
essentially the same economic functions of allocating risk in the probability of
future price uncertainty. However
futures have some distinct advantages over forward contracts as they eliminate c
ounterparty risk and offer
more liquidity and price transparency. However, it should be noted that forwards
enjoy the benefit of being
customized to meet specific client requirements. The advantages and limitations
of futures contracts are as
follows;
Advantages of Futures:
- Transparency and efficient price discovery. The market brings together diverge
nt categories of buyers
and sellers.
- Elimination of Counterparty credit risk.
- Access to all types of market participants. (Currently, in the Foreign Exchang
e OTC markets one side
of the transaction has to compulsorily be an Authorized Dealer – i.e. Bank).
- Standardized products.
- Transparent trading platform.
Limitations of Futures:
- The benefit of standardization which often leads to improving liquidity in fut
ures, works against this
product when a client needs to hedge a specific amount to a date for which there
is no standard
contract
- While margining and daily settlement is a prudent risk management policy, some
clients may prefer
not to incur this cost in favor of OTC forwards, where collateral is usually not
demanded
23
3.5 INTEREST RATE PARITY AND PRICING OF CURRENCY FUTURES
For currencies which are fully convertible, the rate of exchange for any date ot
her than spot, is a function of
spot and the relative interest rates in each currency. The assumption is that, a
ny funds held will be invested in
a time deposit of that currency. Hence, the forward rate is the rate which neutr
alizes the effect of differences in
the interest rates in both the currencies.
In the context of currencies, like USD/INR which are not fully convertible, forw
ards and futures prices can be
influenced by several factors including regulations that are in place at any giv
en point in time. The forward rate
is a function of the spot rate and the interest rate differential between the tw
o currencies, adjusted for time. A
futures contract is a standardized forward contract traded through an exchange t
o eliminate counterparty risk.
In order to derive the forward rate from the spot rate, there are three commonly
used formulae which give
similar results, viz.
a. Term : Base Formula
b. Spot-Forward r& p Formula
c. Continuous Compounding Formula
a. Term : Base Formula
Forward Rate = Spot + Points
Points = Spot 1 + terms i * days
basis _ 1
1 + base i * days
basis
Where:
i = rate of interest
basis = day count basis (Most currencies use a 360-day basis, except the pound s
terling and a few others,
which use a 365-day year.)
b. Spot-Forward r& p Formula
The spot exchange rate is S0. This quote is in USD per INR. The US risk-free int
erest rate is p, and the holding
period is T. You take S0(1+ p)-T INR and buy (1+ p)-T dollars. Simultaneously, y
ou sell one future contract
expiring at time T. The future exchange rate is F0, which is also in INR per dol
lar. You take your (1+ p)-T dollars
and invest them in US T-bills that have a return of p.
When the forward contract expires, you will have 1 dollar. This is because your
(1+ ρ)-T dolla s will have g own
by the facto  (1+ p)T the efo e (1+ p)-T (1+ p)T = 1. You  fo wa d cont act obli
gates you to delive  the dolla , fo 
24
which you eceive F(0,T) INR. In effect, you have invested S0(1+ p)-T and eceiv
ed F(0,T) INR. Since the
t ansaction is iskless, you  etu n should be the INR ate, ; the efo e:
F(0,T) = S0(1+ ) T/ (1+p) T
C. Continuous Compounding Fo mula
F(0,T) = S0e( -p)T
Illust ation:
Conside  the following example f om an Indian pe spective. On Janua y 31 of a pa
ticula  yea , the spot
USD/INR ate was 43.50. The US inte est ate was 3 pe cent, while the Indian int
e est ate was 6 pe cent. The
time to expi ation was 90/360 = 0.25.
This can be solved using th ee diffe ent fo mulae as illust ated below:
(a) Te ms:Base Fo mula (b) Spot Fo wa d & p
Fo mula
(c) Continuous
Compounding Fo mula
Fo wa d Rate = Spot + Points
Points = Spot 1 + te ms i * days
basis _ 1
1 + base i * days
basis
F(0,T) = S0(1+ ) T/
(1+p) T
F(0,T) = S0e( -p)T
Points = 43.5 {[(1+.06*.25)/(1+.03*.25)]-1}
= 0.3238
Fo wa d Rate = 43.5 + (.3238) = 43.8238
F = 43.5 * [(1+.06)^.25]
/ [(1+.03)^.25]
F = 43.5 * e [(.06-.03) *
.25]
Ans: 43.8238 Ans: 43.8133 Ans: 43.8275
The te m ‘e’ is a well-known mathematical exp ession to simplify a la ge  exp ession
:
(1+ /∞)∞ which signifies continuous compounding on a given inte est ate. The best a
pp oximation of e is
2.71828183.
25
As can be noticed f om the above table, the th ee fo mulae give esults which a 
e simila  but not identical. Any
of these fo mulae can be used fo  decision making. Howeve , f om a t ading pe sp
ective, g eate  levels of
accu acy may be desi ed. Hence, t ade s p efe  the Continuous Compounding fo mul
a.
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27
CHAPTER 4 STRATEGIES USING CURRENCY FUTURES
4.1 SPECULATION IN FUTURES MARKETS
Speculato s play a vital ole in the futu es ma kets. Futu es a e designed p ima
ily to assist hedge s in
managing thei  exposu e to p ice isk; howeve , this would not be possible witho
ut the pa ticipation of
speculato s. Speculato s, o  t ade s, assume the p ice isk that hedge s attempt
to lay off in the ma kets. In
othe  wo ds, hedge s often depend on speculato s to take the othe  side of thei 
t ades (i.e. act as counte 
pa ty) and to add depth and liquidity to the ma kets that a e vital fo  the func
tioning of a futu es ma ket. The
speculato s the efo e have a big hand in making the ma ket.
Speculation is not simila  to manipulation. A manipulato  t ies to push p ices i
n the eve se di ection of the
ma ket equilib ium while the speculato  fo ecasts the movement in p ices and thi
s effo t eventually b ings the
p ices close  to the ma ket equilib ium. If the speculato s do not adhe e to the
elevant fundamental facto s of
the spot ma ket, they would not su vive since thei  co elation with the unde ly
ing spot ma ket would be
nonexistent.
4.2 LONG POSITION IN FUTURES
Long position in a cu ency futu es cont act without any exposu e in the cash ma
ket is called a speculative
position. Long position in futu es fo  speculative pu pose means buying futu es
cont act in anticipation of
st engthening of the exchange ate (which actually means buy the base cu ency (
USD) and sell the te ms
cu ency (INR) and you want the base cu ency to ise in value and then you woul
d sell it back at a highe 
p ice). If the exchange ate st engthens befo e the expi y of the cont act then
the t ade  makes a p ofit on
squa ing off the position, and if the exchange ate weakens then the t ade  make
s a loss.
Long Futu e Payoff
P ofit
Loss
P ofit
Loss
0
Payoff – Long Position in Futu es
The g aph above depicts the pay-off of a long position in a futu e cont act, whi
ch does demonst ate that the
pay-off of a t ade  is a linea  de ivative, that is, he makes unlimited p ofit i
f the ma ket moves as pe  his
di ectional view, and if the ma ket goes against, he has equal isk of making un
limited losses if he doesn’t
choose to exit out his position.
Time
28
Hypothetical Example – Long positions in futu es
On May 1, 2008, an active t ade  in the cu ency futu es ma ket expects INR will
dep eciate against USD
caused by India’s sha ply ising impo t bill and poo  FII equity flows. On the bas
is of his view about the
USD/INR movement, he buys 1 USD/INR August cont act at the p evailing ate of Rs
. 40.5800.
He decides to hold the cont act till expi y and du ing the holding pe iod USD/IN
R futu es actually moves as pe 
his anticipation and the RBI Refe ence ate inc eases to USD/INR 42.46 on May 30
, 2008. He squa es off his
position and books a p ofit of Rs. 1880 (42.4600x1000 - 40.5800x1000) on 1 cont 
act of USD/INR futu es
cont act.
Obse vation: The t ade  has effectively analysed the ma ket conditions and has t
aken a ight call by going long
on futu es and thus has made a gain of Rs. 1,880.
4.3 SHORT POSITION IN FUTURES
Sho t position in a cu ency futu es cont act without any exposu e in the cash m
a ket is called a speculative
t ansaction. Sho t position in futu es fo  speculative pu poses means selling a
futu es cont act in anticipation of
decline in the exchange ate (which actually means sell the base cu ency (USD)
and buy the te ms cu ency
(INR) and you want the base cu ency to fall in value and then you would buy it
back at a lowe  p ice). If the
exchange ate weakens befo e the expi y of the cont act, then the t ade  makes a
p ofit on squa ing off the
position, and if the exchange ate st engthens then the t ade  makes loss.
The g aph above depicts the pay-off of a sho t position in a futu e cont act whi
ch does exhibit that the pay-off
of a sho t t ade  is a linea  de ivative, that is, he makes unlimited p ofit if
the ma ket moves as pe  his
di ectional view and if the ma ket goes against his view he has equal isk of ma
king unlimited loss if he doesn’t
choose to exit out his position.
USDINR (May 1 - May 30, 2008)
40
41
42
43
Time
USDINR
Position Squa edoff
USDINR@42.46
USD St engthen by 1.88.
Long Position
Initiated
USDINR@40.58
May 1, ‘08 May 30, ‘08
29
Example – Sho t positions in futu es
On August 1, 2008, an active t ade  in the cu ency futu es ma ket expects INR w
ill app eciate against USD,
caused by softening of c ude oil p ices in the inte national ma ket and hence im
p oving India’s t ade balance.
On the basis of his view about the USD/INR movement, he sells 1 USD/INR August c
ont act at the p evailing
ate of Rs. 42.3600.
On August 6, 2008, USD/INR August futu es cont act actually moves as pe  his ant
icipation and declines to
41.9975. He decides to squa e off his position and ea ns a p ofit of Rs. 362.50
(42.3600x1000 –
41.9975x1000) on squa ing off the sho t position of 1 USD/INR August futu es con
t act.
Obse vation: The t ade  has effectively analysed the ma ket conditions and has t
aken a ight call by going
sho t on futu es and thus has made a gain of Rs. 362.50 pe  cont act with small
investment (a ma gin of 3%,
which comes to Rs. 1270.80) in a span of 6 days.
4.4 HEDGING USING CURRENCY FUTURES
Hedging: Hedging means taking a position in the futu e ma ket that is opposite t
o a position in the physical
ma ket with a view to educe o  limit isk associated with unp edictable changes
in exchange ate.
A hedge  has an Ove all Po tfolio (OP) composed of (at least) 2 positions:
1. Unde lying position
2. Hedging position with negative co elation with unde lying position
Value of OP = Unde lying position + Hedging position; and in case of a Pe fect h
edge, the Value of the OP is
insensitive to exchange ate (FX) changes.
Types of FX Hedge s using Futu es
Long hedge:
• Unde lying position: sho t in the fo eign cu ency
• Hedging position: long in cu ency futu es
Sho t hedge:
• Unde lying position: long in the fo eign cu ency
• Hedging position: sho t in cu ency futu es
The p ope  size of the Hedging position
• Basic App oach: Equal hedge
• Mode n App oach: Optimal hedge
Equal hedge: In an Equal Hedge, the total value of the futu es cont acts involve
d is the same as the value of
the spot ma ket position. As an example, a US impo te  who has an exposu e of £ 1
million will go long on 16
cont acts assuming a face value of £62,500 pe  cont act. The efo e in an equal hed
ge: Size of Unde lying
position = Size of Hedging position.
Optimal Hedge: An optimal hedge is one whe e the changes in the spot p ices a e
negatively co elated with
the changes in the futu es p ices and pe fectly offset each othe . This can gene
ally be desc ibed as an equal
hedge, except when the spot-futu e basis elationship changes. An Optimal Hedge
is a hedging st ategy which
yields the highest level of utility to the hedge .
30
Co po ate Hedging
Befo e the int oduction of cu ency futu es, a co po ate hedge  had only Ove -th
e-Counte  (OTC) ma ket as a
platfo m to hedge his cu ency exposu e; howeve  now he has an additional platfo
m whe e he can compa e
between the two platfo ms and acco dingly decide whethe  he will hedge his expos
u e in the OTC ma ket o  on
an exchange o  he will like to hedge his exposu es pa tially on both the platfo 
ms.
Example 1: Long Futu es Hedge Exposed to the Risk of St engthening USD
Unhedged Exposu e: Let’s say on Janua y 1, 2008, an Indian impo te  ente s into a
cont act to impo t 1,000
ba els of oil with payment to be made in US Dolla  (USD) on July 1, 2008. The p
ice of each ba el of oil has
been fixed at USD 110/ba el at the p evailing exchange ate of 1 USD = INR 39.4
1; the cost of one ba el of
oil in INR wo ks out to be Rs. 4335.10 (110 x 39.41). The impo te  has a isk th
at the USD may st engthen ove 
the next six months causing the oil to cost mo e in INR; howeve , he decides not
to hedge his position.
On July 1, 2008, the INR actually dep eciates and now the exchange ate stands a
t 1 USD = INR 43.23. In
dolla  te ms he has fixed his p ice, that is USD 110/ba el, howeve , to make pa
yment in USD he has to
conve t the INR into USD on the given date and now the exchange ate stands at 1
USD = INR43.23.
The efo e, to make payment fo  one dolla , he has to shell out Rs. 43.23. Hence
the same ba el of oil which
was costing Rs. 4335.10 on Janua y 1, 2008 will now cost him Rs. 4755.30, which
means 1 ba el of oil ended
up costing Rs. 4755.30 - Rs. 4335.10 = Rs. 420.20 mo e and hence the 1000 ba el
s of oil has become dea e 
by INR 4,20,200.
When INR weakens, he makes a loss, and when INR st engthens, he makes a p ofit.
As the impo te  cannot
be su e of futu e exchange ate developments, he has an enti ely speculative pos
ition in the cash ma ket,
which can affect the value of his ope ating cash flows, income statement, and co
mpetitive position, hence
ma ket sha e and stock p ice.
Hedged: Let’s p esume the same Indian Impo te  p e-empted that the e is good p oba
bility that INR will
weaken against the USD given the cu ent mac o economic fundamentals of inc easi
ng Cu ent Account deficit
and FII outflows and decides to hedge his exposu e on an exchange platfo m using
cu ency futu es.
Since he is conce ned that the value of USD will ise he decides go long on cu 
ency futu es, it means he
pu chases a USD/INR futu es cont act. This p otects the impo te  because st engt
hening of USD would lead to
31
p ofit in the long futu es position, which would effectively ensu e that his los
s in the physical ma ket would be
mitigated. The following figu e and Exhibit explain the mechanics of hedging usi
ng cu ency futu es.
Obse vation: Following a 9.7% ise in the spot p ice fo  USD, the US dolla s a e
pu chased at the new, highe 
spot p ice, but p ofits on the hedge foste  an effective exchange ate equal to
the o iginal hedge p ice.
OIL IMPORTER
• Is sho t on USD 110000 in the spot
ma ket
• Is long (buys) 110 USD/INR
futu es cont acts
• Buys back (sells) USD/INR futu es
cont acts to squa e off t ansaction
• Buys USD to meet impo t
equi ement in the spot ma ket
32
Example 2: Sho t Futu es Hedge Exposed to the Risk of Weakening USD
Unhedged Exposu e: Let’s say on Ma ch 1, 2008, an Indian efine  ente s into a con
t act to expo t 1000 ba els
of oil with payment to be eceived in US Dolla  (USD) on June 1, 2008. The p ice
of each ba el of oil has been
fixed at USD 80/ba el at the p evailing exchange ate of 1 USD = INR 44.05; the
p ice of one ba el of oil in
INR wo ks out to be is Rs. 3524 (80 x 44.05). The efine  has a isk that the IN
R may st engthen ove  the next
th ee months causing the oil to cost less in INR; howeve  he decides not to hedg
e his position.
On June 1, 2008, the INR actually app eciates against the USD and now the exchan
ge ate stands at 1 USD =
INR 40.30. In dolla  te ms he has fixed his p ice, that is USD 80/ba el; howeve
, the dolla  that he eceives has
to be conve ted in INR on the given date and the exchange ate stands at 1USD =
INR40.30. The efo e, eve y
dolla  that he eceives is wo th Rs. 40.30 as against Rs. 44.05. Hence the same
ba el of oil that initially would
have ga ne ed him Rs. 3524 (80 x 44.05) will now ealize Rs. 3224, which means 1
ba el of oil ended up
selling Rs. 3524 – Rs. 3224 = Rs. 300 less and hence the 1000 ba els of oil has b
ecome cheape  by INR
3,00,000.
When INR st engthens, he makes a loss and when INR weakens, he makes a p ofit. A
s the efine  cannot be
su e of futu e exchange ate developments, he has an enti ely speculative positi
on in the cash ma ket, which
can affect the value of his ope ating cash flows, income statement, and competit
ive position, hence ma ket
sha e and stock p ice.
Hedged: Let’s p esume the same Indian efine  p e-empted that the e is good p obab
ility that INR will
st engthen against the USD given the cu ent mac oeconomic fundamentals of educ
ing fiscal deficit, stable
cu ent account deficit and st ong FII inflows and decides to hedge his exposu e
on an exchange platfo m
using cu ency futu es.
Since he is conce ned that the value of USD will fall he decides go sho t on cu 
ency futu es, it means he sells
a USD/INR futu e cont act. This p otects the impo te  because weakening of USD w
ould lead to p ofit in the
sho t futu es position, which would effectively ensu e that his loss in the phys
ical ma ket would be mitigated.
The following figu e and exhibit explain the mechanics of hedging using cu ency
futu es.
33
Obse vation: Following an 8.51% fall in the spot p ice fo  USD, the US dolla s a
e sold at the new, lowe  spot
p ice; but p ofits on the hedge foste  an effective exchange ate equal to the o
iginal hedge p ice.
OIL REFINER
• Is long on USD 80000 in the Spot
ma ket
• Is sho t (sells) 80 USD/INR futu es
cont acts
• Buys back USD/INR futu es
cont acts to squa e off t ansaction
• Buys USD to meet impo t
equi ement in the spot ma ket
34
Example 3 (Va iation of Example 1): Long Futu es Hedge Exposed to the Risk of Co
nt act Expi y and
Liquidation on the Same Day
Initiation of hedge Liquidation of hedge
T ansaction date 1-Jan 28-Jun
Spot value date 3-Jan 30-Jun
Futu es delive y date 17-Jun 30-Jun
Spot p ice($/FX) 39.41 43.72
Futu es p ice 39.90 43.72
Results
INR paid fo  USD 110000 on June 30: INR 43.72 x 110000 = INR 4809200
Hedge esult: USD 110000 x (Rs. 43.72 - 39.90) = INR 420200
Effective exchange ate = (INR 4809200 - INR 420200)/110000 = 39.90
Obse vation: The size of the exposu e is USD 110000 and the desi ed value date i
s p ecisely the same as the
futu es delive y date (June 30). Following a 9.5% ise in the spot p ice fo  USD
against INR, the US dolla s a e
pu chased at the new, highe  spot p ice; but p ofits on the hedge foste  an effe
ctive exchange ate equal to the
o iginal futu es p ice because on the date of expi y the spot p ice and the futu
e p ice tend to conve ge.
Example 4: Retail Hedging – Long Futu es Hedge Exposed to the Risk of a st onge  U
SD
On 1st Ma ch 2008, a student decides to en oll fo  CMT-USA Octobe  2008 exam fo 
which he needs to make a
payment of USD 1,000 on 15th Septembe , 2008. On 1st Ma ch, 2008 USD/INR ate of
40.26, the p ice of
en olment in INR wo ks out to be Rs. 40,260. The student has the isk that the U
SD may st engthen ove  the
next six months causing the en olment to cost mo e in INR hence decides to hedge
his exposu e on an
exchange platfo m using cu ency futu es.
Since he is conce ned that the value of USD will ise, he decides go long on cu 
ency futu es; it means he
pu chases a USD/INR futu es cont act. This p otects the student because st ength
ening of USD would lead to
p ofit in the long futu es position, which would effectively ensu e that his los
s in the physical ma ket would be
mitigated. The following figu e and Exhibit explain the mechanics of hedging usi
ng cu ency futu es.
35
Obse vation: Following a 14.25% ise in the spot p ice fo  USD (against INR), th
e US dolla s a e bought at the
new, highe  spot p ice; but p ofits on the hedge foste  an effective exchange a
te equal to the o iginal hedge
p ice.
Example 5: Retail Hedging – Remove Fo ex Risk while Investing Ab oad
Let’s say when USD/INR at 44.20, an active stock ma ket investo  decides to invest
USD 200,000 fo  a pe iod
of six months in the S&P 500 Index with a pe spective that the ma ket will g ow
and his investment will fetch
him a decent etu n. In Indian te ms, the investment is about Rs. 8,840,000.
Let’s say that afte  six months, as pe  his anticipation, the ma ket whe ein he ha
s invested has app eciated by
10% and now his investment of USD 200,000 stands at USD 220,000. Having ea ned a
decent etu n the
investo  decides to squa e off all his positions and b ing back his p oceeds to
India.
The cu ent USD/INR exchange ate stands at 40.75 and his investment of USD 220,
000 in Indian te m stands
at Rs. 8,965,000. Thus fetching him a meage  etu n of 1.41% as compa ed to etu
n of 10% in USD, this is
because du ing the same pe iod USD has dep eciated by 7.81% against the INR and
the efo e the poo  etu n.
Consequently, even afte  gauging the ove seas stock ma ket movement co ectly he
is not able to ea n the
desi ed ove seas etu n because he was not able to captu e and manage his cu en
cy exposu e.
Let’s p esume the same Indian investo  p e-empted that the e is good p obability t
hat the USD will weaken
given the then ma ket fundamentals and has decided to hedge his exposu e on an e
xchange platfo m using
cu ency futu es.
Since he was conce ned that the value of USD will fall he decides go sho t on cu
ency futu es, it means he
sells a USD/INR futu es cont act. This p otects the investo  because weakening o
f USD would lead to p ofit in
36
the sho t futu es position, which would effectively ensu e that his loss in the
investment ab oad would be
mitigated. The following figu e and Exhibit explain the mechanics of hedging usi
ng cu ency futu es.
Date Spot Ma ket Futu es Ma ket
Leg I
The cu ent exchange ate is INR 44.20 pe  USD,
the efo e the cu ent investment of USD 200000
in INR is Rs. 8840000.
USDINR cont act is at INR 44.50. P ice pe 
cont act is INR 44,500 (44.50*1000). The
app opa iate numbe  of cont act he should sell is
8840000/44500 = 199. Sell 199 Cont acts fo 
8855500.
Leg II
The spot ate is 40.75. Receive 220000 USD fo  his
investmen. Revenues in Rupees: 220000(40.75) =
INR 8965000
Buy back 199 cont act at the p evailing ate of
USDINR 41.05. P ice pe  cont act is INR 41050
(41.05*1000), hence the value of 199 cont acts is
INR 8168950.
INR 8855500 (Sale p ice of futu es)
(INR 8168950) (less - Buy p ice of futu es)
INR 686550 P ofit on futu es
8965000 (Stock P oceedings)
686550 (Futu e gain)
9651550 (Retu n to hedge)
Analysis:
The investment ended up ga ne ing INR 9724000 - INR 8965000 = INR 759000 Less
The p ofit on the futu es t ansaction is:
Mitigating Fo ex Risk - Fetchiong Compa able Stock Ma ket Retu n:
Obse vation – Had the exchange ate been stagnant at 44.20 du ing the six-month in
vestment pe iod the
investment in Rupee te ms would have g own f om INR 884,00,000 to INR 9,724,000
fetching him a etu n of
INR 8,84,000 in absolute te ms. Howeve , du ing the investment pe iod, the USD h
as dep eciated by 7.81%
and hence his investment has ea ned him a etu n of only INR 125,000. Had he hed
ged his exposu e using
37
cu ency futu es, he could have mitigated a majo  po tion of his isk as explain
ed in the above example; he is
not able to mitigate his isk completely even with the basis emaining the same
because du ing the holding
pe iod his investment has g own f om USD 2,00,000 to USD 2,20,000. The exhibit b
elow gives the tabula 
ep esentation of the po tfolio with and without cu ency hedging:
Without Hedging Hedging with Cu ency Futu es
Invests $ 200,000 (USD = Rs. 44.20)
Invests and sells 199 futu es cont acts @ Rs.
44.50
Investment g ows to $ 220,000 afte  six months
Afte  six months, squa es off futu es position @
Rs. 41.05
Offloads investment when the exchange ate is
USD = Rs. 40.75
Retu n in Rs. Te ms:
Retu n in $ te ms = 10% On investment = Rs. 1,25,000
Retu n in Rs. Te ms = 1.41% On futu es = Rs. 686550
i.e. (210,000 x 44) – (200,000 x 45) Net etu n = 9.18%
Po tfolio Retu n
Hence a hedging using cu ency futu e has p ovided him bette  etu n as compa ed
to the one without hedging.
Also, it is not possible fo  eve y investo  to gauge both the ma kets co ectly,
as in this case the investo  may
be an intelligent and well info med stock investo , but he may not be equally go
od when it comes to cu ency
ma ket; also it is not necessa y that both ma kets move in the di ection of the
investo ’s advantage. So it’s
advisable that if an investo  is taking a bet in one ma ket, he will be bette  o
ff if he can mitigate the isk elated
to othe  ma kets.
Example 6: Retail Hedging – Remove Fo ex Risk while T ading in Commodity Ma ket
Gold p ices on Exchanges in India have a ve y high co elation with the COMEX go
ld p ices. That is, Indian
gold p ices dec ease with the dec ease in COMEX p ices and inc ease with the inc
ease in COMEX p ices. But
it doesn’t mean the inc ease and dec ease will be same in Indian exchanges in pe c
entage te ms as that in
COMEX. This is because in both the ma kets the quotation is in diffe ent cu enc
y, fo  COMEX gold is quoted
in USD and in India gold is quoted in INR. Hence any fluctuation in USD/INR exch
ange ate will have an impact
on p ofit ma gins of co po ates/clients having positions in Indian Gold Futu es.
By hedging USD/INR th ough
cu ency futu es, one can offset the deviation caused in COMEX and Indian p ices
. The following example
explains the same.
Let’s say with gold t ading on COMEX at USD 900/T oy Ounce (Oz) with USD/INR at 40
.00, an active
commodity investo , ealizing the unde lying fundamentals, decides that it’s a goo
d time to sell gold futu es. On
the basis of this pe spective, he decides to sell 1 Indian Gold Futu e cont act
@ Rs. 11,580/10 gm.
Let’s say afte  20 days, as pe  his expectation, gold p ices did decline d astical
ly on COMEX platfo m and gold
was now t ading at USD 800/oz, a fall of 11.11%. Howeve , in India gold futu e w
as t ading @ Rs. 11,317/10
gm, which is a p ofit of 2.27%. This is because du ing the same pe iod the INR h
as dep eciated against the
USD by 10% and the p evalent exchange ate was 44.00.
Had the USD/INR exchange ate emained constant at 40.00, the p ice afte  20 day
s on the Indian exchange
platfo m would have been Rs. 10,290 and thus p ofit ealization would have been
the same 11%.
Let’s p esume the same Indian investo  p e-empted that the e is good p obability t
hat the INR will weaken
given the then ma ket fundamentals and has decided to hedge his exposu e on an e
xchange platfo m using
cu ency futu es.
38
Since he was conce ned that the value of USD will ise, he decides go long on cu
ency futu es, it means he
buys a USD/INR futu es cont act. This p otects the investo  because st engthenin
g of USD would lead to p ofit
in the long futu es position, which would effectively ensu e that his loss in th
e commodity t ading would be
mitigated.
4.5 TRADING SPREADS USING CURRENCY FUTURES
.
Sp ead efe s to diffe ence in p ices of two futu es cont acts. A good unde stan
ding of sp ead elation in te ms
of pai  sp ead is essential to ea n p ofit. Conside able knowledge of a pa ticul
a  cu ency pai  is also necessa y
to enable the t ade  to use sp ead t ading st ategy.
Sp ead movement is based on following facto s:
o Inte est Rate Diffe entials
o Liquidity in Banking System
o Moneta y Policy Decisions (Repo, Reve se Repo and CRR)
o Inflation
Int a-Cu ency Pai  Sp ead: An int a-cu ency pai  sp ead consists of one long f
utu es and one sho t futu es
cont act. Both have the same unde lying but diffe ent matu ities.
Inte -Cu ency Pai  Sp ead: An inte –cu ency pai  sp ead is a long-sho t position
in futu es on diffe ent
unde lying cu ency pai s. Both typically have the same matu ity.
Example: A pe son is an active t ade  in the cu ency futu es ma ket. In Septemb
e  2008, he gets an
oppo tunity fo  sp ead t ading in cu ency futu es. He is of the view that in th
e cu ent envi onment of high
inflation and high inte est ate the p emium will move highe  and hence USD will
app eciate fa  mo e than the
indication in the cu ent quotes, i.e. sp ead will widen. On the basis of his vi
ews, he decides to buy Decembe 
cu ency futu es at 47.00 and at the same time sell Octobe  futu es cont act at
46.80; the sp ead between the
two cont acts is 0.20.
Let’s say afte  30 days the sp ead widens as pe  his expectation and now the Octob
e  futu es cont act is
t ading at 46.90 and Decembe  futu es cont act is t ading at 47.25, the sp ead n
ow stands at 0.35. He decides
to squa e off his position making a gain of Rs. 150 (0.35 – 0.20 = 0.15 x $1000) p
e  cont act.
4.6 ARBITRAGE
A bit age means locking in a p ofit by simultaneously ente ing into t ansactions
in two o  mo e ma kets. If the
elation between fo wa d p ices and futu es p ices diffe s, it gives ise to a b
it age oppo tunities. Diffe ence in
the equilib ium p ices dete mined by the demand and supply at two diffe ent ma k
ets also gives oppo tunities
to a bit age.
Example – Let’s say the spot ate fo  USD/INR is quoted @ Rs. 44.325 and one month f
o wa d is quoted at 3
paisa p emium to spot @ 44.3550 while at the same time one month cu ency futu e
s is t ading @ Rs.
44.4625. An active a bit age  ealizes that the e is an a bit age oppo tunity as
the one month futu es p ice is
mo e than the one month fo wa d p ice. He implements the a bit age t ade whe e h
e;
o Sells in futu es @ 44.4625 levels (1 month)
39
o Buys in fo wa d @ 44.3250 + 3 paisa p emium = 44.3550 (1 month) with the same
te m pe iod
o On the date of futu e expi y he buys in fo wa d and delive s the same on excha
nge platfo m
o In a p ocess, he makes a Net Gain of 44.4625-44.3550 = 0.1075
o i.e. App ox 11 Paisa a bit age
o P ofit pe  cont act = 107.50 (0.1075x1000)
Obse vation – The disc epancies in the p ices between the two ma kets have given a
n oppo tunity to
implement a lowe  isk a bit age. As mo e and mo e ma ket playe s will ealize t
his oppo tunity, they may also
implement the a bit age st ategy and in the p ocess will enable ma ket to come t
o a level of equilib ium.
Conclusion
It must be noted that though the above examples illust ate how a hedge  can succ
essfully avoid negative
outcomes by taking an opposite position in FX futu es, it is also possible, that
on occasion the FX fluctuations
may have been beneficial to the hedge  had he not hedged his position and taking
a hedge may have educed
his windfall gains f om these FX fluctuations. FX hedging may not always make th
e hedge  bette -off but it
helps him to avoid the isk (unce tainty) and lets him focus on his co e compete
ncies instead.
Many people a e att acted towa d futu es ma ket speculation afte  hea ing sto ie
s about the amount of money
that can be made by t ading futu es. While the e a e success sto ies, and many p
eople have achieved a mo e
modest level of success in futu es t ading, the keys to thei  success a e typica
lly ha d wo k, a disciplined
app oach, and a dedication to maste  thei  t ade.
An investo  should always emembe  the t ade that he has initiated has the equal
p obability of going w ong
and must the efo e apply meticulous isk management p actices to ensu e the safe
ty of his ha d-ea ned
capital. If you intend to follow this path, this ma ket is the place to be.
This page has
been left blank
intentionally
41
CHAPTER 5 TRADING
In this chapte  we shall take a b ief look at the t ading system fo  the Cu enc
y De ivatives segment. Howeve ,
the best way to get a feel of the t ading system is to actually watch the sc een
and obse ve t ading.
5.1 CURRENCY FUTURES CONTRACT SPECIFICATION
Cont act specification: USD INR Cu ency De ivatives
Unde lying Rate of exchange between one USD and INR
Cont act Size USD 1000
Tick Size Re. 0.0025
P ice Bands Not applicable
T ading Cycle The futu es cont acts will have a maximum of twelve months t ading
cycle. New cont act will be int oduced following the Expi y of cu ent
month cont act.
Expi y Day Last wo king day of the month (subject to holiday calenda s)
Last T ading Day Two wo king days p io  to the last business day of the expi y m
onth at 12
noon.
Settlement Basis Daily ma k to ma ket settlement will be on a T +1 basis and fin
al
settlement will be cash settled on T+2 basis.
Settlement P ice Daily ma k to ma ket settlement p ice will be the closing p ice
of the
futu es cont acts fo  the t ading day and the final settlement p ice shall
be the RBI efe ence ate fo  last t ading date of the cont act.
Settlement Cash settled
Final Settlement P ice The efe ence ate fixed by RBI two wo king days p io  to
the final
settlement date.
Final Settlement Day Last wo king day (excluding Satu days) of the expi y month.
The last wo king day will be the same as that fo  Inte bank Settlements
in Mumbai.
Ma ket Timing is f om 9 am to 5 pm.
5.2 TRADING PARAMETERS
i) Base P ice
Base p ice of the USD/INR Futu es Cont acts on the fi st day shall be the theo e
tical futu es p ice. The base
p ice of the Cont acts on subsequent t ading days will be the daily settlement p
ice of the USD/INR futu es
cont acts.
42
ii) Closing P ice
The closing p ice fo  a futu es cont act is cu ently calculated as the last hal
f an hou  weighted ave age p ice of
the cont act. In case a futu es cont act is not t aded on a day, o  not t aded d
u ing the last half hou , a
theo etical settlement p ice is computed as may be decided by the elevant aut
ho ity f om time to time.
Dissemination of Open, High, Low, and Last-T aded P ices
Du ing a t ading session, the Exchange continuously disseminates open, high, low
, and last-t aded p ices
th ough its t ading system on eal time basis.
5.3 TENORS OF FUTURES CONTRACT
The teno  of a cont act means the pe iod when the cont act will be available fo 
futu es t ading, i.e. the pe iod
between the sta t of t ading and the day it expi es. This pe iod is also known a
s the “t ading cycle” of the
cont act. The cu ency futu e cont act will be available fo  t ading with a maxi
mum matu ity of 12 months.
Expi y Date
All cont acts expi e on the last wo king day (excluding Satu days) of the cont a
ct months. The last day fo  the
t ading of the cont act shall be two wo king days p io  to the final settlement.
Final Settlement Rate
Final Settlement ate would be the Rese ve Bank (RBI) Refe ence ate fo  the dat
e of expi y.
5.4 TRADER WORKSTATION SCREEN (TWS)
Each Exchange has its own unique fo mat of the T ade  Wo kstation Sc een and the
best way to familia ize
oneself with the sc een and its va ious segments would be to actually spend time
studying a live sc een.
Info mation ega ding the TWS can also be obtained f om exchange websites.
5.5 ENTITIES IN THE TRADING SYSTEM
The e a e five entities in the t ading system: T ading membe s, clea ing membe s
, t ading-cum-clea ing
membe s, p ofessional clea ing membe s and pa ticipants.
1) T ading Membe s (TM): T ading membe s a e membe s of an autho ized Exchange.
They can t ade
eithe  on thei  own account o  on behalf of thei  clients including pa ticipants
. The exchange assigns a
t ading membe  ID to each t ading membe . Each t ading membe  can have mo e than
one use . The
numbe  of use s allowed fo  each t ading membe  is notified by the exchange f om
time to time. Each
use  of a t ading membe  must be egiste ed with the exchange and is assigned a
unique use  ID.
The unique t ading membe  ID functions as a efe ence fo  all o de s/t ades of d
iffe ent use s. This ID
is common fo  all use s of a pa ticula  t ading membe . It is the esponsibility
of the t ading membe  to
maintain adequate cont ol ove  pe sons having access to the fi m’s Use  ID.
43
2) Clea ing Membe s (CM): Clea ing membe s a e membe s of the Clea ing Co po ati
on. They ca y
out isk management activities and confi mation/inqui y of pa ticipant t ades th
ough the t ading
system.
3) T ading-cum-Clea ing Membe  (TCM): A membe  with a ight to t ade on its own
account as well
as on account of its clients. He can clea  and settle the t ades fo  self and fo
 othe s th ough the
Clea ing House.
4) P ofessional Clea ing Membe s (PCM): A p ofessional clea ing membe  is a clea
ing membe  who
is not a t ading membe . Typically, banks and custodians become p ofessional cle
a ing membe s and
clea  and settle fo  thei  t ading membe s and pa ticipants.
5) Pa ticipants: A pa ticipant is a client of a t ading membe - like financial i
nstitutions. These clients
may t ade th ough multiple t ading membe s but settle th ough a single clea ing
membe .
5.6 TYPES OF ORDERS
The system allows the t ading membe s to ente  o de s with va ious conditions at
tached to them as pe  thei 
equi ements. These conditions a e b oadly divided into the following catego ies
:
• Time conditions
• P ice conditions
• Othe  conditions
Seve al combinations of the above a e allowed the eby p oviding eno mous flexibi
lity to the use s. The o de 
types and conditions a e summa ized below.
• Time conditions
- Day o de : A day o de , as the name suggests is an o de  which is valid fo  th
e day on
which it is ente ed. If the o de  is not executed du ing the day, the system can
cels the o de 
automatically at the end of the day.
- Immediate o  Cancel (IOC): An IOC o de  allows the use  to buy o  sell a cont 
act as soon
as the o de  is eleased into the system, failing which the o de  is cancelled f
om the system.
Pa tial match is possible fo  the o de , and the unmatched po tion of the o de 
is cancelled
immediately.
• P ice condition
- Ma ket p ice: Ma ket o de s a e o de s fo  which no p ice is specified at the
time the o de  is
ente ed (i.e. p ice is ma ket p ice). Fo  such o de s, the t ading system dete m
ines the p ice.
- Limit p ice: An o de  to a b oke  to buy a specified quantity of a secu ity at
o  below a
specified p ice, o  to sell it at o  above a specified p ice (called the limit p
ice). This ensu es
that a pe son will neve  pay mo e fo  the futu es cont act than whateve  p ice i
s set as
his/he  limit. It is also the p ice of o de s afte  t igge ing f om stop-loss bo
ok.
Stop-loss: This facility allows the use  to elease an o de  into the system, af
te  the ma ket
p ice of the secu ity eaches o  c osses a th eshold p ice e.g. if fo  stop-loss
buy o de , the
t igge  is Rs. 42.0025, the limit p ice is Rs. 42.2575 , then this o de  is ele
ased into the
system once the ma ket p ice eaches o  exceeds Rs. 42.0025. This o de  is added
to the
egula  lot book with time of t igge ing as the time stamp, as a limit o de  of
Rs. 42.2575.
44
Thus, fo  the stop loss buy o de , the t igge  p ice has to be less than the lim
it p ice and fo 
the stop-loss sell o de , the t igge  p ice has to be g eate  than the limit p i
ce.
• Othe  conditions
- P o: P o means that the o de s a e ente ed on the t ading membe  s own account
.
- Cli: Cli means that the t ading membe  ente s the o de s on behalf of a client
.
In exchange t aded de ivative cont acts, the Clea ing Co po ation acts as a cent
al counte pa ty to all t ades
and pe fo ms full novation. The isk to the clea ing co po ation can only be tak
en ca e of th ough a st ingent
ma gining f amewo k. Also, since de ivatives a e leve aged inst uments, ma gins
also act as a cost and
discou age excessive speculation. A obust isk management system should the efo
e, not only impose
ma gins on the membe s of the clea ing co po ation but also enfo ce collection o
f ma gins f om the clients.
P ice Limit Ci cuit Filte 
The e shall be no daily p ice bands applicable fo  Cu ency Futu es cont acts. H
oweve  in o de  to p event
e oneous o de  ent y by membe s, ope ating anges will be kept at +/-3% of the
base p ice fo  cont acts with
tenu e upto 6 months and +/-5% fo  cont acts with tenu e g eate  than 6 months.
In espect of o de s which
have come unde  p ice f eeze, the membe s would be equi ed to confi m to the Ex
change that the e is no
inadve tent e o  in the o de  ent y and that the o de  is genuine. On such conf
i mation, the Exchange may
take app op iate action.
5.7 MARK-to-MARKET
Du ing the t ading session, the system keeps t ack of losses, both notional and
booked, incu ed by eve y
membe  up to the last executed t ade. This is calculated by the system on a eal
-time basis by way of
computing the diffe ence between the actual t ade p ice of a membe  and the dail
y settlement p ice of the
ma ket. Daily settlement p ice on a t ading day is also the closing p ice of the
espective futu es cont acts on
such day. Such calculation happens fo  eve y membe  afte  execution of each and
eve y t ade. The maximum
loss limit, which the system allows a membe  to sustain on a eal-time basis, is
75% of the total deposit. Eve y
time such loss amount goes beyond the levels of 60%, 75%, o  90% of the p io  me
ntioned maximum loss limit,
the membe  gets a wa ning signal. The eafte , when the loss c osses the 75% of t
he total deposit limit, the
membe  is suspended by the system. In such calculations, the e is no allowance g
iven in espect of p ofits
made by such membe s in a diffe ent cont act. This is monito ed by the system to
cu b any default in the
p ocess of day t ading.
5.8 POSITION LIMITS
In o de  to avoid building up of huge open positions, the egulato  has specifie
d the maximum allowable open
position limit ac oss all membe s of the Exchange.
Rules with espect to monito ing and enfo cement of position limits in the cu e
ncy futu es ma ket:
• Positions du ing the day a e monito ed based on the total open inte est at the e
nd of the p evious day’s
t ade.
• The above monito ing is fo  both client level positions (based on the unique cli
ent code) and fo  t ading
membe  level positions.
• The Exchange t eats violation of position limits as an input fo  fu the  su veil
lance action. Upon detecting
la ge open positions, the Exchange conducts detailed analysis based on the ove a
ll natu e of positions,
45
the t ading st ategy, positions in the unde lying ma ket, positions of elated e
ntities (concept of pe sons
acting in conce t would be applied), etc.
• The violato s of position limits a e accountable fo  thei  la ge positions and a
e asked to submit detailed
info mation pe taining to thei  t ading activities wheneve  the info mation is s
ought by the Exchange. The
clea ing membe  is accountable fo  positions of all t ading membe s and clients
of t ading membe s
clea ing th ough him. Simila ly, the t ading membe  is accountable fo  the posit
ions of his clients. The
Exchange also calls fo  info mation di ectly f om the client itself.
The following position limits would be applicable in the cu ency futu es ma ket
:
• Client Level: The g oss open position of the client ac oss all cont acts should
not exceed 6% of the total
open inte est o  USD 10 million whicheve  is highe . The Exchange will dissemina
te ale ts wheneve  the
g oss open position of the client exceeds 3% of the total open inte est at the e
nd of the p evious day’s
t ade.
• Non Bank T ading Membe  Level: The g oss open positions of the t ading membe  ac
oss all cont acts
should not exceed 15% of the total open inte est o  USD 50 million whicheve  is
highe . Howeve , the
g oss open position of a T ading Membe , which is a bank, ac oss all cont acts,
shall not exceed 15% of
the total open inte est o  USD 100 million, whicheve  is highe .
• Clea ing Membe  Level: No sepa ate position limit is p esc ibed at the level of
clea ing membe . Howeve ,
the clea ing membe  shall ensu e that his own t ading position and the positions
of each t ading membe 
clea ing th ough him a e within the limits specified above.
Su veillance System
The su veillance systems of the exchanges a e designed keeping in view all the 
elevant aspects, including the
following:
i. The ale ts in the online su veillance system automatically gene ate mate ial
abe ations f om no mal
activity.
ii. The su veillance systems and p ocesses a e able to:
• Monito  open inte est, cost of ca y, and volatility.
• Monito  closing p ices.
• Captu e and p ocess client level details.
• Develop databases of t ading activity by b oke s as well as clients.
• Gene ate t ading patte n by a b oke  ove  a pe iod of time o  by a client / g ou
p of clients ove  a
pe iod of time.
iii. The info mation and feedback eceived f om membe  inspections a e vital inp
uts fo  effective su veillance.
Fo  this, membe  inspections a e taken up in a ational manne  keeping in view t
he level of t ading activity,
client p ofile, numbe  and natu e of complaints eceived against the membe , his
to y of isk management
elated defaults and egulato y violations, etc. Info mation obtained th ough me
mbe  inspections is made
available to the monito ing/ su veillance depa tments of Exchanges.
iv. The Exchange calls fo  info mation f om membe s in a standa d fo m, and p ef
e ably in elect onic fo m, to
facilitate faste  analysis as well as building up of databases.
Rules, egulations and bye laws of Exchange
Rules, egulation and bye-laws of the Exchange gove n the functions and p ocesse
s of the Exchange. They
guide b oade  aspects, like constitution and composition of the Boa d, the Execu
tive committee, types of
membe ship, c ite ia and eligibility of membe ship, to ope ational issues, like,
how t ansaction is ente ed into
and how it is settled. It also explains p ocess of a bit ation, investo s’ p otect
ion and compensation, and
penalty fo  violation of any of the ules, egulations and bye-laws of the Excha
nge.
This page has
been left blank
intentionally
47
CHAPTER 6 CLEARING, SETTLEMENT AND RISK MANAGEMENT
Clea ing Co po ation unde takes clea ing and settlement of all t ades executed o
n the Cu ency De ivatives
Segment of the exchange. It also acts as legal counte pa ty to all t ades on the
Cu ency De ivatives segment
and gua antees thei  financial settlement.
6.1 CLEARING ENTITIES
Clea ing and settlement activities in the Cu ency De ivatives segment a e unde 
taken by a Clea ing
Co po ation with the help of the following entities:
Clea ing membe s
In the Cu ency De ivatives segment, t ading-cum-clea ing membe , clea  and sett
le thei  own t ades as well
as t ades of othe  t ading membe s (TMs). Besides, the e is a special catego y o
f membe s, called p ofessional
clea ing membe s (PCM) who clea  and settle t ades executed by TMs. The membe s
clea ing thei  own t ades
and t ades of othe s, and the PCMs a e equi ed to b ing in additional secu ity
deposits in espect of eve y TM
whose t ades they unde take to clea  and settle.
Clea ing banks
Funds settlement takes place th ough clea ing banks. Fo  the pu pose of settleme
nt all clea ing membe s a e
equi ed to open a sepa ate bank account with the Clea ing Co po ation designate
d clea ing bank fo  Cu ency
De ivatives segment. The Clea ing and Settlement p ocess comp ises of the follow
ing th ee main activities:
1) Clea ing
2) Settlement
3) Risk Management
6.2 CLEARING MECHANISM
The clea ing mechanism essentially involves wo king out open positions and oblig
ations of clea ing (t adingcum-
clea ing/p ofessional clea ing) membe s. This position is conside ed fo  exposu 
e and daily ma gin
pu poses. The open positions of Clea ing Membe s (CMs) a e a ived at by agg ega
ting the open positions of
all the TMs and all custodial pa ticipants clea ing th ough him, in cont acts in
which they have t aded. A TM s
open position is a ived at as the summation of his p op ieta y open position an
d clients open positions, in the
cont acts in which he has t aded. While ente ing o de s on the t ading system, T
Ms a e equi ed to identify the
o de s, whethe  p op ieta y (if they a e thei  own t ades) o  client (if ente ed
on behalf of clients) th ough
P o/Cli indicato  p ovided in the o de  ent y sc een. P op ieta y positions a 
e calculated on net basis (buy -
sell) fo  each cont act. Clients positions a e a ived at by summing togethe  n
et (buy - sell) positions of each
individual client. A TM s open position is the sum of p op ieta y open position,
client open long position and
client open sho t position.
Conside  the following example given f om Table 6.1 to Table 6.4. The p op ieta 
y open position on day 1 is
simply = Buy - Sell = 20 - 40 = 20 sho t. The open position fo  client A = Buy (
O) – Sell (C) = 40 - 20 = 20 long,
i.e. he has a long position of 20 units. The open position fo  Client B = Sell (
O) – Buy (C) = 60 - 20 = 40 sho t,
i.e. he has a sho t position of 40 cont acts. Now the total open position of the
t ading membe  ABC Ltd. at end
48
of day 1 is 20 (his p op ieta y open position on net basis) plus 60 (the Client
open positions on g oss basis), i.e.
80.
Table 6.1 P op ieta y position of t ading membe  ABC Ltd. on Day 1
T ading membe  ABC Ltd. t ades fo  himself and two of his clients. The table sho
ws his p op ieta y position.
Note: A buy position 20000@ 40.0000"means 20 cont acts bought at the ate of Rs
. 40.0000.
T ading membe  ABC Ltd.
P op ieta y position Buy 20*1000*40.0000 Sell 40*1000*40.1500
Buy: Sell:
20 = numbe  of cont acts 40 = numbe  of cont acts
1000 = cont act size (USD) 1000 = cont act size (USD)
40.0000 = p ice (Rs.) 40.1500 = p ice (Rs.)
Table 6.2 Client position of t ading membe  ABC Ltd. on Day 1
T ading membe  ABC Ltd. t ades fo  himself and two of his clients. The table sho
ws his client position.
T ading membe 
ABC Ltd.
Client position
Client A
Client B
Buy Open
40*1000*40.0000
Sell Close
20*1000*39.0500
Sell Open
60*1000*39.1000
Buy Close
20*1000*40.0000
Table 6.3 P op ieta y position of t ading membe  ABC Ltd. on Day 2
Assume that the position on Day 1 is ca ied fo wa d to the next t ading day and
the following t ades a e also
executed.
T ading membe  ABC Ltd.
P op ieta y position
Buy
20*1000*40.0000
Sell
40*1000*40.1000
49
The p op ieta y open position at end of day 1 is 20 sho t. The end of day open p
osition fo  p op ieta y t ades
unde taken on day 2 is 20 sho t. Hence the net open p op ieta y position at the
end of day 2 is 40 sho t.
Simila ly, Client A s open position at the end of day 1 is 20 long. The end of d
ay open position fo  t ades done
by Client A on day 2 is 20 long. Hence the net open position fo  Client A at the
end of day 2 is 40 long. Client
B s open position at the end of day 1 is 40 sho t. The end of day open position
fo  t ades done by Client B on
day 2 is 20 sho t. Hence the net open position fo  Client B at the end of day 2
is 60 sho t. The net open
position fo  the t ading membe  at the end of day 2 is sum of the p op ieta y op
en position and client open
positions. It wo ks out to be 40 + 40 + 60, i.e. 140 (g oss open positions consi
de ed).
NOTE: All open positions will be multiplied by 1000 (cont act size in USD) to a 
ive at the open position in USD
te ms
Table 6.4 Client position of t ading membe  ABC Ltd. on Day 2
T ading membe  ABC Ltd. t ades fo  himself and two of his clients. The table sho
ws his client position on Day
2.
T ading membe  ABC Ltd.
Client position
Client A
Client B
Buy Open
40*1000*40.0000
Sell Close
20*1000*40.1000
Sell Open
60*1000*40.0000
Buy Close
40*1000*40.1000
The following table illust ates dete mination of open position of a CM, who clea
s fo  two TMs having two
clients.
Table 6.5 Dete mination of open position of a clea ing membe 
TMs
clea ing
th ough
CM
P op ieta y t ades T ades: Client 1 T ades: Client 2 Open position
Buy Sell Net Buy Sell Net Buy Sell Net Long Sho t
ABC 40 20 20 30 10 20 40 20 20 60 -
PQR 20 30 -10 20 10 10 10 20 -10 10 20
Total 60 50 20 50 20 30 50 40 20 70 20
-10 -10
6.3 SETTLEMENT MECHANISM
All futu es cont acts a e cash settled, i.e. th ough exchange of cash in Indian
Rupees. The settlement amount
fo  a CM is netted ac oss all thei  TMs/clients, with espect to thei  obligatio
ns on Ma k-to-Ma ket (MTM)
settlement.
50
Settlement of cu ency futu es cont acts
Cu ency futu es cont acts have two types of settlements, the MTM settlement whi
ch happens on a continuous
basis at the end of each day, and the final settlement which happens on the last
t ading day of the futu es
cont act.
Ma k-to-Ma ket settlement (MTM Settlement):
All futu es cont acts fo  each membe  a e ma ked to ma ket to the daily settleme
nt p ice of the elevant futu es
cont act at the end of each day. The p ofits/losses a e computed as the diffe en
ce between:
1. The t ade p ice and the day s settlement p ice fo  cont acts executed du ing
the day but not squa ed
up.
2. The p evious day s settlement p ice and the cu ent day s settlement p ice fo
 b ought fo wa d
cont acts.
3. The buy p ice and the sell p ice fo  cont acts executed du ing the day and sq
ua ed up.
Table 6.6 explains the MTM calculation fo  a membe . The settlement p ice fo  th
e cont act fo  today is
assumed to be 43.00
The CMs who have a loss a e equi ed to pay the ma k-to-ma ket (MTM) loss amount
in cash which in tu n is
passed on to the CMs who have made a MTM p ofit. This is known as daily ma k-to-
ma ket settlement. CMs
a e esponsible to collect and settle the daily MTM p ofits/losses incu ed by t
he TMs and thei  clients clea ing
and settling th ough them. Simila ly, TMs a e esponsible to collect/pay losses/
p ofits f om/to thei  clients by
the next day. The pay-in and pay-out of the ma k-to-ma ket settlement a e effect
ed on the day following the
t ade day. In case a futu es cont act is not t aded on a day, o  not t aded du i
ng the last half hou , a theo etical
settlement p ice is computed.
Afte  completion of daily settlement computation, all the open positions a e es
et to the daily settlement p ice.
Such positions become the open positions fo  the next day.
Table 6.6 Computation of MTM at the end of the day
The table gives the MTM calculated on va ious positions. The MTM settlement on t
he b ought fo wa d cont act
is the diffe ence between the p evious day s settlement p ice of Rs.40.0000 and
today s settlement p ice of
Rs.43.0000. Hence on account of the position b ought fo wa d, the MTM shows a p 
ofit of Rs.30000. Fo 
cont acts executed du ing the day, the diffe ence between the buy p ice and the
sell p ice dete mines the
MTM. In this example, 20 cont acts a e bought @ Rs. 40.0000 and 10 cont acts sol
d @ Rs. 42.0000 du ing
the day. Hence the MTM fo  the position closed du ing the day shows a p ofit of
Rs.20000. Finally, the open
position of cont acts t aded du ing the day, is ma ked to ma ket at the day s se
ttlement p ice and the p ofit of
Rs.30000 c edited to the MTM account. So the MTM account shows a p ofit of Rs. 8
0,000.
T ade details Bought/sold Settlement p ice
(Rs.)
MTM settlement
(Rs.)
B ought fo wa d f om
p evious day
Bought
10*1000*40.0000
43.0000 30*1000
51
T aded du ing day :
Bought
Sold
20*1000*40.0000
10*1000*42.0000
20*1000
Open position
(not squa ed up)
Bought
10*1000*40.0000
43.0000 30*1000
Total 80*1000
Final settlement fo  futu es
On the last t ading day of the futu es cont acts, afte  the close of t ading hou
s, the Clea ing Co po ation ma ks
all positions of a CM to the final settlement p ice and the esulting p ofit/los
s is settled in cash. Final settlement
loss/p ofit amount is debited/ c edited to the elevant CM s clea ing bank accou
nt on T+2 wo king day following
last t ading day of the cont act (Cont act expi y Day).
Settlement p ices fo  futu es
Daily settlement p ice on a t ading day is the closing p ice of the espective f
utu es cont acts on such day. The
closing p ice fo  a futu es cont act is cu ently calculated as the last half an
hou  weighted ave age p ice of the
cont act in the Cu ency De ivatives Segment of the Exchange. The final settleme
nt p ice is the RBI efe ence
ate fo  the last t ading day of the futu es cont act. All open positions shall
be ma ked to ma ket on the final
settlement p ice. Such ma ked to ma ket p ofit / loss shall be paid to / eceive
d f om clea ing membe s.
6.4 RISK MANAGEMENT MEASURES
Eve y exchange has a comp ehensive isk containment mechanism fo  the Cu ency D
e ivatives segment. The
salient featu es of isk containment mechanism on the Cu ency De ivatives segme
nt a e:
1. The financial soundness of the membe s is the key to isk management. The efo
e, the equi ements
fo  membe ship in te ms of capital adequacy (net wo th, secu ity deposits) a e q
uite st ingent.
2. Upf ont initial ma gin is cha ged fo  all the open positions of a CM. It spec
ifies the initial ma gin
equi ements fo  each futu es cont act on a daily basis. It also follows a value
-at- isk (VaR) based
ma gining th ough SPAN® (Standa d Po tfolio Analysis of Risk). The CM in tu n coll
ects the initial
ma gin f om the TMs and thei  espective clients.
3. The open positions of the membe s a e ma ked to ma ket based on cont act sett
lement p ice fo  each
cont act. The diffe ence is settled in cash on a T+1 basis.
4. The on-line position monito ing system monito s the membe  open positions and
ma gins on a ealtime
basis vis-à-vis the deposits p ovided by the CM o  the limits set fo  the TM by th
e CM. The online
position monito ing system gene ates ale ts wheneve  the ma gins of a membe  ea
ches the
p edete mined pe centage of the capital deposited by the CM o  limits set fo  th
e TM by the CM. The
Clea ing Co po ation monito s the CMs fo  initial ma gin and ext eme loss ma gin
violations, while
TMs a e monito ed fo  initial ma gin violation.
5. CMs a e p ovided with a t ading te minal fo  the pu pose of monito ing the op
en positions of all the
TMs clea ing and settling th ough them. A CM may set limits fo  a TM clea ing an
d settling th ough
him. The Clea ing Co po ation assists the CM to monito  the int a-day limits set
up by a CM and
52
wheneve  a TM exceeds the limits, it stops that pa ticula  TM f om fu the  t adi
ng.
6. A membe  is ale ted of his position to enable him to adjust his position o  b
ing in additional capital.
Ma gin violations esult in withd awal of t ading facility fo  all TMs of a CM i
n case of a violation by the
CM.
7. Sepa ate settlement gua antee funds fo  this segment have been c eated by exc
hanges.
The most c itical component of isk containment mechanism fo  the Cu ency De iv
atives segment is the
ma gining system and on-line position monito ing. The actual position monito ing
and ma gining is ca ied out
on-line th ough Exchange Risk Management Systems that use SPAN® (Standa d Po tfoli
o Analysis of Risk)
methodology, and compute on-line ma gins, based on the pa amete s defined by SEB
I.
6.5 MARGIN REQUIREMENTS
The initial secu ity deposit paid by a membe  is conside ed as his initial ma gi
n fo  the pu pose of allowable
exposu e limits. Initially, eve y membe  is allowed to take exposu es up to the
level pe missible on the basis of
the initial deposit.
Howeve , if a membe  wishes to c eate mo e exposu e, he has to deposit additiona
l ma gins.
If the e is su plus deposit lying with the Exchanges towa d ma gins, it is not 
efunded to the membe  unless a
w itten equest is eceived f om the membe  fo  efund. Howeve , the membe  ece
ives additional exposu e
limit on account of such additional / su plus deposit. In case of eceipt of w i
tten equest fo  efund of additional
deposit, the same may be efunded within 3 wo king days.
The diffe ent types of ma gins collected by the Exchanges a e as follows:
Initial Ma gin
The Initial Ma gin equi ement is based on a wo st case loss of a po tfolio of a
n individual client ac oss va ious
scena ios of p ice changes. The va ious scena ios of p ice changes would be so c
omputed so as to cove  a
99% Value at Risk (VaR) ove  a one-day ho izon. In o de  to achieve this, the p 
ice scan ange is fixed at 3.5
standa d deviation. The initial ma gin so computed would be subject to a minimum
of 1.75% on the fi st day of
cu ency futu es t ading and 1% the eafte . The initial ma gin shall be deducted
f om the liquid netwo th of the
clea ing membe  on an online, eal-time basis.
Po tfolio Based Ma gin
The Standa d Po tfolio Analysis of Risk (SPAN) methodology is adopted to take an
integ ated view of the isk
involved in the po tfolio of each individual client comp ising his positions in
futu es cont acts ac oss diffe ent
matu ities. The client-wise ma gin is g ossed ac oss va ious clients at the T ad
ing / Clea ing Membe  level. The
p op ieta y positions of the T ading / Clea ing Membe  a e t eated as that of a
client.
Real-Time Computation
The computation of wo st scena io loss has two components. The fi st is the valu
ation of the po tfolio unde  the
va ious scena ios of p ice changes. At the second stage, these scena io cont act
values a e applied to the
actual po tfolio positions to compute the po tfolio values and the initial ma gi
n. The Exchange updates the
scena io cont act values at least 5 times in the day, which is ca ied out by ta
king the closing p ice of the
53
p evious day at the sta t of t ading, at the p ices at 11:00 a.m., 12:30 p.m., 2
:00 p.m, and at the end of the
t ading session. The latest available scena io cont act values a e applied to me
mbe /client po tfolios on a ealtime
basis.
Calenda  Sp ead Ma gins
A cu ency futu es position at one matu ity which is hedged by an offsetting pos
ition at a diffe ent matu ity is
t eated as a calenda  sp ead. The calenda  sp ead ma gin is at a value of Rs. 25
0 fo  all months of sp ead.
The benefit fo  a calenda  sp ead continues till expi y of the nea -month cont a
ct. Fo  a calenda  sp ead
position, the ext eme loss ma gin is cha ged on one-thi d of the ma k-to-ma ket
value of the fa -month cont act.
Ext eme Loss Ma gin
Ext eme loss ma gin is computed at 1% on the ma k-to-ma ket value of the G oss O
pen Position. It shall be
deducted f om the liquid assets of the Clea ing Membe .
Liquid Netwo th
The initial ma gin and the ext eme loss ma gin a e deducted f om the liquid asse
ts of the clea ing membe . The
clea ing membe ’s liquid netwo th afte  adjusting fo  the initial ma gin and ext e
me loss ma gin equi ements
must be at least Rs. 50 lakhs at all points in time. The minimum liquid netwo th
is t eated as a capital cushion
fo  days of unfo eseen ma ket volatility.
Liquid Assets
The liquid assets fo  t ading in cu ency futu es a e maintained sepa ately in t
he cu ency futu es segment of
the clea ing co po ation. Howeve , the pe missible liquid assets, the applicable
hai cuts and minimum cash
equivalent no ms would be same as that a e applicable fo  the equity de ivatives
segment.
Ma k-to-Ma ket Settlement
The ma k-to-ma ket gains and losses a e settled in cash befo e the sta t of t ad
ing on T+1 day. If ma k-toma ket
obligations a e not collected befo e sta t of the next day’s t ading, the clea ing
co po ation collects
co espondingly highe  initial ma gin to cove  the potential fo  losses ove  the
time elapsed in the collection of
ma gins.
Ma gin collection and enfo cement
The client ma gins (initial ma gin, ext eme-loss ma gin, calenda -sp ead ma gin,
and ma k-to-ma ket
settlements) a e compulso ily collected and epo ted to the Exchange by the memb
e s. The Exchange imposes
st ingent penalty on membe s who do not collect ma gins f om thei  clients. The
Exchange also conducts
egula  inspections to ensu e ma gin collection f om clients.
The va ious scena ios with espect to pay in / pay out and ma gin payable as ef
lected in the end-ofday
epo t and its impact on the system a e as follows:
• If a membe  has payable obligation towa ds pay-in as well as ma gins, he will no
t be able to place his
o de s the next day mo ning (though he would be able to log in), unless he pays
at least the ma gin
payable amount immediately. If he pays the ma gin demanded, his squa e-off mode
is evoked
54
immediately, but if he also wants to inc ease his exposu e, he has to pay additi
onal ma gins fo  inc easing
his exposu e, failing which he will be allowed to squa e off only.
• If a membe  has only pay-in obligation but no payment equi ed towa ds ma gins,
he will be allowed to
t ade at the commencement of the t ading session the next day mo ning, p ovided
that his available
deposit would be educed by the amount of pay-in. The eafte , as soon as the pay
-in is complete and the
confi mation file is eceived f om the bank, his blocked limit is eleased immed
iately.
• If a membe  is obligated to pay ma gins, while in espect of pay-in he has a ec
eivable amount, he will be
allowed to log into the system and have a view only facility. He will not be all
owed to submit o de s unless
he pays f esh ma gins equivalent to his obligation plus additional ma gins to c 
eate f esh positions.
Howeve , if a membe  pays ma gins only to the extent of his actual ma gin obliga
tion, he will be allowed by
the system only to squa e off his positions, but as soon as he inc eases his pos
itions, he will again be
suspended f om t ading.
Safegua ding Client’s Money
The Clea ing Co po ation seg egates the ma gins deposited by the Clea ing Membe 
s fo  t ades on thei  own
account f om the ma gins deposited with it on client account. The ma gins deposi
ted on client account a e not
utilized fo  fulfilling the dues that a Clea ing Membe  may owe the Clea ing Co 
po ation in espect of t ades on
the membe ’s own account. The client’s money is to be held in t ust fo  client pu po
se only. The following
p ocess is adopted fo  seg egating the client’s money vis-à-vis the clea ing membe ’s
money:
• At the time of opening a position, the membe  indicates whethe  it is a client o
 p op ieta y position.
• Ma gins ac oss the va ious clients of a membe  a e collected on a g oss basis an
d should not be netted off
• When a position is closed, the membe  indicates whethe  it was a client o  his o
wn position which is being
closed.
• In the case of default, the ma gin paid on the p op ieta y position is used by t
he Clea ing Co po ation fo 
ealizing its dues f om the membe .
Pe iodic Risk Evaluation Repo t
The Clea ing Co po ation of the Exchange, on an ongoing basis and at least once
in eve y six months,
conducts back-testing of the ma gins collected vis-à-vis the actual p ice changes.
A copy of the study is
submitted to SEBI along with suggestions on changes to the isk containment meas
u es, if any.
Su veillance
The exchanges as fi st-level egulato s have an online su veillance capability t
hat monito s positions, p ices,
and volumes in eal time so as to dete  ma ket manipulation.
Unique Client Code (UCC)
The Exchange ensu es that each client is assigned a client code that is unique a
c oss all membe s. The
unique client code is assigned with the use of Income Tax Pe manent Account Numb
e  (PAN) numbe .
55
CHAPTER 7 REGULATORY FRAMEWORK FOR CURRENCY DERIVATIVES
The Indian economy is integ ating at a fast pace with the est of the wo ld. Ind
ian Financial Ma kets have also
been g owing significantly. The ave age daily tu nove  in the fo eign exchange m
a ket inc eased f om US $
23.7 billion in Ma ch 2006 to US $ 34.0 billion in Ma ch 2007 in consonance with
the inc ease in fo eign
exchange t ansactions. Although libe alization helped the Indian fo eign exchang
e ma kets in va ious ways,
extensive fluctuations of exchange ate also occu ed. These issues have att act
ed a g eat deal of inte est
f om policy-make s and investo s. Hence in the context of upg ading the Indian f
o eign exchange ma ket to
inte national standa ds, a well-developed fo eign exchange de ivative ma ket (bo
th OTC as well as Exchange
T aded) is equi ed.
The Committee on Fulle  Capital Account Conve tibility had ecommended that cu 
ency futu es may be
int oduced subject to isks being contained th ough p ope  t ading mechanism, st
uctu e of cont acts and
egulato y envi onment. Acco dingly, Rese ve Bank of India in the Annual Policy
Statement fo  the Yea  2007-
08 p oposed to set up a Wo king G oup on Cu ency Futu es to study the inte nati
onal expe ience and suggest
a suitable f amewo k to ope ationalise the p oposal, in line with the cu ent le
gal and egulato y f amewo k.
The g oup has had extensive consultations with a c oss section of ma ket pa tici
pants including banke s’
associations, banks, b oke s, and exchanges, both Indian and Inte national.
7.1 SECURITIES CONTRACTS (REGULATION) ACT, 1956 [SC(R)A]
SC(R)A aims at p eventing undesi able t ansactions in secu ities, by egulating
the business of dealing the ein
and by p oviding fo  ce tain othe  matte s connected the ewith. This is the p in
cipal Act, which gove ns the
t ading of secu ities in India. The te m “secu ities” has been defined in the SC(R)A
. As pe  Section 2(h) of the
Act, the ‘Secu ities’ include:
1. Sha es, sc ips, stocks, bonds, debentu es, debentu e stock o  othe  ma ketabl
e secu ities of a like
natu e in o  of any inco po ated company o  othe  body co po ate.
2. De ivatives
3. Units o  any othe  inst ument issued by any collective investment scheme to t
he investo s in such
schemes.
4. Gove nment secu ities
5. Such othe  inst uments as may be decla ed by the Cent al Gove nment to be sec
u ities.
6. Rights o  inte ests in secu ities.
“De ivative” is defined to include:
• A secu ity de ived f om a debt inst ument, sha e, loan whethe  secu ed o  unsecu
ed, isk inst ument
o  cont act fo  diffe ences o  any othe  fo m of secu ity.
• A cont act which de ives its value f om the p ices, o  index of p ices, of unde 
lying secu ities.
Section 18A p ovides that notwithstanding anything contained in any othe  law fo
 the time being in fo ce,
cont acts in de ivative shall be legal and valid if such cont acts a e:
• T aded on a ecognized stock exchange
• Settled on the clea ing house of the ecognized stock exchanges, in acco dance w
ith the ules and
bye–laws of such stock exchanges.
56
7.2 SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992
SEBI Act, 1992 p ovides fo  establishment of Secu ities and Exchange Boa d of In
dia (SEBI) with statuto y
powe s fo  (a) p otecting the inte ests of investo s in secu ities (b) p omoting
the development of the secu ities
ma ket and (c) egulating the secu ities ma ket. Its egulato y ju isdiction ext
ends ove  co po ates in the
issuance of capital and t ansfe  of secu ities, in addition to all inte media ie
s and pe sons associated with
secu ities ma ket.
SEBI has been obligated to pe fo m the afo esaid functions by such measu es as i
t thinks fit. In pa ticula , it
has powe s fo :
• egulating the business in stock exchanges and any othe  secu ities ma kets,
• egiste ing and egulating the wo king of b oke s, sub–b oke s etc.,
• p omoting and egulating self- egulato y o ganizations,
• p ohibiting f audulent and unfai  t ade p actices,
• calling fo  info mation f om, unde taking inspection, conducting inqui ies and a
udits of the stock
exchanges, mutual funds and othe  pe sons associated with the secu ities ma ket
and inte media ies
and self– egulato y o ganizations in the secu ities ma ket,
• pe fo ming such functions and exe cising such powe s unde  the Secu ities Cont a
cts (Regulation)
Act, 1956, as may be delegated to it by the Cent al Gove nment.
7.3 RBI-SEBI STANDING TECHNICAL COMMITTEE ON EXCHANGE TRADED CURRENCY
AND INTEREST RATE DERIVATIVES
With a view to enable entities to manage volatility in the cu ency ma ket, RBI
on Ap il 20, 2007 issued
comp ehensive guidelines on the usage of fo eign cu ency fo wa ds, swaps and op
tions in the OTC ma ket. At
the same time, RBI also set up an Inte nal Wo king G oup to explo e the advantag
es of int oducing cu ency
futu es. The Repo t of the Inte nal Wo king G oup of RBI submitted in Ap il 2008
, ecommended the
int oduction of exchange t aded cu ency futu es. With the expected benefits of
exchange t aded cu ency
futu es, it was decided in a joint meeting of RBI and SEBI on Feb ua y 28, 2008,
that an RBI-SEBI Standing
Technical Committee on Exchange T aded Cu ency and Inte est Rate De ivatives wo
uld be constituted. To
begin with, the Committee would evolve no ms and ove see the implementation of E
xchange t aded cu ency
futu es. The Te ms of Refe ence to the Committee we e as unde :
1. To coo dinate the egulato y oles of RBI and SEBI in ega d to t ading of Cu
ency and Inte est Rate
Futu es on the Exchanges.
2. To suggest the eligibility no ms fo  existing and new Exchanges fo  Cu ency
and Inte est Rate
Futu es t ading.
3. To suggest eligibility c ite ia fo  the membe s of such exchanges.
4. To eview p oduct design, ma gin equi ements and othe  isk mitigation measu
es on an ongoing
basis
5. To suggest su veillance mechanism and dissemination of ma ket info mation.
6. To conside  mic ost uctu e issues, in the ove all inte est of financial stabi
lity.
This committee submitted its epo t on 29th May 2008.
The Repo t of the RBI-SEBI Standing Technical Committee on Exchange T aded Cu e
ncy Futu es is available
in SEBI’s web site.
57
The t ading of de ivatives is gove ned by the p ovisions contained in the SC(R)A
, the SEBI Act, the ules and
egulations f amed the eunde  and the ules and bye–laws of stock exchanges.
7.4 FOREIGN EXCHANGE MANAGEMENT ACT, 1999 - PROVISIONS
The eafte , a se ies of egulato y measu es we e taken so as to implement the e
commendations of both the
committees and int oduce Exchange T aded Cu ency Futu es in the Indian ma ket.
These egulato y measu es a e summa ised below:
1) The Fo eign Exchange Management (Fo eign Exchange De ivative Cont acts) Regul
ations, 2000
(Notification No. FEMA 25/RB-2000 dated May 3, 2000) was amended by RBI in exe c
ise of the powe s
confe ed by clause (h) of sub-section 2 of Section 47 of the Fo eign Exchange M
anagement Act, 1999
(Act 42 of 1999).
2) This amendment inco po ated a new clause afte  clause (v) in egulation 2 ea
ding "(va) Cu ency
Futu es’ means a standa dised fo eign exchange de ivative cont act t aded on a ec
ognized stock
exchange to buy o  sell one cu ency against anothe  on a specified futu e date,
at a p ice specified on the
date of cont act, but does not include a fo wa d cont act."
3) A new egulation (5A) was inse ted afte  egulation 5 of the p incipal egula
tion, eading:
"5A. Pe mission to a pe son esident in India to ente  into cu ency
futu es
A pe son esident in India may ente  into a cu ency futu es in a stock
exchange ecognized unde  section 4 of the Secu ities Cont act (Regulation)
Act, 1956, to hedge an exposu e to isk o  othe wise, subject to such te ms
and conditions as may be set fo th in the di ections issued by the Rese ve
Bank of India f om time to time."
4) These amendments have defined the meaning of ‘Cu ency Futu es’ and also pe mitte
d a pe son esident
in India to ente  into a Cu ency Futu e T ansaction to hedge on exposu e to is
k o  othe wise.
5) On 6th August 2008 RBI had issued Notification No. FED.1/DG(SG)-2008 in exe c
ise of powe s confe ed
by section 45W of the Rese ve Bank of India Act, 1934. The di ections issued und
e  this notification a e
titled “Cu ency Futu es (Rese ve Bank) Di ections, 2008” which came into fo ce w.e.
f. 6th August, 2008.
The salient featu es of this notification a e:
(i) Cu ency Futu es means a standa dised fo eign exchange de ivative cont act t
aded on a
ecognized stock exchange to buy o  sell one cu ency against anothe  on a speci
fied futu e
date, at a p ice specified on the date of cont act, but does not include a fo wa
d cont act.
(ii) Cu ency Futu es ma ket means the ma ket in which cu ency futu es a e t ad
ed.
(iii) Cu ency futu es a e pe mitted in US Dolla  - Indian Rupee o  any othe  cu
ency pai s, as may
be app oved by the Rese ve Bank f om time to time.
(iv) Only ‘pe sons esident in India’ may pu chase o  sell cu ency futu es.
58
(v) The Standa dized cu ency futu es shall have the following featu es:
a. Only USD-INR cont acts a e allowed to be t aded.
b. The size of each cont act shall be USD 1000.
c. The cont acts shall be quoted and settled in Indian Rupees.
d. The matu ity of the cont acts shall not exceed 12 months.
(vi) The Scheduled Banks have to obtain pe mission f om the espective Regulato 
y Depa tments of
RBI to pa ticipate in Cu ency Futu es Ma kets.
(vii) Othe  egulated entities have to obtain concu ence f om thei  espective
egulato s fo 
pa ticipation in Cu ency Futu es Ma kets.
(viii) The membe ship of the cu ency futu es ma ket of a ecognised stock excha
nge shall be
sepa ate f om the membe ship of the equity de ivative segment o  the cash segmen
t.
(ix) Banks autho ized by the Rese ve Bank of India unde  section 10 of the Fo ei
gn Exchange
Management Act, 1999 as ‘AD Catego y - I bank’ a e pe mitted to become t ading and c
lea ing
membe s of the cu ency futu es segment of the ecognized stock exchanges, on th
ei  own
account and on behalf of thei  clients, subject to fulfilling the following mini
mum p udential
equi ements:
a) Minimum net wo th of Rs. 500 c o es.
b) Minimum CRAR of 10 pe  cent.
c) Net NPA should not exceed 3 pe  cent.
d) Made net p ofit fo  last 3 yea s.
(x) AD Catego y - I banks, excluding U ban Co-ope ative Banks, which fulfill the
above RBI
p udential equi ements should fo mulate detailed guidelines fo  T ading and Cle
a ing of
cu ency futu es cont acts and management of isks. These guidelines should be a
pp oved by
thei  Boa ds.
(xi) The exposu e of the banks, on thei  own account, in the cu ency futu es ma
ket shall fo m pa t
of thei  Net Open Position (NOP) and Agg egate Gap (AG) limits.
(xii) The position limits fo  va ious classes of pa ticipants in the cu ency fu
tu es ma kets, the
su veillance and disclosu es of t ansactions in the cu ency futu es ma ket shal
l be in
acco dance with the guidelines issued by the SEBI.
(xiii) Unde  section 10 (1) of the Fo eign Exchange Management Act, 1999, Recogn
ized Stock
Exchanges and thei  espective Clea ing Co po ations must hold an autho ization
issued by the
Rese ve Bank to deal in o  othe wise unde take the business elating to cu ency
futu es.
6) Rese ve Bank of India, Fo eign Exchange Depa tment have issued A.P. (DIR Se i
es) Ci cula  No. 05
dated August 06, 2008 (RBI/2008-09/122) titled ‘Guidelines on t ading of Cu ency
Futu es in
Recognised Stock / New Exchanges’.
RBI has advised in this ci cula  that “Pe sons esident in India have a menu of ov
e -the-counte  (OTC)
p oducts, such as cu ency fo wa ds, swaps and options fo  hedging thei  cu enc
y isk. In the context
of libe alisation of the capital account, as also continued development of the f
inancial ma kets, it is felt
that wide  hedging oppo tunities could enhance the flexibility fo  the esidents
to manage thei 
cu ency isk dynamically. Inte national expe iences have also established that
the exchange t aded
cu ency futu es cont acts facilitate efficient p ice discove y, enable bette  c
ounte pa ty c edit isk
59
management, wide  pa ticipation, t ading of standa dized p oduct, educe t ansac
tion costs, etc.
Acco dingly, as a pa t of fu the  developing the de ivatives ma ket in India and
adding to the existing
menu of fo eign exchange hedging tools available to the esidents, it has been d
ecided to int oduce
cu ency futu es in ecognized stock exchanges o  new exchanges ecognized by th
e Secu ities and
Exchange Boa d of India (SEBI) in the count y. The cu ency futu es ma ket would
function subject to
the di ections, guidelines, inst uctions issued by the Rese ve Bank and the SEBI
, f om time to time.”
7) Rese ve Bank of India, Depa tment of Banking Ope ations and Development in th
ei  Ci cula 
DBOD.No.FSD.BC. 29 /24.01.001/2008-09 dated August 6, 2008 (RBI/2008-09/123) tit
led
‘Int oduction of Cu ency Futu es–Pe mitting banks to become t ading /clea ing membe
s of
SEBI-app oved exchanges’ stated that ‘Banks which fulfill the conditions mentioned i
n the
Notification No. FED.1/DG(SG)-2008 dated August 6, 2008 should lay down detailed
guidelines with
thei  Boa d s app oval fo  conduct of this activity and management of isks. It
should be ensu ed that
the bank’s position is kept distinct f om the clients position. In case of supe v
iso y discomfo t with the
functioning of a bank, the Rese ve Bank may impose est ictions on the bank ega
ding the conduct of
this business as it deems fit.
8) This ci cula  also stated that the banks which do not meet the minimum p esc 
ibed p udential
equi ements a e pe mitted to pa ticipate in the cu ency futu es ma ket only as
clients.
7.5 REGULATORY FRAMEWORK FOR EXCHANGES
A ecognized stock exchange having nationwide te minals o  a new exchange ecogn
ized by SEBI may set up
cu ency futu es segment afte  obtaining SEBI’s app oval. The cu ency futu es seg
ment should fulfill the
following eligibility conditions fo  app oval:
1. The t ading should take place th ough an online sc een-based t ading system,
which also has a
disaste  ecove y site.
2. The clea ing of the cu ency de ivatives ma ket should be done by an independ
ent Clea ing
Co po ation. The Clea ing Co po ation should satisfy the conditions stipulated i
n the following section
(Section 7.6).
3. The exchange must have an online su veillance capability which monito s posit
ions, p ices and
volumes in eal time so as to dete  ma ket manipulation.
4. The exchange shall have a balance sheet netwo th of at least Rs. 100 c o es.
5. Info mation about t ades, quantities, and quotes should be disseminated by th
e exchange in eal time
to at least two info mation vending netwo ks which a e accessible to investo s i
n the count y. The pe half-
hou  capacity of the compute s and the netwo k should be at least 4 to 5 times o
f the anticipated
peak load in any half hou , o  of the actual peak load seen in any half-hou  du 
ing the p eceding six
months, whicheve  is highe . This shall be eviewed f om time to time on the bas
is of expe ience. The
segment should have at least 50 membe s to sta t cu ency de ivatives t ading. T
he exchange should
have a bit ation and investo  g ievances ed essal mechanism ope ative f om all
the fou 
a eas/ egions of the count y. The exchange should have adequate inspection capab
ility. If al eady
existing, the exchange should have a satisfacto y eco d of monito ing its membe
s, handling investo 
complaints and p eventing i egula ities in t ading.
A ecognized stock exchange whe e othe  secu ities a e also being t aded may set
up a sepa ate cu ency
futu es segment in the following manne :
1. The t ading and the o de  d iven platfo m of cu ency futu es should be sepa 
ate f om the t ading
platfo ms of the othe  segments.
60
2. The membe ship of the cu ency futu es segment should be sepa ate f om the me
mbe ship of the
othe  segments.
7.6 REGULATORY FRAMEWORK FOR CLEARING CORPORATIONS
A Clea ing Co po ation in the cu ency futu es segment can function only afte  o
btaining SEBI app oval. The
conditions inte -alia includes the following:
• The Clea ing Co po ation should be a company inco po ated unde  the Companies Ac
t, 1956 and
should be distinct f om the exchange.
• The Clea ing Co po ation must pe fo m full novation.
• The Clea ing Co po ation should enfo ce the stipulated ma gin equi ements, ma k
to ma ket
settlement, elect onic funds t ansfe , etc.
• A sepa ate settlement gua antee fund should be c eated and maintained fo  meetin
g the obligations
a ising out of the cu ency futu es segment. A sepa ate investo  p otection fund
should also be
c eated and maintained fo  the cu ency futu es ma ket.
7.7 GOVERNING COUNCIL OF THE EXCHANGE AND CLEARING CORPORATION
The cu ency futu es segment of the Exchange should have a sepa ate Gove ning Co
uncil on which the
ep esentation of T ading /Clea ing Membe s of the cu ency futu es segment shou
ld not exceed 25%. Fu the ,
50% of the public ep esentatives on the Gove ning Council of the cu ency futu 
es segment can be common
with the Gove ning Council of the cash/equity de ivatives segments of the Exchan
ge. The Chai man of the
Gove ning Council of the cu ency futu es segment of the Exchange shall be a mem
be  of the Gove ning
Council. If the Chai man is a T ading Membe / Clea ing Membe , then he shall not
ca y on any
t ading/clea ing business on any Exchange du ing his tenu e as Chai man. No t ad
ing / clea ing membe 
should be allowed simultaneously to be on the Gove ning Council of the cu ency
futu es segment and the
cash/equity de ivatives segment.
The cu ency futu es segment of the Clea ing Co po ation should be gove ned by a
sepa ate Gove ning
Council which should not have any t ading membe  ep esentation.
7.8 ELIGIBILITY CRITERIA FOR MEMBERS
The membe ship of the Cu ency De ivatives Segment shall be sepa ate f om the me
mbe ship of the Equity
De ivative Segment o  the Cash Segment of a ecognized stock exchange. Membe s i
n Cu ency De ivatives
segment a e equi ed to seek sepa ate egist ation f om SEBI, in addition to the
i  egist ation as membe s of
existing stock exchanges. The membe s of an existing segment of the Exchange wou
ld not automatically
become the membe s of Cu ency De ivatives Segment.
61
Eligibility C ite ia fo  membe s in Cu ency De ivatives Segment
The following entities a e eligible to apply fo  membe ship subject to the egul
ato y no ms and p ovisions of
SEBI and as p ovided in the Rules, Regulations, Byelaws and Ci cula s of the Exc
hange -
1. Individuals;
2. Pa tne ship Fi ms egiste ed unde  the Indian Pa tne ship Act, 1932;
3. Co po ations, Companies o  Institutions o  subsidia ies of such Co po ations,
Companies o 
Institutions set up fo  p oviding financial se vices;
4. Such othe  pe son as may be pe mitted unde  the Secu ities Cont acts (Regulat
ion) Rules 1957
Individuals
C ite ia
AGE Minimum age : 21 yea s
Maximum age : 60 yea s
STATUS Indian Citizen
EDUCATION At least a g aduate o  equivalent qualification
EXPERIENCE Should have a minimum expe ience in as p esc ibed by Secu ities and E
xchange
Boa d of India
Pa tne ship Fi ms
C ite ia
AGE Minimum age : 21 yea s (applicable fo  pa tne s)
STATUS Registe ed Pa tne ship fi m unde  Indian Pa tne ship Act, 1932
EDUCATION Pa tne s should be at least a g aduate o  equivalent qualification
DESIGNATED
PARTNERS
EXPERIENCE
Should have a minimum expe ience in as p esc ibed by
Secu ities and Exchange Boa d of India
Co po ates
A company as defined in the Companies Act, 1956 (1 of 1956), shall be eligible t
o be admitted as a membe  of
a Stock Exchange p ovided:
i. such company is fo med in compliance with the p ovisions of Section 12 of the
said Act;
ii. it unde takes to comply with such othe  financial equi ements and no ms as
may be specified by the
Secu ities and Exchange Boa d of India fo  the egist ation of such company unde
 sub-section (1) of
section 12 of the Secu ities and Exchange Boa d of India Act, 1992 (15 of 1992);
iii. the di ecto s of such company a e not disqualified fo  being membe s of a s
tock exchange unde  clause
(1) of ule 8 [except sub-clauses (b) and (f) the eof] o  clause (3) of ule 8 [
except sub-clauses (a) and (f)
the eof] of the Secu ities Cont acts (Regulation) Rules, 1957 and the di ecto s
of the company had not
62
held the offices of the di ecto s in any company which had been a membe  of the
stock exchange and had
been decla ed defaulte  o  expelled by the stock exchange.
C ite ia
AGE Minimum age : 21 yea s (applicable fo  di ecto s)
STATUS Co po ate egiste ed unde  The Companies Act, 1956 (Indian)
EDUCATION Two Di ecto s (Designated di ecto s) should be at least g aduate o  eq
uivalent
qualification
DESIGNATED
DIRECTORS
EXPERIENCE
Should have a minimum expe ience in as p esc ibed by Secu ities and Exchange
Boa d of India
MINIMUM PAID UP
EQUITY CAPITAL As stipulated by the Exchange
P ofessional Clea ing Membe 
The following pe sons a e eligible to become PCMs fo  Cu ency Futu es De ivativ
es p ovided they fulfill the
p esc ibed c ite ia:
1. SEBI Registe ed Custodians; and
2. Banks
Banks
Banks autho ized by the Rese ve Bank of India unde  section 10 of the Fo eign Ex
change Management Act,
1999 as ‘AD Catego y - I bank’ a e pe mitted to become t ading and clea ing membe s
of the cu ency futu es
ma ket of the ecognized stock exchanges, on thei  own account and on behalf of
thei  clients, subject to
fulfilling the following minimum p udential equi ements:
a) Minimum net wo th of Rs. 500 c o es.
b) Minimum CRAR of 10 pe  cent.
c) Net NPA should not exceed 3 pe  cent.
d) Made net p ofit fo  last 3 yea s.
The AD Catego y - I banks which fulfill the p udential equi ements a e equi ed
to lay down detailed guidelines
with the app oval of thei  Boa ds fo  t ading and clea ing in cu ency futu es c
ont acts and management of
isks.
AD Catego y - I banks which do not meet the above minimum p udential equi ement
s and AD Catego y - I
banks which a e U ban Co-ope ative banks o  State Co-ope ative banks can pa tici
pate in the cu ency futu es
ma ket only as clients, subject to app oval f om the espective egulato y Depa 
tments of the Rese ve Bank.
Othe  applicable eligibility c ite ia
1. Whe e the applicant is a pa tne ship fi m/co po ate entity, the applicant sha
ll identify a Dominant P omote 
G oup as pe  the no ms of the Exchange at the time of making the application. An
y change in the
63
sha eholding of the company including that of the said Dominant P omote  G oup o
 thei  sha eholding
inte est shall be effected only with the p io  pe mission of the Exchange/SEBI.
2. The applicant has to ensu e that at any point of time they would ensu e that
at least individual/one
pa tne /one designated di ecto /compliance office  would have a valid ce tificat
ion as pe  the equi ements
of the Exchange. The above no m would be a continued admittance no m fo  membe s
hip of the
Exchange.
3. An applicant must be in a position to pay the membe ship and othe  fees, depo
sits etc, as applicable at the
time of admission within th ee months of intimation to him of admission as a T a
ding Membe  o  as pe  the
time schedule specified by the Exchange.
4. The t ading membe s and sales pe sons in the cu ency futu es ma ket must hav
e passed a ce tification
p og amme which is conside ed adequate by SEBI. The app oved use s and sales pe 
sonnel of the
t ading membe  should have passed the ce tification p og amme.
5. At p esent, FIIs and NRIs would not be pe mitted to pa ticipate in cu ency f
utu es ma ket.
6. St ict enfo cement of “Know You  Custome ” (KYC) ule is equi ed. The efo e eve 
y client shall be
egiste ed with the membe . The membe s a e also equi ed to make thei  clients
awa e of the isks
involved in de ivatives t ading by issuing to the client the Risk Disclosu e Doc
ument and obtain a copy of
the same duly acknowledged by the client. The membe s shall ente  into a membe 
constituent ag eement
as stipulated.
7. The Exchange may specify such standa ds fo  investo  se vice and inf ast uctu
e with ega d to any
catego y of applicants as it may deem necessa y, f om time to time.
Who cannot become a membe ?
No entity shall be admitted as a membe /pa tne  o  di ecto  of the membe  if
a. It has been adjudged bank upt o  a eceive  o de  in bank uptcy has been made
against him o 
he has been p oved to be insolvent even though he has obtained his final discha 
ge;
b. it has compounded with his c edito s fo  less than full discha ge of debts;
c. it has been convicted of an offence involving a f aud o  dishonesty;
d. it is engaged as a p incipal o  employee in any business othe  than that of S
ecu ities, except as a
b oke  o  agent not involving any pe sonal financial liability o  fo  p oviding
me chant banking,
unde w iting o  co po ate o  investment adviso y se vices, unless he unde takes
to seve e its
connections with such business on admission, if admitted;
e. it has been at any time expelled o  decla ed a defaulte  by any othe  Stock E
xchange o  he has
been deba ed f om t ading in secu ities by an Regulato y Autho ities like SEBI,
RBI etc;
f. it incu s such disqualification unde  the p ovisions of the Secu ities Cont a
ct (Regulations) Act,
1956 o  Rules made the e-unde  so as to disentitle such pe sons f om seeking mem
be ship of a
stock exchange;
g. it incu s such disqualification consequent to which the Exchange dete mines i
t to be not in public
inte est to admit him as a membe  on the Exchange, p ovided that in case of egi
ste ed fi ms,
body co po ates and companies, the condition f om (will apply to all pa tne s in
case of
pa tne ship fi ms, all di ecto s in case of companies) the Exchange may f om tim
e to time modify
64
/ expand the scope of activities that could be conside ed as elevant expe ience
fo  the above
pu pose.
Fu the , the Exchange ese ves the ight to accept o  eject any application o 
amend the te ms and conditions
without assigning any eason whatsoeve .
Fo ms of collate als acceptable by the Clea ing Co po ation
Membe s have to fulfill ce tain equi ements and p ovide collate al deposits to
the Clea ing Co po ation. All
collate al deposits a e seg egated into cash component and non-cash component. C
ash component means
cash, bank gua antee, fixed deposit eceipts, T easu y bills and dated gove nmen
t secu ities. Non-cash
component mean all othe  fo ms of collate al like app oved demat secu ities.
Requi ements to become autho ized / app oved use 
T ading membe s and pa ticipants a e entitled to appoint, with the app oval of t
he Cu ency De ivatives
segment of the exchange, autho ized pe sons and app oved use s to ope ate the t 
ading wo kstation(s). These
autho ized use s can be individuals, egiste ed pa tne ship fi ms o  co po ate b
odies.
These Autho ized Pe sons cannot collect any commission o  any amount di ectly f 
om the clients they
int oduce to the t ading membe  who appointed him. Howeve  they can eceive a co
mmission o  any such
amount f om the t ading membe  who appointed them as p ovided unde  egulation.
65
CHAPTER 8 ACCOUNTING AND TAXATION
8.1 ACCOUNTING
The Institute of Cha te ed Accountants of India (ICAI) has issued guidance notes
on accounting of index
futu es cont acts f om the view point of pa ties who ente  into such futu es con
t acts as buye s o  selle s. Fo 
othe  pa ties involved in the t ading p ocess, like b oke s, t ading membe s, cl
ea ing membe s and clea ing
co po ations, a t ade in cu ency de ivatives is simila  to a t ade in, say sha 
es, and does not pose any peculia 
accounting p oblems. It is not clea , as of now, whethe  any sepa ate guidance n
otes would be issued fo 
cu ency de ivatives. If issued, pa ticipants will have to conside  such guidanc
e shall p evail.
Hence in this section, just as a pa allel on the lines of guidelines fo  equity
de ivatives, we shall la gely focus
on the accounting t eatment of cu ency futu es in the books of the client. But
befo e we do so, a quick e-look
at some of the te ms used.
1. Clea ing co po ation/house: Clea ing co po ation/house means a clea ing co po
ation/house
app oved by SEBI fo  clea ing and settlement of t ades on the cu ency de ivativ
es
exchange/segment.
2. Clea ing membe : Clea ing membe  means a membe  of the clea ing co po ation a
nd includes all
catego ies of clea ing membe s as may be admitted as such by the clea ing co po 
ation to the
cu ency segment.
3. Client: A client means a pe son, on whose inst uctions and on whose account,
the t ading membe 
ente s into any cont act fo  the pu chase o  sale of any cont act o  does any ac
t in elation the eto.
4. Cont act month: Cont act month means the month in which the exchange/clea ing
co po ation ules
equi e a cont act to be finally settled.
5. Daily settlement p ice: Daily settlement p ice is the closing p ice of the cu
ency futu es cont act fo 
the day o  such othe  p ice as may be decided by the clea ing house f om time to
time.
6. Cu ency De ivatives exchange/segment: Cu ency De ivative exchange means an
exchange
app oved by SEBI as a cu ency de ivative exchange. Cu ency De ivative segment
means segment
of an existing exchange app oved by SEBI as cu ency de ivative segment.
7. Final settlement p ice: The final settlement p ice is the closing p ice of th
e cu ency futu es cont act
on the last t ading day of the cont act o  such othe  p ice as may be specified
by the clea ing
co po ation, f om time to time.
8. Long position: Long position in a cu ency futu es cont act means outstanding
pu chase obligations
in espect of the cu ency futu es cont act at any point of time.
9. Open position: Open position means the total numbe  of cu ency futu es cont 
acts that have not yet
been offset and closed by an opposite position.
10. Settlement date: Settlement date means the date on which the settlement of o
utstanding obligations
in a cu ency futu es cont act a e equi ed to be settled as p ovided in the Bye
-Laws of the Cu ency
De ivatives exchange/segment.
11. Sho t position: Sho t position in a cu ency futu es cont act means outstand
ing sell obligations in
66
espect of a cu ency futu es cont act at any point of time.
12. T ading membe : T ading membe  means a Membe  of the Cu ency De ivatives ex
change/segment
and egiste ed with SEBI.
Accounting at the inception of a cont act
Eve y client is equi ed to pay to the t ading membe /clea ing membe , the initi
al ma gin dete mined by the
clea ing co po ation as pe  the bye-laws/ egulations of the exchange fo  ente in
g into cu ency futu es
cont acts. Such initial ma gin paid/payable should be debited to “Initial ma gin -
cu ency futu es account”.
Additional ma gins, if any, should also be accounted fo  in the same manne . It
may be mentioned that at the
time when the cont act is ente ed into fo  pu chase/sale of cu ency futu es, no
ent y is passed fo  eco ding
the cont act because no payment is made at that time except fo  the initial ma g
in. At the balance sheet date,
the balance in the ‘Initial ma gin - cu ency futu es account’ should be shown sepa 
ately unde  the head
‘cu ent assets’. In those cases whe e any amount has been paid in excess of the ini
tial/additional ma gin, the
excess should be disclosed sepa ately as a deposit unde  the head ‘cu ent assets’.
In cases whe e instead of
paying initial ma gin in cash, the client p ovides bank gua antees o  lodges sec
u ities with the membe , a
disclosu e should be made in the notes to the financial statements of the client
.
Accounting at the time of daily settlement
This involves the accounting of payment/ eceipt of ma k-to-ma ket ma gin money.
Payments made o  eceived
on account of daily settlement by the client would be c edited/debited to the ba
nk account and the
co esponding debit o  c edit fo  the same should be made to an account titled a
s “Ma k-to-ma ket ma gin -
cu ency futu es account”.
Some times the client may deposit a lump sum amount with the b oke /t ading memb
e  in espect of ma k-toma ket
ma gin money instead of eceiving/paying ma k-to-ma ket ma gin money on daily ba
sis. The amount so
paid is in the natu e of a deposit and should be debited to an app op iate accou
nt, say, “Deposit fo  ma k-toma ket
ma gin account”. The amount of “ma k-to-ma ket ma gin” eceived/paid f om such account
should be
c edited/debited to “Ma k-to-ma ket ma gin – cu ency futu es account” with a co espo
nding debit/c edit to
“Deposit fo  ma k-to-ma ket ma gin account”. At the yea -end, any balance in the “Depo
sit fo  ma k-to-ma ket
ma gin account” should be shown as a deposit unde  the head “cu ent assets”.
Accounting fo  open positions
Position left open on the balance sheet date must be accounted fo . Debit/c edit
balance in the “ma k-to-ma ket
ma gin - cu ency futu es account”, maintained on global basis, ep esents the net
amount paid/ eceived on the
basis of movement in the p ices of cu ency futu es till the balance sheet date.
Keeping in view ‘p udence’ as a
conside ation fo  p epa ation of financial statements, p ovision fo  anticipated
loss, which may be equivalent to
the net payment made to the b oke  ( ep esented by the debit balance in the “ma k-
to-ma ket ma gin -
cu ency futu es account”) should be c eated by debiting the p ofit and loss accou
nt. Net amount eceived
( ep esented by c edit balance in the “ma k-to-ma ket ma gin - cu ency futu es ac
count”) being anticipated
p ofit should be igno ed and no c edit fo  the same should be taken in the p ofi
t and loss account. The debit
balance in the said “ma k-to-ma ket ma gin - cu ency futu es account”, i.e., net pa
yment made to the b oke ,
may be shown unde  the head “cu ent assets, loans and advances” in the balance shee
t and the p ovision
c eated the e-against should be shown as a deduction the ef om. On the othe  han
d, the c edit balance in the
said account, i.e., the net amount eceived f om the b oke , should be shown as
a cu ent liability unde  the
head “cu ent liabilities and p ovisions in the balance sheet”.
67
Accounting at the time of final settlement
This involves accounting at the time of final settlement o  squa ing-up of the c
ont act. At the expi y of a se ies
of cu ency futu es, the p ofit/loss, on final settlement of the cont acts in th
e se ies, should be calculated as the
diffe ence between final settlement p ice and cont act p ices of all the cont ac
ts in the se ies. The p ofit/loss, so
computed, should be ecognized in the p ofit and loss account by co esponding d
ebit/c edit to “ma k-to-ma ket
ma gin - cu ency futu es account”. Howeve , whe e a balance exists in the p ovisi
on account c eated fo 
anticipated loss, any loss a ising on such settlement should be fi st cha ged to
such p ovision account, to the
extent of the balance available in the p ovision account, and the balance of los
s, if any, should be cha ged to
the p ofit and loss account. Same accounting t eatment should be made when a con
t act is squa ed-up by
ente ing into a eve se cont act. It appea s that, at p esent, it is not feasibl
e to identify the cu ency futu es
cont acts. Acco dingly, if mo e than one cont act in espect of the se ies of cu
ency futu es cont acts to which
the squa ed-up cont act pe tains is outstanding at the time of the squa ing of t
he cont act, the cont act p ice of
the cont act so squa ed-up should be dete mined using Fi st-In, Fi st-Out (FIFO)
method fo  calculating
p ofit/loss on squa ing-up.
On the settlement of a cu ency futu es cont act, the initial ma gin paid in es
pect of the cont act is eleased,
which should be c edited to “Initial ma gin - cu ency futu es account”, and a co e
sponding debit should be
given to the bank account o  the deposit account (whe e the amount is not eceiv
ed).
Accounting in case of a default
When a client defaults in making payment in espect of a daily settlement, the c
ont act is closed out. The
amount not paid by the Client is adjusted against the initial ma gin. In the boo
ks of the Client, the amount so
adjusted should be debited to “ma k-to-ma ket - cu ency futu es account” with a co 
esponding c edit to “Initial
ma gin - cu ency futu es account”. The amount of initial ma gin on the cont act,
in excess of the amount
adjusted against the ma k-to-ma ket ma gin not paid, will be eleased. The accou
nting t eatment in this ega d
will be the same as explained above. In case, the amount to be paid on daily set
tlement exceeds the initial
ma gin the excess is a liability and should be shown as such unde  the head ‘cu e
nt liabilities and p ovisions’,
if it continues to exist on the balance sheet date. The amount of p ofit o  loss
on the cont act so closed out
should be calculated and ecognized in the p ofit and loss account in the manne 
dealt with above.
Disclosu e equi ements
The amount of bank gua antee and book value as also the ma ket value of secu iti
es lodged should be
disclosed in espect of cont acts having open positions at the yea  end, whe e i
nitial ma gin money has been
paid by way of bank gua antee and/o  lodging of secu ities.
Total numbe  of cont acts ente ed and g oss numbe  of units of cu ency futu es
t aded (sepa ately fo 
buy/sell) should be disclosed in espect of each se ies of cu ency futu es.
The numbe  of cu ency futu es cont acts having open position, numbe  of units o
f cu ency futu es pe taining
to those cont acts and the daily settlement p ice as of the balance sheet date s
hould be disclosed sepa ately
fo  long and sho t positions, in espect of each se ies of cu ency futu es.
68
8.2 TAXATION OF DERIVATIVE TRANSACTION IN SECURITIES
Taxation of P ofit/Loss on de ivative t ansaction in secu ities
P io  to Financial Yea  2005–06, t ansaction in de ivatives we e conside ed as spe
culative t ansactions fo  the
pu pose of dete mination of tax liability unde  the Income-tax Act. This is in v
iew of section 43(5) of the Incometax
Act which defined speculative t ansaction as a t ansaction in which a cont act f
o  pu chase o  sale of any
commodity, including stocks and sha es, is pe iodically o  ultimately settled ot
he wise than by the actual
delive y o  t ansfe  of the commodity o  sc ips. Howeve , such t ansactions ente
ed into by hedge s and stock
exchange membe s in cou se of jobbing o  a bit age activity we e specifically ex
cluded f om the pu view of
definition of speculative t ansaction.
In view of the above p ovisions, most of the t ansactions ente ed into in de iva
tives by investo s and
speculato s we e conside ed as speculative t ansactions. The tax p ovisions p ov
ided fo  diffe ential t eatment
with espect to set off and ca y fo wa d of loss on such t ansactions. Loss on
de ivative t ansactions could be
set off only against othe  speculative income and the same could not be set off
against any othe  income. This
esulted in payment of highe  taxes by an assesse.
Finance Act, 2005 has amended section 43(5) so as to exclude t ansactions in de 
ivatives ca ied out in a
“ ecognized stock exchange” fo  this pu pose. This implies that income o  loss on de
ivative t ansactions which
a e ca ied out in a “ ecognized stock exchange” is not taxed as speculative income
o  loss. Thus, loss on
de ivative t ansactions can be set off against any othe  income du ing the yea .
In case the same cannot be set
off, it can be ca ied fo wa d to subsequent assessment yea  and set off against
any othe  income of the
subsequent yea . Such losses can be ca ied fo wa d fo  a pe iod of 8 assessment
yea s. It may also be noted
that secu ities t ansaction tax paid on such t ansactions is eligible as deducti
on unde  Income-tax Act, 1961.
69
CHAPTER 9 CODES OF CONDUCT AND INVESTOR PROTECTION MEASURES
9.1 ADHERENCE TO SEBI CODES OF CONDUCT FOR BROKERS/ SUB-BROKERS
All t ading membe s must at all times adhe e to the Code of Conduct as specified
by the Secu ities and
Exchange Boa d of India (Stock B oke s and Sub-B oke s) Regulations, 1992.
CODE OF CONDUCT FOR BROKERS
A egiste ed b oke  must at all times abide by the Code of Conduct as given belo
w:
I. Gene al
a) Integ ity: A b oke  should maintain high standa ds of integ ity, p omptitude
and fai ness in the conduct of all
his business.
b) Exe cise of Due Skill and Ca e: A b oke  should act with due skill, ca e and
diligence in the conduct of all his
business.
c) Manipulation: A b oke  should not indulge in manipulative, f audulent o  dece
ptive t ansactions o  schemes
o  sp ead umou s with a view to disto ting ma ket equilib ium o  making pe sona
l gains.
d) Malp actices: A b oke  should not c eate false ma ket eithe  singly o  in con
ce t with othe s o  indulge in any
act det imental to the investo s’ inte est o  which leads to inte fe ence with the
fai  and smooth functioning of
the ma ket. A b oke  should not involve himself in excessive speculative busines
s in the ma ket beyond
easonable levels.
e) Compliance with Statuto y Requi ements: A b oke  should abide by all the p ov
isions of the Act and the
ules, egulations issued by the Gove nment, SEBI and the stock exchanges f om t
ime to time as may be
applicable to him.
II. Duty to the client
a) Execution of O de s: A b oke , in his dealings with the clients and the gene 
al public, should faithfully
execute the o de s fo  buying and selling of secu ities at the best available ma
ket p ice. A b oke  should
p omptly info m his client about the execution o  non-execution of an o de .
b) Issue of Cont act Note: A b oke  should issue without delay to his client o 
client of sub-b oke  a cont act
note fo  all t ansactions in the fo m specified by the exchanges.
c) B each of T ust: A b oke  should not disclose o  discuss with any othe  pe so
n o  make imp ope  use of the
details of pe sonal investments and othe  info mation of a confidential natu e o
f the client which he comes to
know in his business elationship.
d) Business and Commission:
(i) A b oke  should not encou age sales o  pu chases of secu ities with the sole
object of gene ating
b oke age o  commission.
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(ii) A b oke  should not fu nish false o  misleading quotations o  give any othe
 false o  misleading
advice o  info mation to the clients with a view of inducing him to do business
and enabling himself to
ea n b oke age o  commission the eby.
e) Business of Defaulting Clients: A b oke  should not deal o  t ansact business
knowingly, di ectly o  indi ectly
o  execute an o de  fo  a client who has failed to ca y out his commitments in
elation to secu ities with
anothe  b oke .
f) Fai ness to Clients: A b oke , when dealing with a client, should disclose wh
ethe  he is acting as a p incipal
o  as an agent and should ensu e at the same time that no conflict of inte est a
ises between him and the
client. In the event of a conflict of inte est, he should info m the client acco
dingly and should not seek to gain a
di ect o  indi ect pe sonal advantage f om the situation and should not conside 
client’s inte est infe io  to his
own.
g) Investment Advice: A b oke  should not make a ecommendation to any client wh
o might be expected to ely
the eon to acqui e, dispose of, etain any secu ities unless he has easonable g
ounds fo  believing that the
ecommendation is suitable fo  such a client upon the basis of the facts, if dis
closed by such a client as to his
own secu ity holdings, financial situation and objectives of such investment. Th
e b oke  should seek such
info mation f om clients, whe eve  he feels it is app op iate to do so.
h) Investment Advice in publicly accessible media:
(i) A b oke  o  any of his employees should not ende , di ectly o  indi ectly,
any investment advice
about any secu ity in the publicly accessible media, whethe  eal-time o  non e
al-time; unless a
disclosu e of his inte est including thei  long o  sho t position in the said se
cu ity has been made,
while ende ing such advice.
(ii) In case, an employee of the b oke  is ende ing such advice, he should also
disclose the inte est of
his dependent family membe s and the employe  including thei  long o  sho t posi
tion in the said
secu ity, while ende ing such advice.
(iii) Competence of B oke : A b oke  should have adequately t ained staff and a 
angements to ende 
fai , p ompt and competent se vices to his clients.
III. B oke s vis-à-vis othe  b oke s
(a) P otection of Clients Inte ests: A b oke  should extend fullest coope ation
to othe  b oke s in p otecting the
inte ests of his clients.
(b) T ansactions with B oke s: A b oke  should ca y out his t ansactions with o
the  b oke s and should comply
with his obligations in completing the settlement of t ansactions with them.
(c) Adve tisement and Publicity: A b oke  should not adve tise his business publ
icly unless pe mitted by the
exchange.
(d) Inducement of Clients: A b oke  should not eso t to unfai  means of inducin
g clients f om othe  b oke s.
(e) False o  Misleading Retu ns: A b oke  should not neglect o  fail o  efuse t
o submit the equi ed etu ns and
not make any false o  misleading statement on any etu ns equi ed to be submitt
ed to the Boa d and the
exchange.
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CODE OF CONDUCT FOR SUB-BROKERS
The sub-b oke  at all times abides by the Code of Conduct as given he eunde :
I. Gene al
(a) Integ ity: A sub-b oke  should maintain high standa ds of integ ity, p ompti
tude and fai ness in the conduct
of his business.
(b) Exe cise of Due Skill and Ca e: A sub-b oke  should act with due skill, ca e
and diligence in the conduct of
his business.
II. Duty to the Client
1. Execution of O de s:
(a) A sub-b oke , in his dealings with the clients and the gene al public, shoul
d faithfully execute the o de s fo 
buying and selling of secu ities at the best available ma ket p ice. A sub-b oke
 should p omptly info m his
client about the execution o  non-execution of an o de .
2. Issue of Pu chase o  Sale Notes:
(a) A sub-b oke  should issue p omptly to his clients pu chase o  sale notes fo 
all the t ansactions ente ed into
by him with his clients.
(b) A sub-b oke  should not match the pu chase and sale o de s of his clients an
d each such o de  must
inva iably be outed th ough a membe -b oke  of the stock exchange with whom he
is affiliated.
3. B each of T ust: A sub-b oke  should not disclose o  discuss with any othe  p
e son o  make imp ope  use of
the details of pe sonal investments and othe  info mation of a confidential natu
e of the client which he comes
to know in his business elationship.
4. Business and Commission:
(a) A sub-b oke  should not encou age sales o  pu chases of secu ities with the
sole object of gene ating
b oke age o  commission.
(b) A sub-b oke  should not fu nish false o  misleading quotations o  give any o
the  false o  misleading advice
o  info mation to the clients with a view to induce him to do business and enabl
ing himself to ea n b oke age o 
commission the eby.
5. Business of Defaulting Clients: A sub-b oke  should not deal o  t ansact busi
ness knowingly, di ectly o 
indi ectly o  execute an o de  fo  a client who has failed to ca y out his comm
itments and is in default with
anothe  b oke  o  sub-b oke .
6. Fai ness to Clients: A sub-b oke , when dealing with a client, should disclos
e that he is acting as an agent
ensu ing at the same time, that no conflict of inte est a ises between him and t
he client. In the event of a
conflict of inte est, he should info m the client acco dingly and should not see
k to gain a di ect o  indi ect
pe sonal advantage f om the situation and should not conside  clients’ inte est in
fe io  to his own.
7. Investment Advice: A sub-b oke  should not make a ecommendation to any clien
t who might be expected to
ely the eon to acqui e, dispose of, etain any secu ities unless he has easona
ble g ounds fo  believing that
72
the ecommendation is suitable fo  such a client upon the basis of the facts, if
disclosed by such a client as to
his own secu ity holdings, financial situation and objectives of such investment
. The sub-b oke  should seek
such info mation f om clients, whe eve  they feel it is app op iate to do so.
8. Investment Advice in publicly accessible media:
(a) A sub-b oke  o  any of his employees should not ende , di ectly and indi ec
tly any investment advice about
any secu ity in the publicly accessible media, whethe  eal-time o  non- eal-tim
e, unless a disclosu e of his
inte est including his long o  sho t position in the said secu ity has been made
, while ende ing such advice.
(b) In case, an employee of the sub-b oke  is ende ing such advice, he should a
lso disclose the inte est of his
dependent family membe s and the employe  including thei  long o  sho t position
in the said secu ity, while
ende ing such advice.
9. Competence of Sub-b oke : A sub-b oke  should have adequately t ained staff a
nd a angements to ende 
fai , p ompt and competent se vices to his clients and continuous compliance wit
h the egulato y system.
III. Sub-B oke s vis-à-vis B oke s
(a) P otection of Clients Inte ests: A sub-b oke  should extend fullest coope at
ion to his b oke  in p otecting the
inte ests of thei  clients.
(b) T ansactions with B oke s: A sub-b oke  should not fail to ca y out his b o
king t ansactions with his b oke 
no  should he fail to meet his business liabilities o  show negligence in comple
ting the settlement of
t ansactions with them.
(c) Ag eement between sub-b oke , client of the sub-b oke  and main b oke :
A sub-b oke  should ente  into a t ipa tite ag eement with his client and with t
he main b oke  specifying the
scope of ights and obligations of the b oke , sub-b oke  and such client of the
sub-b oke .
(d) Adve tisement and Publicity: A sub-b oke  should not adve tise his business
publicly unless pe mitted by
the exchanges.
(e) Inducement of Clients: A sub-b oke  should not eso t to unfai  means of ind
ucing clients f om othe 
b oke s.
IV. Sub-b oke s vis-a-vis Regulato y Autho ities
(a) Gene al Conduct: A sub-b oke  should not indulge in dishonou able, disg acef
ul o  diso de ly o  imp ope 
conduct on the exchange no  shall he willfully obst uct the business of the exch
ange. He should comply with
the ules, byelaws and egulations of the stock exchange.
(b) Failu e to give Info mation: A sub-b oke  should not neglect o  fail o  efu
se to submit to SEBI o  the
exchange with which he is egiste ed, such books, special etu ns, co espondenc
e, documents, and pape s o 
any pa t the eof as may be equi ed.
(c) False o  Misleading Retu ns: A sub-b oke  should not neglect o  fail o  efu
se to submit the equi ed etu ns
and not make any false o  misleading statement on any etu ns equi ed to be sub
mitted to SEBI o  the
exchanges.
(d) Manipulation: A sub-b oke  should not indulge in manipulative, f audulent o 
deceptive t ansactions o 
schemes o  sp ead umou s with a view to disto ting ma ket equilib ium o  making
pe sonal gains.
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(e) Malp actices: A sub-b oke  should not c eate false ma ket eithe  singly o  i
n conce t with othe s o  indulge
in any act det imental to the public inte est o  which leads to inte fe ence wit
h the fai  and smooth function of
the ma ket mechanism of the stock exchanges. A sub-b oke  should not involve him
self in excessive
speculative business in the ma ket.
9.2 ADHERENCE TO CODES OF CONDUCT SPECIFIC TO ETCF SEGMENT
Exchange egulations specify codes of conduct elated to the ETCF segment. All t
ading membe s must
comply with these. These a e detailed below.
GENERAL PRINCIPLES
(a) A T ading Membe  shall make adequate disclosu es of elevant mate ial info m
ation in his dealings with his
clients.
(b) No T ading Membe  o  pe son associated with the T ading Membe  shall gua ant
ee a client against a loss
in any t ansactions effected by the T ading Membe  fo  such client.
(c) P ofessionalism: A T ading Membe  in the conduct of his business shall obse 
ve high standa ds of
comme cial honou  of just and equitable p inciples of t ade.
(d) Adhe ence to T ading P actices: T ading Membe s shall adhe e to the Rules, R
egulations and Bye - laws of
the Exchanges and shall comply with such ope ational pa amete s, ulings, notice
s, guidelines and inst uctions
of the Relevant Autho ity as may be applicable f om time to time.
(e) Honesty and Fai ness: In conducting his business activities, a T ading Membe
 shall act honestly and fai ly,
in the best inte ests of his constituents.
(f) Capabilities: A T ading Membe  shall have and employ effectively the esou c
es and p ocedu es which a e
needed fo  the p ope  pe fo mance of his business activities.
TRADING PRINCIPLES
(a) T ading Membe s/Pa ticipants shall ensu e that the fiducia y and othe  oblig
ations imposed on them and
thei  staff by the va ious statuto y acts, ules and egulations is complied wit
h.
(b) T ading Membe s/Pa ticipants shall ensu e –
(i) that any employee who commits the T ading Membe s o  Pa ticipants to a t ans
action has the
necessa y autho ity to do so.
(ii) that employees a e adequately t ained in ope ating in the elevant ma ket s
egment in which they
deal, a e awa e of thei  own, and thei  o ganization’s esponsibilities as well as
the elevant statuto y
acts gove ning the T ading Membe , the Rules, Regulations and Bye-laws of the Cu
ency De ivatives
Segments of the Exchanges including any additions o  amendments the eof.
(c) A T ading Membe  shall be esponsible fo  all the actions including t ades o
iginating th ough o  with the
use of all following va iables - T ading Membe  Id and Use  Id, at that point of
time. Howeve  if the T ading
Membe  satisfies the Cu ency De ivatives Segment of the Exchanges that the acti
on(s) and/o  t ade(s) took
place due to f aud o  mis ep esentation by any othe  pe son othe  than his autho
ized pe son(s) and that the
action(s) and/o  t ades did not o iginate f om any of his app oved wo kstations,
the Cu ency De ivatives
74
Segment of the Exchanges may issue such di ections as they conside s just and e
asonable. The di ections
may include efe ing the matte  to a bit ation and/o  annulment of t ade(s) so
affected.
(d) When ente ing into t ansactions on behalf of constituents, the T ading Membe
s shall ensu e that they
abide by the Code of Conduct and egulations.
(e) No T ading Membe  o  pe son associated with a T ading Membe  shall make imp 
ope  use of constituent’s
secu ities/positions in de ivatives cont acts o  funds.
(f) No T ading Membe  shall publish and ci culate o  cause to be published o  ci
culated, any notice, ci cula ,
adve tisement, newspape  a ticle, investment se vice o  communication of any kin
d which pu po ts to epo t
any t ansaction as a pu chase o  sale of any de ivatives cont acts unless such T
ading Membe  can establish if
called fo , that such t ansaction was a bonafide pu chase o  sale of such cont a
ct; o  which pu po ts to quote
the pu chase/sale p ice fo  any de ivatives cont act unless such T ading Membe 
can establish if called fo  that
such quotation ep esents a bonafide o de  of such de ivatives cont act.
(g) When ente ing into o  a anging a t ansaction, T ading Membe s must ensu e t
hat at all times g eat ca e is
taken not to mis ep esent in any way, the natu e of t ansaction.
(h) No T ading Membe  shall exe cise any disc etiona y powe  in a constituent’s ac
count unless such
constituent has given p io  w itten autho isation to a stated individual o  indi
viduals and the account has been
accepted by the T ading Membe , as evidenced in w iting by the T ading Membe .
(i) A T ading Membe  shall not act as a p incipal o  ente  into any ag eement o 
a angement with a constituent
o  constituent’s agents, employees o  any othe  pe son connected to the constituen
t, employee o  agency,
whe eby special o  unusual ates a e given with an intent to give special o  unu
sual advantage to such
constituent fo  the pu pose of secu ing his business.
(j) The T ading Membe  shall not disclose the name and beneficial identity of a
constituent to any pe son
except to the Cu ency De ivatives Segment of the Exchanges as and when equi ed
by it.
(k) The facility of placing o de s on ‘P o-account’ th ough t ading te minals shall
be availed by the T ading
Membe s only at one location of the T ading Membe s as specified / equi ed by t
he T ading Membe s. Any
t ading te minal located at a place othe  than the above location shall have a f
acility to place o de  only fo  and
on behalf of a Constituent by ente ing client code details as equi ed/specified
by the Exchange / SEBI. In case
any T ading Membe  equi es the facility of using ‘P o-account’ th ough t ading te m
inals f om mo e than one
location, such T ading Membe  shall equest the Exchange stating the eason fo 
using the ‘P o-account’ at
multiple locations and the Exchange may, on a case to case basis afte  due dilig
ence, conside  extending the
facility of allowing use of ‘P o-account’ f om mo e than one location.
GENERAL GUIDELINES
A T ading Membe  shall desist f om the following t ading p actices while conduct
ing business on the Cu ency
De ivatives Segment of the Exchanges.
(a) Shielding o  Assisting:
No T ading Membe  shall shield o  assist o  omit to epo t any othe  T ading Mem
be  whom he has known to
have committed a b each o  evasion of any Rules, Bye-Laws o  Regulations of the
Cu ency De ivatives
Segment of the Exchanges o  of any esolution, o de , notice o  di ection the eu
nde  of the Gove ning Boa d o 
the Managing Di ecto  o  of any committee o  office  of the Cu ency De ivatives
Segment of the Exchanges
autho ised in that behalf.
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(b) Suspended De ivatives Cont acts
Except with the pe mission of the Cu ency De ivatives Segment of the Exchanges,
business shall not be
t ansacted by the T ading Membe  in de ivatives cont acts which have been suspen
ded f om official quotation.
(c) Misleading T ansactions
A T ading Membe  shall not -
(i) make bids and/o  offe s fo  de ivatives cont acts with an intention of c eat
ing a false o  misleading
appea ance with espect to the ma ket fo , o  the p ice of any de ivatives cont 
acts,
(ii) make a t ansaction o  give an o de  fo  the pu chase o  sale of de ivatives
cont acts, the execution of which
would involve no change of beneficial owne ship, unless the T ading Membe  had n
o knowledge that the
t ansaction would not involve a change in the beneficial owne ship of de ivative
s cont acts.
(d) Use of Info mation obtained in Fiducia y Capacity
A T ading Membe  who in the capacity of paying agent, t ansfe  agent, t ustee, o
 in any othe  simila  capacity,
has eceived info mation as to the pu chase/sale of de ivatives cont acts, shall
unde  no ci cumstance make
use of such info mation fo  the pu pose of soliciting pu chases/sales except at
the equest and on behalf of the
issue , if any.
9.3 GRIEVANCE REDRESSAL MECHANISM FOR INVESTORS
Each Exchange has a p ocess fo  G ievance Red essal. The gene al featu es of the
se p ocesses a e
mentioned below.
Investo  G ievance Resolution Mechanism (against t ading membe s)
All exchanges have a dedicated depa tment to handle g ievances of investo s agai
nst the T ading Membe s
and Issue s. Gene ally these depa tments ope ate f om all offices of the exchang
e so as to p ovide easy
access to investo s. All exchanges also have supe vision mechanisms fo  the func
tioning of this depa tment/
cell. These include the Investo  Se vice Committees (ISC) consisting of Exchange
officials and independent
expe ts whose nomination is app oved by Secu ities and Exchange Boa d of India.
SEBI also monito s
exchange pe fo mance elated to investo  g ievance ed essal.
P ocess
Receipt of Complaints
The investo  is equi ed to submit his complaint in the p esc ibed complaint fo 
m against the t ading membe 
p oviding the details as specified in the inst uctions annexed to the complaint
egist ation fo m along with
suppo ting documents substantiating his claim.
On eceipt of the complaint, exchanges sc utinize the natu e of complaint and ad
equacy of documents
submitted along with the complaint. If all the elevant documents a e submitted,
the complaint is eco ded, a
complaint numbe  is assigned and an acknowledgement towa ds eceipt of complaint
is sent to the investo . If
the documents a e inadequate, the investo  is advised to set ight the deficienc
ies in the documents.
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Red essal of Complaints
Gene ally, exchanges initially t y to esolve the complaint by following up with
the membe  and the
complainant. The issues aised by the complainant a e analyzed and the complaint
is taken up the conce ned
t ading membe  fo  esolution / esponse within the set timef ame. Subsequently,
the esponse eceived f om
the t ading membe  is eviewed.
• If the T ading Membe  has ag eed with the contents of the complaint, he is advis
ed to settle the
matte  immediately and confi m
• If the T ading Membe  states that he has al eady settled the complaint, p oof of
settlement is
solicited and c oss confi mation is obtained f om the investo 
• If the T ading Membe  aises issues f om his side, the comments a e analyzed and
fo wa ded to the
investo  fo  his views and comments. If diffe ences pe sist the Exchange holds m
eeting with the
pa ties at the Exchange p emises fo  expeditious esolution of the complaints. I
ncase diffe ences
still pe sist the investo  is info med that he may opt fo  A bit ation p oceedin
gs.
• If the T ading Membe  has justifiable easons fo  his actions which a e within t
he egulato y
f amewo k, the investo  is enlightened on the co ect position on the matte .
Natu e of Complaints
Exchanges p ovide assistance if the complaints fall within the pu view of the Ex
change and a e elated to
t ades that a e executed on the Exchange Platfo m. These may be of the following
types:
• Non-Receipt of Co po ate Benefit (Dividend/Inte est/Bonus etc.)
• Complaints against t ading membe s on account of the following :
◊ Non-receipt of funds / securities
◊ Non- receipt of documents such as member client agreement, contract notes,
settlement of accounts, order trade log etc.
◊ Non-Receipt of Funds / Securities kept as margin
◊ Trades executed without adequate margins
◊ Delay /non – receipt of funds
◊ Squaring up of positions without consent
◊ Unauthorized transaction in the account
◊ Excess Brokerage charged by Trading Member / Sub-broker
◊ Unauthorized transfer of funds from commodities account to other accounts etc.
• Complaints in cases where the member has surrendered his membership and the comp
lainant has
approached the Exchange before expiry of the time mentioned in the public notice
Exchanges may not take up the following types of complaints
a. Complaints in respect of transactions which are already subject matter of Arb
itration proceedings,
b. Complaints involving payment of funds and transfer of securities to entities
other than Trading
Member,
77
c. Claims for mental agony/harassment and expenses incurred for pursuing the mat
ter with the ISC,
d. Claims for notional loss, opportunity loss for the disputed period or trade,
e. Complaints pertaining to trades not executed on the Exchange by the complaina
nt,
f. Claims of sub-broker/authorized persons for private commercial dealings with
the trading member,
g. Claims relating to transactions which are in the nature of loan or financing
which are not within the
framework defined by the Exchange.
Arbitration
SEBI has instructed the exchange to have arbitration committees so that differen
ces, disputes and claims
between trading members and investors can be settled effectively and in a short
time. Arbitration is also
governed by Exchange Bye-laws.
Arbitration is a quasi judicial process of settlement of disputes between Tradin
g Members, Investors, Subbrokers
& Clearing Members and between Investors and Issuers (Listed Companies). General
ly the application
for arbitration has to be filed at the Arbitration Centres established by the ex
changes.
The parties to arbitration are required to select the arbitrator from the panel
of arbitrators provided by the
Exchange. The arbitrator conducts the arbitration proceeding and passes the awar
d normally within a period of
three months from the date of initial hearing.
The arbitration award is binding on both the parties. However, the aggrieved par
ty, within fifteen days of the
receipt of the award from the arbitrator, can file an appeal to the arbitration
tribunal for re-hearing the whole
case. On receipt of the appeal, the Exchange appoints an Appellate Bench consist
ing of five arbitrators who rehear
the case and then give the decision. The judgment of the Bench is by a ‘majority’ an
d is binding on both
the parties. The final award of the Bench is enforceable as if it were the decre
e of the Court.
Any party who is dissatisfied with the Appellate Bench Award may challenge the s
ame only in a Court of Law.
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APPENDIX A SAFEGUARDS FOR INVESTORS
Investors must understand the process that is required to be followed while tran
sacting on exchanges. 
Investors must also be aware of their rights vis- -vis trading members. The follow
ing section contains some of
these processes that must be understood before trading in the securities market.
1. Selecting a Broker/ Sub - Broker
Investors must deal only with a SEBI registered Broker / Sub - broker after due
diligence. Details of
the registered brokers can be obtained from the Exchange websites.
2. Entering into an Agreement with the Trading member (broker)/ Sub-broker
Investors must:
• Fill in a Client registration form with the Broker / Sub - broker
• Enter into Broker / Sub - broker - Client Agreement. This agreement is mandatory
for all investors
for registering as a client of a Trading Member.
• Ensure the following before entering into an agreement:
• Carefully read and understand the terms and conditions of the agreement before e
xecuting the
same on a valid stamp paper of the requisite value.
• Agreement must be signed on all the pages by the Client and the Member or their
representative
who has the authority to sign the agreement. Agreement has also to be signed by
the witnesses by
giving their names and addresses.
• Investors must note that Regulatory Authorities have not stipulated for executio
n of any document
other than Broker/ Sub - Broker / Client Agreement.
3. Transacting
Investors must:
• Specify to the Broker / Sub - broker, the exchange through which the trade is to
be executed and
maintain separate account for each exchange.
• Obtain a valid Contract Note from the Broker / Sub-broker within 24 hours of the
execution of the
trade.
Contract note is a confirmation of trade(s) done on a particular day for and on
behalf of a client in
the prescribed format. It establishes a legally enforceable relationship between
the Trading Member
and his Client in respect of settlement of trades executed on the exchange as st
ated in the Contract
Note.
Contract Notes are made in duplicate, and the Trading Member and Client, both ar
e provided one
copy each. The Client is expected to sign on the duplicate copy of the Contract
Note, confirming
receipt of the original. The following are the prescribed types of contract note
s.
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◊ Contract Note - Form A - Contract Note issued where Member is acting for
constituents as brokers/ agents.
◊ Contract Note - Form B - Contract Note issued by Members dealing with
constituents as principals.
• Ensure that the Contract Note:
◊ Contains SEBI registration number of the Trading Member/ Sub – broker.
◊ Contains details of trade such as, Order number, trade number, trade time, quant
ity,
price, brokerage, settlement number, and details of other levies.
◊ Shows trade price separately from the brokerage charged.
◊ Shows brokerage within SEBI stipulated limits. As stipulated by SEBI, the maximu
m
brokerage that can be charged is 2.5% of the contract price. This maximum
brokerage is inclusive of the brokerage charged by the sub-broker (Sub-brokerage
cannot exceed 1.5% of the contract price). Additional charges that a Trading
Member can charge include Service Tax on the brokerage, any penalties arising on
behalf of client and Securities Transaction Tax (STT).
◊ The brokerage, service tax and STT are indicated separately in the Contract Note
.
◊ Contains signature of authorised representative of the broker.
◊ Contains arbitration clause stating jurisdiction of relevant courts.
4. Settlement
Investors must:
• Ensure delivery of securities/ payment of money to the broker immediately upon g
etting the
Contract Note for sale / purchase but in any case, before the prescribed pay-in-
day.
• Give the Depository Participant (DP), Delivery out instructions to transfer th
e same from the
beneficiary account to the pool account of broker through whom shares and securi
ties have been
sold, so as to deliver securities from ‘demat’ account.
The instructions must contain: details of the pool a/c of broker to which the sh
ares are to be
transferred, details of security, quantity etc.
As per the requirement of depositories the Delivery out Instruction should be
given at least 48
hours prior to the cut-off time for the prescribed securities ‘pay-in’.
• Give the Depository Participant (DP) ‘Delivery in instructions to accept shares i
n beneficiary
account from the pool account of broker through whom shares have been purchased,
so as to
receive shares in the demat account.
• Ensure that the members pay the money or securities to the investor within 24 ho
urs of the payout.
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GENERAL DO S AND DON’TS FOR INVESTORS
Investors must follow some Do’s and Don’ts while transacting in the securities marke
t. Given below are some
general Do’s and Don’ts for investors:
Do’s
Investors must:
• Always deal with the market intermediaries registered with SEBI / stock exchange
s.
• Carry out due diligence before registering as client with any intermediary. Care
fully read and
understand the contents stated in the Risk Disclosure Document, which forms part
of the investor
registration requirement for dealing through brokers.
• Collect photocopies of all documents executed for registration as a client, imme
diately on its
execution.
• Ensure that the documents or forms for registration as Client are fully filled i
n.
• Give clear and unambiguous instructions to their broker / agent / depository par
ticipant.
• Always insist on contract notes from their brokers/sub-brokers. In case of doubt
in respect of the
transactions, verify the genuineness of the same from the exchange.
• Always settle the dues through the normal banking channels with the market inter
mediaries.
• Adopt trading / investment strategies commensurate with their risk-bearing capac
ity as all
investments carry some risk, the degree of which varies according to the investm
ent strategy
adopted.
• Be cautious about securities which show a sudden spurt in price or trading activ
ity, especially low
price stocks.
• Remember that there are no guaranteed returns on investment in the stock market.
• Read the terms and conditions and understand the risk factors associated with th
e commodity
market investment
• Always keep copies of all investment documentation (e.g. application forms, ackn
owledgements
slips, contract notes).
• Send important documents by a reliable mode (preferably through registered post)
to ensure
delivery.
• Ensure that they have money and will be able to pay, before you buy.
• Ensure that they hold securities and will be able to deliver, before they sell.
• Follow up diligently and promptly e.g. If the required documentation is not rece
ived within a
reasonable time, investors must contact the concerned person at the Trading Memb
er immediately.
82
Don’ts
Investors must not:
• Deal with unregistered brokers / sub - brokers, or other unregistered intermedia
ries.
• Execute any documents with any intermediary without fully understanding its term
s and conditions.
• Leave the custody of their Demat Transaction slip book in the hands of any inter
mediary.
• Make any payments in cash
• Accept unsigned/ duplicate or incomplete contract notes
• Deal based on rumours or tips .
• Get swayed by promises of high returns.
• Fall prey to promises of guaranteed returns.
• Get misled by guarantees of repayment of their investments through post-dated ch
eques.
• Get carried away by luring advertisements of any nature in print and electronic
media.
• Blindly follow media reports on corporate developments, as some of these could b
e misleading.
• Blindly imitate investment decisions of others who may have profited from their
investment
decisions.
• Forgo obtaining all documents of transactions, in good faith even from people wh
om they ‘know’.
• Delay approaching concerned authorities in case of a dispute. Written complaints
must be filed with
the Exchange as soon as possible.
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APPENDIX B SAMPLE QUESTIONS
1) The market where currencies are traded is known as the ______.
(a) Equity Market
(b) Bond Market
(c) Fixed Income Market
(d) Foreign Exchange Market
2) The USD/CAD (US – Canadian Dollars) currency pair settles in _____ basis.
(a) T+1
(b) T+2
(c) T+3
(d) T+4
3) A derivatives contract cannot exist without an ________.
(a) Exchange
(b) Underlying, be it equity, interest rate etc.
(c) Increase in volatility
(d) Increase in arbitrage
4) The first participants who traded in derivatives where those exposed to _____
_____.
(a) Exchange rate risk
(b) Interest Rate risk
(c) Equity price risk
(d) Commodity price risk
5) OTC Derivatives stand for ________.
(a) Over the Counter Derivatives
(b) Outstanding Transaction Credit Derivatives
(c) Options Trade Credit Derivatives
(d) Commodity price risks
6) There are no formal rules or mechanisms for ensuring market stability and int
egrity, and for safeguarding the
collective interests of market participants. Which type of Derivatives contracts
are being referred to here?
(a) Over the Counter Derivatives
(b) Exchange traded derivatives
(c) Stock Futures
(d) Commodity derivatives
7) In a currency pair, term currency is in the:
(a) Numerator
(b) Denominator
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8) Bids and offers are for the:
(a) Counter Currency
(b) Term Currency
(c) Base Currency
(d) All the above
9) A quotation for “dollar-rupee” means the dollar is the:
(a) Counter Currency
(b) Term Currency
(c) Base Currency
(d) All the above
10) For most currencies, bid and offer quotes are presented to the fourth decima
l place usually called a:
(a) Value
(b) Quotes
(c) Unit
(d) Pip
11) The forward rate for any two currencies is generally a function of their spo
t rate and:
(a) Trade Difference
(b) Difference in the exchange rate
(c) Interest rate differential between them
(d) Both B and C
12) The underlying for futures contract that is presently permitted in India is:
(a) USD/INR
(b) Euro/Dollar
(c) Dollar/Yen
(d) Euro/INR
13) Closing price of USD/INR futures contract at the end of an active trading se
ssion will be calculated based
on the:
(a) Weighted average of the last 30 trades done in the last 60 minutes
(b) Weighted average of the last 5 trades done in the last 60 minutes
(c) Weighted average of all the trades done in the last 30 minutes
(d) Simple average of the last 30 trades done in the last 30 minutes
14) In Exchange-traded currency futures contracts, who acts as a central counter
party to all trades?
(a) Government
(b) Regulator
(c) Market Maker
(d) Clearing House
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15) If the numbers of trades during the last 30 minutes are less than 5, then th
e closing price is based on the:
(a) Weighted average price of the last 5 trades executed during the day.
(b) Weighted average price of the last 10 trades executed during the day.
(c) Weighted average price of the last 15 trades executed during the day.
(d) Weighted average price of the last 25 trades executed during the day.
16) If the numbers of trades during the day are less than 5, then the closing pr
ice is taken as the:
(a) Weighted average price of the last 3 trades executed during the day.
(b) Weighted average price of the last 4 trades executed during the day.
(c) Weighted average price of the last 2 trades executed during the day.
(d) Weighted average of all trades executed during the day
17) Exchanges in India trade in Currency Options. True or False?
(a) True
(b) False
18) Arbitragers take advantage of ____ in the markets?
(a) Hedgers
(b) Volatility
(c) Mispricing
(d) Speculators
19) On 15th January Mr. Arvind Sethi bought a January USD/INR futures contract w
hich cost him Rs.43,000.
Each USD/INR futures contract is for delivery of USD1000. The RBI reference rate
for final settlement was
fixed as 43.10. How much profit/loss did he make?
(a) (+) Rs. 1000
(b) (+) Rs. 100
(c) (-) Rs.100
(d) (-) Rs. 1000
20) If you are bullish about the Indian Rupee, you would ____.
(a) Short USD/INR currency futures
(b) Go long USD/INR currency futures
(c) Buy Dollars
(d) Say neutral since markets may turn volatile
21) Presume Mr. A is expecting a remittance for USD 5000 on 29 August. Wants to
lock in the foreign
exchange rate today so that the value of inflow in Indian Rupee terms is safegua
rded. Mr. A can do so by
________.
(a) Buying five contracts of USD/INR futures
(b) Selling five contracts of USD/INR futures
(c) Selling five thousand contracts of USD/INR futures
(d) Buying five thousand contracts of USD/INR futures
86
22) On August 1, 2008, an active trader in the currency futures market expects I
NR will appreciate against
USD, caused by softening of crude oil prices in the international market and hen
ce helping India’s trade
balance. On the basis of his view, he should:
(a) Go long on USD/INR futures contract
(b) Go short on USD/INR futures contract
(c) Do nothing
(d) Both A and B
23) One year interest rates in US and India are say 5% and 10% respectively and
the spot rate of USD in
India is Rs. 43. Then one year USD/INR futures fair value is :
(a) Rs. 41.25
(b) Rs. 43.70
(c) Rs. 45.20
(d) Rs. 41.63
24) Under normal circumstances the Futures price trades at a ____ price than the
Spot price :
(a) Higher
(b) Lower
(c) Same price as spot
(d) Depends on the type of contract
25) Clearing Members are entities in the clearing and settlement system of the C
urrency Derivatives Segment.
True or False?
(a) True
(b) False
26) There are designated currency future’s market makers assigned for making marke
ts in the Currency
Derivatives Market Segment. True or False?
(a) True
(b) False
27) For stop-loss buy order, the trigger price is ______ the limit price.
(a) Less than
(b) Greater than
(c) Equal to
(d) None of the above
28) If a day order does not find a match in the trading system, it is _____
(a) Removed from the trading system after seven days
(b) Removed from the trading system at the end of the day
(c) Removed from the trading system on the expiry day
(d) Removed from the trading system when the buyer / seller wishes
87
29) A client of a trading member is required to enter into _____ with the tradin
g member before he can
commence trading.
(a) An understanding
(b) An arrangement
(c) Negotiations
(d) An agreement
30) A trading member has more than one user.
(a) True
(b) False
31) A Trading Member can trade __________
(a) on their own account
(b) on behalf of their clients
(c) on behalf of participants
(d) all of the above
32) While entering a stop loss order, one needs to specify the _____
(a) High price
(b) Trigger price
(c) Low price
(d) Price band
33) The limit price is necessarily set higher than the market price irrespective
of buy/sell trade.
(a) True
(b) False
34) For stop-loss buy order, the trigger price is ______ the limit price
(a) Less than
(b) Greater than
(c) Equal to
(d) None of the above
35) An Indian refiner enters into a contract to export 1000 barrels of oil with
payment to be received in US
Dollar (USD) in next three months. His risk is:
(a) When INR weakens, he makes a loss
(b) When INR weakens, he makes a profit
(c) When INR strengthens, he makes a profit
(d) When INR strengthens, he makes a loss
88
36) An exchange, during a trading session disseminates ______ prices through its
trading system in real time
basis
(a) open
(b) high and low
(c) last traded
(d) all of the above
37) For a USD/INR Currency Futures contract, the previous day s settlement price
is Rs.41.0000 and today s
settlement price is Rs.40.0000. An investor s ‘Sell’ position of 30 contracts is bro
ught forward from the
previous day. What will be his market to market settlement value?
(a) (-) Rs. 30,000
(b) (+) Rs. 30,000
(c) (-) Rs. 3,000
(d) (+) Rs. 3,000
38) Proprietary position : Buy 20*1000*40.0000 indicates :
(a) A Buy position of 20 contracts with contract size of 1000 and a price of Rs.
40.0000
(b) A Buy position of 1000 contracts with contract size of 20 and a price of Rs.
40.0000
(c) A Buy position of 2000 contracts with contract size of 1000 and a price of R
s. 40.0000
(d) A Buy position of 20000 contracts a price of Rs. 40.0000
39) In the Currency Derivatives Segment, clients positions are arrived at by su
mming together _____positions
of each individual client.
(a) Gross (buy + sell)
(b) Net (buy - sell)
(c) Net or Gross
(d) Client’s positions are not taken into account in the Currency Derivatives Segm
ent
40) For a USD/INR Currency Futures contract, the previous day s settlement price
is Rs.40.0000 and today s
settlement price is Rs.41.0000. An investor s ‘Sell’ position of 50 contracts is bro
ught forward from the
previous day. What will be his market to market settlement value?
(a) (-) Rs. 50,000
(b) (+) Rs. 50,000
(c) (-) Rs. 5,000
(d) (+) Rs. 5,000
PLEASE NOTE THAT THESE ARE ONLY SAMPLE QUESTIONS PROVIDED AS A GUIDE TO
CANDIDATES AND MAY NOT BEAR ANY RESEMBLANCE TO QUESTIONS IN THE CERTIFICATION
EXAMINATION.
89
ANSWERS
1 (d) 21 (b)
2 (a) 22 (b)
3 (b) 23 (c)
4 (d) 24 (a)
5 (a) 25 (a)
6 (a) 26 (b)
7 (b) 27 (a)
8 (c) 28 (b)
9 (c) 29 (d)
10 (d) 30 (a)
11 (c) 31 (d)
12 (a) 32 (b)
13 (c) 33 (b)
14 (d) 34 (b)
15 (a) 35 (d)
16 (d) 36 (d)
17 (b) 37 (b)
18 (c) 38 (a)
19 (b) 39 (b)
20 (a) 40 (a)
Disclaimer: Please note that NISM modifies the list of sample questions from tim
e to time. Candidates are
advised to compare questions and answers with the latest version of sample quest
ions from the NISM website.
Please visit www.nism.ac.in for more information about NISM and NISM Certificati
on Examinations.
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91
APPENDIX C EXCHANGES TRADING IN CURRENCY FUTURES
Bombay Stock Exchange Ltd., popularly known as BSE, is the oldest stock exchange
in Asia with a rich
heritage. It was established as "The Native Share & Stock Brokers Association"
in 1875. BSE s pivotal and
pre-eminent role in the development of the Indian capital market is widely recog
nized. Today, BSE is the
world s number ‘1’ exchange in terms of the number of listed companies and the world
s 5th in transaction
numbers. The BSE Index, SENSEX, is India s first stock market index that enjoys
an iconic stature, and is
tracked worldwide. BSE provides an efficient and transparent market for trading
in equity, debt instruments and
derivatives. It has a nation-wide reach with a presence in more than 359 cities
and towns of India. BSE also
offers Currency Futures trading (US Dollar- Indian Rupee contracts currently) th
rough its Currency Derivatives
Segment christened BSE-CDX. For more information please visit www.bseindia.com.
Bombay Stock Exchange (BSE)
MCX Stock Exchange Ltd. (MCX – SX) has been promoted by Multi Commodity Exchange o
f India Ltd. (MCX)
and Financial Technologies (India) Ltd (FTIL). MCX - SX’s currency derivatives seg
ment commenced
operations on
MCX Stock Exchange Ltd. (MCX – SX)
October, 2008, within the regulatory framework of Securities & Exchange Board of
India (SEBI)
and Reserve Bank of India (RBI). The all-India electronic trading platform of MC
X-SX offers participants the
benefits of high liquidity, trade transparency, easy online accessibility and co
unterparty guarantee through
MCX – SX Clearing Corporation Ltd. (MCX-SX CCL), established on the lines of globa
l clearing corporations.
MCX-SX has emerged as the first exchange in India to provide currency futures ra
tes on a real-time basis
through mobile across all service providers, to publish a primer on currency fut
ures trade for guidance of
interested parties and to launch websites in various regional languages. MCX – SX
has also signed MOUs with
various trade associations across India. For more information please visit www.m
cx-sx.com.
National Stock Exchange (NSE) commenced operations in 1994 and provides a nation
wide electronic trading
platform for various types of securities for investors under one roof. These ins
truments are available for trading
under different segments: Wholesale Debt Market Segment; Capital Market Segment,
Futures and Options
Segment and Currency Derivatives Segment. Derivatives trading at NSE commenced i
n the year 2000, and the
product base includes trading in futures and options on S&P CNX Nifty Index, CNX
IT Index, Bank Nifty Index,
CNX Nifty Junior Index, CNX 100 Index, Nifty Midcap 50 Index, S&P CNX Defty Inde
x ; futures and options on
around 200 single stocks; and currency futures on the USD/INR contracts presentl
y. NSE’s trading presence is
now in over 1,500 cities across India. NSE ranks
National Stock Exchange (NSE)
in the world, in terms of number of transactions executed on
a stock exchange; 2nd in the world, in terms of the number of contracts traded i
n Single Stock Futures; 3rd in
the world, in terms of number of contracts traded, in Stock Index Futures; and 2
nd in Asia, in terms of number
of contracts traded, in equity derivatives instrument. For more information plea
se visit www.nseindia.com.
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93
LIST OF ABBREVATIONS
AG Aggregate Gap
CAD Canadian Dollar
CBOT Chicago Board of Trade
CM Clearing Member
CME Chicago Mercantile Exchange
CRAR Capital Risk Adjusted Ratio
CRR Cash Reserve Ratio
DP Depository Participant
ETCF Exchange Traded Currency Futures
FEDAI Foreign Exchange Dealers Association of India
FEMA Foreign Exchange Management Act
FIFO First-in First-out
FII Foreign Institutional Investor
FX Foreign exchange
GBP Great Britain Pound
GDP Gross Domestic Product
ICAI Institute of Chartered Accountants of India
INR Indian Rupee
IOC Immediate or Cancel
KYC Know Your Customer
LTP Last Traded Price
MTM Mark-to-Market
NOP Net Open Position
NPA Non Performing Assets
NRI Non-resident Indian
OTC Over-the-Counter
PAN Permanent Account Number
PCM Professional Clearing Member
Pro/Cli Proprietary order / Client order
RBI Reserve Bank of India
SC(R)A Securities Contracts (Regulation) Act, 1956
SDR Special Drawing Rights
SEBI Securities and Exchange Board of India
SPAN Standard Portfolio Analysis of Risk
STT Securities Transaction Tax
TCM Trading-cum-Clearing Member
TM Trading Member
TWS Trader Workstation
UCC Unique Client Code
USD Us Dollar
USD/INR US Dollar – Indian Rupee Forex Transaction
VaR Value-at-Risk
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