Each country has its own currency through which both national and international transactions are performed. All the international business transactions involve an exchange of one currency for another. For example, If any Indian firm borrows funds from international financial market in US dollars for short or long term then at maturity the same would be refunded in particular agreed currency along with accrued interest on borrowed money. It means that the borrowed foreign currency brought in the country will be converted into Indian currency, and when borrowed fund are paid to the lender then the home currency will be converted into foreign lenders currency. Thus, the currency units of a country involve an
exchange of one currency for another. The price of one currency in terms of other currency is known as exchange rate. The foreign exchange markets of a country provide the mechanism of exchanging different currencies with one and another, and thus, facilitating transfer of purchasing power from one country to another. With the multiple growths of international trade and finance all over the world, trading in foreign currencies has grown tremendously over the past several decades. Since the exchange rates are continuously changing, so the firms are exposed to the risk of exchange rate movements. As a result the assets or liability or cash flows of a firm which are denominated in foreign currencies undergo a change in value over a period of time due to variation in exchange rates. This variability in the value of assets or liabilities or cash flows is referred to exchange rate risk. Since the fixed exchange rate system has been fallen in the early 1970s, specifically in developed countries, the currency risk has become substantial for many business firms. As a result, these firms are increasingly turning to various risk hedging products like foreign currency futures, foreign currency forwards, foreign currency options, and foreign currency swaps.
Currency futures were first created at the Chicago Mercantile Exchange (CME) in 1972.The contracts were created under the guidance and leadership of Leo Melamed, CME Chairman Emeritus. The FX contract capitalized on the U.S. abandonment of the Bretton Woods agreement, which had fixed world exchange rates to a gold standard after World War II. The abandonment of the Bretton Woods agreement resulted in currency values being allowed to float, increasing the risk of doing business. By creating another type of market in which futures could be traded, CME currency futures extended the reach of risk management beyond commodities, which were the main derivative contracts traded at CME until then. The concept of currency futures at CME was revolutionary, and gained credibility through endorsement of Nobel-prize-winning economist Milton Friedman.
Today, CME offers 41 individual FX futures and 31 options contracts on 19 currencies, all of which trade electronically on the exchanges CME Globex platform. It is the largest regulated marketplace for FX trading. Traders of CME FX futures are a diverse group that includes multinational corporations, hedge funds, commercial banks, investment banks, financial managers, commodity trading advisors (CTAs), proprietary trading firms; currency overlay managers and individual investors. They trade in order to transact business, hedge against unfavorable changes in currency rates, or to speculate on rate fluctuations. Source: - (NCFM-Currency future Module)
forwards, futures, options and swaps. We take a brief look at various derivatives contracts that have come to be used. FORWARD :
The basic objective of a forward market in any underlying asset is to fix a price for a contract to be carried through on the future agreed date and is intended to free both the purchaser and the seller from any risk of loss which might incur due to fluctuations in the price of underlying asset.
A forward contract is customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price. The exchange rate is fixed at the time the contract is entered into. This is known as forward exchange rate or simply forward rate. FUTURE :
A currency futures contract provides a simultaneous right and obligation to buy and sell a particular currency at a specified future date, a specified price and a standard quantity. In another word, a future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Future contracts are special types of forward contracts in the sense that they are standardized exchange-traded contracts.
SWAP :
Swap is private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolio of forward contracts.
The currency swap entails swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. There are a various types of currency swaps like as fixed-to-fixed currency swap, floating to floating swap, fixed to floating currency swap.
(1) Initial exchange of principal amount (2) Ongoing exchange of interest (3) Re - exchange of principal amount on maturity. OPTIONS :
Currency option is a financial instrument that give the option holder a right and not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period ( until the expiration date ). In other words, a foreign currency option is a contract for future delivery of a specified currency in exchange for another in which buyer of the option has to right to buy (call) or sell (put) a particular currency at an agreed price for or within specified period. The seller of the option gets the premium from the buyer of the option for the obligation undertaken in the contract. Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer dated options are called warrants and are generally traded OTC.
Non Bank entities i.e. the customers who wish to exchange currencies to contractual obligations i.e. arising from exports, imports, remittances etc. Commercial Banks which exchange currencies to meet client requirements.
meet
Central Banks which in most countries are charged with the responsibility of maintaining the external value of the currency of the country.Apart from the intervention, Central Banks deal in Foreign Exchange markets for the purpose of Exchange Rate Management and Reserve Management. Exchange brokers play a very important role in the foreign exchange market. Speculators buying and selling currencies in the hope of profiting from price movement. Besides these entities, Commercial Companies, Hedge Funds as well as Investment Management Firms play a very vital role in the Foreign Exchange Market.
Hedgers:Example
Presume Entity A is expecting a remittance for USD 1000 on 27 August 08. Wants to lock in the foreign exchange rate today so that the value of inflow in Indian rupee terms is safeguarded. The entity can do so by selling one contract of USDINR futures since one contract is for USD 1000. Presume that the current spot rate is Rs.43 and USDINR 27 Aug 08 contract is trading at Rs.44.2500. Entity A shall do the following: Sell one August contract today. The value of the contract is Rs.44,250. Let us assume the RBI reference rate on August 27, 2008 is Rs.44.0000. The entity shall sell on August 27, 2008, USD 1000 in the spot market and get Rs. 44,000. The futures contract will settle at Rs.44.0000 (final settlement price = RBI reference rate). The return from the futures transaction would be Rs. 250, i.e. (Rs. 44,250 Rs. 44,000). As may be observed, the effective rate for the remittance received by the entity A is Rs.44. 2500 (Rs.44,000 + Rs.250)/1000, while spot rate on that date was Rs.44.0000. The entity was able to hedge its exposure.
Assuming he buys USD 10000, it would require an investment of Rs.4,20,000. If the exchange rate moves as he expected in the next three months, then he shall make a profit of around Rs.10000.This works out to an annual return of around 4.76%. It may please be noted that the cost of funds invested is not considered in computing this return.A speculator can take exactly the same position on the exchange rate by using futures contracts. Let us see how this works. If the INR USD is Rs.42 and the three month futures trade at Rs.42.40. The minimum contract size is USD 1000. Therefore the speculator may buy 10 contracts. The exposure shall be the same asabove USD 10000. Presumably, the margin may be around Rs.21, 000. Three months later if the Rupee depreciates to Rs. 42.50 against USD, (on the day of expiration of the contract), the futures price shall converge to the spot price (Rs.42.50) and he makes a profit of Rs.1000 on an investment of Rs.21, 000. This works out to an annual return of 19 percent. Because of the leverage they provide, futures form an attractive option for speculators.
Arbitragers:Example
Arbitrage is the strategy of taking advantage of difference in price of the same or similar product between two or more markets. That is, arbitrage is striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. If the same or similar product is traded in say two different markets, any entity which has access to both the markets will be able to identify price differentials, if any. If in one of the markets the product is trading at higher price, then the entity shall buy the product in the cheaper market and sell in the costlier market and thus benefit from the price differential without any additional risk. One of the methods of arbitrage with regard to USD-INR could be a trading strategy between forwards and futures market. As we discussed earlier, the futures price and forward prices are arrived at using the principle of cost of carry. Such of those entities who can trade both forwards and futures shall be able to identify any mis-pricing between forwards and futures. If one of them is priced higher, the same shall be sold while simultaneously buying the other which is priced lower. If the tenor of both the contracts is same, since both forwards and futures shall be settled at the same RBI reference rate, the transaction shall result in a risk less profit.
Purchase price: Price increases by one tick: New price: Purchase price: Price decreases by one tick: New price:
The value of one tick on each contract is Rupees 2.50. So if a trader buys 5 contracts and the price moves up by 4 tick, she makes Rupees 50. Step 1: Step 2: Step 3: 42.2600 42.2500 4 ticks * 5 contracts = 20 points 20 points * Rupees 2.5 per tick = Rupees 50
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FUTURE TERMINOLOGY
SPOT PRICE : The price at which an asset trades in the spot market.The transaction in which securities and foreign exchange get traded for immediate delivery. Since the exchange of securities and cash is virtually immediate, the term, cash market, has also been used to refer to spot dealing. In the case of USDINR, spot value is T + 2. FUTURE PRICE : The price at which the future contract traded in the future market.
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CONTRACT CYCLE : The period over which a contract trades. The currency future contracts in Indian market have one month, two month, three month up to twelve month expiry cycles. In NSE/BSE will have 12 contracts outstanding at any given point in time. VALUE DATE / FINAL SETTELMENT DATE : The last business day of the month will be termed the value date /final settlement date of each contract. The last business day would be taken to the same as that for inter bank settlements in Mumbai. The rules for inter bank settlements, including those for known holidays and would be those as laid down by Foreign Exchange Dealers Association of India (FEDAI). EXPIRY DATE : It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. The last trading day will be two business days prior to the value date / final settlement date. CONTRACT SIZE : The amount of asset that has to be delivered under one contract.Also called as lot size. In case of USDINR it is USD 1000. BASIS : In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.
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COST OF CARRY : The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance or carry the asset till delivery less the income earned on the asset. For equity derivatives carry cost is the rate of interest. INITIAL MARGIN : When the position is opened, the member has to deposit the margin with the clearing house as per the rate fixed by the exchange which may vary asset to asset. Or in another words, the amount that must be deposited in the margin account at the time a future contract is first entered into is known as initial margin. MARKING TO MARKET : At the end of trading session, all the outstanding contracts are reprised at the settlement price of that session. It means that all the futures contracts are daily settled, and profit and loss is determined on each transaction. This procedure, called marking to market, requires that funds charge every day. The funds are added or subtracted from a mandatory margin(initial margin) that traders are required to maintain the balance in the account. Due to this adjustment, futures contract is also called as daily reconnected forwards. MAINTENANCE MARGIN : Members account are debited or credited on a daily basis. In turn customers account are also required to be maintained at a certain level, usually about 75 percent of the initial margin, is called the maintenance margin. This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.
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Trading Hours
The trading on currency futures would be available from 9 a.m. to 5 p.m.
Quotation
The currency futures contract would be quoted in rupee terms. However, the outstanding positions would be in dollar terms.
Available contracts
All monthly maturities from 1 to 12 months would be made available.
Settlement mechanism
The currency futures contract shall be settled in cash in Indian Rupee.
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Settlement price
The settlement price would be the Reserve Bank Reference Rate on the date of expiry. The methodology of computation and dissemination of the Reference Rate may be publicly disclosed by RBI.
The contract specification in a tabular form is as under: Underlying Trading Hours (Monday to Friday) Contract Size Tick Size Trading Period Contract Months Final Settlement date/ Value date Last Trading Day Settlement Final Settlement Price Rate of exchange between one USD and INR 09:00 a.m. to 05:00 p.m. USD 1000 0.25 paisa or INR 0.0025 Maximum expiration period of 12 months 12 near calendar months Last working day of the month (subject to holiday calendars) Two working days prior to Final Settlement Date Cash settled The reference rate fixed by RBI two working days prior to the final settlement date will be used for final settlement
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TRADER ( BUYER )
TRADER ( SELLER )
Purchase order
Sales order
MEMBER ( BROKER )
MEMBER ( BROKER )
It has been observed that in most futures markets, actual physical delivery of the underlying assets is very rare and hardly it ranges from 1 percent to 5 percent.The currency futures contracts are settled in cash in Indian Rupee. Most often buyers and sellers offset their original position prior to delivery date by taking opposite positions. This is because most of futures contracts in different products are predominantly speculative instruments. For example, X purchases American Dollar futures and Y sells it. It leads to two contracts, first, X party and clearing house and second Y party and clearing house. Assume next day X sells same contract to Z, then X is out of the picture and the clearing house is seller to Z and buyer from Y, and hence, this process goes on.
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Currency Forward
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today.[1] This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are exchanged.Theforward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party.Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.A Forward contract is closely related to afutures contract; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets.Forwards also typically have no interim partial settlements or "true-ups" in margin requirements like futures - such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open. However, being traded OTC, forward contracts specification can be customized and may include mark-to-market and daily margining.Hence, a forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain.
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Delivery date
Standardized
Method of transaction
Open auction among buyers and seller on the floor of recognized exchange.
Participants
Banks, brokers, forex dealers, multinational companies, institutional investors, arbitrageurs, traders, etc.
Banks, brokers, multinational companies, institutional investors, small traders, speculators, arbitrageurs, etc.
Maturity
Standardized
Market place
Accessibility
Open to any one who is in need of hedging facilities or has risk capital to speculate
Delivery
Actual delivery has very less even below one percent Highly secured through margin deposit.
Secured
Inter-bank market accessed through Accessibility Telephone High bid-ask spread due to high Price Transparency transaction cost owning to bank Charges Contract Size Customized. Banks prefer forward contracts for at least US$ 1 million
Online electronic trading through leased line, VSAT, Internet Transparent online trading platform ensures uniform real-time price access for all market participants Standard futures contract lot size as low as US$ 1,000 No counterparty default risk due to novation and settlement guarantee by clearing house
Credit Exposure
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Settlement only on maturity date in case of profits from cancelled Settlement forward contracts. Loss to be paid immediately Clients: Higher of 6% of open Proof of underlying import / export exposure Compensating bank balances or credit lines needed (such as FD, Margin Deposits ranges from 5% to 10% depending on the credit profile of client Wider participation by all strata of market participants, including banks, Handled by exchange clearing house with 100% guarantee against default using Value-at-Risk (VaR) measures Bank Guarantee, etc.). Usually Margin is as low as 3% to 5% of total exposure. Tracked on real-time basis Mandatory as per RBI guidelines interest or US$ 5 million Members: Higher of 15% of open interest or US$ 25 million Banks: Higher of 15% of open interest or US$ 100 million Settlement only in INR based on mark-to-market T+1 day basis
Banks, Corporates having mandatory Handled by individual authorised forex intermediaries banks
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NOV 08 DEC 08 JAN 09 FEB 09 MAR 09 APRIL 09 MAY 09 JUNE 09 JULU 09 AUG 09
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CONCLUSION
By far the most significant event in the Indian financial sector during the past decade has been the extraordinary development and expansion of financial derivativesThese instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it. This process has undoubtedly improved national
The currency future gives a safe and standardized contract to its investors and individuals who are aware about the forex market or predict the movement of exchange rates so they will get the right platform for trading in currency future. Because of exchange traded future contract and its standardized nature counter party risk is minimized.
Initially only NSE provided this platform, but now BSE and MCX have also started currency future trading. This shows how currency futures and Forwards cover ground as compared to other available derivative instruments. Not only HNIs, exporters and
importers use this but also individuals who are interested and have knowledge of the forex market can invest in currency futures and forwards
The Currency Futures and Forwards Market in India is very big and as and when the awareness of these markets increases a lot many investors will be attracted to invest in this sector .
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