Research Project An History On Currency Derivatives Finance Essay - Free Essay Example

Sample details Pages: 23 Words: 6919 Downloads: 10 Date added: 2017/06/26 Category Finance Essay Type Cause and effect essay Did you like this example? The money usage spans thousands of years. Earlier many items have been used as commodity money such as precious metals, cowry shells, beads etc. as well as many other things that could be thought of as having some value. Don’t waste time! Our writers will create an original "Research Project An History On Currency Derivatives Finance Essay" essay for you Create order The first people didnt buy goods from other people with money. They used barter. Barter is the exchange of personal possessions of value for other goods that you want. This kind of exchange started at the beginning of humankind and is still used today. From 9,000-6,000 B.C., livestock was often used as a unit of exchange. Later, as agriculture developed, people used crops for barter. For example, one could ask another farmer to trade a pound of apples for a pound of bananas. At about 1200 B.C. in China, cowry shells became the first medium of exchange, or money. The cowry has served as money throughout history even to the middle of this century.   They can be thought of as the original development of metal currency. In addition, tools made of metal, like knives and spades, were also used in China as money.   From these models, coins were developed which are in daily use. The Chinese coins were usually made out of base metals which had holes in them so that these c oins could be put together to make a chain. At about 500 B.C., pieces of silver were the earliest coins.  Ãƒâ€šÃ‚   Eventually in time they took the appearance of today and were imprinted with numerous gods and emperors to mark their value. These coins were first shown in Lydia, or Turkey, during this time, but the methods were used over and over again, and further improved upon by the Greek, Persian, Macedonian, and Roman empires. Not like Chinese coins, which relied on base metals, these new coins were composed from scarce metals such as bronze, gold, and silver, which had a lot of intrinsic value. In 118 B.C., banknotes in the form of leather money were used in China. One-foot square pieces of white deerskin edged in vivid colors were exchanged for goods. This is believed to be the beginning of a kind of paper money. During the ninth century A.D., the Danes in Ireland had an expression To pay through the nose. It comes from the practice of cutting the noses of tho se who were careless in paying the Danish poll tax. From the ninth century to the fifteenth century A.D., in China, the first actual paper currency was used as money. Through this period the amount of currency skyrocketed causing severe inflation. Unfortunately, in 1455 the use of the currency vanished from China. European civilization still would not have paper currency for many years. In 1500, North American Indians engaged in potlach, a term that describes the exchange of gifts at banquets, dances, and various rituals. Since the trading of gifts was so important in figuring the leaders community status, potlach went out of control as the gifts became more extravagant in an effort to surpass others gifts. In 1535, though likely well before this earliest recorded date, strings of beads made from clam shells, called wampum, are used by North American Indians as money. Wampum means white, the color of the clam shells and the beads. In 1816, England made gold a benchmark o f value. This meant that the value of currency was pegged to a certain number of ounces of gold. This would help to prevent inflation of currency. The U.S. went on the gold standard in 1900. Because of the depression of the 1930s, the U.S. began a world wide movement to end tying currency to gold. Today, few nations tie the value of their currency to the price of gold. Other government and financial institutions now try to control inflation. At present, nations continue to change their currencies. For example, the U.S. has already changed its $100 and $20 banknotes. More changes are in the works. Modern money is essentially a token in other words, an abstraction. Paper currency is perhaps the most common type of physical money today. The Sumer civilization developed a large scale economy based on commodity money. The Babylonians and neighboring city states later developed the earliest system of economics as we think of it today, in terms of rules on debt, legal contracts and law codes relating to business practices and private property. Future of money: Tomorrow is already here. Electronic money (or digital cash) is already being exchanged over the Internet. THE PROJECT Each country has own currency through which both national and international business transactions are conducted. All the international business transactions involve exchange of a currency for another. Foreign exchange markets provide the mechanism of exchanging different currencies with one and another, and thus, facilitating business transactions from a country to another. With the growth of international trade, trading in foreign currencies has grown many folds over the past. Since the exchange rates are volatile, trading firms are exposed to the risk of exchange rate fluctuations. As a result the assets or liability or cash flows of a firm which are denominated in foreign currencies change in value over a period of time due to exchange rate variation. The financial environment today has become riskier than before. Firms, which are able to manage these risks effectively are Successful business firms today. Due to changes in the macroeconomic structures, there has been a dra matic increase in the volatility of economic variables such as interest rates, exchange rates, commodity prices etc. Firms must monitor their risks carefully and manage their risks with judicious policies to enjoy a more stable business. Suitable mechanisms to manage and reduce such risks which are influenced by factors external to the business need to be adopted. One of the modern day solutions to manage financial risks is hedging. In this paper I have tried to examine about what are the hedging instruments (Currency Derivatives) available in India and how the business corporations are using currency derivatives as a risk management tool. CURRENCY DERIVATIVES A BRIEF HISTORY Bretton Woods system of administering fixed foreign exchange rates was abolished in favor of market-determination of foreign exchange rates in 1971, and a system of fluctuating exchange rates was introduced. Besides market-determined fluctuations, volatility in other markets around the world prevailed due to increased inflation and the oil crisis. Companies tried hard to come up with the uncertainty in transactions. Thats how financial derivatives foreign currency, interest rate, and commodity derivatives emerged as means of managing risks facing corporations. First ever future contracts were created by The Chicago Mercantile Exchange (CME) created FX futures in the year 1972. Leo Melamed, CME Chairman Emeritus helped creating these contracts by providing necessary guidance and leadership. FX contracts capitalized on the abandonment of the Bretton Woods agreement, which had fixed world exchange rates to a gold standard after World War II by USA. By creating another type of mark et 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. DEVELOPMENT IN INDIA The economic liberalization in early nineties provided the rationale for the introduction of FX derivatives. Business houses started actively approaching foreign markets not only with their products but also as a source of capital and direct investment opportunities. When limited convertibility on the trade account was introduced in 1993, environment became more favorable for the introduction of these products. Hence, the development in the Indian forex derivatives market follows the steps taken to gradually reform the Indian financial markets. The first step towards introduction of derivatives trading in India was the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options securities. SEBI set up a 24 member committee under the chairmanship of Dr. L. C. Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee recommended that the derivatives should be declared as securities so that regu latory framework applicable to trading of securities could also govern trading of derivatives. Trading in index options commenced in June 2001 trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. Standing technical committee was jointly constituted by RBI SEBI to analyze the currency market around the world and lay down the guidelines to introduce Exchange Traded Currency Futures in the Indian market. The committee submitted its report on May 29, 2008. RBI and SEBI issued circulars in this regard on August 06, 2008. Currently, Indian Currency market trades with all the major currencies like USD, EURO, YEN and POUND are traded. The rationale for introducing futures in the Indian context has been outlined in the report of the internal working group of Currency Futures (Reserve Bank of India, April 2008) as follows: The rationale for establishing currency futures market is diverse. Both residents and non-residents purchase domestic currency assets. If the exchange rate remains unchanged from the time of purchase of the asset to its sale, no gains and losses are made out of currency exposures. But if domestic currency depreciates (appreciates) against the foreign currency, the exposure would result in gain (loss) for residents purchasing foreign assets and loss (gain) for non residents purchasing domestic assets. In this backdrop, unpredicted movements in exchange rates expose investors to currency risks. Currency futures enable these companies to hedge their risks. Nominal exchange rates are often random walks with or without drift, while real exchange rates over long run are mean reverting. As such, it is possible that over a long run, the incentive to hedge currency risk may not be large. However, financial planning horizon is much smaller in the long-run, which is typically inter generational in the context of exchange rates. As such, there is a strong need to hedge currency risk and this need has grown diversely with fast growth in cross-border trade and investment flows. The argument for hedging currency risks appear to be natural in case of assets and applies equally to trade in goods and services, which results in income flows with leads and lags and get converted into different currencies at the market rates. Empirically, changes in exchange rate are found to have very low correlations with foreign equity and bond returns. Thus theoretically it should have low portfolio risk. Therefore, sometimes it is argued against the need of hedging currency risks but there is strong empirical evidence to suggest that hedging reduces the volatility of returns and indeed considering the episodic nature of currency returns. There are strong arguments to use instruments to hedge currency risks. Chronological sequence of derivatives in India Date Progress 14 December 1995 NSE asked SEBI for permission to trade index futures. 18 November 1996 SEBI setup L. C. Gupta Committee to draft a policy framework for index futures 11 May 1998 L. C. Gupta Committee submitted report. 7 July 1999 RBI permitted OTC forward rate agreements (FRAs) and interest rate swaps 24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian index. 25 May 2000 SEBI gave permission to NSE and BSE to do index futures trading. 9 June 2000 Trading of BSE Sensex futures commenced at BSE. 12 June 2000 Trading of Nifty futures commenced at NSE. 31 August 2000 Trading of futures and options on Nifty to commence at SIMEX June 2001 Trading of Equity Index Options at NSE July 2001 Trading of Stock Options at NSE 9 November 2002 Trading of Single Stock futures at BSE June 2003 Trading of Interest Rate Futures at NSE 13 September 2004 Weekly Options at BSE 1 January 2008 Tra ding of Chhota(Mini) Sensex at BSE 1 January 2008 Trading of Mini Index Futures Options at NSE 6 August 2008 Circulars regarding Currency Futures by RBI SEBI 29 August 2008 Trading of Currency Futures at NSE 2 October 2008 Trading of Currency Futures at BSE 7 October 2008 MCX-SX came into existence with USD/INR pair 16 June 2010 The all new United Stock Exchange started mock trading in Currency Futures. Chapter 2 WHAT IS DERIVATIVES? Derivative is a product whose value is derived from the value of one or more basic variables, called bases (i.e. underlying asset, index, or reference rate), in a contracted manner. The underlying asset can be in the form of equity, foreign exchange, commodity or any other asset having commercial value. For example, a cotton farmer may wish to sell his harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of cotton which is the underlying. In the Indian context the Securities Contracts (Regulation) Act, 1956 [SC(R)A] defines Derivative to include- 1. A security derived from a debt instrument, share, loan whether secured or unsecured, 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 underlying securities. The Underlying Securities f or Derivatives are : Commodities: Castor seed, Grain, Pepper, Potatoes, etc. Precious Metal: Gold, Silver Short Term Debt Securities: Treasury Bills Interest Rates Common shares/stock Currency derivatives TYPES OF FINANCIAL DERIVATIVES Derivative instruments can be classified between commodity derivatives and financial derivatives. The basic difference between these is the nature of the underlying instrument assets. In commodity derivatives the underlying instrument is commodity which may be wheat, tea, cotton, pepper, sugar, jute, turmeric, corn, crude oil, natural gas etc. In financial derivatives the underlying instruments are treasury bills, stocks, bonds, foreign exchange, stock index etc. It may be noted that financial derivative is fairly standard and there are no quality issues whereas in commodity derivative, the quality may be the underlying matters. TRADING OF FINANCIAL DERIVATIVES Derivatives traded at exchanges are standardized contracts having standard delivery dates and trading units. OTC derivatives are customized contracts which enable parties to select trading units and delivery dates to suit their requirements. Major difference between the two is that of counterparty risk i.e. risk of default by either party. With the exchange traded derivatives, the risk is controlled by exchanges through clearing house which act as a contractual intermediary and impose margin requirement. In contrast, OTC derivatives signify greater liability. DEFINITIONS Futures: Futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain agreed price. Futures contracts are special types of forward contracts in the sense that they are standardized and are generally traded on an exchange. 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. Forwards: Forward contract is a customized contract between two parties, 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. The basic objective of a forward market 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. Swaps: Swaps are agr eements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios 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. In a swap normally three basic steps are involved Initial exchange of principal amount Ongoing exchange of interest Re exchange of principal amount on maturity. Options: Options are of two types calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given 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 within specified period. In India only currency forwards and currency futures are only allowed. Currency swaps and currency option is yet not allowed in India. Recently MCX-SX has started to offer currency futures contracts in US Dollar-Indian Rupee (USD-INR,) Euro-Indian Rupee (EUR-INR), Pound Sterling-Indian Rupee (GBP-INR) and Japanese Yen-Indian Rupee (JPY-INR). Clearing and Settlement is conducted through the MCX Stock Exchange Clearing Corporation Ltd (MCX-SX CCL). SEBI is also considering about launching Currency Options for facilitating all the investors, exporters, importers and MNCs. CURRENCY FORWARDS MARKETS Forward contracts are agreements to exchange currencies at an agreed rate on a specified future date. The actual settlement date is after two working days after the deal date. The agreed rate is called forward rate and the difference between the spot rate and the forward rate is called as forward margin. Forward contracts are bilateral contracts and are privately negotiated, traded outside a regulated stock exchange and suffer from counter -party risks and liquidity risks. Counter Party risk means that one party in the contract may default on fulfilling its obligations thereby causing loss to the other party. An important segment of the Forex derivatives market in India is the Rupee forward contracts market. This has been growing rapidly with increasing participation from companies, exporters, importers, banks and FIIs. Till February 1992, forward contracts were permitted only against trade related exposures and these contracts could not be cancelled except where the underlying transactions failed to materialize. In March 1992, unrestricted booking and cancellation of forward contracts for all genuine exposures, whether trade related or not, were permitted to provide operational freedom to corporate entities. During the Asian crisis, freedom to re-book cancelled contracts was suspended, which has been since relaxed for the exporters but the restriction still remains for the importers. THE FUTURE MARKET Futures is a standardized forward contract to buy (long) or sell (short) the underlying asset at a specified price at a specified future date through a specified exchange. Futures contracts are traded on exchanges working as buyers or sellers for the counterparty. Exchange sets the standardized terms in term of quality, quantity, price quotation, date and delivery place (only in case of commodity). Features: The features of a futures contract may be specified as follows: These are traded on an organized exchange like NSE, BSE, MCX etc. These involve standardized contract terms viz. the underlying asset, the time of maturity and the manner of maturity etc. These are associated with a clearing house to ensure smooth functioning of the market. There are margin requirements and daily settlement to act as further safeguard. These provide for supervision and monitoring of contract by a regulatory authority. Almost ninety percent future contracts are settled via cash settlement instead of actual delivery of underlying asset. Futures contracts being traded on organized exchanges impart liquidity to the transaction. The clearinghouse, being the counter party to both sides of a transaction, provides a mechanism that guarantees the honoring of the contract and ensuring very low level of default. Types: Following are the important types of financial futures contract: Stock Future or equity futures, Stock Index futures, Currency futures, and Interest Rate bearing securities like Bonds, T- Bill Futures. Chapter 3 WHAT IS CURRENCY FUTURES? A future 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 commodity the contract is termed as Commodity Future Contract. When the underlying is an exchange rate, the contract is termed a Currency Futures Contract. Therefore, the buyer and the seller enter into a contract for an exchange rate for a specific value or delivery date. Both parties of the future contract must fulfill their obligations on the settlement date. Currency futures can be settled by delivering the obligation of the seller and buyer respectively. All settlements go through the exchange. Currency futures are a linear product, and calculating profits or losses on currency futures will be similar to calculating profits or losses on index futures. In determining profits and losses, it is essential to know both the contract size and also tick value, A tick value is the minimum trading increment or price differential at which traders are able to enter bids and offers. Tick value differ for different currency pairs. In case of USD-INR currency futures contract the tick size shall be 0.25 Paise. For example, if a trader buys a contract at Rs. 42.2500 one tick move on this contract will translate to Rs. 42.2475 or Rs. 42.2525 depending on the direction of market movement. UTILITY OF CURRENCY DERIVATIVES Traders in the foreign exchange market make numerous trades daily, buying and selling currencies while exchanging market information may be used for varied purposes: For the import and export needs of companies and individuals For direct foreign investment To profit from the short-term fluctuations in exchange rates To manage existing positions or To purchase foreign financial instruments Exchange rates are important consideration while taking international investment decisions. When an investor decides to cash out, or bring his money home, any gains could be magnified or wiped out depending on the change in the exchange rates in the interim. Changes in exchange rates can have following effects on economy: Affects the prices of imported goods Affects the overall level of price and wage inflation Influences tourism patterns May influence consumers buying decisions and investors long-term commitments. In the volatile Forex market, traders constantl y try to foretell the behavior of other market participants. By correctly anticipating opponents strategies, they can act first and beat the competition. Traders profit by purchasing currency and selling it later at a higher price, or, anticipating the market is heading down, selling at a high price and buying back at a lower price later. To predict the movements of currencies, traders often try to determine whether the currencys price reflects its fundamental value in terms of current economic conditions. Examining inflation, interest rates, and the relative strength of the countrys economy are some of the factors which help them make a determination. Currency-based derivatives are used mainly by exporters invoicing receivables in foreign currency who are willing to protect their earnings from the foreign currency depreciation by locking the currency conversion rate at a high level. Importers use these derivatives in hedging foreign currency payables. It is effective wh en the payment currency is expected to appreciate and the importers would like to guarantee a lower conversion rate. Investors in foreign currency denominated securities like to secure strong foreign earnings by obtaining the right to sell foreign currency at a high conversion rate, thus defending their revenue from the foreign currency depreciation. Multinational companies use currency derivatives in direct investments overseas. They want to guarantee the rate of purchasing foreign currency for various payments related to the installation of a foreign branch or subsidiary, or to a joint venture with a foreign partner. High degree of volatility of exchange rates creates an opportunity for foreign exchange speculators. Their objective is to ensure a high selling rate of foreign currency by obtaining a derivative contract while expecting to buy the currency at a low rate in the future. Alternatively, they may want to obtain a foreign currency forward buying contract, expectin g to sell the appreciating currency at a high future rate. In either case, they are exposed to the currency fluctuations risk in the future betting on the pattern of the spot exchange rate adjustment consistent with their initial expectations. Most commonly used instrument among the currency derivatives are currency forward contracts. These are large notional value selling or buying contracts obtained by exporters, importers, investors and speculators from banks with denomination normally exceeding 2 million USD. Contracts guarantee the future conversion rate between two currencies and can be obtained for any customized amount and any date in the future. They normally do not require a security deposit since their purchasers are mostly large business firms and investment institutions, although the banks may require compensating deposit balances or lines of credit. Their transaction costs are set by spread between banks buy and sell prices. Currency futures provide an additio nal tool for hedging currency risk by. Further development of domestic foreign exchange market. Permit trades other than hedges with a view to moving gradually towards fuller capital account convertibility. Provide a platform to retail segment of the market to ensure broad based participation based on equal treatment. Efficient method of credit risk transfer through the Exchange. Create a market to facilitate large volume transactions to go through on an anonymous basis without distorting the levels. PARTICIPANTS OF CURRENCY MARKET Hedgers: They use derivatives markets to reduce or eliminate the risk associated with price of an asset. Majority of the participants in derivatives market belongs to this category. Speculators: They transact futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture. Arbitrageurs: Their behavior is guided by the desire to take advantage of a discrepancy between prices of more or less the same assets or competing assets in different markets. If, for example, they see the 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. BASE CURRENCY TERMS CURRENCY In foreign exchange markets, base currency is the first currency in a currency pair and second currency is called as the terms currency. Exchange rates are quoted in per unit of the base currency. That is the expression Dollar-Rupee, tells that the Dollar is being quoted in terms of the Rupee. Dollar is the base currency and the Rupee is the terms currency. Exchange rates are constantly changing, which means that the value of one currency in terms of the other is constantly in flux. Changes in rates are expressed as strengthening or weakening of one currency vis-à  -vis the second currency. Changes are also expressed as appreciation or depreciation of one currency in terms of the second currency. Whenever the base currency buys more of the terms currency, the base currency is said to have been strengthened / appreciated and the terms currency has weakened / depreciated. Chapter 4 EXCHANGE TRADED CURRENCY FUTURES Future markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in future at a certain price. Unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in futures contracts, exchange specifies certain standard features of the contract. A futures contract is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered (or can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity entering into an equal and opposite transaction. NEED FOR EXCHANGE TRADED CURRENCY FUTURES Exchange traded futures as compared to OTC forwards serve the same economic purpose yet differ in fundamental ways. An individual entering into a forward contract agrees to transect at a forward price on a future date. On the maturity date, the obligation of the individual equals to the forward price at which the contract was executed. Except on the maturity date no money changes hands. On the other hand in case of exchange traded currency futures contract mark to market obligation is settled on a daily basis. Since the profit or loss in a future market are collected/ paid on a daily basis, the scope of building mark to market loss in the books of various participants gets limited. Counterparty risk in future contract is further eliminated by the presence of a clearing corporation, which by assuming counterparty guarantee eliminates credit risk. Further in an exchange traded scenario where the market lot is fixed at a much lesser size than the OTC market, equitable opportunit y is provided to all the classes of investors whether large or small to participate in the future market. The transaction on an exchange are executed on a price time priority ensuring that the best price is available to all categories of market participant irrespective of their size. Other advantages of an exchange traded market would be greater transparency, efficiency and accessibility. FUTURES TERMINOLOGY Spot price: The price at which an asset trades in the spot market. In the case of USD/INR, spot value is T + 2. Futures price: The price at which the futures contract trades in the futures market. Contract cycle: The period over which a contract trades. Currency futures contracts on the SEBI recognized exchanges have one-month, two-month, and three-month up to twelve-month expiry cycles. Hence, these exchanges will have 12 contracts outstanding at any given point in time. Value Date/Final Settlement Date: The last business day of the month will be termed the Value date/ Final Settlement date of each contract. 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 subsequently declared holiday 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. All contracts expire on the last working day (excluding Saturdays) of the contract months. The last day for the trading of the contract shall be two working days prior to the final settlement date or value date. Contract size: The amount of assets that have to be delivered under a contract, which is 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. 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. 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 (in commodity markets) the storage cost plus the interest that is paid to finance or carry the asset till deliver y 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 time 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 margin account is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is called marking-to-market. CONTRACT SPECIFICATION DETAILS OF CONTRACT SPECIFICATION OF USD/INR FUTURES Symbol USDINR Instrument Type FUTCUR Unit of trading 1 (1 unit denotes 1000 USD) Underlying The exchange rate in Indian Rupees for a US Dollar Tick size Rs.0.25 paise or INR 0.0025 Trading hours Monday to Friday 9:00 a.m. to 5:00 p.m Contract trading cycle 12 month trading cycle. Last trading day Two working days prior to the last business day of the expiry month at 12 noon. Final settlement day Last working day (excluding Saturdays) of the expiry month. The last working day will be the same as that for Interbank Settlements in Mumbai. Quantity Freeze Above 10,000 Base price Theoretical price on the 1st day of the contract. On all other days, DSP of the contract Price operating range Tenure up to 6 months Tenure more than 6 months +- 3% of base price +- 5% of base price Position limits Clients Trading members Banks Higher of 6% of Higher of 15% Higher of total open interest of the total open 15% of total or USD 10 million interest or open interest USD 50 million or USD 100 Million Minimum initial margin 1.75% on day 1, 1% thereafter Extreme loss margin 1% of MTM value of open position. Calendar spreads Minimum Rs. 250/- per contract for all months of spread Settlement Daily settlement : T + 1 Final settlement : T + 2 Mode of settlement Cash settled in Indian Rupees Daily settlement price (DSP) Calculated on the basis of the last half an hour weighted average price Final settlement price (FSP) RBI reference rate NSE trades Currency Derivatives contracts having near 12 calendar month expiry cycles. All contracts expire two working days prior to the last working day of every calendar month (subject to holiday calendars). This is also the last trading day for the expiring contract. The contract would cease to trade at 12:00 noon on the last trading day. A new contract with 12th month expiry would be introduced immediately ensuring availability of 12 monthly contracts for trading at any point. The Instrument type: FUTCUR refers to Futures contract on currency and Contract symbol: USDINR denotes a currency pair of US Dollars Indian Rupee. Each futures contract has a separate limit order book. All passive orders are stacked in the system in terms of price-time priority and trades take place at the passive order price (order which has come earlier and residing in the system). The best buy order for a given futures contract will be the order to buy at the highest price wh ereas the best sell order will be the order to sell at the lowest price. TRANSACTION OF A CONTRACT FACTS FIGURES ABOUT USD/INR FUTURES CONTRACT Trade Date Total Contracts Total Value Spread Volume Open Interest RBI Reference Rate (in Rs. Cr.) 19-Nov-08 179362 895.68 64676 49.74 01-Dec-08 192221 970.1 71325 50.09 01-Jan-09 97289 474.66 133015 48.73 01-Dec-09 1845073 8571.3 221069 580426 46.45 01-Jan-10 948881 4437.47 250133 468156 46.65 29-Jan-10 2919761 13557.42 421800 595355 46.37 17-June-2010 36,85,770 17049.6 1276594 46.16 Chapter 5 EXAMPLES OF HEDGING 1). Suppose a machinery importer wants to import machinery worth USD 100,000 and places his import order on June 12, 2010, with the delivery date being 4 months ahead. At the time of placing the contract one USD is worth Rs 46.50 in the spot market. But, suppose the Indian Rupee depreciates to INR 46.75 per USD when the payment is due in October 2010, the value of the payment for the importer goes up to Rs 4,675,000, rather than Rs 4,650,000. The hedging strategy for the importer, thus, would be: Current Spot Rate (12th June 10) 46.5000 Buy 100 USD INR Oct 10 Contracts on 12th June 10 (1000 * 46.5500) * 100 (Assuming the Oct 10 contract is trading at 46.5500 on 12th June, 10) Sell 100 USD INR Oct 10 Contracts in Oct 10 Profit/Loss (futures market) 46.7500 1000 * (46.75 46.55) * 100 = 20,000 Purchases in spot market @ 46.75 Total cost of hedged transaction 46.75 * 100,000 100,000 * 46.75 20,000 = Rs 4,655,000 2). A garment exporter of Ludhiana, w ho is exporting Garments worth USD 100,000, wants protection against possible Indian Rupee appreciation in Dec 10, i.e. when he receives his payment. He wants to lock-in the exchange rate for the above transaction. His strategy would be: One USD INR contract size USD 1,000 Sell 100 USD INR Dec 10 Contracts (on 12th June 10) 47.2925 Buy 100 USD INR Dec 10 Contracts in Dec 10 47.1025 Sell USD 100,000 in spot market @ 47.1025 in Dec 10 (Assume that initially Indian rupee depreciated , but later appreciated to 47.1025 per USD as foreseen by the exporter by end of Dec 10) Profit/Loss from futures (Dec 10 contract) 100 * 1000 *(47.2925 47.1025) = 0.19 *100 * 1000 = Rs 19,000  The net receipt in INR for the hedged transaction would be: 100,000 *47.1025 + 19,000 = 2,355,125 + 19,000 = Rs 2,374,125. Had he not participated in futures market, he would have got only Rs 2,355,125. Thus, he kept his sales unexposed to foreign exchange rate risk. 3). Suppose an Indian exporter receives an export order worth 100,000 from a European customer with the delivery date being in 3 months time. At the time of placing the contract, the Euro is worth Rs 56.05 in the spot market, while a futures contract for an expiry date that matches with order payment date is trading at Rs 56. This puts the value of the order, when placed, at Rs 5,605,000. However, if the domestic exchange rate appreciates significantly (to Rs 55.20) when the order is paid for (which is one month after the delivery date), the firm would receive only Rs 5,520,000 rather than Rs 5,605,000. To insure against such losses, the firm can, at the time it receives the order, can enter into 100 Euro futures contract of 1000 each to sell at Rs 56 a Euro, which involves contracting to sell a foreign currency on expiry date at the agreed exchange rate. Suppose on payment date the exchange rate is Rs 55.20, the exporter would receives only Rs 5,520,000 on selling the Euro in the spot market, but gains Rs 80,000 (i.e. 56 55.20 * 100 * 1000) in the futures market. Thus, overall the firm receives Rs 5,600,000 and protects itself from the sharp appreciation of domestic currency against Euro. 4). A dealer in India placed an import order worth 100,000 with a German manufacturer. The current spot rate of the Euro is Rs 56.05 and at this rate the value of the order is Rs 5,605,000. The importer is concerned about sharp depreciation of the Indian Rupee against the Euro in coming months when the payment is due. So, the importer buys 100 Euro futures contract (1000 each) at Rs 56 a Euro. Suppose, at expiry date, the Rupee depreciated to Rs 57, the importer would have to pay Rs 5,700,000, but he would gain Rs 100,000 (i.e. Rs.67 56 * 100 * 1000) from the futures market and the resultant outflow would be only Rs 5,600,000. In the short term, firms can make gains or losses from hedging. But the basic purpose of hedging is to protect against excessive losses. Firms also tend to benefit from knowing exactly how much they will pay for the import order and avoid the uncertainty associated with future exchange rate movements. ADVANTAGES OF CURRENCY FUTURES Low Commissions: A highly competitive market keeps a tab on brokerage, keeping fees to bare minimum. No Middlemen: Futures/Options currency trading allows clients to trade directly on the exchange platform. Standardized Lot Size: Lots or contract sizes are determined and fixed by the exchanges. Low Transaction Cost: The retail transaction cost (the bid/ask spread) is typically less than 0.1 percent under normal market conditions. Almost Instantaneous Transactions: High liquidity and low bid/ask spreads lead to immediate trades. Affordability: Margins are very low and the contract size is very small. As per the specification of NSE, USD-INR currency future contract, lot size is 1000$. Margin is 1.75%. Low Margins, High Leverage: Margins of 3-5% increase leverage possibilities. These 2 factors increase the potential for making higher profits (and losses). Online Access: The advent of online (Internet) trading platforms helps you to trade at your convenience from your home, office or on the go. No one can corner the market: The Forex market is so vast and has so many participants that no single entity, not even a central bank, can control the market price for an extended period of time. Even interventions by mighty central banks are becoming increasingly ineffectual and short-lived. Thus central banks are becoming less and less inclined to intervene to manipulate market prices. Transparency: It is possible for everyone to verify trade details on NSE if anyone have a doubt that the broker has tried to cheat. DISADVANTAGES OF FUTURES The futures are also disadvantageous in a few areas when compared to OTC market. The major disadvantages are: Standardization: It is not possible to obtain a perfect hedge in terms of amount and timing. Cost: Forwards have no upfront cost, while margining requirements may effectively drive the cost of hedging in futures up. Small lots: Generally it is not possible to hedge small exposures. Chapter 6 CONCLUSION Most significant event in the field of finance during the past decade has been the extraordinary development and expansion of financial derivatives. These instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it a process that has undoubtedly improved national productivity growth and standards of livings. Currency futures provide the safe and standardized contract to its investors and individuals who are aware about the forex market or predict the movement of exchange rate so they will get the right platform for the trading in currency future. Because of exchange traded future contract and its standardized nature gives counter party risk minimization. Initially only NSE had the permission but now BSE MCX-SX has also started currency future contracts. It shows that how currency future covers ground in the compare of the other available derivative instruments. Last month MCX-SX ranked top amongst all three with m ore than 50% trades of currency futures contracts in India in sense of volumes and number of contracts also. Not only big business houses, exporters and importers use this but individuals who are interested and having knowledge about forex market they can also invest in currency future. Exchange between USD-INR markets in India is very big and along with it other currency contracts of Euro, Pound and Japanese Yen are in the market and attracting the investors which is the reason behind higher growth rate of currency futures in India. I am extremely thankful to Dr H K Pradhan for providing with an opportunity to this very insightful study which has helped understand International Finance Management better. Chapter 7