Managing Foreign Exchange Risk via Currency Derivatives

INTRODUCTION

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.

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 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 that was the reason behind development of currency derivatives.

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THE PROJECT

The financial environment today has more risks than earlier. Successful business
firms are those that are able to manage these risks effectively. Due to changes in the
macroeconomic structures and increasing internationalization of businesses, there has been a
dramatic increase in the volatility of economic variables such as interest rates, exchange
rates, commodity prices etc. Firms that monitor their risks carefully and manage their risks
with judicious policies enjoy a more stable business than those who are unable to identify
and manage their risks. There are many risks which are influenced by factors external to the
business and therefore suitable mechanisms to manage and reduce such risks need to be
adopted. One of the modern day solutions to manage financial risks is ‘hedging’.
The project is all 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.

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INDUSTRY

HISTORY OF CURRENCY DERIVATIVES

In 1971, the Bretton Woods system of administering fixed foreign exchange rates
was abolished in favour of market-determination of foreign exchange rates; a system of
fluctuating exchange rates was introduced. Besides market-determined fluctuations, there
was a lot of volatility in other markets around the world due to increased inflation and the
oil shock. Corporates struggled to cope up with the uncertainty in profits. It was then that
financial derivatives – foreign currency, interest rate, and commodity derivatives emerged as
means of managing risks facing corporations.
The Chicago Mercantile Exchange (CME) created FX futures, the first ever financial
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. 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.

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DEVELOPMENT IN INDIA:
In India, the economic liberalization in the early nineties provided the economic
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. With limited convertibility on the trade account being
introduced in 1993, the environment became even more favorable for the introduction of
these hedge products. Hence, the development in the Indian forex derivatives market should
be seen along with 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 regulatory framework applicable to trading of ‘securities’ could also govern trading of
derivatives.
The trading in index options commenced in June 2001 and the trading in options on
individual securities commenced in July 2001. Futures contracts on individual stocks were
launched in November 2001.
RBI and SEBI jointly constituted a standing technical committee 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. Further RBI and SEBI issued circulars in this regard on August 06, 2008.
Currently, India is USD XXXX billion Currency market, where all the majir
currencies like USD, EURO, YEN and POUND are traded.

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The rationales 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 them to hedge these 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 than 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. This in theory should lower portfolio risk. Therefore,
sometimes argument is advanced 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.

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Derivatives in India: A Chronology

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 Trading 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

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THE COMPANY

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INTRODUCTION TO MARWADI GROUP

MISSION & VISION

"To be a world-class financial services provider by arranging all conceivable

financial services under one-roof at affordable costs through cost effective
delivery systems, and achieve organic growth in business by adding newer
lines of business.”

COMPANY PROFILE

Marwadi Shares & Finance Limited is a Gujarat based financial service group
dealing in equities / commodities broking and portfolio management services. In the last 15
years MSFL has grown into a network of more than70 branches with an 850+ committed
professional people and 475+ channel partners across India. MSFL has kept the faith of over
1.90 lakh investors and it's growing. After establishing supremacy in Gujarat, now
expanding nationwide and to fuel growth plans they recently raised capital from UK-based
investment companies. MSFL got 5th rank in best broking houses also.

Marwadi Group strength lies in its team of confident, young, talented, qualified and
experienced professionals to carry out different functions under the able leadership of its
management.

“Marwadi Shares and Finance Limited” is a huge and very reputed organization in
the world of securities and finance. The organization enjoys a large market share with highly
loyal customers, who in-turn provides a huge business to them.

MEMBERSHIP:

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Equity & Derivatives:

 National Stock Exchange of India Ltd. (NSE)

 Bombay Stock Exchange Ltd. (BSE)

 Multi Commodity Exchange of India Ltd.

Commodities Derivatives:

 National Commodity & Derivatives Exchange Ltd.

 Multi Commodity Exchange of India Ltd.

Depository participation of:

 National Securities Depository Ltd. (NSDL)

 Central Depository Services India Ltd. (CDSL)

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MILESTONES

The company crossed the following milestones to reach its present position as
the leading retail broking house in India:

 1992 - Marwadi Shares And Finance Pvt. Ltd. was incorporated.

 1996 - Became a corporate member of National Stock Exchange Of India - (NSE)
 1998 - Became a member of Saurashtra Kutch Stock Exchange (MARWADI
SHARES & FINANCE LTD.)
 1999 - Launched Depository services of Depository Participant under National
Depository Security Ltd. (NSDL)
 2000 - Commenced Derivative trading after obtaining registration as Clearing and
Trading Member in NSE.
 2003 - (MCBPL) became a corporate member of the National Commodity and
Derivatives Exchange of India Ltd.
 2003 - (MCBPL) became a corporate member of The Multi Commodity Exchange of
India Ltd.
 2004 - Became a corporate member of Bombay Stock Exchange Ltd. (BSE)
 2004 - Launched Depository Services of Depository Participant under Central
Depository Services (India) Ltd.
 2005 - Launched Portfolio Management Services
 2006 - MSFPL converted to Public Limited (Marwadi Shares And Finance Limited)
 2006 - The Company raised private equity from ICGU Limited, a wholly owned
subsidiary of India Capital Growth Fund.
 2007 - The Company raised further private equity from Caledonia Investments plc.

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SERVICES @ MARWADI:

 Equity & Derivatives

 Commodity
 Internet Trading
 Depository Participant
 IPO
 Mutual Fund
 PMS
 Research

CORE COMPETENCE:

 Commodities research & broking services

 Online or offline trading facility
 Depository services through CDSL
 Web based 24 x 7 back office software
 Good understanding of the sub-broker and retail customer needs
 Professional work culture with a personal touch
 Cost- effective processes
 Streaming quotes & real time charts for BSE /NSE [cash / derivatives]
 Single connectivity and speedy execution of trades.
 Online technical support & help desk.

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COMPETITORS:

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OBJECTIVES & METHODOLOGY

OBJECTIVES OF THE PROJECT

The basic idea behind undertaking Currency Derivatives project is to gain

knowledge about currency market.

Primary objectives:

 To study the basic concept of currency future.

 To study exchange traded currency future.
 To analyze different currency derivatives products.

Secondary objective:

 To know how the currency futures are used as risk management tool.

METHODOLOGY

All the data and information is collected by me from different sources for the
preparation of this report. To prepare this report, I have adopted following methodology.

PRIMARY DATA

 The primary data has been collected from experts, officials and employees working
in MARWADI SHARES & FINANCE LTD.

SECONDARY DATA

 For secondary data, I have use internet. Links are given for the same.

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INTRODUCTION

Introduction to derivative

 There is no universally satisfactory definition available for the term “Derivative”. But
in general it can be said that, "Derivative" is an instrument which does not have its
own independent value, i.e. its value is entirely "derived" from the value of the
underlying asset.

 The underlying asset can be securities, commodities, bullion, currency, livestock or

anything else.

 The Underlying Securities for Derivatives are :

1. Commodities: Castor seed, Grain, Pepper, Potatoes, etc.
2. Precious Metal: Gold, Silver
3. Short Term Debt Securities: Treasury Bills
4. Interest Rates
5. Common shares/stock
6. Currency derivatives

 Derivative includes forward, future, option or any other hybrid contract of pre
determined fixed duration, linked for the purpose of contract fulfillment to the value
of a specified real or financial asset or to an index of securities.

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NECESSITY OF MANAGING FOREIGN EXCHANGE RISK

A key assumption in the concept of foreign exchange risk is that exchange rate
changes are not predictable and that this is determined by how efficient the markets for
foreign exchange are.

Research in the area of efficiency of foreign exchange markets has thus far
been able to establish only a weak form of the efficient market hypothesis conclusively
which implies that successive changes in exchange rates cannot be predicted by analyzing
the historical sequence of exchange rates.

However, when the efficient markets theory is applied to the foreign

exchange market under floating exchange rates there is some evidence to suggest that the
present prices properly reflect all available information.

This implies that exchange rates react to new information in an immediate

and unbiased fashion, so that no one party can make a profit by this information and in
any case, information on direction of the rates arrives randomly so exchange rates also
fluctuate.

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CURRENCY DERIVATIVE PRODUCTS

Derivative contracts have several variants. The most common variants are 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 today’s 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.

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 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.

In a swap normally three basic steps are involve___

1. Initial exchange of principal amount

2. Ongoing exchange of interest

3. Re - exchange of principal amount on maturity.

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 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.

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).

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DIFFRENCE BETWEEN FORWARDS & FUTURES

 Standardization:-

In forward contracts, the amount of the assets to be delivered and the

maturity date are negotiated between the buyer and seller and can be tailor made,
while infutures contract amount of the asset and maturity date both are standardized
by the exchange on which the contract is to be traded.

 Margins:-

Trading in futures requires keeping the margin money with the broker while
purchasing the futures contract, but in the forward contract there is no margin
money to be kept at the time of purchase of the forward contractbecause it is
between buyer and seller.

 Mark – to – market:-

Buyers of the futures contract have to provide with the additional margin, if
the price of the futures contract decreases or increases, but in the case of forwards
contract such margin is not settled on daily basis.

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UTILITY OF CURRENCY DERIVATIVES

Traders in the foreign exchange market make thousands of 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 an important consideration when making international

investment decisions. The money invested overseas incurs an exchange rate risk.

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.
Thus, changes in exchange rates can have many effects on an 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.

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In the volatile FX market, traders constantly try to predict the behavior of other
market participants. If they correctly anticipate their opponents’ strategies, they can act
first and beat the competition.

Traders make money 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.

Trader purchases a lot of currency long on the currency

Trader sells a lot of a currency Short on the currency

To predict the movements of currencies, traders often try to determine whether

the currency’s price reflects its fundamental value in terms of current economic
conditions. Examining inflation, interest rates, and the relative strength of the country’s
economy helps them make a determination.

Currency underpriced Price will go up

Currency overpriced Price will go down

Currency-based derivatives are used by exporters invoicing receivables in

foreign currency, willing to protect their earnings from the foreign currency depreciation
by locking the currency conversion rate at a high level.

Their use by importers hedging foreign currency payables is effective when the
payment currency is expected to appreciate and the importers would like to guarantee a
lower conversion rate.

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Investors in foreign currency denominated securities would 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 being engaged in direct

investment 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.

A high degree of volatility of exchange rates creates a fertile ground for foreign
exchange speculators. Their objective is to guarantee a high selling rate of a foreign
currency by obtaining a derivative contract while hoping to buy the currency at a low
rate in the future.

Alternatively, they may wish to obtain a foreign currency forward buying

contract, expecting to sell the appreciating currency at a high future rate. In either case,
they are exposed to the risk of currency fluctuations in the future betting on the pattern
of the spot exchange rate adjustment consistent with their initial expectations.

The 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.

The 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

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or lines of credit. Their transaction costs are set by spread between bank's buy and sell
prices.

Exporters invoicing receivables in foreign currency are the most frequent users
of these contracts. They are willing to protect themselves from the currency depreciation
by locking in the future currency conversion rate at a high level.

A similar foreign currency forward selling contract is obtained by investors in

foreign currency denominated bonds (or other securities) who want to take advantage of
higher foreign that domestic interest rates on government or corporate bonds and the
foreign currency forward premium.

They hedge against the foreign currency depreciation below the forward selling
rate which would ruin their return from foreign financial investment. Investment in
foreign securities induced by higher foreign interest rates and accompanied by the
forward selling of the foreign currency income is called a covered interest arbitrage.

Currency futures provide an additional tool for hedging currency risk.

 Further development of domestic foreign exchange market.

 Permit trades other than hedges with a view to moving gradually towards fuller
capital account convertibility.

 Provide a platform to retail segment of the market to ensure broad based

participation based on equal treatment.

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 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.

THE FORWARD MARKET

The rupee-dollar forward market is a bilaterally negotiated market: there was no pre-
trade or post-trade transparency in 2006-2007, 85,106 numbers of forward transactions
came to CCIL for settlement, with notional value of $342 billion. In late 2006, forward
market turnover was nudging $2 billion a day.

There are three remarkable features about the Indian currency forwards market:

 Even though trading is negotiated off exchange, there is netting by novation at

CCIL, so that credit risk is eliminated.

 Even though it an OTC market, it trades standardized contracts that expire on the
last business day of each month.

 Ordinarily, currency forward markets have pricing that is controlled by Covered

Interest Parity (CIP).

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 However, the system of capital controls involves considerable barriers on CIP

arbitrage. Hence, it is often the case that the forward price strays away from fair
value.

In addition to the onshore rupee-dollar forward market; there is active trading for
cash-settled rupee-dollar forwards in Hong Kong, Singapore, Dubai and London on what
are termed no deliverable forwards (NDF).

THE CURRENCY FUTURE MARKET

 A futures contract is a promise to buy or to deliver a certain quantity of a standardized

good by a specific future date.

 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 futures contract”. In other words, it is a contract to exchange one
currency for another currency at a specified date and a specified rate in the future.

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 Therefore, the buyer and the seller lock themselves into an exchange rate for a specific
value or delivery date. Both parties of the futures contract must fulfill their obligations
on the settlement date.

 Currency futures can be cash settled or settled by delivering the respective obligation of
the seller and buyer. All settlements however, unlike in the case of OTC markets, 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 profit and loss in futures trading, it is essential to know both the
contract size (the number of currency units being traded) and also what is the value of
tick (minimum trading price differential at which traders are able to enter bids and
offers)?

 A tick is the minimum trading increment or price differential at which traders are able
to enter bids and offers. Tick values differ for different currency pairs and different
underlying. For e.g. in the case of the USD-INR currency futures contract the tick size
shall be 0.25 paisa or 0.0025 Rupees.

 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.42.2525 depending on the direction of
market movement

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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. So if a trader buys 5
contracts and the price moves up by 4 ticks, he/ shemake Rupees 50.

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

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 days (T = Trading day).

 Futures price:The price at which the futures contract trades in the futures market.

 Contract cycle:The period over which a contract trades. The 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.

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 Value Date/Final Settlement 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 ‘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. 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 the case of USD/INR 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.

 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 delivery less the income earned on the asset. For equity derivatives carry
cost is the rate of interest.

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 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 investor's gain or loss depending upon the
futures closing price. This is called marking-to-market.

FOREIGN EXCHANGE QUOTATIONS

Foreign exchange quotations can be confusing because currencies are quoted in

terms of other currencies. It means exchange rate is relative price.

For example, if one US dollar is worth of Rs. 45 in Indian rupees then it implies
that 45 Indian rupees will buy one dollar of USA, or that one rupee is worth of 0.022 US
dollar which is simply reciprocal of the former dollar exchange rate.

QUOTATION

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DIRECT INDIRECT

Types of exchange rates

The number of units of domestic the number of unit of foreign

Currency stated against one unit currency per unit of domestic

Of foreign currency currency

Rs./$ = 45.7250 (or) Rs. 1 = $ 0.02187

$1 = Rs. 45.7250

There are two ways of quoting exchange rates:

1. Direct and

2. Indirect.

Most countries use the direct method. In global foreign exchange market, two rates
are quoted by the dealer: one rate for buying (bid rate), and another for selling (ask or
offered rate) for a currency.

This is a unique feature of this market. It should be noted that where the bank sells
dollars against rupees, one can say that rupees against dollar. In order to separate buying
and selling rate, a small dash or oblique line is drawn after the dash.

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For example, If US dollar is quoted in the market as Rs 46.3500/3550, it means that

the forex dealer is ready to purchase the dollar at Rs 46.3500 and ready to sell at Rs
46.3550. The difference between the buying and selling rates is called spread.

It is important to note that selling rate is always higher than the buying rate.

Traders, usually large banks, deal in two way prices, both buying and selling, are
called market makers.

Base Currency/ Terms Currency:

In foreign exchange markets, the base currency is the first currency in a currency
pair. The second currency is called as the terms currency. Exchange rates are quoted in
per unit of the base currency. That is the expression Dollar-Rupee, tells you that the
Dollar is being quoted in terms of the Rupee. The 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.

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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 has
strengthened / appreciated and the terms currency has weakened / depreciated.

For example, If Dollar – Rupee moved from 43.00 to 43.25. The Dollar has
appreciated and the Rupee has depreciated. And if it moved from 43.0000 to 42.7525 the
Dollar has depreciated and Rupee has appreciated.

The transactions in the interbank market may place for settlement-

1. On the same day; or

2. Two days later; or

3. Some day late: say after a month.

Where the agreement to buy and sell is agreed upon and executed on the same day,
the transaction is known as: Ready or cash – value today, Tomorrow (“tom”) – value
tomorrow, or next working day

The transaction where the exchange of currencies takes place two days after the date
of the contract is known as spot transaction – value two business days after the trading
day.

Thus, for a spot transaction done Monday, currencies will change hands the
following Wednesday assuming this is a working day in both the centers. Similarly, for a
spot transaction done Thursday, currencies will change hands the following Monday.

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The transaction in which the exchange of currencies takes place at a specified future
date, subsequent to the spot date, is known as a forward transaction.

Forward rate may be the same as the spot rate for the currency. Then it is said to be
‘at par’ with the spot rate. But this rarely happens. More often the forward rate for a
currency may be costlier or cheaper than its spot rate.

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

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Final settlement day
Quantity Freeze
Base price
Price operating range
Position limits
Minimum initial margin
Extreme loss margin
Calendar spreads
Settlement
Mode of settlement
Daily settlement price
(DSP)
Final settlement price
(FSP)
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at 12 noon.
Last working day (excluding Saturdays) of the expiry month. The last
working day will be the same as that for Interbank Settlements in
Mumbai.
Above 10,000
Theoretical price on the 1st day of the contract. On all other days,
DSP of the contract
Tenure up to 6 months Tenure more than 6 months
+\- 3% of base price +\- 5% of base price
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
1.75% on day 1, 1% thereafter
1% of MTM value of open position.
Rs. 400/- for a spread of 1 month, Rs. 500/- for a spread of 2 months,
Rs. 800/- for a spread of 3 months & Rs. 1000/- for a spread of 4
months or more
Daily settlement : T + 1
Final settlement : T + 2
Cash settled in Indian Rupees
Calculated on the basis of the last half an hour weighted average
price
RBI reference rate
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FACTS & FIGURES ABOUT THE MOVEMENTS OF TRADING IN

USD/INR FUTURES CONTRACT

Total Value RBI

Total Spread Open
Trade Date Reference
Contracts (inRs. Cr.) Volume Interest
Rate
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

Table - 1

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From the above table, we can see that there is constant increase in the value of the contracts
and event in number of the contracts traded in Indian market.

ADVANTAGES OF CURRENCY FUTURES

 EASY ACCESSIBILITY: Currency future is being offered on the recognized

exchanges in India. NSE (National Stock Exchange), MCX (Multi-Commodity
Exchange), BSE (Bombay Stock Exchange) have commenced currency futures
trading.Small investors would get an easy access to currency futures trading on the
popular exchanges. It is as easy as trading in a blue chip stock on any of your favorite
exchange.

 EASY 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 TRANSACTION COSTS :When you trade in INT currency futures on

NSE in India, you have to pay a small amount of brokerage fees and statutory duties
and taxes. In overseas Forex trading you have to pay commissions to the banks or

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foreign exchange agents in the form of spread. Spread is the difference in the buy/sell
price over the reference rate, which can be very high.

 TRANSPERANCY: It is possible for you to verify trade details on NSE if you

have a doubt that the broker has tried to cheat you.

 EFFICIENT PRICE DISCOVERY: Internationally it has been established

that currency future is a better and efficient mechanism for price discovery. With its
state of the art automated electronic trading system where the orders are executed on
the basis of price-time priority, NSE is well poised to offer efficient price discovery.

 COUNTER-PARTY DEFAULT RISKS: All the trades done on the

recognized exchanges are guaranteed by the clearing corporations and hence it
eliminates the risks associated with counter party default. NSCCL (National Securities
Clearing Corporation Limited) carries out all the novation, clearing and settlement
process of currency futures trading.

 STANDARDIZED CONTRACTS: Exchange Traded currency futures are

standardized in respect of lot size (1000$) and maturity (12 monthly contracts). Retail
investors with their limited resources would find it tremendously beneficial to take
positions in standardized USD INR futures contracts

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DISADVANTAGES OF FUTURES

The futures are also disadvantageous in a few areas when compared to OTC market.
The major disadvantages are:

1. Standardization: It is not possible to obtain a perfect hedge in terms of

amount and timing.

2. Cost: Forwards have no upfront cost, while margining requirements may

effectively drive the cost of hedging in futures up.

3. Small lots: Not possible to hedge small exposures generally

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CONCLUSION

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BIBLIOGRAPHY

 http://www.mcx-sx.com/SitePages/mkt_data.aspx

 http://www.investopedia.com/terms/c/currencyrisk.asp

 http://timesofindia.indiatimes.com/biz/india-business/Currency-futures-clock-
1500-growth-in-1-year/articleshow/4952394.cms

 http://www.rbi.org.in/scripts/PublicationReportDetails.aspx?ID=532

 http://www.mcx-sx.com/abt_us.htm

Books

P.G. APTE - International financial management

V. SHARAN - International financial management

Workbook for NISM-Series-I Currency Derivatives Certification Examination

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