Currency Futures

Currency Futures
By dvk

Author:
Dr Vinod Kumar
Table of Content ….
Overview of International Currency Market
 International Currency Market
 Brief History of Currency Systems
 Approaches to Investing in Currencies
 Factors Affects the Foreign Exchange Market


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 The growth and workings of Currency Futures

 Participants in the currency futures market
 Tactics using currency futures

Chapter – 1 Overview of International Forex Markets

Currencies have developed over centuries and most major

currencies have free floating exchange rates today, which help
increase financial stability. Globalization in trade and later in
services increased the exposure to other than the home currency
among global market participants. Thus, investors became aware
of the highly liquid and global FX market and over time came to
regard currencies as an asset class with diversification benefits.
The currency market’s biggest players are financial institutions,
which actively use exchange rate movements to generate returns
rather than to simply hedge currency exposure.

1.1 International Forex Market

The foreign exchange (currency or forex or FX) market exists

wherever one currency is traded for another. It is the largest and
most liquid financial market in the world, and includes trading
between large banks, central banks, currency speculators,
multinational corporations, governments, and other financial
markets and institutions. The average daily trade in the global
forex and related markets currently is almost US$ 6.6 trillion.
The foreign exchange market is unique because of:
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 its huge trading volumes,

 the extreme liquidity of the market,
 the large number of, and variety of, traders in the
market,
 its geographical dispersion,
 its long trading hours: 24 hours a day except on
weekends (from 5pm EST on Sunday until 4pm EST
Friday),
 the variety of factors that affect exchange rates.
 the low margins of profit compared with other markets
of fixed income (but profits can be high due to very
large trading volumes)
 the use of leverage

What Determines Exchange Rates?

The exchange rate gives the relative value of a currency against
another currency. An exchange rate USD/INR of 73 for
example, indicates that 1 dollar will buy 73 Indian rupees. The
U.S. dollar is most commonly used as reference currency, which
means currencies are usually quoted against the U.S. dollar and
indeed the majority of FX trades. A similar principle applies
when we look at money itself and consider interest as the price
for money. If the real return on a financial asset differed from
one country to another, investors would flock to the country
with the relatively higher returns. Interest rates have to change
to stop this movement and rebalance the markets. The theory
behind this relationship is called the interest rate parity theory.
When looking at interest rates it is important to distinguish
between real rates and nominal rates, with the difference
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reflecting inflation. The higher the (expected) inflation in a

country, the more compensation will investors demand when
investing in a particular currency.
1.2 Brief History of Currency Systems
Trading in currencies has not always been that lively, mainly
because exchange rates between two currencies were not
flexible or “free floating” as most major currencies are today. In
the 19th century, national currencies started to be backed by a
government’s gold reserves and the price of a currency was
fixed against a certain amount of gold. This gold parity gave
citizens confidence both in a currency and its stability in terms
of value. The U.K. first introduced the “gold standard” in 1821
and by the beginning of the 20th century most major players in
world trade had followed. Under the gold standard, a
government or central bank has to maintain enough gold
reserves to match money supply in a country and ensure full
convertibility of currency against gold at all times. In times of
war or crisis, maintaining sufficient gold reserve levels can be
difficult. During World War I many countries had to abandon
the gold standard. In the late 1920s a “gold exchange standard”
was introduced that allowed the exchange of a local currency
against gold or currencies from countries like the U.K. and the
U.S. that were still backed by gold – and thus the first “reserve
currencies” were born. The economic crisis that began in 1929
took its toll, though, and in 1931 the U.K. suspended the gold
standard and many other countries followed and moved away
from gold standard. At the end of World War II, another system
of fixed – but adjustable – exchange rates was born with the
Bretton Woods agreement between 40 nations, which tied their

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currencies to the U.S. dollar. The U.S. in return agreed to

maintain a gold standard. Bretton Woods suffered a similar fate
like the gold standard when it was abandoned in the 1970s after
the U.S. gave up the gold standard.
Most major economies today have free floating currencies,
which allow exchange rates to adjust to economic and market
relevant developments automatically. The emergence of floating
currencies is often credited for improving financial stability
worldwide. In many countries, independent central banks like
the federal reserve board in the U.S. or the Bank of England in
the U.K. watch over the stability of the nation’s currency.
However, Fixed rates can still be found today, with the Chinese
Yuan pegged against the U.S. dollar as one of the most
prominent examples.

1.3 Approaches to Investing in Currencies

Even though currencies are considered an asset class an investor
cannot simply invest in, for example, U.S. dollars or Swiss
francs. An investment requires a second currency to make a pair.
An investor is therefore investing into the exchange rate
movements of the U.S. dollar against the Swiss franc and
requires taking a view of relative valuations and market trends.
Several approaches exist to invest in currencies, although the
Carry trade has clearly made the most headlines over the last
few years. The carry approach – also known as forward rate
bias – takes advantage of different interest rate levels in two
countries. An investor will borrow money in a low-interest rate
currency and invest in a higher yielding currency. Companies
and investors often use a so-called fundamental approach to

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determine the fair value of a currency. This approach is based on

fundamental analysis where an investor or company tries to
identify the fair value of a currency and from it a future price
movement. The wide range of users makes it one of the most
common FX approaches in practice.

Reading material IFRM JIMS 19th DEC 2020

1.4 Factors affecting currency trading

The foreign exchange market can make or break a country. The
currency of a country is very important to the world stage. No
matter where one lives, they are affected by the process and
what happens to it on a daily basis.
A person can make their portfolio investments more fruitful if
they understand all they can about the role it plays in their daily
life. Making money can be a good thing if one only grasps the
concept of how to increase not only personal wealth, but also
that of their country. Although exchange rates are affected by
many factors, in the end, currency prices are a result of supply
and demand forces. The world's currency markets can be viewed
as a huge melting pot: in a large and ever-changing mix of
current events, supply and demand factors are constantly
shifting, and the price of one currency in relation to another
shifts accordingly. No other market encompasses (and distills)
as much of what is going on in the world at any given time as
foreign exchange.
Supply and demand for any given currency, and thus its value,
are not influenced by any single element, but rather by several.

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These elements generally fall into three categories: economic

factors, political conditions and market psychology.
Economic factors Political conditions Market psychology.

1.4.1 Economic factors

These include economic policy, disseminated by government
agencies and central banks, economic conditions, generally
revealed through economic reports, and other economic
indicators. Economic policy comprises government fiscal
policy (budget/spending practices) and monetary policy (the
means by which a government's central bank influences the
supply and "cost" of money, which is reflected by the level of
interest rates).
Economic conditions include:

 Government budget deficits or surpluses: The market

usually reacts negatively to widening government budget
deficits, and positively to narrowing budget deficits. The
impact is reflected in the value of a country's currency.
 Balance of trade levels and trends: The trade flow
between countries illustrates the demand for goods and
services, which in turn indicates demand for a country's
currency to conduct trade. Surpluses and deficits in trade of
goods and services reflect the competitiveness of a nation's
economy. For example, trade deficits may have a negative
impact on a nation's currency.

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 Inflation levels and trends: Typically, a currency will lose

value if there is a high level of inflation in the country or if
inflation levels are perceived to be rising. This is because
inflation erodes purchasing power, thus demand, for that
particular currency.
 Economic growth and health: Reports such as gross
domestic product ( GDP), employment levels, retail sales,
capacity utilization and others, detail the levels of a
country's economic growth and health. Generally, the
more healthy and robust a country's economy, the better its
currency will perform, and the more demand for it there
will be.
1.4.2 Political conditions
Internal, regional, and international political conditions and
events can have a profound effect on currency markets. For
instance, political upheaval and instability can have a negative
impact on a nation's economy. The rise of a political faction that
is perceived to be fiscally responsible can have the opposite
effect. Also, events in one country in a region may spur positive
or negative interest in a neighboring country and, in the process,
affect its currency.

1.4. 3 Market psychology

Market psychology and trader perceptions influence the foreign
exchange market in a variety of ways:
 Flights to quality: Unsettling international events can lead
to a " flight to quality," with investors seeking a " safe
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haven". There will be a greater demand, thus a higher

price, for currencies perceived as stronger over their
relatively weaker counterparts.
 Long-term trends: Currency markets often move in
visible long-term trends. Although currencies do not have
an annual growing season like physical commodities,
business cycles do make themselves felt. Cycle analysis
looks at longer-term price trends that may rise from
economic or political trends.
 "Buy the rumor, sell the fact:" This market truism can
apply to many currency situations. It is the tendency for the
price of a currency to reflect the impact of a particular
action before it occurs and, when the anticipated event
comes to pass, react in exactly the opposite direction. This
may also be referred to as a market being "oversold" or
"overbought". To buy the rumor or sell the fact can also be
an example of the cognitive bias known as anchoring,
when investors focus too much on the relevance of outside
events to currency prices.
 Economic numbers: While economic numbers can
certainly reflect economic policy, some reports and
numbers take on a talisman-like effect: the number itself
becomes important to market psychology and may have an
immediate impact on short-term market moves. "What to
watch" can change over time. In recent years, for example,
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money supply, employment, trade balance figures and

inflation numbers have all taken turns in the spotlight.
 Technical trading considerations: As in other markets,
the accumulated price movements in a currency pair such
as EUR/USD can form apparent patterns that traders may
attempt to use. Many traders study price charts in order to
identify such patterns

1.5 Financial instruments There are several types of

financial instruments commonly used in forex market .

 Spot : A spot transaction is a two-day delivery transaction,

as opposed to the futures contracts, which are usually
three months. This trade represents a “direct exchange”
between two currencies, has the shortest time frame,
involves cash rather than a contract; and interest is not
included in the agreed-upon transaction. The data for this
study come from the spot market. Spot has the largest
share by volume in FX transactions among all instruments.
 Forward transaction : One way to deal with the Forex risk
is to engage in a forward transaction. In this transaction,
money does not actually change hands until some agreed
upon future date. A buyer and seller agree on an exchange
rate for any date in the future, and the transaction occurs on

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that date, regardless of what the market rates are then. The
duration of the trade can be a few days, months or years.
 Futures : Foreign currency futures are forward transactions
with standard contract sizes and maturity dates — for
example, 500,000 British pounds for next November at an
agreed rate. Futures are standardized and are usually traded
on an exchange created for this purpose. The average
contract length is roughly 3 months. Futures contracts are
usually inclusive of any interest amounts.
 Swap : The most common type of forward transaction is
the currency swap. In a swap, two parties exchange
currencies for a certain length of time and agree to reverse
the transaction at a later date. These are not standardized
contracts and are not traded through an exchange.
 Options : A foreign exchange option (commonly
shortened to just FX option) is a derivative where the
owner has the right but not the obligation to exchange
money denominated in one currency into another currency
at a pre-agreed exchange rate on a specified date. The FX
options market is the deepest, largest and most liquid
market for options of any kind in the world.

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Chapter – 2 Participants in the currency futures market

There are four categories of participants in the currency

futures market:

Hedgers Speculators Arbitrageurs Investors

Hedgers
Currency Futures can be used to hedge against currency risk.
Currency hedging refers to the elimination of currency risk by
entering into an equal but opposite currency futures position
which responds to a change in the exchange rate in the opposite
manner to an existing currency position Participants would enter
in a long currency futures position in order to protect themselves
against depreciation in local currency, that is, rand weakening.
These investors may have a payment, quoted in a foreign
currency, expected in three months time, and are thus exposed to
an increase in the exchange rate, that is, an appreciation of the
foreign currency.

Speculators
Speculators are directly opposite to hedgers. Where hedgers try
to eliminate risk speculators want to increase risk in the hope
that they will make a short-term profit. Speculators enter into
currency futures contracts in order to take a view on the
movement of the underlying exchange rate
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Speculators that view the underlying exchange rate to increase

(local currency depreciation) will go long a currency futures
contract, that is, buy US$ currency futures contracts. Speculators
that view the underlying exchange rate to decrease (local
currency appreciation) will go short a currency futures contract,
that is, sell the US$ currency futures contract.

Arbitrageurs
Arbitrageurs profit from price differentials of similar products in
different markets, for example, price
differentials between the underlying exchange rate and futures
price or between the pricing of currency futures on different
markets, for example, New York and London. Arbitrage
requires live data on all these markets and the ability to execute
transactions quickly and cost effectively. The average person
will find it difficult to effect arbitrage transactions due to the
limited access to data, foreign markets and cost structures.

Investors
Investors use Currency Futures to enhance the long-term
performance of a portfolio of assets.

As the currency futures market evolves, you would see different

opportunities in it. The opportunities in forex could be spread
trading and cross-spreading, other than arbitrage and
speculation. Spread trading consists of calendar trades, where
one buys one expiration month and sells another. Cross-
spreading is where one buys one futures contract and sells

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another. The opportunity is quite lucrative in case of spread

trading in the initial part of the launch, when there is less
liquidity. But over a period, the opportunity diminishes, as the
difference gets limited.
The players involved in currency markets have different
objectives. There are exporters, importers, speculators, market-
makers and arbitrageurs. RBI, which understands the importance
of the export-import trade, ensures a balance of the exchange
rate by regular interventions in the forex market, which would
not make the rate move one-sided. This makes the currency
market much more speculative and unpredictable and hence
forecasting becomes difficult. Hence, if you expect that the
rupee to appreciate from Rs 42 to Rs 39 due to foreign
institutional flows within the next six months, that actually may
not happen because RBI could intervene to ensure that exporters
stay afloat.

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Chapter – 3 Basics of Currency Futures

Foreign currencies are traded in both forward and futures
markets in all the developed countries. But in India, in the
absence of a regulated currency futures market, there is only a
forward market and that too mainly for the dollar/ rupee.
Forward rates for other currencies are based on the cross rates of
dollar/ rupee and dollar/ other currencies. Forward markets for
foreign currencies have been in existence for a long time all over
the world, but the foreign exchange futures market developed
only in the early 1970s, with trading beginning on 16 May 1972
on the International Monetary Market (IMM) of the Chicago
Mercantile Exchange (CME). The presence of a strong and
successful forward market retarded the development of a futures
market for foreign exchange. In this dual market system, the
futures market cannot exist in isolation from the forward market.
The forward markets in currencies still continue to be larger than
futures markets. Many traders are active in both the markets.
Cash-carry and reverse cash-carry arbitrage strategies ensure
that proper price relationship is maintained between the two
markets.
 
In the forward market, the specific need of a hedger can be
attended to, including the exact amount of exposure period etc.
A standardised futures contract, however, can provide a hedger
up to the nearest value and period. Since most of the operators
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are international banks and financial institutions, the forward

market in this segment has grown more than the futures market.
 
The most important factors determining the exchange rates
between the two currencies are the exchange rate regimes (fixed
versus floating rates), the question of devaluation and the
influence of the balance of payments. Against this institutional
background, a no-arbitrage price relationship such as interest
rate parity theorem (IRP) and the purchasing power parity
theorem (PPP) are discussed in this chapter. These models
essentially express the pricing relationship of the cost-of-carry
model.
 
A major impetus to futures in foreign exchange was given by the
end of fixed exchange rates and the widespread acceptance of
floating rates, which increased exchange rate volatility
dramatically and therefore increased exchange rate risk. A fixed
exchange rate exists when a currency's value is fixed relative to
other currencies. Intervention by the central bank is usually
needed to maintain a fixed rate. In the floating exchange rate
system, the values of currencies are permitted to fluctuate freely
in response to demand and supply.

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In the international market, futures trade on seven currencies

visa-vis the US dollar is conducted. These are the Australian
dollar, the British pound, the euro, the Canadian dollar, the
Japanese yen and the Swiss franc. About 29 million currency
futures contracts were traded on the US exchange in 1990,
accounting for about 10 percent of all futures trading, in the US.
These contracts are similar to one another, the major difference
being the quantity of currency represented by one futures
contract. These range from 62,500 British pounds to 12,500,000
Japanese yen. In dollar terms, almost all contracts have a value
ranging between $78,000 and $120,000. The following table
shows the specifications of the most active currency futures
contracts:
 
  Pounds Canadian Japanese Swiss Australian
dollars Yen franc dollars
 
Trading 62,500 100,000 12,500,000 125,000 100,000
unit
Minimum $12.50 $10   $12.5 $10
price
change
Price limit none none none none none
Contracts March, June, September , December
months
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3.1 Introduction: Currency futures contracts can be hard-

working additions to any investor’s or trader’s portfolio. They
provide a way to hedge the risk to which a currency exposes the
investor or to speculate when the belief is that the exchange
rates will change. Currency Futures offer gearing on exchange
rates in a cost effective way.

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How are currency futures prices determined?

Currency futures prices are dependent on the underlying
exchange rate as well as the interest rate differential between the
two relevant countries in question.
The following equation explains the currency futures pricing
model and would be
referred to as the fair value price:
F = S*[1 + {(rd-rf)*T / 365}]
Where:
• F is the fair value futures contract price quoted in local
currency units per one
unit of foreign currency;
• S is the underlying exchange rate (spot rate) quoted in local
currency units per one unit of foreign currency
• T is time to maturity of the futures contract;
• rd is domestic interest rate; and
• rf is foreign currency interest rate.
Market makers will then add a spread either side of this fair
value as their fee as detailed below. However, market forces of
supply and demand and the expected increase in trade in these
products will invariably lead to the bids and offers
narrowing (getting closer together) as market participants jostle
to be the best bid
or offer.
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Currency futures trading sees nine-fold jump in turnover

Making investments in currencies earning different interest rates

produces the same return once we take into account changes in
their exchange rates. This is what we call a condition of interest
rate parity—a world that does not offer free lunches.
For example, if deposits denominated in dollars are earning 10%
interest and deposits denominated in euros are earning 15%
interest, then for establishing interest rate parity, the value of the
euro must depreciate by 5% with respect to the dollar; or
conversely, the value of the dollar must appreciate by 5% with
respect to the euro, so that the overall return generated by the
two currencies is the same once we take into account their
appreciation or depreciation.

What interest rate parity implies is that it makes no sense to

borrow in one currency and invest in another just because of the

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difference in interest rates. If it were not so, then anybody could

earn a risk-less profit by borrowing in a currency available at a
lower interest rate and converting the same into a deposit
denominated in a currency offering a higher interest rate and
hedging the exchange rate risk in the forward currency market.
But the cost involved in hedging the exchange rate risk takes
away the margin of profit. That’s why any opportunity of
interest rate arbitrage, or what we also call the opportunity of
carry trade between two currencies, evaporates quickly.

Interest parity equation by thinking in terms of demand and

supply.
Let’s presume that the dollar can be borrowed at 5% and
invested into a euro-denominated deposit at 8%. What would be
the effect of this action in terms of demand and supply? Any
increase in the demand of loans denominated in dollars should
push borrowing rates in dollars upwards, whereas an increase in
the supply of deposits denominated in euros should push deposit
rates in euros downwards. But despite the obvious imbalance in
demand and supply, interest rates in the two countries might not
change. In that case, exchange rates should change. The
conversion of dollars into euros for investing in euro-
denominated deposits should lead to appreciation in current
exchange rate of euros in terms of dollars. But in future, for
paying back the loan, the deposits in euros would be required to
be converted into dollars, which means that the euro should
depreciate in terms of dollars. The forward currency market
keeps this in mind. That’s the reason why a currency having a
lower interest rate sells at a premium to the currency having

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higher interest rate in the forward market. The premium that you
pay for hedging the exchange rate more or less nullifies the gain
made due to difference in interest rates. All in all, it’s about
market common sense. No one would be willing to hold a
currency offering a lower interest rate in case there is no other
incentive. Appreciation in exchange rates of a currency in a way
provides compensation for lower interest rates.
The whole idea of interest rate parity sounds convincing, but
there are certain drawbacks which we should keep in mind.
First, the condition interest rate parity requires is full mobility of
capital between two countries. Many countries impose
restrictions on capital movement due to which interest rate
parity may not actually exist. Further, this theory presumes that
there are no risks other than exchange rate risk for holding
deposits denominated in different currencies—which again may
not be true. Sometimes a deposit in a particular currency may be
offering a high interest rate just to compensate for default risk.

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Interest rate parity is an economic term describing the

relationship among spot currency exchange rates, forward
currency exchange rates and interest rates. It is used in
international banking to determine the rate at which to buy or
sell currencies.
Spot and Forward Rates
1. The spot rate is the rate at which currency is exchanged today.
The forward rate is the rate established today that applies to a
currency trade that will occur in the future.
Interest Rates
2. Investors can earn interest by lending currency. Interest rate
parity suggests that the rate at which currency A can be
exchanged for currency B is related to the interest rates that
can be earned in countries A and B.
No Arbitrage
3. To prevent arbitrage opportunities from arising, the ratio of
the forward exchange rate to the spot exchange rate must
equal the ratio of the currency returns for the two countries.
Interest Rate Parity Formula
4. (Forward rate / spot rate) = (1 + interest rate A) / (1 + interest
rate B)

Exchange rates are expressed as the quantity of A required to

purchase one B.
Practical Considerations
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5. Interest rate parity assumes that there will be no transaction

fees and that neither party will default on the transaction. In
actual practice, currency prices quoted by banks to customers
often include a risk premium.

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Interest rate parity

THERE are many theories on what influences the forward rate

(premium/discount). It is believed that the interest rates of two
countries influences the forward rate and swap points. Interest
rate parity illustrates why a particular currency might be at a
forward discount/premium. The currency of one country with a
lower interest rate should be at a forward premium in terms of
the currency of a country with higher interest rates and vice
versa.
A firm should be indifferent about investing at home or
investing abroad if the home interest rate equals the foreign
interest rate plus the annualised forward exchange
premium/discount on the foreign currency.
Similarly the firm should invest at home when the domestic
interest rate exceeds the sum of the foreign interest rate plus the
foreign exchange premium/discount, and it should invest abroad
when the domestic rate is less than this sum. It is understood t
hat the mere comparison of interest is not sufficient. Hence one
should compare the interest rates differentials with the forward
premium/discount rates to find out where the investments should
be made for gain. The chances are many for speculators cashi ng
in on interest rate differentials. This is technically referred to as
covered interest arbitrage.
This discussion brings out a rule for arbitrage as follows:

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If the interest rate differential (IRD) is greater than the

premium/discount (annualised) rates, then invest in the currency
bearing a higher rate of interest and the converse is also true.
If the interest rate differential (IRD) is lower than the
premium/discount (annualised) rates, then invest in the currency
bearing a lower rate of interest.
This brings out a second rule for arbitrage as follows:
Domestic rate Foreign rate +or Forward Premium/Discount rates
invest in foreign shores.
Domestic rate > Foreign rate +ors Forward Premium/Discount
rates invest in domestic shores.
*Consider the following exchange rates:
Canadian $1.5140 per US$ (Spot)
Canadian $1.5552 per US$ (6 months forward)
6 months interest rate: C$ 10 per cent pa
US$ 6 per cent pa
Work out the possibilities of arbitrage gain. Assume 1,000 units
of currency.
*Based on the First Rule:
Since IRD 4 per cent (10 per cent-6 per cent) l the forward
premium rate annualised 5.44 per cent, investment shall be made
in the US (having lower rate of interest 610).

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Based on the Second Rule:

Domestic center is Canada where the rate is 10 per cent US
interest rate of 6 per cent + 5.44 per cent towards Forward
Premium rate. Investment should be made in the US.
An illustration
Step 1: Borrow C$ 1,000 @ 10 per cent pa for six months term
and convert at spot rate into US$660.50.
Step 2: Invest in US$660.50 @ 6 per cent pa for six months
getting a maturity value of US$680.32 and revert to C$ at the
forward rate. This would realise Canadian $1,058.03.
Step 3: Pay the loan borrowed in C$1,050 and gain C$8.03.
*Consider the following exchange rates:
FFr / $7.4675 (Spot)
FFr / $7.3706 (6 months forward)
Six months interest rate: FFr 8 per cent pa
$11 per cent pa
Work out the possibilities of arbitrage gain. Assume 1,000 units
of currency.
*Based on the First Rule:
Since IRD 3 per cent (11-8 per cent) L the forward discount rate
annualised 2.6 per cent, investment shall be made in the US
(having higher interest rate 11>8)
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Based on the Second Rule:

Domestic Center is France where the rate of interest is 8 per cent
the US interest rate of 11 per cent - 2.6 per cent Forward
Discount rate. The investment should be made in the US.
An illustration
Step 1: Borrow FFr 1,000 @ 8 per cent pa for six months term
and convert at spot rate into US$ 133.91.
Step 2: Invest in US$133.91 @ 11 pa for six months, getting a
maturity value of US$141.28 and revert to FFr at the forward
rate. This would realise FFr 1,041.32.
Step 3: Pay the loan borrowed in FFr 1,040 and gain FFr 1.32.
Purchasing power parity
Forward rates are also believed to be influenced by the law of
one price. This law says that a commodity will be priced the
same regardless of the country in which it is purchased/sold.
Based on the purchasing power of the consumers in the
countries, the exchange rates are influenced. The purchasing
power is once again dependent on the inflation rate plaguing the
countries.
*Suppose over a period of two years, the US price index moves
from 110 to 135 and the Japanese price index moves from 105 to
112. The spot exchange rate is $1=124.1545. What would be
spot rate after two years from now? The answer is in Table 5.

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*A customer in Germany buys an item for 335 DM. He makes

enquiry in France for that item by the same time. The quotation
is FFr 100. What is the spot rate of FFr in Germany?
Expectation theory
Forward rate and expected future spot rate are two different
things to be understood. Forward rate is the rate negotiated for
the delivery to be made/taken on a future date for a present
transaction. Future spot rate is the actual rate prevailing on the
agreed future date. An equilibrium is achieved only when the
forward (premium/discount) points equal to the expected change
in the future spot rate. However, it generally overshoots one way
or the other.
Fisher's Inflation and Real Interest Rate Theory
Relative inflation rates also affect interest rates. The interest rate
of one country is largely dependent on the inflation rates. Hence
countries suffering higher inflation would experience higher
interest rates and vice-versa is also true. High inflati on and high
interest rate would add fuel to the fire, which in turn depreciates
its currency against stronger foreign currency over time. If two
countries experience the same, inflation rates would experience
the same interest rates. This, in union with the Fisher effect,
would mean that the difference in the money rate of interest
would be equal to the expected difference in inflation rates.
AThe expected annual inflation in India is 5 per cent. The
expected inflation for the US is 3.5 per cent. Estimate the
expected one-year future spot rate, when the spot rate is Rs

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46.62=$1. *Expected spot rate = (1 + inflation rate in India) / (1

+ infla tion rate in the US) * Spot rate
=(1+0.05) / (1+0.035) * 46.62 = Rs 47.30
Hedging with the Currency Futures
 
The advantages of derivative products emanate from the
flexibility they have in providing the hedge to the persons who
have exchange exposure. We know that exports and imports are
exposed to the currency risk. This exposure can be hedged
through the derivatives like futures, options, etc. Futures are
one of the derivatives where an exporters and importers can
hedge their positions by selling or buying the futures. Since the
futures market does not require upfront premium for entering
into the contract as in the case of options, it provides a cost-
effective way for hedging the exchange risk. The basic
advantage of using currency futures is that it provides a means
to hedge the trader’s position or anybody who wishes to lock-in
exchange rates on future currency transactions. By purchasing
(long hedge) or selling (short hedge) foreign exchange futures a
corporate or an individual can fix the incoming and outgoing
cash flows in one currency with respect to another currency.
Anyone who is dealing with a foreign currency is faced with an
exchange risk since the cash flows in terms of domestic
currency are known only at the time of conversion. The
objective of avoiding exchange risk can be achieved by using
different tools including futures. A person who is long or
expected to be long in a foreign currency will have to sell the
same on a given day. A hedge can be obtained now by selling
futures in that currency against the domestic currency.

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Similarly, a person who is short or expected to be short in a

foreign currency will have to go long on the same on a given
day. A hedge can be obtained now by buying futures in that
currency against the domestic currency instead of buying the
currency later in the spot market. However, the major
disadvantage in foreign exchange futures is that, they are
limited to a few currencies only. The following illustration
explains how a US exporter, using futures, hedges his Euro
inflows.
 
Illustration 4.1
 
Assume that a US exporter is exporting goods to his German
client. On September 14, the exporter got the confirmation from
the German importer that the payment of Euro 625,000 will be
made on November 1, 1998. Here the US exporter is exposed to
the risk due to currency fluctuations. If the Euro depreciates
there will be loss on his dollar receivables. To cover this risk
the exporter can sell Euro futures contract on the CME. The
following working explains how the exporter is hedged.

September 14
 
Spot Market
 
Exporter gets confirmation of receivables equal to Euro
625,000 on November 1.
 

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Spot rate is $/ 0.5900; Expected cash inflows are $3,68,750 i.e.

625,000 x 0.5900 if he were able to convert Euro to US dollars.
But he cannot do so since he did not receive the Euro.
However, he can go to futures market and sell futures in Euro.
 
Futures Market
 
Sell five December Euro futures contracts, since size of each
contract is 125,000, at the rate which is prevailing in the
market. Let the rate be $/Euro 0.6000. Hence, the equivalent
notional amount in Dollars will be $3,75,000 (i.e. 0.6000 x
Euro625,000).
November 1
 
Spot Market
 
Dollar has appreciated and spot exchange rate is 0.5400. The
dollar value of Euro625,000 now is $3,37,500.
 
Loss on spot market position
                                   
= $3,68,750 – $3,37,500 = $31,250
 
Futures Market
 
Buy five December Euro futures contracts. The quantity of
futures contracts bought should be same as that sold on
September 14. Let the futures rate be 0.5500. This gives the
exporter the notional right to buy 6,25,000 by paying $3,43,750
i.e. 6,25,000 x 0.5500.

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Profit on futures contracts    = $3,75,000 – $34,33,750     =

$31,250.
 
The loss in the spot market, arising from the appreciation of
dollar, is offset by the profit in the futures market. In the above
illustration the exporter received the same amount of US dollars
as if he had sold Euro in the market on September 14, 1998.
This is because the change in the rate of Euro during the period
and the change in the price of futures during the same period
are equal.
 
Spot Price (t0) – Spot Price (t1) = 0.5900 – 0.5400 = 0.05
Futures Price (t0) – Futures Price (t1) = 0.6000 – 0.5500 = 0.05
 
The difference between spot price and futures price is known as
basis. The basis at time in the above illustration is 0.1000 and
the basis at time is also 0.1000;
 
Date Spot Futures Basis
14 Sep., 1998 0.5900 0.6000 –0.1000
01 Nov., 1999 0.5400 0.5900 –0.1000
 
We observe that the basis remained unchanged. When the basis
remains unchanged, the gain/loss in spot market matches with
the loss/gain in futures market and hence the amounts are
exactly offset. However, it is unlikely that the basis remains the
same through out the period.
 
Illustration 4.2
 

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In the above illustration, we have seen that the rate in the

futures market moved in line with that in the spot market, and
absolute price change is equal in both markets. However, the
change in futures rate need not be equal to the change in the
spot exchange rate. If the spot and futures rates change by
different amounts, there will be a change in the basis. Due to
this, a degree of imperfection enters the hedge. This situation is
explained in this illustration, which is different from the earlier
illustration only in the assumption that the rate of exchange for
December futures would be 1Euro = $0.5700 rather than 1Euro
= $0.5500. Due to this the basis changes from 0.1000 to
$0.3000 and, as a result, the hedge will not be perfect.
 
Date Spot Futures Basis
14 Sep., 1998 0.5900 0.6000 0.1000
01 Nov., 1999 0.5400 0.5700 0.3000
 
The change in basis results in a net gain of $12500 (i.e. $31,250
– $18,750). Hence, the hedge is only partially successful. The
hedger replaces outright risk with basis risk and consequently
brings down the loss from $31,250 to $12,500.
 
September 14, 1998
 
Spot Market
 
Exporter gets confirmation of receivables equal to Euro 625,000
on November, 1.
 

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Spot rate is 0.5900; Expected cash inflows are $3,68,750 i.e.

Euro5 x 125,000 x 0.5900 if he were able to convert Euro to US
dollars. But he cannot do so since he did not receive the Euro.
However, he can go to futures market and sell futures in Euro.
 
Futures Market
 
Sell five December Euro futures contracts. Size of each
contract would be 125,000 at the exchange rate which is
prevailing in the market. The rate is 0.6000. Hence the
equivalent notional amount in dollars will be $3,75,000 (i.e.
0.6000 x 5 x 125,000).
 
November 1, 1998
 
Spot Market
 
Dollar has appreciated and spot exchange rate is 0.5400. The
dollar value of 625,000 now is $3,37,500.
 
Loss on spot market position = $3,68,750 – $3,37,500
                                            = $31,250.
Futures Market
 
Buy five December Euro futures contracts. The quantity of
futures contracts bought will be the same as that of sale. The
buying rate is 0.5700. This gives the exporter the notional right
to buy 6,25,000 by paying $3,56,250 i.e. 5 x 125,000 x 0.5700.
 
Profit on futures contracts     = $3,75,000 – $3,56,250      =
$18,750.
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Currency Futures

 
In the above illustration we have seen that the Euro inflows are
being hedged by using Euro futures. This type of hedge is
called direct currency hedge. A direct currency hedge
involves the two currencies which are directly involved in the
transaction. Thus, an Indian firm, which has a dollar payable
maturing after three months may buy dollar futures, priced in
terms of rupees or sell rupee futures priced in terms of dollars.
If such futures are not available, a cross hedge can be used. Let
us assume that the rupee and sterling movements are strongly
interlinked. In that case, the firm can buy dollar futures priced
in terms of sterling or sell sterling futures priced in terms of
dollars. For a cross hedge to be effective, the firm has to choose
a contract on an underlying currency which is almost perfectly
correlated with the exposure which is being hedged. This
effectively means that dollar exposure is converted to a sterling
exposure.
 
Determining the Effective Price Using Futures
 
Let Sp1 be the spot price at time T 1
Sp2 be the spot price at time T 2
Ft1 be the futures price at time T1
Ft2 be the futures price at time T2
Sp1 – Ft1 = Basis at T1
Sp2 – Ft2 = Basis at T2
 
In the earlier illustration US exporter hedged Euro receivables
by selling futures on Euro. Let us assume that the transaction
has taken place at T1 and closed at T2. Profits made in futures

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markets by closing out position at T 2 = Ft1 – Ft2 (of course, this

represents a loss if Ft1 < Ft2).
 
Price received for asset while selling in the spot market = Sp 2
 
Which implies, the effective price at which the US exporter
sold the Euro is
                     = Sp2 + (Ft1 – Ft2)
                     = Ft1 + (Sp2 – Ft2)
                     = Ft1 + b2
where b2 represents basis at time t 2
 
Since b2 isunknown, the futures transaction is exposed to basis
risk. If b2 = b1, then the effective price at which Euro sold will
be Ft1 + Sp1 – Ft1 = Sp1. Due to this the risk is completely
eliminated and the dollars inflows will be at today’s spot price.
 
Hedge Ratio
 
A hedger has to determine the number of futures contracts that
provide best hedge for his/her risk-return profile. The hedge
ratio allows the hedger to determine the number of contracts
that must be employed in order to minimize the risk of the
combined cash-futures position. We can define hedge ratio “as
the number of futures contracts to hold for a given position in
the underlying asset”.
 
HR =
 
In illustration 11.1 we considered that US exporter will hedge
625,000 receivables by selling 5 contracts on Euro futures i.e. 5
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x 125,000. In that case, the hedge ratio is 1.0. The hedge ratio
1.0 will give perfect hedge when there is no change in the basis.
The loss on the underlying asset position is offset by profit on
the futures position and vice versa. In illustration 11.2, we
mentioned that when the US exporter took a short position on 5
contracts, he made a profit on the futures position which was
less than the loss on the spot position. This resulted in an
imperfect hedge. Had the US exporter taken a short position on
8.33333 contracts he would have got perfect hedge.
 
Speculation Using Futures
 
Speculation differs from hedging in the sense that the basic
objective of speculation is to capitalize on the difference
between the expectation of speculator and that of the market.
Speculation using futures can be of two types: open position
trading and spread trading. When a speculator is betting on the
price movements associated with a particular contract, it is
called open position trading. When the speculator is trying to
take advantage of movements in the price differentials between
two separate futures contracts, it is called spread trading. An
open position is relatively a riskier proposition than spread
trading since in the former the speculator takes either a long or
short position in any one contract whereas in a spread trading
the speculator takes both long and short position in different
contracts. Hence the risk involved in open position is higher
than in spread position. We shall see some examples for both
types of trading strategies in the following sections.
 
Pricing of Currency Futures
 
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Pricing of the currency futures also follows the cost-carry-

relationship, but in a different way. The assets which are being
purchased and sold are currencies, interest rates for both the
currencies determine the cost-carry-relationship. A theoretical
currency futures price will be the price at which a profitable
cash and carry arbitrage does not exist, more specifically, it will
be where a covered interest rate arbitrage is not profitable.
 
Hence a currency futures price depends on the prevailing spot
rate of exchange and interest rates of both the currencies
concerned.
 
Example: On June 20, the 3-month interest rates in the US and
Canada are 5.7% p.a. and 3.5% p.a. respectively. The $/Can$
Spot price is 0.6560. The theoretical futures price of September
Can$ futures contract (delivery is on September 18) will be as
follows:
 
USr                =     5.7%       p.a.
Can$              =     3.5%       p.a.
 Sp $/Can$     = 0.6560
T                    = 91 (days)
 
Futures price = S x                           
                     = 0.6560 x
 
                     = 0.6560 x 1.0054 = 0.6595
 
 
Currency Futures Market in India - Future Prospects
 
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Currency Futures

The foreign exchange market has been strictly regulated in

India. The RBI used to monitor and maintain foreign exchange
rates within a particular range of values. Demand and supply of
foreign currency became relevant after the Liberalized Exchange
Rate Mechanism (LERMS) started in 1992. The US dollar
became the intervening currency in place of the pound sterling.
Today, more than 80 percent of India's foreign trade is
denominated in US dollars. Now there is a floating exchange
rate in India, which is determined by market forces. The RBI
intervenes in the market at times to give proper direction to the
exchange rate or to curb speculative volatility. The rupee has
been convertible on current account since 1993, which means
that there is no restriction on foreign exchange for trade and
other current account transactions. However, capital account
transactions like FDI, investments abroad, borrowings in
international markets etc are still regulated. The Tarapore
committee, set up to study capital account convertibility, has
suggested that certain milestones have to be crossed before
permitting capital account convertibility. These include NPA of
banks to be less than 5 percent, fiscal deficit to be contained to
3.5 percent, etc. This process was further delayed with the
currency crisis in south-east Asia. Though we have sufficient
foreign exchange reserves, enough to take care of eight months'
imports, the government and the RBI are being cautious as far as
capital account convertibility is concerned.
 

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Exchange rate fluctuations started the moment LERMS was

introduced. From 1992 to 1994, the exchange rate was more or
less stable, with the dollar quoted at Rs 31.37. However, it
witnessed sharp volatility after that. In February 1996, the rupee
plunged to Rs 38.40 in just five-six days before it stabilized at
around Rs 35. This volatility forced importers, exporters and
other corporates that had an exposure in the foreign exchange to
take forward cover. The forward premium on the dollar used to
be more than Re 1 for 3-6 months' forward. Since the volatility
was not in a particular direction, both buyers and sellers of
dollars in forward had to cover their exposures. This increased
the costs of businesses that had international exposures.
 
In USA, all futures markets are regulated by the Commodities
Futures Trade Commission (CFTC). The currency futures
market is also regulated by the CFTC. The cash market for
currency is under the jurisdiction of the Federal Reserve. This
could be because the aim of the cash market is to create
securities, whereas the futures market serves the purpose of
price discovery and hedging. In India, no such regulatory
authority exists for the futures market. The RBI is to take active
steps to create a futures market in currencies. It might be
difficult for the futures market to pick up immediately in India
in the face of the large number of controls and restrictions, but
nevertheless, a beginning has to be made. Initially, authorised
dealers (whose number exceeds 100), with some forex brokers
etc., can be made the members of such a futures exchange,
which can provide futures contracts in major currencies like the
US dollar, the Japanese yen, the euro etc. Futures contracts up to
one year can be permitted on the lines of the IMM. This will not
only provide a cost-effective hedge to Indian importers,
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Currency Futures

exporters and corporates, it will also provide a platform for

capital inflows into India. Efforts in this direction would be very
helpful in the post-capital account convertibility scenario. There
exists tremendous potential for such a futures market in India,
and it can give a boost to the Indian economy. Let us hope that a
futures exchange for foreign currencies will be in place within
the next two-three years.
transactions like FDI, investments abroad, borrowings in
international markets etc are still regulated. The Tarapore
committee, set up to study capital account convertibility, has
suggested that certain milestones have to be crossed before
permitting capital account convertibility. These include NPA of
banks to be less than 5 percent, fiscal deficit to be contained to
3.5 percent, etc. This process was further delayed with the
currency crisis in south-east Asia. Though we have sufficient
foreign exchange reserves, enough to take care of eight months'
imports, the government and the RBI are being cautious as far as
capital account convertibility is concerned.
 
Exchange rate fluctuations started the moment LERMS was
introduced. From 1992 to 1994, the exchange rate was more or
less stable, with the dollar quoted at Rs 31.37. However, it
witnessed sharp volatility after that. In February 1996, the rupee
plunged to Rs 38.40 in just five-six days before it stabilized at
around Rs 35. This volatility forced importers, exporters and
other corporates that had an exposure in the foreign exchange to
take forward cover. The forward premium on the dollar used to
be more than Re 1 for 3-6 months' forward. Since the volatility
was not in a particular direction, both buyers and sellers of

DVK. Page 42
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dollars in forward had to cover their exposures. This increased

the costs of businesses that had international exposures.
 
In USA, all futures markets are regulated by the Commodities
Futures Trade Commission (CFTC). The currency futures
market is also regulated by the CFTC. The cash market for
currency is under the jurisdiction of the Federal Reserve. This
could be because the aim of the cash market is to create
securities, whereas the futures market serves the purpose of
price discovery and hedging. In India, no such regulatory
authority exists for the futures market. The RBI is to take active
steps to create a futures market in currencies. It might be
difficult for the futures market to pick up immediately in India
in the face of the large number of controls and restrictions, but
nevertheless, a beginning has to be made. Initially, authorised
dealers (whose number exceeds 100), with some forex brokers
etc., can be made the members of such a futures exchange,
which can provide futures contracts in major currencies like the
US dollar, the Japanese yen, the euro etc. Futures contracts up to
one year can be permitted on the lines of the IMM. This will not
only provide a cost-effective hedge to Indian importers,
exporters and corporates, it will also provide a platform for
capital inflows into India. Efforts in this direction would be very
helpful in the post-capital account convertibility scenario. There
exists tremendous potential for such a futures market in India,
and it can give a boost to the Indian economy. Let us hope that a
futures exchange for foreign currencies will be in place within
the next two-three years.
 
FOREIGN CURRENCY OPTIONS
 
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The presence of an active and liquid forex derivatives market is

required to enhance the spectrum of hedging products available
to residents and non-residents in order to hedge currency
exposures. To ensure this, the RBI took the initiative and
introduced foreign currency rupee options on 7th July 2003. The
aim was to neutralize currency risk on the country's large
external debt portfolio and to provide banks and corporates with
an effective hedging tool against currency risk. The market
witnessed volumes to the tune of $250 million on 7 th July 2003,
the very day it was introduced, showing the necessity of such an
instrument in the foreign currency derivatives market. Foreign
currency options allow one to purchase or sell a particular
currency at a price denominated in another currency for a
premium. The option premium varies from bank to bank
depending on their out look on the currency. Only scheduled
commercial banks, financial institutions and primary dealers are
allowed to buy and sell rupee options.
 
The currency options provide the hedger with an advantage which
is not available under a forward contract. If a US exporter has
taken a forward contract to sell pound at $1.6500 he will receive
only $1.6500 irrespective of whether pound is at $1.6000 or
$1.7000. It will be an advantage if the exporter can get $1.6500
when the rate is $1.6000 and $1.7000 when the rate is $1.7000. It
is this advantage which is available to a hedger when he uses an
option contract. Options are available on many assets such as
foreign exchange (e.g. on $/£, $/¥), equities (e.g. stocks and stock
indices), commodities (e.g. gold, oil, soyabeans etc.,) and futures
(currency, interest rate, etc.). Options are traded both on OTC and
on exchange.
 
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The options on foreign exchange markets particularly find

option useful as they have traditionally been very volatile. In all
the option contracts there will be two parties:
 
i.            The option seller or writer and
ii.          The option buyer.
 
The buyer of the option always has a right and no obligation
whereas a seller always has an obligation and no right. Thus, the
buyer of an option controls the exercise of right of buying (or
the right of selling) currencies at the price fixed in the option
contract. The seller of an option is thus dependent on the buyer’s
decision. The buyer has the potential for limited loss and
unlimited gain; the seller has potential for unlimited loss and
limited gain.
 
A currency option, facilitates the hedging of an exchange rate
exposure at a cost known upfront. The option writer assumes the
exchange rate risk. Currency options are of two types:
 
·            Call option
·            Put option.
 
Call Option: A call option is an option to buy a currency. Thus,
the buyer of a currency call option has the right to buy (take
delivery of) a currency on or before a specified date at a
predetermined exchange rate. The writer of a currency call
option has the obligation to sell (deliver) a currency on or before
a specified date and at the predetermined exchange rate.
 

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Put Option: The buyer of currency put option has the right to
sell (deliver) a currency on or before a specified date and at a
predetermined exchange rate. The writer of a currency put
option has the obligation to buy (take delivery of) a currency on
or before a specified date at the predetermined exchange rate.
 
Hedging with Currency Options
 
The increasing use of currency options stems mainly from the
realization that they permit far greater flexibility in managing
the risk of foreign exchange. The hedger has an opportunity to
hedge the exchange risk by using a simple call or put option or
by acquiring positions in multiple options so that the
combination provides a unique pay-off profile. It is not possible
to give an exhaustive list of such combinations. The selection of
an appropriate alternative by the hedger depends on the risk
profile and view about the future market prices of the underlying
asset.
 
The examples presented in this section are meant to give an
overview of the available risk protection for a hedger with long
or short position in a currency.
 
Hedging for Exporter
 
An Indian company exported goods to the US and expects
payment after three months. The amount is equal to US$ 10
million. The amount of rupees the exporter will be receiving will
depend on the spot rate of exchange prevailing then. Here, the
exporter is exposed to vagaries of currency rates which may
result in reduction of profit in the transaction or even resulting in
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a loss. The exporter, therefore, wants to hedge his rupee inflows

through options. The hedger can be obtained by selecting one of
the following alternatives.
 
Alternative 1: Buy a put option on US dollar with a strike price of
Rs.43 by paying a premium of Rs.0.50.
 
Alternative 2: Sell a call option on US dollar with a strike price of
Rs.43 by paying a premium of Rs.0.60.
 
Alternative 1: Exporter bought a put option at a strike price of
Rs.43.00 per dollar by paying a premium of Rs.0.50 per dollar.
Maturity of the contract is 3 months from now. Table 4.1
provides the rupee inflow to the exporter depending on spot rate
prevailing at the time of realization of the receivables.
 
Table 4.1
 
Exchange
Option Outflow on
Rate Rs. Net
exercised account of
 (3 months Inflow inflow
Yes/No premium
hence) Rs./$
40.00 Yes 43.00 0.50 42.50
40.50 Yes 43.00 0.50 42.50
41.00 Yes 43.00 0.50 42.50
41.50 Yes 43.00 0.50 42.50
41.90 Yes 43.00 0.50 42.50
42.00 Yes 43.00 0.50 42.50
42.50 Yes 43.00 0.50 42.50
43.00 Indifferent 43.00 0.50 42.50
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Currency Futures

43.50 No 43.50 0.50 43.00

44.00 No 44.00 0.50 43.50
44.10 No 44.10 0.50 43.60
44.50 No 44.50 0.50 44.00
45.00 No 45.00 0.50 44.50
45.50 No 45.50 0.50 45.00
 
At a Rs.0.50 premium, the effective delivery price after three
months would be 42.50 (i.e 43.00 – 0.50) or more. If the dollar
appreciates relative to the rupee well beyond the 43.00 level, the
exporter will be able to sell the dollar currency at a spot price
and hence the option is allowed to expire. If the spot price is less
than or equal to Rs.43 then the option is exercised. Thus, the
exporter is able to benefit from two advantages that the option
market offered over the forward market, namely an opportunity
to profit from a rally in the currency market and protection
against a drop in the currency.
 
Alternative 2: Exporter is having another choice to hedge the
receivables by selling the call option at a strike price of
Rs.43.00/$ by receiving premium of say Rs.0.60 per dollar, for
the contract maturing 3 months from now. Table 4.2 provides
the rupee inflows to the exporter depending on the spot prices
prevailing at the time of realization of receivables.
 
Table 4.2
 

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Exchange
Option Inflow on
Rate Rs. Net
exercised account of
 (3 months Inflow inflow
Yes/No premium
hence) Rs./$
40.00 No 40.00 0.60 40.60
40.50 No 40.50 0.60 41.10
41.00 No 41.00 0.60 41.60
41.50 No 41.50 0.60 42.10
41.90 No 41.90 0.60 42.50
42.00 No 42.00 0.60 42.60
42.50 No 42.50 0.60 43.10
43.00 Indifferent 43.00 0.60 43.60
43.50 Yes 43.00 0.60 43.60
44.00 Yes 43.00 0.60 43.60
44.10 Yes 43.00 0.60 43.60
44.50 Yes 43.00 0.60 43.60
45.00 Yes 43.00 0.60 43.60
45.50 Yes 43.00 0.60 43.60
 
Considering the premium of Rs.0.60 per dollar receiving for
selling a call option, the effective delivery price after three
months would be 43.60 (i.e 43.00 + 0.60) or less. If the dollar
appreciates relatively to the rupee well beyond the 43.00 level,
the option buyer will exercise the call option, the exporter will be
able to deliver the dollar, received from the exports to the buyer.
 
As we see from both the tables 4.1 and 4.2, we find that rupee
inflow under alternative 1 is higher than the inflow under
alternative 2 when the spot rate is less than Rs.41.90 and when
the spot rate is more than Rs.44.10. Where as the inflow under
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alternative 2 is more than the inflow under alternative 1 when

the spot rate lies between Rs.41.90 and Rs.44.10. So the selling
call option is superior to the buying put if the expected spot
price at the maturity lies within the range of strike price the sum
of two premiums. Thus, the selection of long put or short call
depends on the expectation of the hedger about the spot prices
that are likely to prevail at the time of exercising option.

Hedging for Importer

 
An Indian company is importing goods from Gulf country after
three months. The payment is expected to be made in dollars at
the time of importing goods. The value of import is US$ 10
million. The amount of rupees the importer will be paying will
depend on the spot rate of exchange prevailing then. Here the
importer is exposed to vagaries of currency rates which may
result in reduction of profit in the transaction or even resulting in
a loss. The importer, therefore, wants to hedge his rupee
outflows through currency options. The hedge can be obtained
by selecting one of the two alternatives.
 
Alternative 1:  Buy call option on US$ with a strike price of
Rs.43 by paying premium of Rs.0.60 per dollar.
 
Alternative 2: Sell put option on US$ with a strike price of
Rs.43 by receiving premium of Rs.0.50 per dollar.
 
Alternative 1: Indian company bought call option at a strike
price of Rs.43.00 per dollar by paying a premium of Rs. 0.60 per

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dollar. Maturity of the contract is 3 months from now. Table 4.3

provides the rupee outflows to the importer depending on the
spot price prevailing at the time of realization of payables.
Table 4.3
 
Exchange Option Rs. Outflow on Net
Rate exercised Outflow account Outflow
 (3 months Yes/No  of premium
hence) Rs./$
40.00 No 40.00 0.60 40.60
40.50 No 40.50 0.60 41.10
41.00 No 41.00 0.60 41.60
41.50 No 41.50 0.60 42.10
41.90 No 41.90 0.60 42.50
42.00 No 42.00 0.60 42.60
42.50 No 42.50 0.60 43.10
43.00 Indifferent 43.00 0.60 43.60
43.50 Yes 43.00 0.60 43.60
44.00 Yes 43.00 0.60 43.60
44.10 Yes 43.00 0.60 43.60
44.50 Yes 43.00 0.60 43.60
45.00 Yes 43.00 0.60 43.60
45.50 Yes 43.00 0.60 43.60
 
Importer by paying a Rs.0.60 premium, the effective price after
three months would be 43.60 (i.e. 43.00 + 0.60) or less. If the
dollar depreciates relative to the rupee below the 43.00 level, the
public limited company will be able to buy the dollar currency at

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a spot price and hence the option is allowed to expire. If the spot
price is more than Rs.43.00 or equal then the option is exercised.
 
Alternative 2: The Indian company is having another
alternative to hedge the dollar payables by selling the put option
at a strike price of Rs.43.00 per dollar by receiving premium of say
Rs.0.50 per dollar, for the contract maturing 3 months from now.
Table 4.4 provides the rupee outflows to the importer depending
on the spot price prevailing at the time of realization of payables.
Table 4.4
 
Exchange
Rate Option Inflow on
Rs. Net
 (3 months exercised account
Outflow Outflow
hence) Yes/No  of premium
 Rs./$
40.00 Yes 43.00 0.50 42.50
40.50 Yes 43.00 0.50 42.50
41.00 Yes 43.00 0.50 42.50
41.50 Yes 43.00 0.50 42.50
41.90 Yes 43.00 0.50 42.50
42.00 Yes 43.00 0.50 42.50
42.50 Yes 43.00 0.50 42.50
43.00 Indifferent 43.00 0.50 42.50
43.50 No 43.50 0.50 43.00
44.00 No 44.00 0.50 43.50
44.10 No 44.10 0.50 43.60
44.50 No 44.50 0.50 44.00
45.00 No 45.00 0.50 44.50

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Exchange
Rate Option Inflow on
Rs. Net
 (3 months exercised account
Outflow Outflow
hence) Yes/No  of premium
 Rs./$
45.50 No 45.50 0.50 45.00
 
Considering the premium of Rs.50 per dollar receiving for
selling a call option, the effective delivery price after three
months would be 43.50 (i.e. 43.00 + 0.50) or more. If the dollar
depreciates relative to the rupee well below the 43.00 level, the
option buyer will exercise the put option; the importer will be
able to take delivery of the dollar which will be used for import
payments.
 
As we see from both the tables 4.3 and 4.4, we find that rupee
outflow under alternative 1 is less than the outflow under
alternative 2 when the spot rate is less than Rs.41.90 and when
the spot rate is more than Rs.44.10. Whereas the outflow under
alternative 2 is less than the outflow under alternative 1 when
the spot rate lies between Rs.41.90 and Rs.44.10. So the selling
put option is superior to the buying call if the expected spot price
at the maturity lies within range of strike price the sum of two
premiums. Thus the selection of long call or short put depends on
the expectation of the hedger about the spot prices that are likely to
prevail at the time of exercising option.
 
RBI Guidelines for Currency Options
 

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An authorised dealer (AD) can offer currency options on the

fulfillment of the conditions laid down by the RBI. These
include:
 
•    The ADs, basically banks, must have a minimum CRAR of 9
percent.
•    Continuous profitability for at least three years.
•    Minimum net worth of Rs 200 crore.
•    Net NPAs (non-performing assets) at reasonable levels, i.e., not
more than 5 percent of net advances.
•    Trading in plain vanilla OTC European options is permitted
·          Currency options are limited to the currencies of G-7
countries.
•    Customers can purchase call and put options, the writing of
options is not permitted.
•    ADs may quote the option premium in rupees or as a
percentage of the rupee/foreign currency notional.
•    Only one hedge transaction can be booked against a particular
exposure or part thereof for a given period.
•     Banks should mark to market the portfolio on a daily basis.
•    All the conditions applicable for rolling over, booking and
cancellation of forwards contracts would be applicable to
options contracts also,
•    ADs have to report to the RBI on a weekly basis.
•    Options contracts can be settled on maturity either by the
delivery on spot basis or by net cash settlement in rupees on spot
basis specified in the contract.
 
Table 4.3
 

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Exchange Option Rs. Outflow on Net

Rate exercised Outflow account Outflow
 (3 months Yes/No  of premium
hence) Rs./$
40.00 No 40.00 0.60 40.60
40.50 No 40.50 0.60 41.10
41.00 No 41.00 0.60 41.60
41.50 No 41.50 0.60 42.10
41.90 No 41.90 0.60 42.50
42.00 No 42.00 0.60 42.60
42.50 No 42.50 0.60 43.10
43.00 Indifferent 43.00 0.60 43.60
43.50 Yes 43.00 0.60 43.60
44.00 Yes 43.00 0.60 43.60
44.10 Yes 43.00 0.60 43.60
44.50 Yes 43.00 0.60 43.60
45.00 Yes 43.00 0.60 43.60
45.50 Yes 43.00 0.60 43.60
 
Importer by paying a Rs.0.60 premium, the effective price after
three months would be 43.60 (i.e. 43.00 + 0.60) or less. If the
dollar depreciates relative to the rupee below the 43.00 level, the
public limited company will be able to buy the dollar currency at
a spot price and hence the option is allowed to expire. If the spot
price is more than Rs.43.00 or equal then the option is exercised.
 
Alternative 2: The Indian company is having another
alternative to hedge the dollar payables by selling the put option
at a strike price of Rs.43.00 per dollar by receiving premium of say
Rs.0.50 per dollar, for the contract maturing 3 months from now.
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Table 4.4 provides the rupee outflows to the importer depending

on the spot price prevailing at the time of realization of payables.
Table 4.4
 
Exchange
Rate Option Inflow on
Rs. Net
 (3 months exercised account
Outflow Outflow
hence) Yes/No  of premium
 Rs./$
40.00 Yes 43.00 0.50 42.50
40.50 Yes 43.00 0.50 42.50
41.00 Yes 43.00 0.50 42.50
41.50 Yes 43.00 0.50 42.50
41.90 Yes 43.00 0.50 42.50
42.00 Yes 43.00 0.50 42.50
42.50 Yes 43.00 0.50 42.50
43.00 Indifferent 43.00 0.50 42.50
43.50 No 43.50 0.50 43.00
44.00 No 44.00 0.50 43.50
44.10 No 44.10 0.50 43.60
44.50 No 44.50 0.50 44.00
45.00 No 45.00 0.50 44.50
45.50 No 45.50 0.50 45.00
 
Considering the premium of Rs.50 per dollar receiving for
selling a call option, the effective delivery price after three
months would be 43.50 (i.e. 43.00 + 0.50) or more. If the dollar
depreciates relative to the rupee well below the 43.00 level, the
option buyer will exercise the put option; the importer will be

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able to take delivery of the dollar which will be used for import
payments.
 
As we see from both the tables 4.3 and 4.4, we find that rupee
outflow under alternative 1 is less than the outflow under
alternative 2 when the spot rate is less than Rs.41.90 and when
the spot rate is more than Rs.44.10. Whereas the outflow under
alternative 2 is less than the outflow under alternative 1 when
the spot rate lies between Rs.41.90 and Rs.44.10. So the selling
put option is superior to the buying call if the expected spot price
at the maturity lies within range of strike price the sum of two
premiums. Thus the selection of long call or short put depends on
the expectation of the hedger about the spot prices that are likely to
prevail at the time of exercising option.
 
RBI Guidelines for Currency Options
 
An authorised dealer (AD) can offer currency options on the
fulfillment of the conditions laid down by the RBI. These
include:
 
•    The ADs, basically banks, must have a minimum CRAR of 9
percent.
•    Continuous profitability for at least three years.
•    Minimum net worth of Rs 200 crore.
•    Net NPAs (non-performing assets) at reasonable levels, i.e., not
more than 5 percent of net advances.
•    Trading in plain vanilla OTC European options is permitted
·          Currency options are limited to the currencies of G-7
countries.

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•    Customers can purchase call and put options, the writing of
options is not permitted.
•    ADs may quote the option premium in rupees or as a
percentage of the rupee/foreign currency notional.
•    Only one hedge transaction can be booked against a particular
exposure or part thereof for a given period.
•     Banks should mark to market the portfolio on a daily basis.
•    All the conditions applicable for rolling over, booking and
cancellation of forwards contracts would be applicable to
options contracts also,
•    ADs have to report to the RBI on a weekly basis.
•    Options contracts can be settled on maturity either by the
delivery on spot basis or by net cash settlement in rupees on spot
basis specified in the contract.

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Chapter – 4 Tactics using currency futures

The rapid globalization of trade in the last decade of the

twentieth century has fuelled growth in foreign exchange
transactions and generated new strategies in the interbank
market. Foreign exchange exposure for businesses, once limited
to one or two currencies, has expanded to include a wide variety
of countries in different regions.

Hedging and Speculation using Forwards

• Expect a currency to appreciate
– Buy that currency forward (Long Position)
• Expect a currency to depreciate
– Sell that currency forward (Sell Position)
• Profit/Loss in a long position:
ST – K
• Profit/Loss in a short position:
K – ST
Where ST is the spot exchange rate at maturity and K is the
forward exchange rate at which you buy/sell a currency
forward.

Currency futures is a standardised exchange-traded contract, to

buy or sell a certain underlying instrument at a certain date in
the future, at a specified price and the underlying instrument is a
foreign exchange rate. Other types of currency derivative
products are currency swaps and options, just like we have
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futures and options in the equity market. Swaps, on the other

hand, are altogether a different product, wherein a currency is
exchanged with another, like the rupee with the yen, for a fixed
period and a specified exchange rate. Ideally, one would take
exposure in this market for the purpose of hedging and
speculation.
Hedging is undertaken to protect one's inflow and outflow of
funds. This is ideally done by investors who receive or send
regular or one-time money in foreign currency, maybe in dollars
or euro. If someone is getting $1,000 every month from the US
and the dollar-rupee rate is 42, he would get Rs 42,000. Now if
the dollar depreciates to Rs 41, then the loss would be Rs 1,000.
So to get a fixed inflow of Rs 42,000, which may be the
minimum requirement, he may take exposure by going short for
the near month and that would ensure he receives a similar
amount. Hedging is much more important to an exporter or
importer as the margins could be hurt badly. Exporter margins
have gone down due to appreciation of the rupee against the
dollar. On the other hand, this is beneficial for importers, as the
product ultimately becomes cheaper.
Speculation, on the other hand, is a type of trading activity
ideally done by a trader in a stock market. It increases liquidity
in the market, which is important for any market to develop.
Speculation is ideally done by large traders and institutional
players. Internationally, speculation is done by a host of players
like hedge funds.

Scenario:
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An investor believes that an upcoming decision by the World

Trade Organization concerning trade policy for certain
agricultural commodities will benefit the European Union. A
favorable decision is expected to generate a brief upswing in the
euro against the U.S. dollar. The value of the euro, while
generally declining over the previous month, has edged up in the
past three days.

Strategy:
Because the euro/U.S. dollar contracts are quoted in dollars per
regular euro, the investor establishes a long euro futures
position in early August by buying 3 September euro contracts
at a prevailing rate of 1.0667 dollars per euro. Each
contract represents 100,000 euro. The total contract value is
$320,010.00 (3 x 100,000 x 1.0667).
Result:
Three weeks later the World Trade
Organization decision does favor the
European Union and the euro appreciates
against the dollar, reaching a rate of
1.0880 dollars per euro. The investor closes
out his euro position by selling three euro
contracts at 1.0880 (total contract value of
$326,400.00) and realizes a profit of .0213
dollars/euro (total profit = $6,390.00).

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After over a year of introduction of exchange-traded currency

futures in the USD-INR pair on the stock exchanges in the
country, the market regulators have now permitted trading of
Euro-INR, Japanese Yen-INR and Pound Sterling-INR on the
exchange platform. This is a move that the market had been
demanding for a long time. This is an apt time to review how the
exchange-traded currency market has fared so far and what lies
ahead as it ventures further into new currency pairs.
The currency derivatives segment on the NSE and MCX has
witnessed consistent growth both in traded value and open
interest since its inception. The total turnover in the segment has
increased incredibly from $3.4bn in October 2008 to $84bn in
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December 2009. The average daily turnover reached $4bn in

December 2009. Open interest in the segment on the NSE and
MCX stood at around 4 lakh contracts till end-December 2009.
India already has an active over-the-counter (OTC) market in
currency derivatives where the average daily turnover was
$29bn in 2008 and $21bn in 2009 (till September 2009). This
market is being driven by its ability to meet the respective needs
of participants. For example, it is used by importers/exporters to
hedge their payables/receivables; foreign institutional investors
(FIIs) and NRIs use it to hedge their investments in India;
borrowers find it an effective way to hedge their foreign
currency loans and resident Indians find it an effective tool to
hedge their investments offshore. Further, for arbitrageurs it
presents an opportunity to arbitrage between onshore and non-
deliverable forward (NDF) markets.
The exchange-traded currency futures market is an extension of
this already available OTC market, but with added benefits of
greater accessibility to potential participants; high price
transparency; high liquidity; standardised contracts;
counterparty risk management through clearing corporation and
no requirement of underlying exposure in the currency. As the
market participants are realising these benefits of exchange-
traded market in currency, they are choosing this market over
OTC.
However, it is too early to see a major shift in activity from OTC
to exchange-traded market as it has created a niche for itself and
it would perhaps take some time for the currency futures market
to create one for itself. Globally, too, the foreign exchange
market is largely OTC in character. While the notional amount
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outstanding of OTC derivatives was as high as $63trn in June

2008, the exchange-traded market is rather non-existent with
notional amount outstanding as end-June 2009 being only 0.5%
of that in the OTC segment.
However, there is a renewed debate on the level of transparency
and counterparty risk in the OTC market kindled by the sub-
prime mortgage crisis in the US and the need to regulate OTC
transactions effectively. This throws up certain important issues
which, at best, may need to be handled separately.
India has, in this light, embarked upon an experiment by
attempting to make the exchange-traded currency market
popular and a first choice for investors. Though the market has
not been able to evince the kind of activity that the OTC market
has witnessed as yet, the recent phenomenal growth is a pointer
towards better days ahead for this market. Some of the issues
plaguing the market at present include the fact that many
corporates using currency derivatives for hedging their foreign
currency exposure find the requirement of margin and settlement
of daily mark-to-market differences cumbersome, especially
since there is no such requirement for OTC trades. It would
conceivably take some time for them to realise the concomitant
benefits of these risk containment measures. Also, there is a
perceived resistance to change and switchover from OTC to
exchange-traded framework following a level of comfortability
reached by market players with the OTC market framework.
Further, the market has been restricted in a number of ways. Till
recently only USD-INR futures contracts were permitted. One
hopes to see more activity in the segment with more currency
pairs being added. Also to start with, FIIs have not been
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permitted to participate in this market. This has in effect

restricted the liquidity that FIIs could have otherwise created.
FIIs are already active in Dubai Gold and Commodity Exchange
(DGCX). There is an opportunity for business for domestic
exchanges and intermediaries to be created in bringing this
market onshore. According to the latest release from DGCX,
Indian rupee futures volume rose 530% in 2009 to 66,346
contracts on the exchange. Volume in December 2009 was
346% higher compared with the same period last year. Though
small in comparison to volumes being traded on Indian
exchanges, there is still merit in getting this market onshore.
Additionally, the offshore NDF market in Indian rupee has also
been witnessing increasing volumes. The average daily volumes
on the NDF rupee market have increased from $38mn in 2003
Q1 to $800mn during 2008-09 (Asian Capital
Markets Monitor of ADB, April, 2009). Most of the major
foreign banks offer NDFs, but Indian banks are barred from
doing so. These markets have evolved for the Indian rupee
following foreign exchange convertibility restrictions. It is
serving as an avenue for non-domestic players, private
companies and investors in India to hedge foreign currency
exposure. It also derives liquidity from non-residents wishing to
speculate in the Indian rupee without exposure to the currency
and from arbitrageurs who try to exploit the differentials in the
prices in the onshore and offshore markets. Though foreign
investors can now transact in the onshore Indian forward
markets with greater flexibility following various measures
taken by RBI in recent years, allowing them access to the
exchange-traded currency futures platform would further help in

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getting the volumes in the NDF market onshore and enhance

liquidity on domestic exchanges.
India has witnessed enhanced foreign investment inflows and
trade flows in recent years. The Indian currency is now
becoming an important international currency. Though India
accounts for a very small proportion of the total foreign
exchange market turnover in the world as compared to other
countries, its share has been slowly but continuously increasing.
According to BIS estimates, the percentage share of Indian
rupee in total daily average foreign exchange turnover has
increased from 0.1% in 1998 to 0.2% in 2001 to 0.3% in 2004
and to 0.9% in April 2007 (updated data will be available in
April 2010). All of this implies greater need for hedging
currency risk in Indian rupee, particularly given that the
exchange rate has been quite volatile during the last few years
and hence increased importance of exchange-traded currency
market.
In conclusion, considering the nascent stage of development of
exchange-traded currency market in the country, the cautious
approach of the regulators is understandable. One hopes to see
further developments in the market’s regulatory framework over
time. There is no doubt that this is a market which will
eventually establish its own forte and will be an area of activity
to watch and gain from for all market participants in the near
future.

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Long Positions in Futures

Long Future Payoff

Profit

Profit

Time
0

Loss

Loss

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