CURENCY

DERIVATIVES -
FORWARDS, FUTURES, FORWARD RATE
AGREEMENT, OPTIONS, SWAPS
NAME OF THE FACULTY:Ms. N. RADHIKA
CURRENCY DERIVATIVES

• A derivative is a financial contract or an

instrument, whose returns and values are
derived from the value and the performance of
some underlying asset. The price of the
derivative instrument varies as per the price
fluctuations (value) in an underlying asset.
There exists direct relationship between the
price of an instrument and the value of an
asset. As soon as the price increases, asset
tends to acquire higher value and vice versa.
 CLASSIFICATION OF
CURRENCY DERIVATIVES
• EXCHANGE TRADED DERIVATIVES
• OVER THE COURIER DERIVATIVES
OPTIONS
• FUTURES
• SWAPS
• FORWARDS
• The following points highlight the four main
products of currency derivatives. The
products are:
• 1. Forward Contract
• 2. Futures Contract
• 3. Options Contract
• 4. Swaps.
• 1. Forward Contract:
• Forward contracts are used by companies and
individuals to hedge currency risk. In December
2003, the RBI permitted resident individuals to
enter into forward contracts to hedge their foreign
exchange risk. Resident Indians with foreign
currency deposits face the risk that the rupee will
appreciate against the foreign currency in which the
deposit is denominated. ICICI bank was the first to
offer such forward contracts to depositors, based on
demand. Variants of the forward contract are the
non-deliverable forward contract (NDF) and the
option dated forward.
• A non-deliverable forward (NDF) is a forward contract
in which both parties decide on the forward rate, the
currency pair, and the date of settlement. The NDF
market evolved in countries in which there were
currency controls. There are NDF markets for
currencies of several Asian countries (Indonesia,
Philippines, Korea and Taiwan), Eastern European
countries and Latin American countries. Not all
countries with capital controls have NDFs. There is no
NDF market for the Malaysian ringgit or the Thai baht.
Trading occurs in an offshore financial centre.
Therefore, the NDF market escapes the regulatory
control of the country whose currency is being traded.
• The main features of an NDF are:
• (i) The contract is for a notional amount and there is
no delivery of currencies on the maturity date.
• (ii) The contract is cash settled on the maturity date.
• (iii) The fixing date is a day that is two business days
before the settlement date.
• (iv) The forward rate is compared to the spot rate
for the currency pair on the fixing date. The
difference between the spot price and the forward
rate is multiplied by the notional amount.
• (v) This amount is paid by one party to the other
(usually in the US dollar) on the maturity date
• (vi) Two-way quotes are available from one week up to one year.
• (vii) The AD imposes a penalty if the contract is cancelled by the
other party.
• (viii) A forward contract is different from a forward rate
agreement (FRA). An FRA is entered into by two parties who
want to protect themselves against future interest rate
movements. The parties decide on a principal (say US $1
million) on which the interest rate should be calculated. This is
called the notional principal. Suppose current interest rates are
9% p.a. The buyer of an FRA believes that interest rates will
rise to 12%. So he agrees to pay a 10% interest rate on the
notional principal. The seller of an FRA believes that interest
rates are likely to fall to 8%, so he agrees to receive a 10%
interest rate on the notional principal.
• In an option dated forward contract, both
parties decide to exchange a currency pair
at a pre-determined price, but between two
pre-determined dates. The contract makes
allowances for shipment delays, or
uncertainty in delivery. It is ideally suited to
a corporate customer who has a foreign
currency receivable or payable but is not
clear on the exact date on which the receipt
(or payment) is due.
• 2. Futures Contract:
• Currency futures contracts on four currency pairs are
available on the USE, NSE and MCX. Trading requires
the opening of a currency futures account with a
member of the concerned exchange. The NSE pioneered
currency futures trading in August 2008. Its currency
derivatives trading system, NEAT–CDS (National
Exchange for Automated Trading-Currency Derivatives
Segment) provides fully automated screen-based
trading. The USE is India’s youngest exchange. It
commenced trading in September 2010, and is India’s
only dedicated currency derivatives exchange. The MCX
is a commodities exchange that began offering currency
derivatives in 2008.
• The important features of currency futures trading in India are:
• i. Currency futures are traded online and prices are displayed
on real-time basis.
• ii. Four currency pairs are traded on the NSE, USE, and the
MCX—USD/INR, Euro/INR, Japanese Yen/INR and Pound
sterling/INR.
• iii. The method of quotation refers to the number of units of
foreign currency in the currency pair. For the $/INR, €/INR and
£/INR, the method of quotation is the exchange rate in Indian
rupees for one unit of the foreign currency. But the method of
quotation for the ¥/INR is Indian rupees for 100 ¥.
• iv. The trading symbols on the NSE are – USD/INR, EUR/INR,
GBP/INR and JPY/INR.
• v. The NSE levies an extreme loss margin at 1% of the MTM
value of an open position.
• vi. Futures contracts are available for up to 12 months,
in multiples of one month. A new contract is introduced
each month.
• vii. A contract with a maturity of 1 month is called a
near-month contract and a contract with maturity of 11
months or 12 months is called a far-month contract.
• viii. Contract size is the number of units of foreign
currency in one futures contract. The contract size for
the $/INR, €/INR and £/INR is 1,000 units of the foreign
currency in the currency pair—for example, one
contract of $/INR is for $1,000. But the contract size for
the ¥/ INR is 100,000 units of the yen— so one unit of
¥/INR refers to yen 100,000.
• ix. The settlement rate is the RBI reference rate two
days prior to the settlement date. Contracts can be
settled in two ways – (i) Contracts open at expiry
are cash settled in Indian rupees, on the last
working day (excluding Saturdays) of the expiry
month. The final settlement price is the RBI
reference rate on the last trading day of the futures
contract, (ii) MTM settlement occurs at the end of
each day. The daily settlement price on a trading
day is the closing price of the futures contracts on
that day.
• x. Trading is online. The ICCL clears trades on the
USE and the NSSCL clears trades on the NSE.
• 3. Options Contract:
• The RBI granted permission to the NSE and
USE for exchange-traded currency options on
October 28, 2010. Residents of India were
permitted to participate in this market, subject
to RBI’s Exchange Traded Currency Options
(Reserve Bank) Directions of July 2010. The
currency options market is regulated by SEBI
and RBI.
• The RBI permitted banks to undertake exchange-based trading
of currency options, subject to certain conditions:
• (i) The bank should have a minimum net worth of Rs. 500
crores.
• (ii) The bank has a minimum capital adequacy ratio of 10%.
• (iii) The bank’s non-performing assets do not exceed 3%.
• (iv) The bank should have earned profits in the preceding three
financial years.
• It also permitted banks to trade in currency futures. Banks in
India can now undertake client-based trades, as well as
proprietary trades in exchange-traded currency options. Banks
could also undertake clearing of currency options and apply to
the concerned stock exchange, to become trading members and
clearing members.
• Types of Options:
• Specific combinations of options are known by
different names. For example, in a 3-month call
option, both parties may agree that the buyer has
the right to exercise the option on the 1st and the
15th of each month of the 3 months. This is called
a Bermuda option. It is a combination of a
European and an American option. Similarly, a
look back option gives the buyer the right to buy
(or sell) at the lowest (or highest) spot price from
inception of the contract to the date of maturity.
• Other combinations are:
• (i) The purchase of a call option, and the simultaneous sale of a
call option, each with different strike prices but with the same
maturity date, is called a bull spread.
• (ii) The simultaneous purchase of an out of the money call option
and an out of the money put option is called a collar.
• (iii) The purchase of a put option and the simultaneous sale of a
call option at different strike prices are called a cylinder.
• (iv) The sale of two at the money call options and the
simultaneous purchase of one in the money call option is called a
butterfly. It can also be the purchase of two at the money call
options, and the simultaneous sale of one in the money call option.
• (v) The purchase of a call and a put with the same strike
price and the same expiry date is called a long straddle.
• (vi) The sale of a call and a put with the same strike
price and the same expiry date is called a short straddle.
• (vii) The purchase of a call option and a put option with
strike prices that are equally out of the money, is called a
long strangle.
• (viii) The sale of a call option and a put options with
strike prices that are equally out of the money is called a
short strangle.
• (ix) The purchase of foreign currency and the purchase
of a put option on the currency, is called a protective
put.
• A break forward is a combination of a forward and an option. It is a
forward contract on currencies that is attached to an option contract
to do the opposite for the same currencies, at a different exchange
rate. For example, a forward contract to buy US dollars and sell
British Pounds at a specified forward rate (say $1.17/£), is attached to
an option to sell US dollars and buy British Pounds at another rate ($
1.19/£).
• A kick in forward is an option which automatically becomes a
forward contract when the spot rate reaches a particular pre-
determined rate. Suppose the pre-determined rate is Rs. 39.55/$.The
exercise price on a three-month call option entered into on 10th June,
with a maturity date of 10th September, is Rs. 39.50/$. If the
INR/USD spot rate reaches Rs. 39.55/ USD on 20 July, the contract
becomes a forward contract.
• An interest rate guarantee (IRG) is an option on a
forward rate agreement (FRA). Since the buyer of
an FRA expects interest rates to rise, he can enter
into an IRG instead of directly entering into an
FRA. He decides to buy the right to enter into an
FRA 3 months later at a pre-determined interest
rate for a pre-determined period (say 2 years). This
is called a buyer’s IRG. Similarly the seller who
believes that interest rates are likely to fall can enter
into an IRG to sell an FRA in future. This is called a
seller’s IRG. Note that in an IRG, the buyer (seller)
does not have the obligation to enter into an FRA at
the preset date in future.
• Options Specifications on the United Stock
Exchange (USE):
• In the money, at the money and out of the money
European call and put options on USD/ INR began
trading at the end of October 2010.
• i. The US dollar-Indian rupee spot rate is the
‘underlying’. The lot size is 1 contract. Each
contract is for $1,000. The outstanding position is in
USD.
• ii. The option premium is in rupee terms and must
be paid by the buyer to the exchange in cash, which
in turn hands over the premium to the seller.
• iii. Spot months are March, June, September and December. Each
contract is traded up to two working days prior to the last business
day of the expiry month at 12 noon. The exchange adopted the
same holidays as those declared by FEDAI.
• iv. The minimum tick size is Rs. 0.25.
• v. The exchange levies an initial margin and an extreme loss
margin. Both margins are deducted by the exchange online.
• vi. Contracts are settled in cash in Indian rupees, on the last
working day of the expiry month. On that date, all open ‘in the
money’ contracts are assumed to have been exercised at the final
settlement price. Table 5.7 shows the contract specifications for
currency call options as per the RBI reference rate of October 29,
2010.
• Reading Options Information:
• At any point of time, a currency derivatives
exchange publishes data on a number of call options
contracts and put option contracts outstanding.
Each options contract is identified by the spot
month (the month of maturity). Thus, a June call
options contract is one that matures in June. In
May, the June contract is called the near month
contract, and the August call options contract is
called the far month contract. For each options
contract (whether call or put), the data will specify
the strike price and the option premium.
• For each of the three spot months (June, July and August) there
can be several call option contracts and three put option contracts
with different strike prices, and different premiums:
• 1. An options contract in different spot months can have the same
strike price.
• 2. For a given strike price, the option premium will increase as the
spot month is farther into the future. Therefore, the option
premium for a call options contract with a strike price of $1.06 can
be $0.04 for spot June, $0.05 for spot July, and $0.06 for spot
August. This is because the option premium is composed of two
elements—the intrinsic value and the time value. The time value is
higher for longer maturity contracts. As the maturity increases
(whether for a call or a put option contract) the time value rises.
• 3. For a given spot month, the option
premium decreases for a call options
contract.
• 4. For a given spot month, the option
premium increases for a put options
contract.
• Option Greeks:
• Option Greeks (delta, gamma, theta, vega and
rho) are symbols whose values are calculated
for individual options, and a portfolio of
options, using the currency pair’s spot price
and the option premium. Theta is calculated
for a portfolio of currency options, and vega is
calculated for a portfolio of currency
derivatives. Delta is the rate of change in the
option price with respect to the spot price of
the underlying currency pair.
• Gamma is the rate of change in delta with
respect to the spot price of the underlying
currency pair. In a portfolio of currency
options, theta is the rate of change of the
portfolio’s value overtime. In a portfolio of
derivatives, vega is the rate of change of the
portfolio’s value with respect to the
underlying currency pair’s volatility. Rho is
the rate of change of the portfolio’s value,
when interest rates change.
• 4. Swaps:
• There are different types of swaps in the foreign exchange
market. A coupon only swap is also called an annuity swap.
Only the interest payments in two different currencies are
exchanged and there is no exchange of principal.
• A forward start swap is a deal which gets activated after a
‘deferral period’ mutually agreed upon by both parties. It is
also known as a delayed start swap. For example A’ enters
into a two-year swap deal with ‘B’ on January 10, 2011, with
a deferral period of three months. The trade date is January
10, 2011. The two-year period is counted from April 10, 2011.
The maturity date is April 10, 2013.
• In a basis swap, counter-parties exchange the currencies in which they
each pay floating rate of interest. For example A’ is paying a floating
rate of interest in pounds at LIBOR +1.5 %, and ‘B’ is paying a
floating rate of interest in Euros at LIBOR + 1.3 %.. ‘A’ swaps its
pound payments of interest for ‘B’s euros payment of interest.
• A spot-forward swap is a swap of a currency pair in the spot market
and another swap (of the same currency pair) in the forward market.
Both transactions are bilaterally negotiated by the same parties, and
entered into on the same day. For example, a dealer buys $10 million
in exchange for Euros in spot market from Bank XYZ. The swap of
dollars for euros takes place immediately. The dealer simultaneously
sells the $10 million in exchange for euros back to Bank XYZ in the
forward market, for delivery three months hence. The swap occurs at
a pre­determined future date, three months later. This is a Spot-
forward swap.
• A forward-forward swap is a swap consisting
of two deals in the forward market but with
exchange of currencies at two different and
pre-determined dates in the future. A dealer
sells $10 million forward for delivery in one
month at an exchange rate of €1.17/ $, and
simultaneously buys $10 million forward for
delivery in two months at an exchange rate
of €1.16/$.
• A cross-currency interest rate swap is the exchange of future interest
payments and the currencies in which the interest payments are to be
made. It is entered into to deal with currency mismatch. Perhaps a
company had to raise a US dollar loan in the USA for its project in
France, because it was cheaper to raise a loan in the home market (USA)
than in France. But revenues from the project will be received in euros. To
make the interest payments in the same currency as the revenue receipts,
the company will choose an interest rate swap, and swap its dollar-
denominated interest payments for euro-denominated interest payments.
• A cross-currency interest rate swap enables both the parties to the contract
to hedge exchange rate risk (caused by fluctuation of exchange rates
during the period of the swap contract) and interest rate risk (caused by
fluctuation of interest rates during the period of the swap contract).
• Cross-currency interest rate swaps are of different kinds depending
upon the structuring of the swap deal:
• i. In a fixed for fixed swap, both parties pay a fixed interest rate. It. is fixed
for fixed callable swap, when one of the parties has the right (but not the
obligation) to cancel the swap after a certain date, or at a certain time.
• ii. In a fixed for floating swap, one party swaps its fixed interest rate
payment, for the other’s floating interest rate payment. If an upper limit is
set on the floating interest rate, it is called a capped swap.
• iii. In a basis swap, two parties exchange floating interest rate
commitments. Each party has an existing floating interest rate payment
linked to a different benchmark. The exchange is done to match the return
on assets with the return on liabilities. It is also called a floating for
floating swap. Suppose a company has assets that earn a return (in British
pounds) linked to a three-month LIBOR, but has a liability on which it has
to pay interest (in US dollar) linked to six-month LIBOR. It goes in for a
cross-currency basis swap, by taking a British pound-denominated three-
month LIBOR linked interest rate swap.
• iv. A cross-currency swap is an option on a swap. The buyer of a swap
buys the right but not the obligation to enter into a cross currency swap
with the seller.
• v. A contingent swap is one which is activated when interest rates reach a
pre-specified level.
• vi. In a reversible swap, one of the parties has the option to alter the
payment basis (from fixed to floating) after a certain period.
• vii. In a zero for floating swap, one party accepts the other party’s
payments (in another currency) of a floating interest rate.
• viii. In a puttable swap, the party that is paying a fixed rate of interest has
the right but not the obligation, to cancel the swap on or after a certain
date. It combines a swap with the buyer’s position in an options contract.
• ix. In an extendable swap, the party that is paying a fixed rate of interest
has the right but not the obligation to extend the swap for a pre-determined
period. An example is a two- year swap agreement extendable for one
year.