PROJECT REPORT

ON
ANALYTICAL STUDY ON CURRENCY
DERIVATIVES IN INDIA

By: Nitin Gupta

Reg. No. 201300744

Guided By:Bhupinder Singh

(Manager)

SYMBIOSIS CENTRE FOR DISTANCE LEARNING

Year -2013-16

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This is to certify that Nitin Gupta is permitted to use relevant data / information of this
organization for his project in fulfillment of the PGDBA Program.

We wish him all the success.

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Place:
Date:

DECLARATION

This is to declare that I have carried out this project work myself in part fulfillment of the
PGDBA Program of SCDL.
The work is original, has not been copied from anywhere else and has not been submitted to
any other

University/Institute for an award of any degree/diploma.

Signature

Nitin Gupta

CERTIFICATE OF GUIDE

Certified that the work incorporated in this Project Report ANALYTICAL STUDY
ON CURRENCY DERIVATIVES IN INDIA submitted by Nitin Gupta is his original
work and completed under my supervision. Material obtained from other sources has been
duly acknowledged in the Project Report

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TABLE OF CONTENTS

1) Introduction
2) Objectives of the study
3) Literature review & problem formulation
i)

History and Development of Currency Derivative

ii)

Brief overview of foreign exchange market.

iii)

Rationale for Introducing Currency Futures

4) Research methodology
5) Analysis & Interpretation
6) Key findings
7) Suggestion
8) Limitation of the study
9) Annexure
10) Bibliography

INTRODUCTION

Each country has its own currency through which both national and international transactions
are performed. All the inter national business transactions involve an exchange of one
currency for another.
The foreign exchange markets of a country provide the mechanism of exchanging different
currencies with one and another, and thus, facilitating transfer of purchasing power
from one country to another .
With the multiple growths of international trade and finance all over the world, trading
in foreign currencies has grown tremendously over the past several decades.
Since the exchange rates are continuously changing, so the firms are exposed to the risk of
exchange rate movements. As a result the assets or liability or cash flows of a firm which are
denominated in foreign currencies undergo a change in value over a period of time due to
variation in exchange rates.
This variability in value of assets or liabilities or cash flows is referred to exchange
rate risk. Since the fixed exchange rate system has been fallen in the early
1970s, specifically in developed countries, the currency risk has become substantial for
many business fir ms that was the reason behind development of currency derivatives.
Each country has its own currency through which both national and international transactions
are performed.

All the international business transactions involve an exchange of one

currency for another.

For example,
If any Indian firm borrows funds from international financial market in US dollars for short
or long term then at maturity the same would be refunded in particular agreed currency along
with accrued interest on borrowed money. It means that the borrowed foreign currency
brought in the country will be converted into Indian currency, and when borrowed fund are
paid to the lender then the home currency will be converted into foreign lenders currency.
Thus, the currency units of a country involve an exchange of one currency for another. The
price of one currency in terms of other currency is known as exchange rate.

The foreign exchange markets of a country provide the mechanism of exchanging different
currencies with one and another, and thus, facilitating transfer of purchasing power from one
country to another.
With the multiple growths of international trade and finance all over the world, trading in
foreign currencies has grown tremendously over the past several decades.

Since the

exchange rates are continuously changing, so the firms are exposed to the risk of exchange
rate movements. As a result the assets or liability or cash flows of a firm which are
denominated in foreign currencies undergo a change in value over a period of time due to
variation in exchange rates.
This variability in the value of assets or liabilities or cash flows is referred to exchange rate
risk. Since the fixed exchange rate system has been fallen in the early 1970s, specifically in
developed countries, the currency risk has become substantial for many business firms.

OBJECTIVES OF STUDY
The primary objective of the study is first to gain some practical knowledge regarding the
functioning of Currency Derivatives and how are they traded in the market. Also it is
necessary to understand there primary functions and knowledge about various future
derivatives instruments.

The other objectives were:

To study the Importance of Currency Derivatives.

To study the role of working of future and options market.

To study the process and functions of Currency Derivatives .To explore the
methodology and types of Derivatives provided in India.

To study the purpose, process, principle, functions of the Currency Derivatives.

To study the different types of methods/techniques used to evaluate them.

To study the level of evaluations.

Know the challenges which are faced in present market scenario.

INTRODUCTION TO FINANCIAL DERIVATIVES

By far the most significant event in finance during the past decade has been the
extraordinary development and expansion of

financial derivativesThese instruments

enhances the ability to differentiate risk and allocate it to those investors most able and
willing to take it- a process that has undoubtedly improved national productivity growth
and standards of livings.

Alan Greenspan , Former Chairman

US Federal Reserve Bank
The past decades has witnessed the multiple growths in the volume of international trade
and business due to the wave of globalization and liberalization all over the world.

As a

result, the demand for the international money and financial instruments increased
significantly at the global level. In this respect, changes in the interest rates, exchange rate
and stock market prices at the different financial market have increased the financial risks
to the corporate world.

**DEFINITION OF FINANCIALDERIVATIVES**
A word formed by derivation. It means, this word has been arisen by derivation.
Something derived; it means that some things have to be derived or arisen out of the
underlying variables. A financial derivative is an indeed derived from the financial
market.
Derivatives are financial contracts whose value/price is independent on the behavior
of the price of one or more basic underlying assets. These contracts are legally
binding agreements, made on the trading screen of stock exchanges, to buy or sell an

asset in future. These assets can be a share, index, interest rate, bond, rupee dollar
exchange rate, sugar, crude oil, soybeans, cotton, coffee and what you have.
A very simple example of derivatives is curd, which is derivative of milk. The price
of curd depends upon the price of milk which in turn depends upon the demand and
supply of milk.
The Underlying Securities for Derivatives are :
Commodities: Castor seed, Grain, Pepper, Potatoes, etc.
Precious Metal : Gold, Silver
Short Term Debt Securities : Treasury Bills
Interest Rates
Common shares/stock
Stock Index Value : NSE Nifty
Currency : Exchange Rate

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TYPES OF FINANCIAL DERIVATIVES

Financial derivatives are those assets whose values are determined by the value of some
other assets, called as the underlying.

Presently there are Complex varieties of

derivatives already in existence and the markets are innovating newer and newer ones
continuously. For example, various types of financial derivatives based on their different
properties like, plain, simple or straightforward, composite, joint or hybrid, synthetic,
leveraged, mildly leveraged, OTC traded, standardized or organized exchange traded, etc.
are available in the market. Due to complexity in nature, it is very difficult to classify the
financial derivatives, so in the present context, the basic financial derivatives which are
popularly in the market have been described. In the simple form, the derivatives can be
classified into different categories which are shown below :
DERIVATIVES

Financials

Commodities

Basics

Complex

1. Forwards

1. Swaps

2. Futures

2.Exotics (Non STD)

3. Options
4. Warrants and Convertibles
One form of classification of derivative instruments is between commodity derivatives and
financial derivatives. The basic difference between these is the nature of the underlying
instrument or assets. In commodity derivatives, the underlying instrument is commodity
which may be wheat, cotton, pepper, sugar, jute, turmeric, corn, crude oil, natural gas,
gold, silver and so on. In financial derivative, the underlying instrument may be treasury
bills, stocks, bonds, foreign exchange, stock index, cost of living index etc. It is to be
11

noted that financial derivative is fairly standard and there are no quality issues whereas in
commodity derivative, the quality may be the underlying matters.

Another way of classifying the financial derivatives is into basic and complex. In this,
forward contracts, futures contracts and option contracts have been included in the basic
derivatives whereas swaps and other complex derivatives are taken into complex category
because they are built up from either forwards/futures or options contracts, or both. In
fact, such derivatives are effectively derivatives of derivatives.
Derivatives are traded at organized exchanges and in the Over The Counter
( OTC ) market :
Derivatives Trading Forum

Organized Exchanges

Over The Counter

Commodity Futures

Forward Contracts

Financial Futures

Swaps

Options (stock and index)

Stock Index Future
Derivatives traded at exchanges are standardized contracts having standard delivery dates
and trading units. OTC derivatives are customized contracts that enable the parties to
select the trading units and delivery dates to suit their requirements.
A major difference between the two is that of counterparty riskthe risk of default by
either party. With the exchange traded derivatives, the risk is controlled by exchanges
through clearing house which act as a contractual intermediary and impose margin
requirement. In contrast, OTC derivatives signify greater vulnerability.

12

DERIVATIVES INTRODUCTION IN INDIA

The first step towards introduction of derivatives trading in India was the promulgation of
the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on
options in securities. SEBI set up a 24 member committee under the chairmanship of
Dr. L.C. Gupta on November 18, 1996 to develop appropriate regulatory framework for
derivatives trading in India, submitted its report on March 17, 1998. The committee
recommended that the derivatives should be declared as securities so that regulatory
framework applicable to trading of securities could also govern trading of derivatives.
To begin with, SEBI approved trading in index futures contracts based on S&P CNX
Nifty and BSE-30 (Sensex) index. The trading in index options commenced in June 2001
and the trading in options on individual securities commenced in July 2001. Futures
contracts on individual stocks were launched in November 2001.

HISTORY OF CURRENCY DERIVATIVES

Currency futures were first created at the Chicago Mercantile Exchange (CME) in 1972.The
contracts were created under the guidance and leadership of Leo Melamed, CME Chairman
Emeritus. The FX contract capitalized on the U.S. abandonment of the Bretton Woods
agreement, which had fixed world exchange rates to a gold standard after World War II. The
abandonment of the Bretton Woods agreement resulted in currency values being allowed to
float, increasing the risk of doing business. By creating another type of market in which
futures could be traded, CME currency futures extended the reach of risk management
beyond commodities, which were the main derivative contracts traded at CME until then. The
concept of currency futures at CME was revolutionary, and gained credibility through
endorsement of Nobel-prize-winning economist Milton Friedman.
Today, CME offers 41 individual FX futures and 31 options contracts on 19 currencies, all of
which trade electronically on the exchanges CME Globex platform. It is the largest regulated
marketplace for FX trading. Traders of CME FX futures are a diverse group that includes
multinational corporations, hedge funds, commercial banks, investment banks, financial
managers, commodity trading advisors (CTAs), proprietary trading firms; currency overlay
13

managers and individual investors. They trade in order to transact business, hedge against
unfavorable changes in currency rates, or to speculate on rate fluctuations.
Source: - (NCFM-Currency future Module)

UTILITY OF CURRENCY DERIVATIVES

Currency-based derivatives are used by exporters invoicing receivables in foreign currency,
willing to protect their earnings from the foreign currency depreciation by locking the
currency conversion rate at a high level. Their use by importers hedging foreign currency
payables is effective when the payment currency is expected to appreciate and the importers
would like to guarantee a lower conversion rate. Investors in foreign currency denominated
securities would like to secure strong foreign earnings by obtaining the right to sell foreign
currency at a high conversion rate, thus defending their revenue from the foreign currency
depreciation. Multinational companies use currency derivatives being engaged in direct
investment overseas. They want to guarantee the rate of purchasing foreign currency for
various payments related to the installation of a foreign branch or subsidiary, or to a joint
venture with a foreign partner.
A high degree of volatility of exchange rates creates a fertile ground for foreign exchange
speculators. Their objective is to guarantee a high selling rate of a foreign currency by
obtaining a derivative contract while hoping to buy the currency at a low rate in the future.
Alternatively, they may wish to obtain a foreign currency forward buying contract, expecting
to sell the appreciating currency at a high future rate. In either case, they are exposed to the
risk of currency fluctuations in the future betting on the pattern of the spot exchange rate
adjustment consistent with their initial expectations.
The most commonly used instrument among the currency derivatives are currency forward
contracts. These are large notional value selling or buying contracts obtained by exporters,
importers, investors and speculators from banks with denomination normally exceeding 2
million USD. The contracts guarantee the future conversion rate between two currencies and
can be obtained for any customized amount and any date in the future. They normally do not
require a security deposit since their purchasers are mostly large business firms and
14

investment institutions, although the banks may require compensating deposit balances or
lines of credit. Their transaction costs are set by spread between bank's buy and sell prices.
Exporters invoicing receivables in foreign currency are the most frequent users of these
contracts. They are willing to protect themselves from the currency depreciation by locking in
the future currency conversion rate at a high level. A similar foreign currency forward selling
contract is obtained by investors in foreign currency denominated bonds (or other securities)
who want to take advantage of higher foreign that domestic interest rates on government or
corporate bonds and the foreign currency forward premium. They hedge against the foreign
currency depreciation below the forward selling rate which would ruin their return from
foreign financial investment. Investment in foreign securities induced by higher foreign
interest rates and accompanied by the forward selling of the foreign currency income is called
a covered interest arbitrage.
Source :-( Recent Development in International Currency Derivative Market by Lucjan T.
Orlowski)

15

INTRODUCTION TO CURRENCY DERIVATIVES

Each country has its own currency through which both national and international
transactions are performed.

All the international business transactions involve an

exchange of one currency for another.

For example,
If any Indian firm borrows funds from international financial market in US
dollars for short or long term then at maturity the same would be refunded in particular
agreed currency along with accrued interest on borrowed money.

It means that the

borrowed foreign currency brought in the country will be converted into Indian currency,
and when borrowed fund are paid to the lender then the home currency will be converted
into foreign lenders currency.

Thus, the currency units of a country involve an exchange

of one currency for another.

The price of one currency in terms of other currency is known as exchange rate.
The foreign exchange markets of a country provide the mechanism of exchanging different
currencies with one and another, and thus, facilitating transfer of purchasing power from
one country to another.
With the multiple growths of international trade and finance all over the world, trading in
foreign currencies has grown tremendously over the past several decades. Since the
exchange rates are continuously changing, so the firms are exposed to the risk of exchange
rate movements. As a result the assets or liability or cash flows of a firm which are
denominated in foreign currencies undergo a change in value over a period of time due to
variation in exchange rates.
This variability in the value of assets or liabilities or cash flows is referred to exchange
rate risk. Since the fixed exchange rate system has been fallen in the early 1970s,
specifically in developed countries, the currency risk has become substantial for many
business firms. As a result, these firms are increasingly turning to various risk hedging
products like foreign currency futures, foreign currency forwards, foreign currency
options, and foreign currency swaps.
16

INTRODUCTION TO CURRENCY FUTURE

A futures contract is a standardized contract, traded on an exchange, to buy or sell a certain

underlying asset or an instrument at a certain date in the future, at a specified price. When
the underlying asset is a commodity, e.g. Oil or Wheat, the contract is termed a

commodity futures contract. When the underlying is an exchange rate, the contract is

termed a currency futures contract. In other words, it is a contract to exchange one

currency for another currency at a specified date and a specified rate in the future.
Therefore, the buyer and the seller lock themselves into an exchange rate for a specific
value or delivery date. Both parties of the futures contract must fulfill their obligations on
the settlement date.
Currency futures can be cash settled or settled by delivering the respective obligation of
the seller and buyer. All settlements however, unlike in the case of OTC markets, go
through the exchange.
Currency futures are a linear product, and calculating profits or losses on Currency Futures
will be similar to calculating profits or losses on Index futures. In determining profits and
losses in futures trading, it is essential to know both the contract size (the number of
currency units being traded) and also what is the tick value. A tick is the minimum trading
increment or price differential at which traders are able to enter bids and offers. Tick
values differ for different currency pairs and different underlying. For e.g. in the case of
the USD-INR currency futures contract the tick size shall be 0.25 paise or 0.0025 Rupees.
To demonstrate how a move of one tick affects the price, imagine a trader buys a contract
(USD 1000 being the value of each contract) at Rs.42.2500. One tick move on this
contract will translate to Rs.42.2475 or Rs.42.2525 depending on the direction of market
movement.

Purchase price:

Rs .42.2500

Price increases by one tick:

+Rs. 00.0025

New price:

Rs .42.2525

17

Purchase price:
Price decreases by one tick:

Rs .42.2500
Rs. 00.0025

New price:

Rs.42. 2475

The value of one tick on each contract is Rupees 2.50. So if a trader buys 5 contracts and
the price moves up by 4 tick, she makes Rupees 50.
Step 1:

42.2600 42.2500

Step 2:

4 ticks * 5 contracts = 20 points

Step 3:

20 points * Rupees 2.5 per tick = Rupees 50

BRIEF OVERVIEW OF FOREIGN EXCHANGE MARKET

OVERVIEW OF THE FOREIGN EXCHANGE MARKET IN INDIA
During the early 1990s, India embarked on a series of structural reforms in the foreign
exchange market. The exchange rate regime, that was earlier pegged, was partially floated in
March 1992 and fully floated in March 1993. The unification of the exchange rate was
instrumental in developing a market-determined exchange rate of the rupee and was an
important step in the progress towards total current account convertibility, which was
achieved in August 1994.
Although liberalization helped the Indian forex market in various ways, it led to extensive
fluctuations of exchange rate. This issue has attracted a great deal of concern from policymakers and investors. While some flexibility in foreign exchange markets and exchange rate
determination is desirable, excessive volatility can have an adverse impact on price discovery,
export performance, sustainability of current account balance, and balance sheets. In the
context of upgrading Indian foreign exchange market to international standards, a welldeveloped foreign exchange derivative market (both OTC as well as Exchange-traded) is
imperative.
With a view to enable entities to manage volatility in the currency market, RBI on April 20,
2007 issued comprehensive guidelines on the usage of foreign currency forwards, swaps and
options in the OTC market. At the same time, RBI also set up an Internal Working Group to
18

explore the advantages of introducing currency futures. The Report of the Internal Working
Group of RBI submitted in April 2008, recommended the introduction of Exchange Traded
Currency Futures.
Subsequently, RBI and SEBI jointly constituted a Standing Technical Committee to analyze
the Currency Forward and Future market around the world and lay down the guidelines to
introduce Exchange Traded Currency Futures in the Indian market. The Committee submitted
its report on May 29, 2008. Further RBI and SEBI also issued circulars in this regard on
August 06, 2008.
Currently, India is a USD 34 billion OTC market, where all the major currencies like USD,
EURO, YEN, Pound, Swiss Franc etc. are traded. With the help of electronic trading and
efficient risk management systems, Exchange Traded Currency Futures will bring in more
transparency and efficiency in price discovery, eliminate counterparty credit risk, provide
access to all types of market participants, offer standardized products and provide transparent
trading platform. Banks are also allowed to become members of this segment on the
Exchange,

thereby

providing

them

with

new

opportunity.

Source :-( Report of the RBI-SEBI standing technical committee on exchange traded
currency futures) 2008.

19

CURRENCY DERIVATIVE PRODUCTS

Derivative contracts have several variants. The most common variants are forwards,
futures, options and swaps. We take a brief look at various derivatives contracts that have
come to be used.
FORWARD :
The basic objective of a forward market in any underlying asset is to fix a price for a
contract to be carried through on the future agreed date and is intended to free both
the purchaser and the seller from any risk of loss which might incur due to
fluctuations in the price of underlying asset.
A forward contract is customized contract between two entities, where settlement
takes place on a specific date in the future at todays pre-agreed price. The exchange
rate is fixed at the time the contract is entered into. This is known as forward
exchange rate or simply forward rate.
FUTURE :
A currency futures contract provides a simultaneous right and obligation to buy and
sell a particular currency at a specified future date, a specified price and a standard
quantity. In another word, a future contract is an agreement between two parties to
buy or sell an asset at a certain time in the future at a certain price. Future contracts
are special types of forward contracts in the sense that they are standardized
exchange-traded contracts.
SWAP :
Swap is private agreements between two parties to exchange cash flows in the future
according to a prearranged formula. They can be regarded as portfolio of forward
contracts.

20

The currency swap entails swapping both principal and interest between the parties,
with the cash flows in one direction being in a different currency than those in the
opposite direction. There are a various types of currency swaps like as fixed-to-fixed
currency swap, floating to floating swap, fixed to floating currency swap.
In a swap normally three basic steps are involve___
(1) Initial exchange of principal amount
(2) Ongoing exchange of interest
(3) Re - exchange of principal amount on maturity.
OPTIONS :
Currency option is a financial instrument that give the option holder a right and not
the obligation, to buy or sell a given amount of foreign exchange at a fixed price per
unit for a specified time period ( until the expiration date ). In other words, a foreign
currency option is a contract for future delivery of a specified currency in exchange
for another in which buyer of the option has to right to buy (call) or sell (put) a
particular currency at an agreed price for or within specified period. The seller of the
option gets the premium from the buyer of the option for the obligation undertaken in
the contract. Options generally have lives of up to one year, the majority of options
traded on options exchanges having a maximum maturity of nine months. Longer
dated options are called warrants and are generally traded OTC.

21

FOREIGN EXCHANGE SPOT (CASH) MARKET

The foreign exchange spot market trades in different currencies for both spot and forward
delivery. Generally they do not have specific location, and mostly take place primarily by
means of telecommunications both within and between countries.
It consists of a network of foreign dealers which are oftenly banks, financial institutions,
large concerns, etc. The large banks usually make markets in different currencies.
In the spot exchange market, the business is transacted throughout the world on a
continual basis. So it is possible to transaction in foreign exchange markets 24 hours a
day. The standard settlement period in this market is 48 hours, i.e., 2 days after the
execution of the transaction.
The spot foreign exchange market is similar to the OTC market for securities. There is no
centralized meeting place and no fixed opening and closing time. Since most of the
business in this market is done by banks, hence, transaction usually do not involve a
physical transfer of currency, rather simply book keeping transfer entry among banks.

Exchange rates are generally determined by demand and supply force in this market.
The purchase and sale of currencies stem partly from the need to finance trade in goods
and services.

Another important source of demand and supply arises from the

participation of the central banks which would emanate from a desire to influence the
direction, extent or speed of exchange rate movements.

22

FOREIGN EXCHANGE QUOTATIONS

Foreign exchange quotations can be confusing because currencies are quoted in terms of
other currencies. It means exchange rate is relative price.
For example,
If one US dollar is worth of Rs. 45 in Indian rupees then it implies that 45
Indian rupees will buy one dollar of USA, or that one rupee is worth of 0.022 US dollar
which is simply reciprocal of the former dollar exchange rate.

EXCHANGE RATE

Direct

Indirect

The number of units of domestic

The number of unit of foreign

Currency stated against one unit

currency per unit of domestic

of foreign currency.

currency.

Re/$ = 45.7250 ( or )

Re 1 = $ 0.02187

$1 = Rs. 45.7250

There are two ways of quoting exchange rates: the direct and indirect.
Most countries use the direct method. In global foreign exchange market, two rates are
quoted by the dealer: one rate for buying (bid rate), and another for selling (ask or
offered rate) for a currency. This is a unique feature of this market. It should be noted
that where the bank sells dollars against rupees, one can say that rupees against dollar. In
order to separate buying and selling rate, a small dash or oblique line is drawn after the
dash.
23

For example,
If

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

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

It is important to note that selling rate is always higher than the buying rate.
Traders, usually large banks, deal in two way prices, both buying and selling, are called
market makers.

Base Currency/ Terms Currency:

In foreign exchange markets, the base currency is the first currency in a currency pair. The
second currency is called as the terms currency. Exchange rates are quoted in per unit of
the base currency. That is the expression Dollar-Rupee, tells you that the Dollar is being
quoted in terms of the Rupee. The Dollar is the base currency and the Rupee is the terms
currency.
Exchange rates are constantly changing, which means that the value of one currency in
terms of the other is constantly in flux. Changes in rates are expressed as strengthening or
weakening of one currency vis--vis the second currency.
Changes are also expressed as appreciation or depreciation of one currency in terms of
the second currency. Whenever the base currency buys more of the terms currency, the
base currency has strengthened / appreciated and the terms currency has weakened /
depreciated.

24

For example,
If Dollar Rupee moved from 43.00 to 43.25. The Dollar has appreciated and
the Rupee has depreciated. And if it moved from 43.0000 to 42.7525 the Dollar has
depreciated and Rupee has appreciated.
NEED FOR EXCHANGE TRADED CURRENCY FUTURES
With a view to enable entities to manage volatility in the currency market, RBI on April
20, 2007 issued comprehensive guidelines on the usage of foreign currency forwards,
swaps and options in the OTC market. At the same time, RBI also set up an Internal
Working Group to explore the advantages of introducing currency futures. The Report of
the Internal Working Group of RBI submitted in April 2008, recommended the
introduction of exchange traded currency futures. Exchange traded futures as compared to
OTC forwards serve the same economic purpose, yet differ in fundamental ways. An
individual entering into a forward contract agrees to transact at a forward price on a future
date. On the maturity date, the obligation of the individual equals the forward price at
which the contract was executed. Except on the maturity date, no money changes hands.
On the other hand, in the case of an exchange traded futures contract, mark to market
obligations is settled on a daily basis. Since the profits or losses in the futures market are
collected / paid on a daily basis, the scope for building up of mark to market losses in the
books of various participants gets limited.
The counterparty risk in a futures contract is further eliminated by the presence of a
clearing corporation, which by assuming counterparty guarantee eliminates credit risk.
Further, in an Exchange traded scenario where the market lot is fixed at a much lesser size
than the OTC market, equitable opportunity is provided to all classes of investors whether
large or small to participate in the futures market. The transactions on an Exchange are
executed on a price time priority ensuring that the best price is available to all categories
of market participants irrespective of their size. Other advantages of an Exchange traded
market would be greater transparency, efficiency and accessibility.
Source :-( Report of the RBI-SEBI standing technical committee on exchange traded
currency futures) 2008.
25

RATIONALE FOR INTRODUCING CURRENCY FUTURE

Futures markets were designed to solve the problems that exist in forward markets. A futures
contract is an agreement between two parties to buy or sell an asset at a certain time in the
future at a certain price. But unlike forward contracts, the futures contracts are standardized
and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies
certain standard features of the contract. A futures contract is standardized contract with
standard underlying instrument, a standard quantity and quality of the underlying instrument that
can be delivered, (or which can be used for reference purposes in settlement) and a standard
timing of such settlement. A futures contract may be offset prior to maturity by entering into an
equal and opposite transaction.
The standardized items in a futures contract are:

Quantity of the underlying

Quality of the underlying

The date and the month of delivery

The units of price quotation and minimum price change

Location of settlement

The rationale for introducing currency futures in the Indian context has been outlined in the
Report of the Internal Working Group on Currency Futures (Reserve Bank of India, April 2008)
as follows;
The rationale for establishing the currency futures market is manifold. Both residents and nonresidents purchase domestic currency assets. If the exchange rate remains unchanged from the
time of purchase of the asset to its sale, no gains and losses are made out of currency exposures.
But if domestic currency depreciates (appreciates) against the foreign currency, the exposure
would result in gain (loss) for residents purchasing foreign assets and loss (gain) for non
residents purchasing domestic assets. In this backdrop, unpredicted movements in exchange
rates expose investors to currency risks.

26

Currency futures enable them to hedge these risks. Nominal exchange rates are often random
walks with or without drift, while real exchange rates over long run are mean reverting. As
such, it is possible that over a long run, the incentive to hedge currency risk may not be large.
However, financial planning horizon is much smaller than the long-run, which is typically intergenerational in the context of exchange rates. As such, there is a strong need to hedge currency
risk and this need has grown manifold with fast growth in cross-border trade and investments
flows. The argument for hedging currency risks appear to be natural in case of assets, and
applies equally to trade in goods and services, which results in income flows with leads and
lags and
get converted into different currencies at the market rates. Empirically, changes in exchange
rate are found to have very low correlations with foreign equity and bond returns. This in
theory should lower portfolio risk. Therefore, sometimes argument is advanced against the need
for hedging currency risks. But there is strong empirical evidence to suggest that hedging
reduces the volatility of returns and indeed considering the episodic nature of currency returns,
there are strong arguments to use instruments to hedge currency risks.

FUTURE TERMINOLOGY
SPOT PRICE :
27

The price at which an asset trades in the spot market. The transaction in which
securities and foreign exchange get traded for immediate delivery.

Since the

exchange of securities and cash is virtually immediate, the term, cash market, has also
been used to refer to spot dealing. In the case of USDINR, spot value is T + 2.
FUTURE PRICE :
The price at which the future contract traded in the future market.
CONTRACT CYCLE :
The period over which a contract trades. The currency future contracts in Indian
market have one month, two month, three month up to twelve month expiry cycles. In
NSE/BSE will have 12 contracts outstanding at any given point in time.
VALUE DATE / FINAL SETTELMENT DATE :
The last business day of the month will be termed the value date /final settlement date
of each contract. The last business day would be taken to the same as that for inter
bank settlements in Mumbai. The rules for inter bank settlements, including those for
known holidays and would be those as laid down by Foreign Exchange Dealers
Association of India (FEDAI).
EXPIRY DATE :
It is the date specified in the futures contract. This is the last day on which the
contract will be traded, at the end of which it will cease to exist. The last trading day
will be two business days prior to the value date / final settlement date.

CONTRACT SIZE :

28

The amount of asset that has to be delivered under one contract.

Also called as lot size. In case of USDINR it is USD 1000.
BASIS :
In the context of financial futures, basis can be defined as the futures price minus the
spot price. There will be a different basis for each delivery month for each contract.
In a normal market, basis will be positive. This reflects that futures prices normally
exceed spot prices.
COST OF CARRY :
The relationship between futures prices and spot prices can be summarized in terms of
what is known as the cost of carry. This measures the storage cost plus the interest
that is paid to finance or carry the asset till delivery less the income earned on the
asset. For equity derivatives carry cost is the rate of interest.
INITIAL MARGIN :
When the position is opened, the member has to deposit the margin with the clearing
house as per the rate fixed by the exchange which may vary asset to asset. Or in
another words, the amount that must be deposited in the margin account at the time a
future contract is first entered into is known as initial margin.
MARKING TO MARKET :
At the end of trading session, all the outstanding contracts are reprised at the
settlement price of that session. It means that all the futures contracts are daily
settled, and profit and loss is determined on each transaction. This procedure, called
marking to market, requires that funds charge every day. The funds are added or
subtracted from a mandatory margin (initial margin) that traders are required to
maintain the balance in the account. Due to this adjustment, futures contract is also
called as daily reconnected forwards.
29

 MAINTENANCE MARGIN :
Members account are debited or credited on a daily basis. In turn customers account
are also required to be maintained at a certain level, usually about 75 percent of the
initial margin, is called the maintenance margin. This is somewhat lower than the
initial margin.
This is set to ensure that the balance in the margin account never becomes negative.
If the balance in the margin account falls below the maintenance margin, the investor
receives a margin call and is expected to top up the margin account to the initial
margin level before trading commences on the next day.
USES OF CURRENCY FUTURES
Hed gin g:
Presume Entity A is expecting a remittance for USD 1000 on 27 August 08. Wants to
lock in the foreign exchange rate today so that the value of inflow in Indian rupee
terms is safeguarded. The entity can do so by selling one contract of USD INR
futures since one contract is for USD 1000.
Presume that the current spot rate is Rs.43 and USDINR 27 Aug 08 contract is
trading at Rs.44.2500. Entity A shall do the following:
Sell one August contract today. The value of the contract is Rs.44,250.
Let us assume the RBI reference rate on August 27, 2008 is Rs.44.0000. The entity
shall sell on August 27, 2008, USD 1000 in the spot market and get Rs. 44,000. The
futures contract will settle at Rs.44.0000 (final settlement price = RBI reference
rate).
The return from the futures transaction would be Rs. 250, i.e. (Rs. 44,250 Rs.
44,000). As may be observed, the effective rate for the remittance received by the

30

entity A is Rs.44. 2500 (Rs.44,000 + Rs.250)/1000, while spot rate on that date was
Rs.44.0000. The entity was able to hedge its exposure.
Speculation: Bullish, buy futures
Take the case of a speculator who has a view on the direction of the market. He would
like to trade based on this view. He expects that the USD-INR rate presently at
Rs.42, is to go up in the next two-three months. How can he trade based on this
belief? In case he can buy dollars and hold it, by investing the necessary capital, he
can profit if say the Rupee depreciates to Rs.42.50. Assuming he buys USD 10000, it
would require an investment of Rs.4,20,000. If the exchange rate moves as he
expected in the next three months, then he shall make a profit of around Rs.10000.
This works out to an annual return of around 4.76%. It may please be noted that the
cost of funds invested is not considered in computing this return.

A speculator can take exactly the same position on the exchange rate by using
futures contracts. Let us see how this works. If the INR- USD is Rs.42 and the three
month futures trade at Rs.42.40. The minimum contract size is USD 1000. Therefore
the speculator may buy 10 contracts. The exposure shall be the same as above USD
10000. Presumably, the margin may be around Rs.21, 000. Three months later if the
Rupee depreciates to Rs. 42.50 against USD, (on the day of expiration of the contract),
the futures price shall converge to the spot price (Rs. 42.50) and he makes a profit of
Rs.1000 on an investment of Rs.21, 000. This works out to an annual return of 19 percent.
Because of the leverage they provide, futures form an attractive option for speculators.

Speculation: Bearish, sell futures

Futures can be used by a speculator who believes that an underlying is over-valued and
is likely to see a fall in price. How can he trade based on his opinion? In the absence
of a deferral product, there wasn 't much he could do to profit from his opinion.
Today all he needs to do is sell the futures.
Let us understand how this works. Typically futures move correspondingly with the
underlying, as long as there is sufficient liquidity in the market. If the underlying
price rises, so will the futures price. If the underlying price falls, so will the futures
price. Now take the case of the trader who expects to see a fall in the price of USD31

INR. He sells one two-month contract of futures on USD say at Rs. 42.20 (each
contact for USD 1000). He pays a small margin on the same. Two months later,
when the futures contract expires, USD-INR rate let us say is Rs.42. On the day of
expiration, the spot and the futures price converges. He has made a clean profit of 20
paise per dollar. For the one contract that he sold, this works out to be Rs.2000.

Arbitrage:
Arbitrage is the strategy of taking advantage of difference in price of the same or
similar product between two or more markets. That is, arbitrage is striking a
combination of matching deals that capitalize upon the imbalance, the profit being
the difference between the market prices. If the same or similar product is traded in
say two different markets, any entity which has access to both the markets will be
able to identify price differentials, if any. If in one of the markets the product is
trading at higher price, then the entity shall buy the product in the cheaper market
and sell in the costlier market and thus benefit from the price differential without
any additional risk.
One of the methods of arbitrage with regard to USD-INR could be a trading strategy
between forwards and futures market. As we discussed earlier, the futures price and
forward prices are arrived at using the principle of cost of carry. Such of those
entities who can trade both forwards and futures shall be able to identify any mispricing between forwards and futures. If one of them is priced higher, the same shall
be sold while simultaneously buying the other which is priced lower. If the tenor of
both the contracts is same, since both forwards and futures shall be settled at the
same RBI reference rate, the transaction shall result in a risk less profit.

32

TRADING PROCESS AND SETTLEMENT PROCESS

Like other future trading, the future currencies are also traded at organized exchanges.
The following diagram shows how operation take place on currency future market:

TRADER

TRADER

( BUYER )

( SELLER )

Sales order

Purchase order

MEMBER

Transaction on the floor (Exchange)

( BROKER )

MEMBER
( BROKER )

Informs
CLEARING
HOUSE

It has been observed that in most futures markets, actual physical delivery of the underlying
assets is very rare and hardly it ranges from 1 percent to 5 percent. Most often buyers and
sellers offset their original position prior to delivery date by taking an opposite positions. This
is because most of futures contracts in different products are predominantly speculative
instruments. For example, X purchases American Dollar futures and Y sells it. It leads to two
contracts, first, X party and clearing house and second Y party and clearing house. Assume
next day X sells same contract to Z, then X is out of the picture and the clearing house is
seller to Z and buyer from Y, and hence, this process is goes on.

33

REGULATORY FRAMEWORK FOR CURRENCY FUTURES

With a view to enable entities to manage volatility in the currency market, RBI on April 20,
2007 issued comprehensive guidelines on the usage of foreign currency forwards, swaps and
options in the OTC market. At the same time, RBI also set up an Internal Working Group to
explore the advantages of introducing currency futures. The Report of the Internal Working
Group of RBI submitted in April 2008, recommended the introduction of exchange traded
currency futures. With the expected benefits of exchange traded currency futures, it was
decided in a joint meeting of RBI and SEBI on February 28, 2008, that an RBI-SEBI
Standing Technical Committee on Exchange Traded Currency and Interest Rate Derivatives
would be constituted. To begin with, the Committee would evolve norms and oversee the
implementation of Exchange traded currency futures. The Terms of Reference to the
Committee was as under:
1. To coordinate the regulatory roles of RBI and SEBI in regard to trading of Currency
and Interest Rate Futures on the Exchanges.
2. To suggest the eligibility norms for existing and new Exchanges for Currency and
Interest Rate Futures trading.
3. To suggest eligibility criteria for the members of such exchanges.
4. To review product design, margin requirements and other risk mitigation measures on
an ongoing basis.
5. To suggest surveillance mechanism and dissemination of market information.
6. To consider microstructure issues, in the overall interest of financial stability.

34

COMPARISION OF FORWARD AND FUTURES

CURRENCY CONTRACT
BASIS
Size

FORWARD
Structured as per

Standardized

FUTURES

Delivery

requirement of the parties

Tailored on individual

Standardized

date
Method of

needs
Established by the bank or

Open auction among buyers and seller on

transaction

broker through electronic

the floor of recognized exchange.

Participants

media
Banks, brokers, forex

Banks, brokers, multinational companies,

dealers, multinational

institutional investors, small traders,

companies, institutional

speculators, arbitrageurs, etc.

investors, arbitrageurs,
Margins

traders, etc.
None as such, but

Margin deposit required

compensating bank
Maturity
Settlement

Market
place

balanced may be required

Tailored to needs: from one

Standardized

week to 10 years
Actual delivery or offset

Daily settlement to the market and

with cash settlement. No

variation margin requirements

separate clearing house

Over the telephone

At recognized exchange floor with

worldwide and computer

worldwide communications

networks
Accessibility Limited to large customers

Open to any one who is in need of

banks, institutions, etc.

hedging facilities or has risk capital to

Delivery

More than 90 percent

speculate
Actual delivery has very less even below

Secured

settled by actual delivery

Risk is high being less

one percent
Highly secured through margin deposit.

RESEARCH METHODOLOGY:
TYPE OF RESEARCH
In this project Descriptive research methodologies were use.
35

The research methodology adopted for carrying out the study was at the first stage
theoretical study is attempted and at the second stage observed online trading on
NSE/BSE.
SOURCE OF DATA COLLECTION
Secondary data were used such as various books, report submitted by
RBI/SEBI committee and NCFM/BCFM modules.
OBJECTIVES OF THE STUDY
The basic idea behind undertaking Currency Derivatives project to gain
knowledge about currency future market.
To study the basic concept of Currency future
To study the exchange traded currency future
To understand the practical considerations and ways of considering currency future
price.
To analyze different currency derivatives products.

36

SCOPE OF PROPOSED STUDY:

Currency-based derivatives are used by exporters invoicing receivables in foreign currency,
willing to protect their earnings from the foreign currency depreciation by locking the
currency conversion rate at a high level. Their use by importers hedging foreign currency
payables is effective when the payment currency is expected to appreciate and the importers
would like to guarantee a lower conversion rate. Investors in foreign currency denominated
securities would like to secure strong foreign earnings by obtaining the right to sell foreign
currency at a high conversion rate, thus defending their revenue from the foreign currency
depreciation. Multinational companies use currency derivatives being engaged in direct
investment overseas. They want to guarantee the rate of purchasing foreign currency for
various payments related to the installation of a foreign branch or subsidiary, or to a joint
venture with a foreign partner.
A high degree of volatility of exchange rates creates a fertile ground for foreign exchange
speculators. Their objective is to guarantee a high selling rate of a foreign currency by
obtaining a derivative contract while hoping to buy the currency at a low rate in the future.
Alternatively, they may wish to obtain a foreign currency forward buying contract, expecting
to sell the appreciating currency at a high future rate. In either case, they are exposed to the
risk of currency fluctuations in the future betting on the pattern of the spot exchange rate
adjustment consistent with their initial expectations.
The most commonly used instrument among the currency derivatives are currency forward
contracts. These are large notional value selling or buying contracts obtained by exporters,
importers, investors and speculators from banks with denomination normally exceeding 2
million USD. The contracts guarantee the future conversion rate between two currencies and
can be obtained for any customized amount and any date in the future. They normally do not
require a security deposit since their purchasers are mostly large business firms and
investment institutions, although the banks may require compensating deposit balances or
lines of credit. Their transaction costs are set by spread between bank's buy and sell prices.
Exporters invoicing receivables in foreign currency are the most frequent users of these
contracts. They are willing to protect themselves from the currency depreciation by locking in
the future currency conversion rate at a high level. A similar foreign currency forward selling
contract is obtained by investors in foreign currency denominated bonds (or other securities)
37

who want to take advantage of higher foreign that domestic interest rates on government or
corporate bonds and the foreign currency forward premium. They hedge against the foreign
currency depreciation below the forward selling rate which would ruin their return from
foreign financial investment. Investment in foreign securities induced by higher foreign
interest rates and accompanied by the forward selling of the foreign currency income is called
a covered interest arbitrage.
DATA COLLECTION

Data collection is a term used to describe a process of preparing and

collecting business data - for example as part of a process improvement or

similar project. Data collection usually takes place early on in an improvement

project, and is often formalized through a data collection Plan which often

contains the following activity.

1. Pre collection activity Agree goals, target data, definitions, methods

2. Collection data collection

3. Present Findings usually involves some form of sorting analysis and/or

presentation

There are two methods of data collection which are discussed below:

38

DATA COLLECTION

Primary Data

Secondary Data

(Data collection techniques)

Questionnaire

Interview

External
Source

Internet

Intrenal
source

PRIMARY DATA
In primary data collection, you collect the data yourself using methods such as interviews and
questionnaires. The key point here is that the data you collect is unique to you and your
research and, until you publish, no one else has access to it. I have tried to collect the data
using methods such as interviews and questionnaires. The key point here is that the data
collected is unique and research and, no one else has access to it. It is done to get the real
scenario and to get the original data of present.

DATA COLLECTION TECHNIQUE

Questionnaire:
Questionnaire are a popular means of collecting data, but are difficult to design and often
require many rewrites before an acceptable questionnaire is produced. The features included
in questionnaire are:

Theme and covering letter

Instruction for completion

39

Types of questions

Length

Interview:

This technique is primarily used to gain an understanding of the underlying reasons and
motivations for peoples attitudes, preferences or behavior. The interview was done by asking
a general question. I encourage the respondent to talk freely. I have used an unstructured
format, the subsequent direction of the interview being determined by the respondents initial
reply, and come to know what is its initial problem is.

SAMPLING METHODOLOGY

Sampling technique:

Initially, a rough draft was prepared keeping in mind the objective of the research. A pilot
study was done in order to know the accuracy of the questionnaire. The final questionnaire
was arrived only after certain important changes were done. Thus my sampling came out to
be judgmental and continent.

Sampling Unit:
The respondents who were asked to fill out questionnaires are the sampling units.
Sampling Size: 20
SECONDARY DATA

All methods of data collection can supply quantitative data (numbers, statistics or financial)
or qualitative data (usually words or text). Quantitative data may often be presented in
tabular or graphical form. Secondary data is data that has already been collected by someone
else for a different purpose to yours.
Need of using secondary data
40

1. Data is of use in the collection of primary data.

2. They are one of the cheapest and easiest means of access to information.

3. Secondary data may actually provided enough information to resolve the Problem being
investigated.

4. Secondary data can be a valuable source of new ideas that can be explored later through
primary research.

Limitation of secondary data

1. May be outdated.

2. No control over data collection.

3. May not be reported in the required form.

4. May not be reported in the required form.

5. May not be very accurate.

6. Collection for some other purpose.

ANALYSIS

41

INTEREST RATE PARITY PRINCIPLE

For currencies which are fully convertible, the rate of exchange for any date other than
spot is a function of spot and the relative interest rates in each currency. The assumption
is that, any funds held will be invested in a time deposit of that currency. Hence, the
forward rate is the rate which neutralizes the effect of differences in the interest rates in
both the currencies. The forward rate is a function of the spot rate and the interest rate
differential between the two currencies, adjusted for time. In the case of fully convertible
currencies, having no restrictions on borrowing or lending of either currency the forward
rate can be calculated as follows;

Future Rate = (spot rate) {1 + interest rate on home currency * period} /

{1 + interest rate on foreign currency * period}

For example,
Assume that on January 10, 2002, six month annual interest rate was 7
percent p.a. on Indian rupee and US dollar six month rate was 6 percent p.a. and spot
( Re/$ ) exchange rate was 46.3500. Using the above equation the theoretical future
price on January 10, 2002, expiring on June 9, 2002 is : the answer will be Rs.46.7908
per dollar. Then, this theoretical price is compared with the quoted futures price on
January 10, 2002 and the relationship is observed.

42

PRODUCT DEFINITIONS OF CURRENCY FUTURE ON NSE/BSE

Underlying
Initially, currency futures contracts on US Dollar Indian Rupee (US$-INR) would be
permitted.
Trading Hours
The trading on currency futures would be available from 9 a.m. to 5 p.m.
Size of the contract
The minimum contract size of the currency futures contract at the time of introduction
would be US$ 1000. The contract size would be periodically aligned to ensure that the size
of the contract remains close to the minimum size.
Quotation
The currency futures contract would be quoted in rupee terms. However, the outstanding
positions would be in dollar terms.
Tenor of the contract
The currency futures contract shall have a maximum maturity of 12 months.
Available contracts
All monthly maturities from 1 to 12 months would be made available.
Settlement mechanism
The currency futures contract shall be settled in cash in Indian Rupee.

Settlement price
The settlement price would be the Reserve Bank Reference Rate on the date of expiry. The
methodology of computation and dissemination of the Reference Rate may be publicly
disclosed by RBI.
Final settlement day
The currency futures contract would expire on the last working day (excluding Saturdays) of
the month. The last working day would be taken to be the same as that for Interbank
Settlements in Mumbai. The rules for Interbank Settlements, including those for known
holidays and subsequently declared holiday would be those as laid down by FEDAI.

The contract specification in a tabular form is as under:

Underlying

Rate of exchange between one USD and

Trading Hours

INR
09:00 a.m. to 05:00 p.m.

(Monday to Friday)
Contract Size

USD 1000

Tick Size

0.25 paisa or INR 0.0025

Trading Period

Maximum expiration period of 12 months

Contract Months
Final Settlement

12 near calendar months

Last working day of the month (subject to

date/

Value date
Last Trading Day

Holiday calendars)
Two working days prior to Final Settlement

Settlement
Final Settlement Price

Date
Cash settled
The reference
RBI

rate

fixed by

two

working days prior to the final settlement

44

CURRENCY FUTURES PAYOFFS

A payoff is the likely profit/loss that would accrue to a market participant with change in the
price of the underlying asset. This is generally depicted in the form of payoff diagrams
which show the price of the underlying asset on the X-axis and the profits/losses on the Yaxis. Futures contracts have linear payoffs. In simple words, it means that the losses as well
as profits for the buyer and the seller of a futures contract are unlimited. Options do not have
linear payoffs. Their pay offs are non-linear. These linear payoffs are fascinating as they can
be combined with options and the underlying to generate various complex payoffs.
However, currently only payoffs of futures are discussed as exchange traded foreign
currency options are not permitted in India.
Payoff for buyer of futures: Long futures
The payoff for a person who buys a futures contract is similar to the payoff for a person who
holds an asset. He has a potentially unlimited upside as well as a potentially unlimited
downside. Take the case of a speculator who buys a two-month currency futures contract
when the USD stands at say Rs.43.19. The underlying asset in this case is the currency,
USD. When the value of dollar moves up, i.e. when Rupee depreciates, the long futures
position starts making profits, and when the dollar depreciates, i.e. when rupee appreciates,
it starts making losses. Figure 4.1 shows the payoff diagram for the buyer of a futures
contract.

Payoff for buyer of future:

The figure shows the profits/losses for a long futures position. The investor bought
futures when the USD was at Rs.43.19. If the price goes up, his futures position
starts making profit. If the price falls, his futures position starts showing losses.

45

P
R
O
F
I
T
0

43.19

USD
L

O
S
S

Payoff for seller of futures: Short futures

The payoff for a person who sells a futures contract is similar to the payoff for a person who
shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited
downside. Take the case of a speculator who sells a two month currency futures contract
when the USD stands at say Rs.43.19. The underlying asset in this case is the currency,
USD. When the value of dollar moves down, i.e. when rupee appreciates, the short futures
position starts 25 making profits, and when the dollar appreciates, i.e. when rupee
depreciates, it starts making losses. The Figure below shows the payoff diagram for the
seller of a futures contract.
Payoff for seller of future:
The figure shows the profits/losses for a short futures position. The investor sold futures
when the USD was at 43.19. If the price goes down, his futures position starts making
profit. If the price rises, his futures position starts showing losses

46

P
R
O
F
I
43.19

T
0

USD
D

L
O
S
S

PRICING FUTURES COST OF CARRY MODEL

Pricing of futures contract is very simple. Using the cost-of-carry logic, we calculate the fair
value of a futures contract. Every time the observed price deviates from the fair value,
arbitragers would enter into trades to capture the arbitrage profit. This in turn would push the
futures price back to its fair value.
The cost of carry model used for pricing futures is given below:
F=Se^(r-rf)T
where:
r=Cost of financing (using continuously compounded interest rate)
rf= one year interest rate in foreign
T=Time till expiration in years
E=2.71828

47

The relationship between F and S then could be given as

F Se^(r rf )T - =
This relationship is known as interest rate parity relationship and is used in international
finance. To explain this, let us assume that one year interest rates in US and India are say 7%
and 10% respectively and the spot rate of USD in India is Rs. 44.
From the equation above the one year forward exchange rate should be
F = 44 * e^(0.10-0.07 )*1=45.34
It may be noted from the above equation, if foreign interest rate is greater than the domestic
rate i.e. rf > r, then F shall be less than S. The value of F shall decrease further as time T
increase. If the foreign interest is lower than the domestic rate, i.e. rf < r, then value of F
shall be greater than S. The value of F shall increase further as time T increases.
HEDGING WITH CURENCY FUTURES
Exchange rates are quite volatile and unpredictable, it is possible that anticipated profit in
foreign investment may be eliminated, rather even may incur loss. Thus, in order to hedge
this foreign currency risk, the traders oftenly use the currency futures. For example, a long
hedge (I.e.., buying currency futures contracts) will protect against a rise in a foreign
currency value whereas a short hedge (i.e., selling currency futures contracts) will protect
against a decline in a foreign currencys value.
It is noted that corporate profits are exposed to exchange rate risk in many situation. For
example, if a trader is exporting or importing any particular product from other countries
then he is exposed to foreign exchange risk. Similarly, if the firm is borrowing or lending or
investing for short or long period from foreign countries, in all these situations, the firms
profit will be affected by change in foreign exchange rates. In all these situations, the firm
can take long or short position in futures currency market as per requirement.

48

The general rule for determining whether a long or short futures position will hedge a
potential foreign exchange loss is:
Loss from appreciating in Indian rupee= Short hedge
Loss form depreciating in Indian rupee= Long hedge

The choice of underlying currency

The first important decision in this respect is deciding the currency in which futures
contracts are to be initiated. For example, an Indian manufacturer wants to purchase some
raw materials from Germany then he would like future in German mark since his exposure
in straight forward in mark against home currency (Indian rupee). Assume that there is no
such future (between rupee and mark) available in the market then the trader would choose
among other currencies for the hedging in futures. Which contract should he choose?
Probably he has only one option rupee with dollar. This is called cross hedge.
Choice of the maturity of the contract
The second important decision in hedging through currency futures is selecting the currency
which matures nearest to the need of that currency. For example, suppose Indian importer
import raw material of 100000 USD on 1 st November 2008. And he will have to pay 100000
USD on 1st February 2009. And he predicts that the value of USD will increase against
Indian rupees nearest to due date of that payment. Importer predicts that the value of USD
will increase more than 51.0000.
So what he will do to protect against depreciating in Indian rupee? Suppose spots value of 1
USD is 49.8500. Future Value of the 1USD on NSE as below:

49

Price Watch

Order Book
Contract

Best

Best

Best

Best

Buy Qty Buy Price Sell Price Sell Qty

LTP

Volume

Open
Interest

USDINR 261108

464

49.8550

49.8575

712 49.8550

58506

43785

USDINR 291208

189

49.6925

49.7000

612 49.7300 176453

111830

USDINR 280109

49.8850

49.9250

2 49.9450

5598

16809

USDINR 250209

100

50.1000

50.2275

1 50.1925

3771

6367

USDINR 270309

100

49.9225

50.5000

5 49.9125

311

892

USDINR 280409

50.0000

51.0000

5 50.5000

278

USDINR 270509

51.0000

5 47.1000

506

USDINR 260609

25

49.0000

- 50.0000

116

USDINR 290709

48.0875

- 49.1500

44

USDINR 270809

48.1625

50.5000

1 50.3000

2215

USDINR 280909

48.2375

- 51.2000

79

USDINR 281009

48.3100

53.1900

2 50.9900

- 50.9275

USDINR 261109
1
48.3825
Volume As On 26-NOV-2008 17:00:00 Hours
IST
No. of Contracts
244645
Archives
As On 26-Nov-2008 12:00:00 Hours IST
Underlying RBI reference rate
USDINR
49.8500

Solution:

50

Rules, Byelaws & Regulations

Membership
Circulars
List of Holidays

He should buy ten contract of USDINR 28012009 at the rate of 49.8850. Value of the
contract is (49.8850*1000*100) =4988500. (Value of currency future per USD*contract
size*No of contract).
For that he has to pay 5% margin on 5988500. Means he will have to pay Rs.299425 at
present.
And suppose on settlement day the spot price of USD is 51.0000. On settlement date payoff
of importer will be (51.0000-59.8850) =1.115 per USD. And (1.115*100000) =111500.Rs.
Choice of the number of contracts (hedging ratio)
Another important decision in this respect is to decide hedging ratio HR. The value of the
futures position should be taken to match as closely as possible the value of the cash market
position. As we know that in the futures markets due to their standardization, exact match
will generally not be possible but hedge ratio should be as close to unity as possible. We
may define the hedge ratio HR as follows:
HR= VF / Vc
Where, VF is the value of the futures position and Vc is the value of the cash position.
Suppose value of contract dated 28th January 2009 is 49.8850.
And spot value is 49.8500.
HR=49.8850/49.8500=1.001.
FINDINGS

Cost of carry model and Interest rate parity model are useful tools to find out
standard future price and also useful for comparing standard with actual future price.
And its also a very help full in Arbitraging.
New concept of Exchange traded currency future trading is regulated by higher
authority and regulatory. The whole function of Exchange traded currency future is

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regulated by SEBI/RBI, and they established rules and regulation so there is very
safe trading is emerged and counter party risk is minimized in currency Future
trading. And also time reduced in Clearing and Settlement process up to T+1 days
basis.
Larger exporter and importer has continued to deal in the OTC counter even
exchange traded currency future is available in markets because,
There is a limit of USD 100 million on open interest applicable to trading member
who are banks. And the USD 25 million limit for other trading members so larger
exporter and importer might continue to deal in the OTC market where there is no
limit on hedges.
In India RBI and SEBI has restricted other currency derivatives except Currency
future, at this time if any person wants to use other instrument of currency
derivatives in this case he has to use OTC.

SUGGESTIONS

Currency Future need to change some restriction it imposed such as cut off limit
of 5 million USD, Ban on NRIs and FIIs and Mutual Funds from Participating.

Now in exchange traded currency future segment only one pair USD-INR is
available to trade so there is also one more demand by the exporters and

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importers to introduce another pair in currency trading. Like POUND-INR,

CAD-INR etc.
In OTC there is no limit for trader to buy or short Currency futures so there
demand arises that in Exchange traded currency future should have increase limit
for Trading Members and also at client level, in result OTC users will divert to
Exchange traded currency Futures.

In India the regulatory of Financial and Securities market (SEBI) has Ban on
other Currency Derivatives except Currency Futures, so this restriction seem
unreasonable to exporters and importers. And according to Indian financial
growth now its become necessary to introducing other currency derivatives in
Exchange traded currency derivative segment.

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CONCLUSIONS
By far the most significant event in finance during the past decade has been the
extraordinary development and expansion of

financial derivativesThese instruments

enhances the ability to differentiate risk and allocate it to those investors most able and
willing to take it- a process that has undoubtedly improved national productivity growth and
standards of livings.
The currency future gives the safe and standardized contract to its investors and individuals
who are aware about the forex market or predict the movement of exchange rate so they will
get the right platform for the trading in currency future. Because of exchange traded future
contract and its standardized nature gives counter party risk minimized.
Initially only NSE had the permission but now BSE and MCX has also started currency
future. It is shows that how currency future covers ground in the compare of other available
derivatives instruments. Not only big businessmen and exporter and importers use this but
individual who are interested and having knowledge about forex market they can also invest
in currency future.
Exchange between USD-INR markets in India is very big and these exchange traded
contract will give more awareness in market and attract the investors.

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LIMITATION OF THE STUDY

The limitations of the study were

The analysis was purely based on the secondary data. So, any error in the secondary
data might also affect the study undertaken.
The currency future is new concept and topic related book was not available in
library and market.
The study is based only on secondary & primary data so lack of keen

observations and interactions were also the limiting factors in the proper conclusion
of the study

55

ANNEXURE

QUESTIONNAIRE

1) What do you understand by training?

a) Learning
b) Enhancement of knowledge, skill and aptitude
c) Sharing information
d) All of above

2) Training is must for enhancing productivity and performance.

a) Completely agree
b) Partially agree
c) Disagree
d) Unsure

3) (i) Have you attended any training programme in the last 01 year?
a) Yes
b) No

(ii) If yes ,which module of soft skill development training?

a) Personality and positive attitude
b) Business communication
c) Team building and leadership
d) Stress management and work-life balance
e) Business etiquettes and corporate grooming
f) All of above
g) If any other please specify ___________________________

56

4) (i) After the training ,have you given feedback of it?

a) Yes
b) No

(ii) If yes, through which method?(can select more than one)

a) Questionnaire
b) Interview
c) Supplement test
d) If any other please specify _______________

5) Which method of post training feedback according to you is more appropriate?

a) Observation
b) Questionnaire
c) Interviews
d) Self diaries
e) Supplement test

6) (i) Do you think that the feedback can evaluate the training effectiveness?
a) Yes
b) No

(ii) If yes, how can the post training feedbacks can help the participants?(can
select more than one)
a) Improve job performance
b) An aid to future planning
c) Motivate to do better
d) All of the above
e) None

57

7) Post training evaluation focus on result rather than on the effort expended

in

conducting training.
a) Completely agree
b) Partially agree
c) Disagree
d) Unsure

8) What should be the ideal time to evaluate the training?

a) Immediate after training
b) After 15 days
c) After 1 month
d) Cant say

9) Should the post training evaluation procedure reviewed and revised

periodically?
a) Yes
b) No
c) Cant say
10) Is the whole feedback exercise after the training worth the time, money and
effort?
a) Yes
b) No
c) Cant say

11) The post training feedbacks can be used :

a) To identify the effectiveness and valuation of the training programme
b) To identify the ROI( return on investment)
c) To identify the need of retraining
d) To provide the points to improve the training

58

e) All of above

12) Any suggestion for improving the post training feedback procedure exists in Sahara
India Pariwar?

59

BIBLIOGRAPHY

Financial Derivatives (theory, concepts and problems) By: S.L. Gupta.

NCFM: Currency future Module.
BCFM: Currency Future Module.
Center for social and economic research) Poland
Recent Development in International Currency Derivative Market by: Lucjan T. Orlowski)
Report of the RBI-SEBI standing technical committee on exchange traded currency futures)
2008
Report of the Internal Working Group on Currency Futures (Reserve Bank of India, April
2008)

Websites:
www.sebi.gov.in
www.rbi.org.in
www.frost.com
www.wikipedia.com
www.economywatch.com
www.bseindia.com
www.nseindia.com

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