A

FINAL PROJECT REPORT

ON

“CURRENCY DERIVATIVES”

In partial fulfillment of the requirement for the degree

Of

Master of Business Administration

Specialization- Finance

Submitted By:
Gourav Sharma
94512236916

Submitted To:
Dr. Navjot Kaur
 CERTIFICATE 1

This is to certify that the project entitled, “Currency Derivatives “submitted for the degree of MBA, (Major-
Finance, and Minor – Marketing) for the Punjab Technical University, Jallandhar, is a bonafide research
work carried out by Gourav Sharma, Roll No. (94512236916) to the best of my knowledge and no part of
this project has been submitted for any other degree.

This assistance and help received during the course of investigation have been fully acknowledged.

(Project Guide)
Dr. Navjot Kaur

2
 TABLE OF CONTENTS

CHAPTER NO SUBJECTS COVERED PAGE NO

1 Introduction to Financial Derivatives 5

 Financial Derivatives
 Types of Financial Derivatives
 Derivatives Introduction in India
 History of currency derivatives
 Utility of currency derivatives

2 Introduction of currency derivatives 17

3 Brief Overview of the foreign exchange market 19
 Overview of foreign exchange market in India
 Currency Derivatives Products
 Foreign Exchange Spot Market
 Foreign Exchange Quotations
 Need for exchange traded currency futures
 Rationale for Introducing Currency Future
 Future Terminology
 Uses of currency futures
 Trading and settlement Process
 Regulatory Framework for Currency Futures
 Comparison of Forward & Future Currency Contracts

4 Review of Literature 40

5 Research Methodology 45
 Scope of Research
 Type of Research
 Source of Data collection
 Objective of the Study
 Data collection
 Limitations
5 Analysis 47
 Interest Rate Parity Principle
 Product Definitions of currency future
 Currency futures payoffs
3
  Pricing Futures and Cost of Carry model
 Hedging with currency futures
6 Findings 58
Conclusions and Suggestions
7 Bibliography 62

4
 CHAPTER-1

INTRODUCTION TO FINANCIAL DEREVATIVES

INTRODUCTION TO FINANCIAL DERIVATIVES

5
 “By far the most significant event in finance during the past decade has been the extraordinary
development and expansion of financial derivatives…These 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. It is therefore, to manage such risks; the new financial
instruments have been developed in the financial markets, which are also popularly known as financial
derivatives.

**DEFINITIONS OF FINANCIAL DERIVATIVES**

 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

6
  Interest Rates
 Common shares/stock
 Stock Index Value : NSE Nifty
 Currency : Exchange Rate

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

7
index etc. It is to be noted that financial derivative is fairly standard and there are no quality issues
whereas in commodity derivative, the quality may be the underlying matters.

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 risk—the 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.

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
8
 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 exchange’s 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 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)

9
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 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)
10
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 lender’s 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.

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.

11
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

Purchase price: Rs .42.2500

Price decreases by one tick: –Rs. 00.0025
New price: Rs.42. 2475

The value of one tick on each contract is Rupees 2.50. So if a trader buys 5 contracts and the price moves
up by 4 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

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 CHAPTER-2

INTRODUCTION

TO

CURRENCY DERIVATIVES

13
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 lender’s 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.

14
 CHAPTER-3

BRIEF OVERVIEW OF FOREIGN EXCHANGE MARKET

15
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 policy-makers 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 well- developed 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 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 a new opportunity.
Source :-( Report of the RBI-SEBI standing technical committee on exchange traded currency futures)
2008.

16
CURRENCY DERIVATIVE PRODUCTS

Derivative contracts have several variants. The most common variants are forwards, futures, options and
swaps. We take a brief look at various derivatives contracts that have come to be used.

 FORWARD :

The basic objective of a forward market in any underlying asset is to fix a price for a contract to be
carried through on the future agreed date and is intended to free both the purchaser and the seller
from any risk of loss which might incur due to fluctuations in the price of underlying asset.

A forward contract is customized contract between two entities, where settlement takes place on a
specific date in the future at today’s pre-agreed price. The exchange rate is fixed at the time the
contract is entered into. This is known as forward exchange rate or simply forward rate.

 FUTURE :

A currency futures contract provides a simultaneous right and obligation to buy and sell a particular
currency at a specified future date, a specified price and a standard quantity. In another word, a
future contract is an agreement between two parties to buy or sell an asset at a certain time in the
future at a certain price. Future contracts are special types of forward contracts in the sense that they
are standardized exchange-traded contracts.

 SWAP :

Swap is private agreements between two parties to exchange cash flows in the future according to a
prearranged formula. They can be regarded as portfolio of forward contracts.

The currency swap entails swapping both principal and interest between the parties, with the cash
flows in one direction being in a different currency than those in the opposite direction. There are a
various types of currency swaps like as fixed-to-fixed currency swap, floating to floating swap, fixed
to floating currency swap.

17
 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.

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.

18
 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.

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.
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.
19
It is important to note that selling rate is always higher than the buying rate.
Traders, usually large banks, deal in two way prices, both buying and selling, are called market makers.

Base Currency/ Terms Currency:

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

Exchange rates are constantly changing, which means that the value of one currency in terms of the other
is constantly in flux. Changes in rates are expressed as strengthening or weakening of one currency vis-à-
vis the second currency.

Changes are also expressed as appreciation or depreciation of one currency in terms of the second
currency. Whenever the base currency buys more of the terms currency, the base currency has
strengthened / appreciated and the terms currency has weakened / depreciated.
For example,
If Dollar – Rupee moved from 43.00 to 43.25. The Dollar has appreciated and the Rupee has
depreciated. And if it moved from 43.0000 to 42.7525 the Dollar has depreciated and Rupee has
appreciated.

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.

20
 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.

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 non-residents
purchase domestic currency assets. If the exchange rate remains unchanged from the time of purchase of the
asset to its sale, no gains and losses are made out of currency exposures. But if domestic currency depreciates
(appreciates) against the foreign currency, the exposure would result in gain (loss) for residents purchasing

21
foreign assets and loss (gain) for non residents purchasing domestic assets. In this backdrop, unpredicted
movements in exchange rates expose investors to currency risks.

Currency futures enable them to hedge these risks. Nominal exchange rates are often random walks with or
without drift, while real exchange rates over long run are mean reverting. As such, it is possible that over a
long – run, the incentive to hedge currency risk may not be large. However, financial planning horizon is much
smaller than the long-run, which is typically inter-generational in the context of exchange rates. As such, there
is a strong need to hedge currency risk and this need has grown 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 :
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

22
 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 :
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

23
 to maintain the balance in the account. Due to this adjustment, futures contract is also called as daily
reconnected forwards.

 MAINTENANCE MARGIN :
Member’s 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 g in 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 USDINR 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 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

24
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 USD-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:

25
 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 mis-pricing 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.

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 )

Purchase order Sales order

Transaction on the floor (Exchange)

MEMBER MEMBER
( BROKER ) ( BROKER )

Informs

CLEARING
HOUSE

26
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.

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.

27
COMPARISION OF FORWARD AND FUTURES CURRENCY CONTRACT
BASIS FORWARD FUTURES
Size Structured as per requirement Standardized
of the parties
Delivery Tailored on individual needs Standardized
date
Method of Established by the bank or Open auction among buyers and seller on the
transaction broker through electronic floor of recognized exchange.
media
Participants Banks, brokers, forex dealers, Banks, brokers, multinational companies,
multinational companies, institutional investors, small traders,
institutional investors, speculators, arbitrageurs, etc.
arbitrageurs, traders, etc.
Margins None as such, but Margin deposit required
compensating bank balanced
may be required
Maturity Tailored to needs: from one Standardized
week to 10 years
Settlement Actual delivery or offset with Daily settlement to the market and variation
cash settlement. No separate margin requirements
clearing house
Market Over the telephone worldwide At recognized exchange floor with worldwide
place and computer networks communications
Accessibility Limited to large customers Open to any one who is in need of hedging
banks, institutions, etc. facilities or has risk capital to speculate
Delivery More than 90 percent settled Actual delivery has very less even below one
by actual delivery percent
Secured Risk is high being less secured Highly secured through margin deposit.

28
 CHAPTER-4

REVIEW OF LITERATURE

29
Papers on "Currency Derivatives Operations" (2006)

This paper defines derivatives as financial instruments such as options, futures, forwards and swaps that are
derived from their underlying currencies. The returns on derivatives are tied to yields of these underlying
securities and currencies. This paper details the essential role the derivatives market plays in the global
economy in countries such as Asia, Germany and Switzerland, in which these economies reap substantial
growth rates due to these financial practices. The writer contends that with the presence of this market the
financial condition of business entities are stabilized and secure from the possibility of hedge currency risks.
The derivatives market also decreases the amplitude in the fluctuation of spot prices and promotes optimal
funds placing. The writer stresses the importance in the implementation and development of the currency
derivatives market as a necessary prerequisite for the growth of international trade volume, expansion of
foreign investment and for the general development of economy.
Currency Derivatives Operations in the World Economy
"Derivatives market in Ukraine was operating from 1994 to 1998. Unfortunately, its work was far beneath
the world standards. From the very beginning the Ukrainian market was developing as an exchange market,
despite the fact that the world derivatives development gained the incentive to growth from over-the-counter
form of these instruments. Hedgers, a category of market subjects, almost did not participate in the activity
of Ukrainian currency exchanges, and the absence of hedgers makes the market non-balanced and not liquid.
Moreover, the world financial crisis of 1997 caused the collapse in currency markets. The National Bank of
Ukraine made a decision to hold up and later to abolish the functioning of currency derivatives in Ukraine.
We would like to underline that despite the crisis in the Russian market, the operations with currency
derivatives were not stopped, but continued to develop."

Lucjan T. Orlowski ,The emergence and evolution of markets, (1997 )

This paper examines currency derivatives that have emerged in international financial markets over the past
two years, emphasizing the departures of spot exchange rate movements from the macroeconomic
fundamentals among the "triad" currencies: the U.S. Dollar (USD), the German Mark (DM), and the
Japanese Yen (YE). Sensitivity of exchange rates to key macroeconomic variables (differentials in interest
rates, income and inflation) is tested for the "triad" currencies in two periods: 1991-1993 and 1994-1995. In

30
the latter period, some considerable misalignments between forward rates and changes in spot exchange
rates are observed. This is contrary to the historical evidence of the validity of the so-called "unbiased
forward rate hypothesis" claiming that forward rates are the best predictor of adjustments of spot rates
(Levich, 1976). It is argued that the recently observed failure of the relationship between forward rates and
lagged spot rates has contributed to significant losses of investors and speculators in international currency

derivative markets.

The examination of these relationships and the recent empirical developments provides useful lessons for the
transition economies of Central and Eastern Europe in their attempts to construct viable modern financial
markets. This study limits the scope of recommendations for developing financial markets to the conditions
of Poland. It assumes that currency-based derivative transactions may play a pivotal role in reducing
systemic risk of external trade and financial contracts in the Polish economy presently undergoing
considerable structural adjustments aimed at promoting export and net capital inflows. It further argues that
an introduction of financial derivatives in Poland shall be preceded by a construction of sound underlying
security markets. A stable currency accompanied by low inflation is necessary prerequisites for a successful
functioning of currency-based derivatives.

Hagelin Nicolas ,Why Firms Hedge with Currency Derivatives: An Examination of Transaction and
Translation Exposure (2003)

I examine Swedish firms' use of currency derivatives to provide empirical evidence on the determinants of
firms' hedging decisions. The study uses survey data in combination with publicly available data. The use of
survey data makes it possible to differentiate between currency derivative usage aimed at hedging translation
exposure and that aimed at hedging transaction exposure. This is of interest since translation exposure and
transaction exposure tend to affect firms differently. The results are consistent with the conjecture that firms
hedge transaction exposure with currency derivatives to increase firm value by reducing indirect costs of
financial distress or alleviating the underinvestment problem. No evidence is found to support the notion that
translation exposure hedges are used to increase firm value.

Anand Manoj,Management Motivations for Use of Foreign Currency Derivatives in India (2008) The
paper examines management motivations of foreign currency derivatives usage in corporate India and
identifies significant differences, if any, in the motivations of the firms who are either using foreign currency
derivatives or having a documented foreign exchange risk management policy vis-¿-vis the firms who do
not. It also captures the management motivations of foreign currency derivatives usage in a factor-analytic
framework.

31
The universe of companies selected for this study consisted of 640 companies, which are common across
two most widely used Indian stock market indices namely S&P CNX 500 and BSE 500 firms as at the end of
March 31, 2004 having foreign exchange exposure, which is a fair representation of corporate India. A
nationwide questionnaire-based survey was conducted to capture the management motivations of foreign
currency derivatives usage. 55 responses were received leading to a response rate of 8.59%.

The most of the respondent firms (70.4%) have documented foreign exchange risk management
plan/policy/programme. The transaction exposure as a foreign currency risk is more critical to the firms
(74.5%) followed by translation exposure (58.3% responded as moderate degree of risk) and economic
exposure (54.3% responded as low degree of risk). To reduce the volatility in profits after tax, cash flows,
and to reduce the cost of capital and thus increase the value of the firm on one side of the pole and to reduce
the risks faced by the management on the other side of the pole are the major motivations of the firms using
foreign currency derivatives in India. The firms with high debt ratio are more likely to use foreign currency
derivatives. The major objective of using derivatives is hedging the risk (96.1% responded as rank one
objective), for arbitrage purpose (55.3% assigned rank two) and price discovery (36.4% assigned rank two
and 33.3% assigned rank three). The speculation as objective of using foreign currency derivative is the least
preferred option (62.1% assigned it as rank four).

The management motivations for the use of foreign currency derivatives captured in factor-analytic
framework are 'hedging to improve value of firm', 'management utility and compensation', 'accounting and
disclosure requirements', 'strengthen control systems', and 'avail tax benefits and reduce cost of capital'. The
firm characteristics such as high degree of debt ratio and ESOPs usage influence the use of foreign currency
derivatives. These seven factors explain 59.28% of the total variance.

32
 CHAPTER-5

RESEARCH METHODOLOGY

33
RESEARCH METHODOLOGY

 TYPE OF RESEARCH
In this project Descriptive research methodologies were use.
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.

 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.

34
CHAPTER-6

ANALYSIS

35
 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.

36
 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

37
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

INR
Trading Hours 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 12 near calendar months
Final Settlement date/ Last working day of the month (subject to
Value date holiday calendars)
Last Trading Day Two working days prior to Final Settlement
Date
Settlement Cash settled
Final Settlement Price The reference rate fixed by RBI two
working days prior to the final settlement
date will be used for final settlement

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 Y-axis. 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

38
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.

P
R
O
F
I
T

43.19

0
USD
D
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.

39
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

P
R
O
F
I
T

43.19

0
USD
D
L
O
S
S

40
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

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.

41
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 currency’s 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 firm’s 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.

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 1st 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:
Price Watch

42
Order Book
Best Best Best Best Open
Contract LTP Volume
Buy Qty Buy Price Sell Price Sell Qty 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 1 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 1 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 1 48.0875 - - 49.1500 - 44
USDINR 270809 2 48.1625 50.5000 1 50.3000 6 2215
USDINR 280909 1 48.2375 - - 51.2000 - 79
USDINR 281009 1 48.3100 53.1900 2 50.9900 - 2
USDINR 261109 1 48.3825 - - 50.9275 - -

Volume As On 26-NOV-2008 17:00:00 Hours IST

No. of Contracts Rules, Byelaws & Regulations
244645 Membership
Archives Circulars
As On 26-Nov-2008 12:00:00 Hours IST List of Holidays
Underlying RBI reference rate
USDINR 49.8500

Solution:

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)

43
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.

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 CHAPTER-7

FINDINGS,

CONCLUSIONS AND SUGGESTIONS

FINDINGS

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  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 it’s 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 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 day’s 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.

CONCLUSIONS

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

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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.

SUGGESTIONS

 Currency Future need to change some restriction it imposed such as cut off limit of 5 million
USD, Ban on NRI’s and FII’s 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 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 it’s become necessary to introducing
other currency derivatives in Exchange traded currency derivative segment.

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 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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