REPORT ON CURRENCY DERIVATIVE

SANDEEP ARORA ITM ,GURGAON

ACKNOWLEDGEMENT On the occasion of completion and submission of project we would li e to express our deep sense of gratitude to USM, KUK for providing us Platform of management studies. We than to our Chairman Dr.D.D.Arora, and Faculty members for their m oral support during the project. We are too glad to give our special than s to our project guide Mr. Shyam Sunder for providing us an opportunity to carryout project on currency derivatives a nd also for their help and tips whenever needed. Without his co-operation it was impossible to reach up to this stage. At last, I sincere regards to my parents and friends who have directly or indire ctly helped me in the project.

CONTENTS CHAPTER NO SUBJECTS COVERED PAGE NO 1 2 Introduction of currency derivatives

Company Profile 4 7 3 Research Methodology Scope of Research Type of Research Source of Data collection Objective of the Study Data collection Limitations 14 4 Introduction to The topic Introduction of Financial Derivatives Types of Financial Derivatives Derivatives Introduction in India History of currency derivatives Utility of currency derivatives Introduction to Currency Derivatives Introduction to Currency Future 17 5 Brief Overview of the foreign exchange mar et Overview of foreign exchange mar et in India Currency Derivatives Products Foreign Exchange Spot Mar et 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 Framewor for Currency Futures Comparison of Forward & Future Currency Contracts 6 Analysis Interest Rate Parity Principle Product Definitions of currency future Currency futures payoffs Pricing Futures and Cost of Carry model Hedging with currency futures 52 Findings suggestions and Conclusions 66 Bibliography 68

29

INTRODUCTION OF CURRENCY DERIVATIVES

INTRODUCTION 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 mar et in US dolla rs for short or long term then at maturity the same would be refunded in particu lar agreed currency along with accrued interest on borrowed money. It means tha t the borrowed foreign currency brought in the country will be converted into In dian currency, and when borrowed fund are paid to the lender then the home curre ncy 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 c urrency in terms of other currency is nown as exchange rate. The foreign exchange mar ets of a country provide the mechanism of exchanging di fferent currencies with one and another, and thus, facilitating transfer of purc hasing 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 deca des. Since the exchange rates are continuously changing, so the firms are expos ed to the ris 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 ch ange 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 ris . Since the fixed exchange rate system has been fallen in the early 1970s, specifically in developed countries, the currency ris has bec ome substantial for many business firms. As a result, these firms are increasing

ly turning to various ris hedging products li e foreign currency futures, forei gn currency forwards, foreign currency options, and foreign currency swaps.

COMPANY PROFILE

AnandRathi Securities Limited AnandRathi (AR) is a leading full service securities firm providing the entire g amut of financial services. The firm, founded in 1994 by Mr. AnandRathi, today h

as a pan India presence as well as an international presence through offices in Dubai and Bang o . AR provides a breadth of financial and advisory services incl uding wealth management, investment ban ing, corporate advisory, bro erage & dis tribution of equities, commodities, mutual funds and insurance, structured produ cts - all of which are supported by powerful research teams. AnandRathi is a leading full service securities firm providing the entire gamut of financial services. The firm, founded in 1994 by Mr. AnandRathi, today has a pan India presence as well as an international presence through offices in Dubai and Bang o . AR provides a breadth of financial and advisory services including wealth management, investment ban ing, corporate advisory, bro erage & distribu tion of equities, commodities, mutual funds and insurance, structured products all of which are supported by powerful research teams. The firm s philosophy is entirely client centric, with a clear focus on providin g long term value addition to clients, while maintaining the highest standards o f excellence, ethics and professionalism. The entire firm activities are divided across distinct client groups: Individuals, Private Clients, Corporates and Ins titutions and was recently ran ed by Asia Money 2006 poll amongst South Asia s t op 5 wealth managers for the ultra-rich. The offices of AnandRathi in 197 cities across 28 cities and it has also branche s in Dubai and Bang o with more than 44000 employees. It has daily turnover in excess of Rs. 4billion. It has 1,00,000+ clients nationwide. It is also leadin g Distributor of IPO s In year 2007 Citigroup Venture Capital International joined the group as a finan cial partner. In India AnandRathi is present in 21 States: AndhraPardesh , Assam, Bihar , Chhatisgarh, Delhi , Goa, Gujrat, Haryana Jammu & Kashmir, Jhar hand, Karnata a, Kerala,,MadhyaPardesh, Maharashtra, Orissa, Pun jab, Rajasthan, Tamil Nadu, UttarPardesh, Uttranchal, WestBengal. Mission To be India s first multinational providing complete financial services solution acrossthe globe Vision "To be a shining example as leader in innovation and the first choice for client s & employees" Milestones 1994: Started activities in consulting and Institutional equity sales with staff of 15 1995: Set up a research des and empanelled with major institutional investors 1997: Introduced investment ban ing businesses Retail bro erage services launched 1999: Lead managed first IPO and executed first M & A deal 2001: Initiated Wealth Management Services 2002: Retail business expansion recommences with ownership model 2003: Wealth Management assets cross Rs1500 crores Insurance bro ing launched Launch of Wealth Management services in Dubai Retail Branch networ exceeds 50

Products Equity & Derivatives Mutual Funds Depository Services Commodities Insurance Bro ing IPOs

Equity & derivatives bro erage AnandRathi provides end-to-end equity solutions to institutional and individual investors. Consistent delivery of high quality advice on individual stoc s, sect or trends and investment strategy has established us a competent and reliable re search unit across the country. Clients can trade through us online on BSE and NSE for both equities and derivat ives. They are supported by dedicated sales & trading teams in our trading des s across the country. Research and investment ideas can be accessed by clients ei ther through their designated dealers, email, web or SMS. Mutual funds AR is one of India s top mutual fund distribution houses. Our success lies in ou r philosophy of providing consistently superior, independent and unbiased advice to our clients bac ed by in-depth research. We firmly believe in the importance of selecting appropriate asset allocations based on the client s ris profile. We have a dedicated mutual fund research cell for mutual funds that consistently churns out superior investment ideas, pic ing best performing funds across asse t classes and providing insights into performances of select funds.

Depository services AR Depository Services provides you with a secure and convenient way for holding your securities on both CDSL and NSDL. Our depository services include settlement, clearing and custody of securities, registration of shares and dematerialization. We offer you daily updated interne t access to your holding statement and transaction summary. commodities Commodities bro ing - a whole new opportunity to hedge business ris and an attr active investment opportunity to deliver superior returns for investors. Our commodities bro ing services include online futures trading through NCDEX an d MCX and depository services through CDSL. Commodities bro ing is supported by a dedicated research cell that provides both technical as well as fundamental re search. Our research covers a broad range of traded commodities including precio us and base metals, Oils and Oilseeds, agri-commodities such as wheat, chana, gu ar, guar gum and spices such as sugar, jeera and cotton. In addition to transaction execution, we provide our clients customized advice o n hedging strategies, investment ideas and arbitrage opportunities. insurance bro ing As an insurance bro er, we provide to our clients comprehensive ris management techniques, both within the business as well as on the personal front. Ris mana gement includes identification, measurement and assessment of the ris and handl ing of the ris , of which insurance is an integral part. The firm deals with bot h life insurance and general insurance products across all insurance companies.

Our guiding philosophy is to manage the clients entire ris set by providing th e optimal level of cover at the least possible cost. The entire sales process an d product selection is research oriented and customized to the client s needs. W e lay strong emphasis on timely claim settlement and post sales services.

IPO We are a leading primary mar et distributor across the country. Our strong perfo rmance in IPOs has been a result of our vast experience in the Primary Mar et, a wide networ of branches across India, strong distribution capabilities and a d edicated research team We have been consistently ran ed among the top 10 distributors of IPOs on all ma jor offerings. Our IPO research team provides clients with indepth overviews of forthcoming IPOs as well as investment recommendations. Online filling of forms is also available. Global Products Structuring of trusts / investment companies Offshore Mutual Funds Structured Products / Deposits including capital-guaranteed notes on Trading in global mar ets (Equities, Bonds, Commodities) Real Estate investments Alternative investments (including hedge funds and fund-of-hedge funds) Our services Ris Management Due diligence and research on policies available Recommendation on a comprehensive insurance cover based on clients needs Maintain proper records of client policies Assist client in paying premiums Continuous monitoring of client account Assist client in claim negotiation and settlement

Management Team AR brings together a highly professional core management team that comprises of individuals with extensive business as well as industry experience. Our senior Management comprises a diverse talent pool that brings together rich experience from across industry as well as financial services. Mr. Anand Rathi - Group Chairman Chartered Accountant Past President, BSE Held several Senior Management positions with one of India s largest industrial groups Mr. Pradeep Gupta - Vice Chairman Plus 17 years of experience in Financial Services Mr. Amit Rathi - Managing Director Chartered Accountant & MBA Plus 11 years of experience in Financial Services Why choose AR? Superior understanding of the Indian economy & mar ets Ability to structure and manage your tax and regulatory compliances

Dedicated relationship team Unparalleled product range - Indian and Global

RESEARCH METHODOLOGY

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 sta ge theoretical study is attempted and at the second stage observed online tradin g on NSE/BSE. SOURCE OF DATA COLLECTION Secondary data were used such as various boo s, report submitted by RBI/SEBI com mittee and NCFM/BCFM modules. OBJECTIVES OF THE STUDY The basic idea behind underta ing Currency Derivatives project to gain nowledge about currency future mar et.

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 futu re 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 second ary data might also affect the study underta en. The currency future is new concept and topic related boo was not available in l ibrary and mar et.

INTRODUCTION TO THE TOPIC

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 instrume nts enhances the ability to differentiate ris and allocate it to those investor s most able and willing to ta e it- a process that has undoubtedly improved nati onal productivity growth and standards of livings. lan Greenspan, Former Chairman.

The past decades has witnessed the multiple growths in the volume of internation al trade and business due to the wave of globalization and liberalization all ov er the world. As a result, the demand for the international money and financ ial instruments increased significantly at the global level. In this respect, c hanges in the interest rates, exchange rate and stoc mar et prices at the diffe rent financial mar et have increased the financial ris s to the corporate world. It is therefore, to manage such ris s; the new financial instruments have been developed in the financial mar ets, which are also popularly nown as financial derivatives.

**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 mar et. Derivatives are financial contracts whose value/price is independent on the beha vior of the price of one or more basic underlying assets. These contracts are le gally binding agreements, made on the trading screen of stoc 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 mil . The price of curd depends upon the price of mil which in turn depends upon the dema nd and supply of mil . The Underlying Securities for Derivatives are : Commodities: Castor seed, Grain, Pepper, Potatoes, etc. Precious Metal : Gold, Silver Short Term Debt Securities : Treasury Bills

US Federal Reserve Ban

Interest Rates Common shares/stoc Stoc 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 var ieties of derivatives already in existence and the mar ets are innovating newer and newer ones continuously. For example, various types of financial derivative s based on their different properties li e, plain, simple or straightforward, co mposite, joint or hybrid, synthetic, leveraged, mildly leveraged, OTC traded, st andardized or organized exchange traded, etc. are available in the mar et. Due to complexity in nature, it is very difficult to classify the financial derivati ves, so in the present context, the basic financial derivatives which are popula rly in the mar et have been described. In the simple form, the derivatives can b e classified into different categories which are shown below : DERIVATIVES Financials Commodities Basics Complex 1. Forwards 2. Futures Non STD) 3. Options 4. Warrants and Convertibles 1. Swaps 2.Exotics (

One form of classification of derivative instruments is between commodity deriva tives and financial derivatives. The basic difference between these is the natu re of the underlying instrument or assets. In commodity derivatives, the underl ying instrument is commodity which may be wheat, cotton, pepper, sugar, jute, tu rmeric, corn, crude oil, natural gas, gold, silver and so on. In financial deri vative, the underlying instrument may be treasury bills, stoc s, bonds, foreign exchange, stoc index, cost of living index etc. It is to be noted that financi al derivative is fairly standard and there are no quality issues whereas in comm odity 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 i ncluded in the basic derivatives whereas swaps and other complex derivatives are ta en into complex category because they are built up from either forwards/futu res or options contracts, or both. In fact, such derivatives are effectively de rivatives of derivatives. Derivatives are traded at organized exchanges and in the Over The Counter ( OTC ) mar et : Derivatives Trading Forum

Organized Exchanges Counter

Over The

Commodity Futures racts Financial Futures Options (stoc and index) Stoc Index Future

Forward Cont Swaps

Derivatives traded at exchanges are standardized contracts having standard deliv ery dates and trading units. OTC derivatives are customized contracts that enab le the parties to select the trading units and delivery dates to suit their requ irements. A major difference between the two is that of counterparty ris the ris of defaul t by either party. With the exchange traded derivatives, the ris is controlled by exchanges through clearing house which act as a contractual intermediary and impose margin requirement. In contrast, OTC derivatives signify greater vulner ability. DERIVATIVES INTRODUCTION IN INDIA The first step towards introduction of derivatives trading in India was the prom ulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. SEBI set up a 24 member committee under th e chairmanship of Dr. L.C. Gupta on November 18, 1996 to develop appropriate reg ulatory framewor for derivatives trading in India, submitted its report on Marc h 17, 1998. The committee recommended that the derivatives should be declared as securities so that regulatory framewor applicable to trading of securities could a lso 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 Jun e 2001 and the trading in options on individual securities commenced in July 200 1. Futures contracts on individual stoc s 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 stan dard after World War II. The abandonment of the Bretton Woods agreement resulted in currency values being allowed to float, increasing the ris of doing busines s. By creating another type of mar et in which futures could be traded, CME curr ency futures extended the reach of ris management beyond commodities, which wer e the main derivative contracts traded at CME until then. The concept of currenc y futures at CME was revolutionary, and gained credibility through endorsement o f Nobel-prize-winning economist Milton Friedman. Today, CME offers 41 individual FX futures and 31 options contracts on 19 curren cies, all of which trade electronically on the exchanges CME Globex platform. It is the largest regulated mar etplace for FX trading. Traders of CME FX futures a

re a diverse group that includes multinational corporations, hedge funds, commer cial ban s, investment ban s, financial managers, commodity trading advisors (CT As), proprietary trading firms; currency overlay managers and individual investo rs. 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 foreig n currency, willing to protect their earnings from the foreign currency deprecia tion by loc ing the currency conversion rate at a high level. Their use by impor ters hedging foreign currency payables is effective when the payment currency is expected to appreciate and the importers would li e to guarantee a lower conver sion rate. Investors in foreign currency denominated securities would li e to se cure strong foreign earnings by obtaining the right to sell foreign currency at a high conversion rate, thus defending their revenue from the foreign currency d epreciation. Multinational companies use currency derivatives being engaged in d irect investment overseas. They want to guarantee the rate of purchasing foreign currency for various payments related to the installation of a foreign branch o r subsidiary, or to a joint venture with a foreign partner. A high degree of volatility of exchange rates creates a fertile ground for forei gn 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 cu rrency at a low rate in the future. Alternatively, they may wish to obtain a for eign currency forward buying contract, expecting to sell the appreciating curren cy at a high future rate. In either case, they are exposed to the ris of curren cy fluctuations in the future betting on the pattern of the spot exchange rate a djustment consistent with their initial expectations. The most commonly used instrument among the currency derivatives are currency fo rward contracts. These are large notional value selling or buying contracts obta ined by exporters, importers, investors and speculators from ban s with denomina tion normally exceeding 2 million USD. The contracts guarantee the future conver sion rate between two currencies and can be obtained for any customized amount a nd any date in the future. They normally do not require a security deposit since their purchasers are mostly large business firms and investment institutions, a lthough the ban s may require compensating deposit balances or lines of credit. Their transaction costs are set by spread between ban 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 dep reciation by loc ing in the future currency conversion rate at a high level. A s imilar foreign currency forward selling contract is obtained by investors in for eign currency denominated bonds (or other securities) who want to ta e advantage of higher foreign that domestic interest rates on government or corporate bonds and the foreign currency forward premium. They hedge against the foreign curren cy depreciation below the forward selling rate which would ruin their return fro m foreign financial investment. Investment in foreign securities induced by high er 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 Mar et by Luc jan T. Orlows i)

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 mar et in US dolla rs for short or long term then at maturity the same would be refunded in particu lar agreed currency along with accrued interest on borrowed money. It means tha t the borrowed foreign currency brought in the country will be converted into In dian currency, and when borrowed fund are paid to the lender then the home curre ncy 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 nown as exchange rate. The foreign exchange mar ets of a country provide the mechanism of exchanging di fferent currencies with one and another, and thus, facilitating transfer of purc hasing 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 deca des. Since the exchange rates are continuously changing, so the firms are expos ed to the ris 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 ch ange 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 ris . Since the fixed exchange rate system has been fallen in the early 1970s, specifically in developed countries, the currency ris has bec ome substantial for many business firms. As a result, these firms are increasin gly turning to various ris hedging products li e foreign currency futures, fore ign 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 Wh eat, the contract is termed a commodity futures contract. When the underlying is a n exchange rate, the contract is termed a currency futures contract. In other word s, 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 loc themselves into an exchange rate for a specific value or delivery date. Both parties of the futures contract must fulfi ll their obligations on the settlement date. Currency futures can be cash settled or settled by delivering the respective obl

igation of the seller and buyer. All settlements however, unli e in the case of OTC mar ets, go through the exchange. Currency futures are a linear product, and calculating profits or losses on Curr ency Futures will be similar to calculating profits or losses on Index futures. In determining profits and losses in futures trading, it is essential to now bo th the contract size (the number of currency units being traded) and also what i s the tic value. A tic is the minimum trading increment or price differential at which traders are able to enter bids and offers. Tic values differ for diffe rent currency pairs and different underlying. For e.g. in the case of the USD-IN R currency futures contract the tic size shall be 0.25 paise or 0.0025 Rupees. To demonstrate how a move of one tic affects the price, imagine a trader buys a contract (USD 1000 being the value of each contract) at Rs.42.2500. One tic mo ve on this contract will translate to Rs.42.2475 or Rs.42.2525 depending on the direction of mar et movement.

The value of one tic on each contract is Rupees 2.50. So if a trader buys 5 con tracts and the price moves up by 4 tic , she ma es Rupees 50. Step 1: 42.2600 42.2500 Step 2: 4 tic s * 5 contracts = 20 points Step 3: 20 points * Rupees 2.5 per tic = Rupees 50

BRIEF OVERVIEW OF FOREIGN EXCHANGE MARKET

Purchase price: Price increases New price: Purchase price: Price decreases New price:

Rs .42.2500 by one tic : Rs .42.2525 Rs .42.2500 by one tic : Rs.42. 2475

+Rs. 00.0025 Rs. 00.0025

OVERVIEW OF THE FOREIGN EXCHANGE MARKET IN INDIA During the early 1990s, India embar ed on a series of structural reforms in the foreign exchange mar et. 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 mar et-determined exchang e rate of the rupee and was an important step in the progress towards total curr ent account convertibility, which was achieved in August 1994. Although liberalization helped the Indian forex mar et in various ways, it led t o extensive fluctuations of exchange rate. This issue has attracted a great deal of concern from policy-ma ers and investors. While some flexibility in foreign exchange mar ets and exchange rate determination is desirable, excessive volatil ity can have an adverse impact on price discovery, export performance, sustainab ility of current account balance, and balance sheets. In the context of upgradin g Indian foreign exchange mar et to international standards, a well- developed f oreign exchange derivative mar et (both OTC as well as Exchange-traded) is imper ative. With a view to enable entities to manage volatility in the currency mar et, RBI on April 20, 2007 issued comprehensive guidelines on the usage of foreign curren cy forwards, swaps and options in the OTC mar et. At the same time, RBI also set up an Internal Wor ing Group to explore the advantages of introducing currency futures. The Report of the Internal Wor ing 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 mar et around the world and lay down th e guidelines to introduce Exchange Traded Currency Futures in the Indian mar et. The Committee submitted its report on May 29, 2008. Further RBI and SEBI also i ssued circulars in this regard on August 06, 2008. Currently, India is a USD 34 billion OTC mar et, where all the major currencies li e USD, EURO, YEN, Pound, Swiss Franc etc. are traded. With the help of electr onic trading and efficient ris management systems, Exchange Traded Currency Fut ures will bring in more transparency and efficiency in price discovery, eliminat e counterparty credit ris , provide access to all types of mar et participants, offer standardized products and provide transparent trading platform. Ban s are also allowed to become members of this segment on the Exchange, thereby providin g them with a new opportunity. Source :-( Report of the RBI-SEBI standing technical committee on exch ange traded currency futures) 2008.

CURRENCY DERIVATIVE PRODUCTS Derivative contracts have several variants. The most common variants are forwar

FORWARD : The basic objective of a forward mar et in any underlying asset is to fix a pric e 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 ris of loss which might inc ur due to fluctuations in the price of underlying asset. A forward contract is customized contract between two entities, where settlement ta es place on a specific date in the future at todays pre-agreed price. The ex change rate is fixed at the time the contract is entered into. This is nown 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 betwee n two parties to buy or sell an asset at a certain time in the future at a certa in 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 fut ure according to a prearranged formula. They can be regarded as portfolio of fo rward contracts. The currency swap entails swapping both principal and interest between the parti es, with the cash flows in one direction being in a different currency than thos e in the opposite direction. There are a various types of currency swaps li e as fixed-to-fixed currency swap, floating to floating swap, fixed to floating curr ency 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 an d not the obligation, to buy or sell a given amount of foreign exchange at a fix ed 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 s pecified currency in exchange for another in which buyer of the option has to ri ght 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 buy er of the option for the obligation underta en in the contract. Options generall y have lives of up to one year, the majority of options traded on options exchan ges having a maximum maturity of nine months. Longer dated options are called w arrants and are generally traded OTC.

ds, futures, options and swaps. We ta e a brief loo tracts that have come to be used.

at various derivatives con

FOREIGN EXCHANGE SPOT (CASH) MARKET The foreign exchange spot mar et trades in different currencies for both spot an d forward delivery. Generally they do not have specific location, and mostly ta e place primarily by means of telecommunications both within and between countr ies. It consists of a networ of foreign dealers which are oftenly ban s, financial i nstitutions, large concerns, etc. The large ban s usually ma e mar ets in diffe rent currencies. In the spot exchange mar et, the business is transacted throughout the world on a continual basis. So it is possible to transaction in foreign exchange mar ets 24 hours a day. The standard settlement period in this mar et is 48 hours, i.e ., 2 days after the execution of the transaction. The spot foreign exchange mar et is similar to the OTC mar et for securities. T here is no centralized meeting place and no fixed opening and closing time. Sin ce most of the business in this mar et is done by ban s, hence, transaction usua lly do not involve a physical transfer of currency, rather simply boo eeping t ransfer entry among ban s. Exchange rates are generally determined by demand and supply force in this mar e t. The purchase and sale of currencies stem partly from the need to finance tra de in goods and services. Another important source of demand and supply arises from the participation of the central ban s 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 te rms 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 exchang e rate.

EXCHANGE RATE Direct Indirect

The number of units of domestic Currency stated against one unit of foreign currency. Re/$ = 45.7250 ( or ) $1 = Rs. 45.7250

The number of unit of foreign currency per unit of domestic currency. Re 1 = $ 0.02187

There are two ways of quoting exchange rates: the direct and indirect. Most countries use the direct method. In global foreign exchange mar et, two rat es are quoted by the dealer: one rate for buying (bid rate), and another for sel ling (as or offered rate) for a currency. This is a unique feature of this mar et. It should be noted that where the ban sells dollars against rupees, one c an 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 mar et as Rs 46.3500/3550 , it means that the forex dealer is ready to purchase the dollar at Rs 46.3500 a nd ready to sell at Rs 46.3550. The difference between the buying and selling r ates is called spread. It is important to note that selling rate is always higher than the buying rate. Traders, usually large ban s, deal in two way prices, both buying and selling, a re called mar et ma ers.

Base Currency/ Terms Currency: In foreign exchange mar ets, the base currency is the first currency in a curren cy pair. The second currency is called as the terms currency. Exchange rates a re 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 i s the base currency and the Rupee is the terms currency. Exchange rates are constantly changing, which means that the value of one curren cy in terms of the other is constantly in flux. Changes in rates are expressed as strengthening or wea ening of one currency vis--vis the second currency. Changes are also expressed as appreciation or depreciation of one currency in te rms of the second currency. Whenever the base currency buys more of the terms c urrency, the base currency has strengthened / appreciated and the terms currency has wea ened / depreciated. For example, If Dollar Rupee moved from 43.00 to 43.25. The Dollar has a ppreciated and the Rupee has depreciated. And if it moved from 43.0000 to 42.752 5 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 mar et, RBI on April 20, 2007 issued comprehensive guidelines on the usage of foreign curren cy forwards, swaps and options in the OTC mar et. At the same time, RBI also set up an Internal Wor ing Group to explore the advantages of introducing currency futures. The Report of the Internal Wor ing Group of RBI submitted in April 2008 , recommended the introduction of exchange traded currency futures. Exchange tra ded futures as compared to OTC forwards serve the same economic purpose, yet dif fer in fundamental ways. An individual entering into a forward contract agrees t o transact at a forward price on a future date. On the maturity date, the obliga tion of the individual equals the forward price at which the contract was execut ed. Except on the maturity date, no money changes hands. On the other hand, in t he case of an exchange traded futures contract, mar to mar et obligations is se ttled on a daily basis. Since the profits or losses in the futures mar et are co llected / paid on a daily basis, the scope for building up of mar to mar et los ses in the boo s of various participants gets limited. The counterparty ris in a futures contract is further eliminated by the presenc e of a clearing corporation, which by assuming counterparty guarantee eliminates credit ris . Further, in an Exchange traded scenario where the mar et lot is fixed at a much lesser size than the OTC mar et, equitable opportunity is provided to all classe s of investors whether large or small to participate in the futures mar et. The transactions on an Exchange are executed on a price time priority ensuring that the best price is available to all categories of mar et participants irrespectiv e of their size. Other advantages of an Exchange traded mar et would be greater transparency, efficiency and accessibility. Source :-( Report of the RBI-SEBI standing technical committee on exchange trade d currency futures) 2008. RATIONALE FOR INTRODUCING CURRENCY FUTURE Futures mar ets were designed to solve the problems that exist in forward mar et s. A futures contract is an agreement between two parties to buy or sell an asse t at a certain time in the future at a certain price. But unli e forward contrac ts, the futures contracts are standardized and exchange traded. To facilitate li quidity in the futures contracts, the exchange specifies certain standard featur es of the contract. A futures contract is standardized contract with standard un derlying instrument, a standard quantity and quality of the underlying instrumen t that can be delivered, (or which can be used for reference purposes in settlem ent) 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 ou tlined in the Report of the Internal Wor ing Group on Currency Futures (Reserve Ban of India, April 2008) as follows; The rationale for establishing the currency futures mar et is manifold. Both res idents 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 deprecia tes (appreciates) against the foreign currency, the exposure would result in gai n (loss) for residents purchasing foreign assets and loss (gain) for non residen

ts purchasing domestic assets. In this bac drop, unpredicted movements in exchan ge rates expose investors to currency ris s. Currency futures enable them to hedge these ris s. Nominal exchange rates are of ten random wal s 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 ris may not be large. However, financial planning horizon is much smaller than the long-run, which is typically inter-generational in the con text of exchange rates. As such, there is a strong need to hedge currency ris a nd this need has grown manifold with fast growth in cross-border trade and inves tments flows. The argument for hedging currency ris s appear to be natural in ca se 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 mar et rates. Empirically, changes in exchange rate are found to have ver y low correlations with foreign equity and bond returns. This in theory should l ower portfolio ris . Therefore, sometimes argument is advanced against the need for hedging currency ris s. But there is strong empirical evidence to suggest th at hedging reduces the volatility of returns and indeed considering the episodic nature of currency returns, there are strong arguments to use instruments to he dge currency ris s. FUTURE TERMINOLOGY SPOT PRICE : The price at which an asset trades in the spot mar et. The transaction in which securities and foreign exchange get traded for immediate delivery. Since the ex change of securities and cash is virtually immediate, the term, cash mar et, 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 mar et. CONTRACT CYCLE : The period over which a contract trades. The currency future contracts in India n mar et 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 settleme nt date of each contract. The last business day would be ta en to the same as t hat for inter ban settlements in Mumbai. The rules for inter ban settlements, including those for nown holidays and would be those as laid down by Foreign Exc hange 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 l

ast trading day will be two business days prior to the value date / final settle ment 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 m inus the spot price. There will be a different basis for each delivery month fo r each contract. In a normal mar et, basis will be positive. This reflects tha t futures prices normally exceed spot prices.

COST OF CARRY : The relationship between futures prices and spot prices can be summarized in ter ms of what is nown as the cost of carry. This measures the storage cost plus t he interest that is paid to finance or carry the asset till delivery less the inco me earned on the asset. For equity derivatives carry cost is the rate of intere st. INITIAL MARGIN : When the position is opened, the member has to deposit the margin with the clear ing house as per the rate fixed by the exchange which may vary asset to asset. O r in another words, the amount that must be deposited in the margin account at t he time a future contract is first entered into is nown 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 proc edure, called mar ing to mar et, requires that funds charge every day. The fund s 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, fu tures contract is also called as daily reconnected forwards. MAINTENANCE MARGIN : Members account are debited or credited on a daily basis. In turn customers accou nt are also required to be maintained at a certain level, usually about 75 perc ent of the initial margin, is called the maintenance margin. This is somewhat l ower than the initial margin. This is set to ensure that the balance in the margin account never becomes negat ive. If the balance in the margin account falls below the maintenance margin, t he 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 Hedging: Presume Entity A is expecting a remittance for USD 1000 on 27 August 08. Wants t o loc 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 USDIN R futures since one contract is for USD 1000. Presume that the current spot rate is Rs.43 and USDINR 27 Aug 08 contract is tradi ng 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 entit y shall sell on August 27, 2008, USD 1000 in the spot mar et and get Rs. 44,000. The futures contract will settle at Rs.44.0000 (final settlement price = RBI re ference rate). The return from the futures transaction would be Rs. 250, i.e. (Rs. 44,250 Rs. 4 4,000). As may be observed, the effective rate for the remittance received by th e entity A is Rs.44. 2500 (Rs.44,000 + Rs.250)/1000, while spot rate on that dat e was Rs.44.0000. The entity was able to hedge its exposure. Speculation: Bullish, buy futures Ta e the case of a speculator who has a view on the direction of the mar et. He would li e to trade based on this view. He expects that the USD-INR rate present ly 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 bu ys USD 10000, it would require an investment of Rs.4,20,000. If the exchange rat e moves as he expected in the next three months, then he shall ma e a profit of around Rs.10000. This wor s out to an annual return of around 4.76%. It may plea se be noted that the cost of funds invested is not considered in computing this return. A speculator can ta e exactly the same position on the exchange rate by using fu tures contracts. Let us see how this wor s. If the INR- USD is Rs.42 and the thr ee month futures trade at Rs.42.40. The minimum contract size is USD 1000. There fore the speculator may buy 10 contracts. The exposure shall be the same as abov e 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) a nd he ma es a profit of Rs.1000 on an investment of Rs.21, 000. This wor s out t o 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-valu ed and is li ely 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 fr om his opinion. Today all he needs to do is sell the futures. Let us understand how this wor s. Typically futures move correspondingly with th e underlying, as long as there is sufficient liquidity in the mar et. If the und erlying price rises, so will the futures price. If the underlying price falls, s o will the futures price. Now ta e the case of the trader who expects to see a f all in the price of USD-INR. He sells one two-month contract of futures on USD s ay 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 h as made a clean profit of 20 paise per dollar. For the one contract that he sold , this wor s out to be Rs.2000. Arbitrage: Arbitrage is the strategy of ta ing advantage of difference in price of the same

or similar product between two or more mar ets. That is, arbitrage is stri ing a combination of matching deals that capitalize upon the imbalance, the profit b eing the difference between the mar et prices. If the same or similar product is traded in say two different mar ets, any entity which has access to both the ma r ets will be able to identify price differentials, if any. If in one of the mar ets the product is trading at higher price, then the entity shall buy the produ ct in the cheaper mar et and sell in the costlier mar et and thus benefit from t he price differential without any additional ris . One of the methods of arbitrage with regard to USD-INR could be a trading strate gy between forwards and futures mar et. As we discussed earlier, the futures pri ce 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 ident ify any mis-pricing between forwards and futures. If one of them is priced highe r, 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 futur es shall be settled at the same RBI reference rate, the transaction shall result in a ris less profit.

TRADING PROCESS AND SETTLEMENT PROCESS Li e other future trading, the future currencies are also traded at organized ex changes. The following diagram shows how operation ta e place on currency future mar et: It has been observed that in most futures mar ets, actual physical delivery of t he underlying assets is very rare and hardly it ranges from 1 percent to 5 perce nt. Most often buyers and sellers offset their original position prior to delive ry date by ta ing an opposite positions. This is because most of futures contrac ts 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 cleari ng 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 mar et, RBI on April 20, 2007 issued comprehensive guidelines on the usage of foreign curren cy forwards, swaps and options in the OTC mar et. At the same time, RBI also set up an Internal Wor ing Group to explore the advantages of introducing currency futures. The Report of the Internal Wor ing Group of RBI submitted in April 2008 , recommended the introduction of exchange traded currency futures. With the exp ected benefits of exchange traded currency futures, it was decided in a joint me eting 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 con stituted. To begin with, the Committee would evolve norms and oversee the implem entation of Exchange traded currency futures. The Terms of Reference to the Comm ittee 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 Curr ency and Interest Rate Futures trading.

3.

To suggest eligibility criteria for the members of such exchanges. mitigation

6. To consider microstructure issues, in the overall interest of financial stability. COMPARISION OF FORWARD AND FUTURES CURRENCY CONTRACT BASIS FORWARD FUTURES Size Structured as per requirement of the parties Standardized Delivery date Tailored on individual needs Standardized Method of transaction Established by the ban or bro er through electronic med ia Open auction among buyers and seller on the floor of recognized exchange . Participants Ban s, bro ers, forex dealers, multinational companies, institut ional investors, arbitrageurs, traders, etc. Ban s, bro ers, multinational co mpanies, institutional investors, small traders, speculators, arbitrageurs, etc. Margins None as such, but compensating ban balanced may be required Margin d eposit required Maturity Tailored to needs: from one wee to 10 years Standardized Settlement Actual delivery or offset with cash settlement. No separate cle aring house Daily settlement to the mar et and variation margin requirements Mar et place Over the telephone worldwide and computer networ s At recog nized exchange floor with worldwide communications Accessibility Limited to large customers ban s, institutions, etc. Open to any one who is in need of hedging facilities or has ris capital to speculate Delivery More than 90 percent settled by actual delivery Actual delivery has very less even below one percent Secured Ris is high being less secured Highly secured through margin deposit.

5. n.

To suggest surveillance mechanism and dissemination of mar et informatio

4. To review product design, margin requirements and other ris measures on an ongoing basis.

ANALYSIS

INTEREST RATE PARITY PRINCIPLE For currencies which are fully convertible, the rate of exchange for any date ot her than spot is a function of spot and the relative interest rates in each curr ency. 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 effe ct 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 t wo currencies, adjusted for time. In the case of fully convertible currencies, h aving no restrictions on borrowing or lending of either currency the forward rat e 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 perc ent 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 compa red with the quoted futures price on January 10, 2002 and the relationship is ob served.

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 introd uction would be US$ 1000. The contract size would be periodically aligned to ens ure 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 outst anding 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 Ban Reference Rate on the date of exp iry. 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 wor ing day (excluding Sa turdays) of the month. The last wor ing day would be ta en to be the same as tha t for Interban Settlements in Mumbai. The rules for Interban Settlements, incl uding those for nown holidays and subsequently declared holiday would be those as l aid down by FEDAI. The contract specification in a tabular form is as under: Underlying Rate of exchange between one USD and INR Trading Hours (Monday to Friday) 09:00 a.m. to 05:00 p.m. Contract Size USD 1000 Tic 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/ Value date Last wor ing day of the month (subject to holiday calendars) Last Trading Day Two wor ing days prior to Final Settlement Date Settlement Cash settled Final Settlement Price The reference rate fixed by RBI two wor ing days prior to the final settlement date will be used for final settlement

CURRENCY FUTURES PAYOFFS A payoff is the li ely profit/loss that would accrue to a mar et participant wit h 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-a xis 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 payof fs. 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 payo ffs. 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. Ta e the case of a speculator who buys a two-mo nth currency futures contract when the USD stands at say Rs.43.19. The underlyin g 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 ma ing profits, and when the dollar depreciates, i.e. when rupee appreciates, it starts ma ing losse s. 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 bo ught futures when the USD was at Rs.43.19. If the price goes up, his futures pos ition starts ma ing profit. If the price falls, his futures position starts show ing losses.

Payoff for seller of future: The figure shows the profits/losses for a short futures position. The investor s old futures when the USD was at 43.19. If the price goes down, his futures posit ion starts ma ing profit. If the price rises, his futures position starts showin g losses

Payoff for seller of futures: Short futures The payoff for a person who sells a futures contract is similar to the payoff fo r a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Ta e the case of a speculator who sells a two month currency futures contract when the USD stands at say Rs.43.19. The underl ying asset in this case is the currency, USD. When the value of dollar moves dow n, i.e. when rupee appreciates, the short futures position starts 25 ma ing prof its, and when the dollar appreciates, i.e. when rupee depreciates, it starts ma ing losses. The Figure below shows the payoff diagram for the seller of a future s contract.

PRICING FUTURES COST OF CARRY MODEL Pricing of futures contract is very simple. Using the cost-of-carry logic, we ca lculate the fair value of a futures contract. Every time the observed price devi ates from the fair value, arbitragers would enter into trades to capture the arb itrage profit. This in turn would push the futures price bac 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 nown as interest rate parity relationship and is used in i nternational finance. To explain this, let us assume that one year interest rate s in US and India are say 7% and 10% respectively and the spot rate of USD in In dia 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 tha n the domestic rate i.e. rf > r, then F shall be less than S. The value of F sha ll decrease further as time T increase. If the foreign interest is lower than th e 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 anticip ated profit in foreign investment may be eliminated, rather even may incur loss. Thus, in order to hedge this foreign currency ris , the traders oftenly use the currency futures. For example, a long hedge (I.e.., buying currency futures cont racts) will protect against a rise in a foreign currency value whereas a short h edge (i.e., selling currency futures contracts) will protect against a decline i n a foreign currencys value. It is noted that corporate profits are exposed to exchange rate ris in many sit uation. For example, if a trader is exporting or importing any particular produc t from other countries then he is exposed to foreign exchange ris . Similarly, i f the firm is borrowing or lending or investing for short or long period from fo reign countries, in all these situations, the firms profit will be affected by ch ange in foreign exchange rates. In all these situations, the firm can ta e long or short position in futures currency mar et as per requirement. The general rule for determining whether a long or short futures position will h edge 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 f utures contracts are to be initiated. For example, an Indian manufacturer wants

to purchase some raw materials from Germany then he would li e future in German mar since his exposure in straight forward in mar against home currency (India n rupee). Assume that there is no such future (between rupee and mar ) available in the mar et then the trader would choose among other currencies for the hedgi ng 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 t he currency which matures nearest to the need of that currency. For example, sup pose 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 v alue of USD will increase against Indian rupees nearest to due date of that paym ent. 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 spo ts value of 1 USD is 49.8500. Future Value of the 1USD on NSE as below: Price Watch Order Boo Contract Best Buy Qty Best Buy Price Best Sell Price Best Sell Qty LTP Interest USDINR 261108 464 49.8550 49.8575 USDINR 291208 189 49.6925 49.7000 USDINR 280109 1 49.8850 49.9250 USDINR 250209 100 50.1000 50.2275 USDINR 270309 100 49.9225 50.5000 USDINR 280409 1 50.0000 51.0000 USDINR 270509 51.0000 USDINR 260609 25 49.0000 USDINR 290709 1 48.0875 USDINR 270809 2 48.1625 50.5000 USDINR 280909 1 48.2375 USDINR 281009 1 48.3100 53.1900 USDINR 261109 1 48.3825 -

Volume Open 712 612 2 1 5 5 5 1 2 49.8550 58506 43785

49.7300 176453 111830 49.9450 5598 50.1925 3771 49.9125 311 50.5000 47.1000 50.0000 49.1500 50.3000 6 51.2000 50.9900 50.9275 16809 6367 892 278 506 116 44 2215 79 2 -

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

Rules, Byelaws & Regulations Membership Circulars List of Holidays

Solution: He should buy ten contract of USDINR 28012009 at the rate of 49.8850. Value of t he contract is (49.8850*1000*100) =4988500. (Value of currency future per USD*co ntract 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 da te payoff of importer will be (51.0000-59.8850) =1.115 per USD. And (1.115*10000 0) =111500.Rs. Choice of the number of contracts (hedging ratio) Another important decision in this respect is to decide hedging ratio HR. The va lue of the futures position should be ta en to match as closely as possible the value of the cash mar et position. As we now that in the futures mar ets due to their standardization, exact match will generally not be possible but hedge rat io 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 p osition. 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 au thority and regulatory. The whole function of Exchange traded currency future is regulated by SEBI/RBI, and they established rules and regulation so there is ve ry safe trading is emerged and counter party ris is minimized in currency Futur e trading. And also time reduced in Clearing and Settlement process up to T+1 da ys basis. Larger exporter and importer has continued to deal in the OTC counter even excha nge traded currency future is available in mar ets because,

There is a limit of USD 100 million on open interest applicable to trading membe r who are ban s. And the USD 25 million limit for other trading members so large r exporter and importer might continue to deal in the OTC mar et 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 der ivatives 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 availabl e to trade so there is also one more demand by the exporters and importers to in troduce another pair in currency trading. Li e POUND-INR, CAD-INR etc. In OTC there is no limit for trader to buy or short Currency futures so there de mand arises that in Exchange traded currency future should have increase limit f or 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 mar et (SEBI) has Ban on oth er Currency Derivatives except Currency Futures, so this restriction seem unreas onable 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. CONCLUSIONS

By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivativesThese instrum ents enhances the ability to differentiate ris and allocate it to those investo rs most able and willing to ta e it- a process that has undoubtedly improved nat ional productivity growth and standards of livings. The currency future gives the safe and standardized contract to its investors a nd individuals who are aware about the forex mar et or predict the movement of e xchange rate so they will get the right platform for the trading in currency fut ure. Because of exchange traded future contract and its standardized nature give s counter party ris minimized. Initially only NSE had the permission but now BSE and MCX has also started curre ncy future. It is shows that how currency future covers ground in the compare o f other available derivatives instruments. Not only big businessmen and exporte r and importers use this but individual who are interested and having nowledge about forex mar et they can also invest in currency future. Exchange between USD-INR mar ets in India is very big and these exchange traded contract will give more awareness in mar et and attract the investors.

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 Mar et by: Lucjan T. Orl ows i) Report of the RBI-SEBI standing technical committee on exchange traded currency futures) 2008 Report of the Internal Wor ing Group on Currency Futures (Reserve Ban of India, April 2008) Websites: www.sebi.gov.in www.rbi.org.in www.frost.com www.wi ipedia.com www.economywatch.com www.bseindia.com www.nseindia.com