OVERVIEW OF CURRENCY MARKET & STRATEGIES USING IN CURRENCY FUTURES

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Overview Of Currency Market & Strategies Using in Currency Futures

A

Project Report

On

“OVERVIEW OF CURRENCY MARKET

&

STRATEGIES USING IN CURRENCY FUTURES”

For The Partial Fulfillment for the Award Of

Degree Of .B.B.A

Vir Narmad South Gujarat University, Surat

Guided By: Submitted By:

Mrs. Cheta Vashi Mr. Gajera Ankit

-:SUBMITTED TO:-

BHAWAN MAHAVIR COLLAGE OF BUSSINESS

ADMINISTRATION

Surat,

2011 – 2012.

Bhagwan Mahavir Collage of Business Administration

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DECLARATION

I, the undersigned hereby declare that the project report on “Overview Of Currency

Market & Strategies Using in Currency Futures” is prepared and submitted by me to

V.N.S.G.U, Surat towards partial fulfillment of the Bachelor of Business Administration.

This is my original work and the report prepared there in is based on the knowledge and

the information gathered by me during my project work.

I further declare that to the best of my knowledge and belief, this project has not been

submitted to the same or any other university for the award of any other degree, diploma

or any other equivalent course.

GAJERA ANKIT S.


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ACKNOWLEDGEMENT

On this occasion, I would like to thank Bhawan Mahavir Collage of Business

Administration and all the faculties, for the learning experience provided throughout the

BBA course.

I thank my project guide Mrs. Cheta Vashi who guided me throughout project

preparation. I would also like to thank all the faculty members of The Bhawan Mahavir

Collage of Business Administration who supported me by giving their precious time and

guiding me in the right direction. This project report of mine would have not been

possible without their support.

At the end I would like to thank all my friends and family members who gave me mental

support for completing my project.

GAJERA ANKIT S.

B.B.A.


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Index

Chapter

No.

Particular Page

No.

1 Introduction Of Currency Markets 6

2 Foreign Exchange Markets 8

1. Foreign Exchange Markets In India 9

2. Market Size And Liquidity 11

3. Market Participants 13

3 Currency Derivatives 18

1. Foreign Exchange 19

2. Volumes In Currency Market 19

3. Currency Market A 24 Hour Market 19

4. The Major Currencies In The World 20

5. Currency Pairs 21

6. Base Currency & Term Currency 21

7. Appreciation And Depreciation Of Currency Exchange

Happen

22

8. How Is Currency Markets Classified? 24

9. Factors That Determine Foreign Exchange Rates 26

10. The Trading Strategies Used In Currency Trading 28

11. Types Of Traders In The Derivatives Markets 30

4 Exchange Traded Currency Futures 32

1. Currency Future Contract: 33

2. Difference Between Currency Forwards And Exchange

Traded Futures?

34

3. Limitations Of Futures 38

4. Advantages Of Future 38

5. The Order Management Conditions In Currency Trading 39

6. Contract Specifications Of Currency Futures Contracts Of 40


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Usd

5 Research Methodology 44

6 Data Analysis& Interpretation 46

Strategies Using Currency Futures 47

1. Speculation In Futures Markets 47

2. Long Position In Futures 47

3. Short Position In Futures 49

4. Hedging Using Currency Futures 50

5. Trading Spreads Using Currency Futures. 62

6. Arbitrage 63

7 Findings 65

8 Suggestions & Recommendations 69

9 Conclusion 73

Glossary Items 75

Bibliography 76


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Chapter-1

Introduction

Of

Currency Markets


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Introduction of Currency Markets

The foreign exchange market or Currency market is a global, worldwide decentralized

over-the-counter financial market for trading currencies. Financial centers around the

world function as anchors of trading between a wide range of different types of buyers

and sellers around the clock, with the exception of weekends.

The foreign exchange market determines the relative values of different currencies. The

primary purpose of the foreign exchange is to assist international trade and investment,

by allowing businesses to convert one currency to another currency. For example, it

permits aUS business to import British goods and pay Pound Sterling, even though the

business’s income is in US dollars.

It also supports direct speculation in the value of currencies, and the carry trade,

speculation on the change in interest rates in two currencies. In a typical foreign

exchange transaction, a party purchases a quantity of one currency by paying a quantity

of another currency.

The modern foreign exchange market began forming during the 1970s after three decades

of government restrictions on foreign exchange transactions (the Bretton Woods system

of monetary management established the rules for commercial and financial relations

among the world’s major industrial states after World War II), when countries gradually

switched to floating exchange rates from the previous exchange rate regime, which

remained fixed as per the Bretton Woods system


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Chapter 2.

Foreign Exchange Markets


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1. Foreign Exchange Markets in India

Historically the value of goods was expressed through

some other goods, for example – a barter economy

where individuals exchange goods. The obvious

disadvantages of such a system encouraged

establishment of more generally accepted and

understand means of goods exchange long time ago in

history - to set a common scale of value. In different

places everything from teeth to jewelry has served this purpose but later metals, and

especially gold and silver, were introduced as an accepted means of payment, and also a

reliable form of value storage.

Originally, coins were basically minted from the metal, but stable political systems

introduced a paper form of IOUs (I owe you) which gained wide acceptance during the

middle Ages. Such paper IOUs became the basis of our modern currencies.

Before First World War most central banks supported currencies with gold. Even though

banknotes always could be exchanged for gold, in reality this did not happen that often,

developing an understanding that full reserves are not really needed.

Sometimes huge supply of banknotes without gold support led to giant inflation and

hence political instability. To protect national interests foreign exchange controls were

introduced to demand more responsibility from market players.

Closer to the end of World War II, the Bretton Woods agreement was signed as the

initiative of the USA in July 1944. The Bretton Woods Conference rejected John

Maynard Keynes suggestion for a new world reserve currency in favor of a system built

on the US dollar. Other international institutions such as the IMF, the World Bank and

GATT (General Agreement on Tariffs and Trade) were created in the same period as the

emerging victors of WW2 searched for a way to avoid the destabilizing monetary crises


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which led to the war. The Bretton Woods agreement resulted in a system of fixed

exchange rates that partly reinstated the gold standard, fixing the US dollar at USD35/oz

and fixing the other main currencies to the dollar - and was intended to be permanent.

The Bretton Woods system came under increasing pressure as national economies moved

indifferent directions during the sixties. A number of realignments kept the system alive

for along time, but eventually Bretton Woods collapsed in the early seventies following

President Nixon’s suspension of the gold convertibility in August 1971. The dollar was

no longer suitable as the sole international currency at a time when it was under severe

pressure from increasing US budget and trade deficits.

The following decades have seen foreign exchange trading develop into the largest global

market by far. Restrictions on capital flows have been removed in most countries, leaving

the market forces free to adjust foreign exchange rates according to their perceived values

But the idea of fixed exchange rates has by no means died. The EEC (European

Economic Community) introduced a new system of fixed exchange rates in 1979, the

European Monetary System. This attempt to fix exchange rates met with near extinction

in 1992-93, when pent-up economic pressures forced devaluations of a number of weak

European currencies. Nevertheless, the quest for currency stability has continued in

Europe with the renewed attempt to not only fix currencies but actually replace many of

them with the Euro in2 0 0 1 .

The lack of sustainability in fixed foreign exchange rates gained new relevance with the

events in South East Asia in the latter part of 1997, where currency after currency was

devalued against the US dollar, leaving other fixed exchange rates, in particular in South

America, looking very vulnerable.

But while commercial companies have had to face a much more volatile currency

environment in recent years, investors and financial institutions have found a new

playground. The size of foreign exchange markets now dwarfs any other investment


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market by a large factor. It is estimated that more than USD 3,000 billion is traded every

day, farmore than the world's stock and bond markets combined.

Forex (Foreign Exchange) is the international financial market used for trade of world

currencies. It has been working since 70s of the 20th century - from the moment when the

biggest world nations decided to switch from fixed exchange rates to floating ones. Daily

volume of Forex trade exceeds 4 trillion United States dollars, and this number is always

growing .Main currency for Forex operations is the United States dollar (USD).

Unlike stock exchanges, Forex market doesn't have any fixed schedule or operating hours

-it's open 24 hours per day, 5 days per week from Monday to Friday, since buy/sell orders

are performed by world banks any time during the day or night (some banks even work

on Saturdays and Sundays). Just like any other exchange, Forex market is driven by

supply and demand of a particular tool. For instance, there are buyers and sellers for

"Euro vs. US dollar".

Exchange rates at Forex are changing constantly, and fluctuations may happen many

times per second - this market is very liquid.

2. Market Size and liquidity

The foreign exchange market is the most liquid financial market in the world. Traders

include large banks, central banks, institutional investors, currency speculators,

corporations, governments, other financial institutions, and retail investors. The average

daily turnover in the global foreign exchange and related markets is continuously

growing. According to the2010 Triennial Central Bank Survey, coordinated by the Bank

for International Settlements, average daily turnover was US$3.98 trillion in April 2010

(vs. $1.7 trillion in 1998). Of this$3.98 trillion, $1.5 trillion was spot foreign exchange

transactions and $2.5 trillion was traded in outright forwards, FX swaps and other

currency derivatives.


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Trading in the UK accounted for 36.7% of the total, making UK by far the most

important global center for foreign exchange trading. In second and third places,

respectively, trading in the USA accounted for 17.9%, and Japan accounted for 6.2%.

Turnover of exchange-traded foreign exchange futures and options have grown rapidly in

recent years, reaching $166 billion in 2010 (double the turnover recorded in April

2007).Exchange-traded currency derivatives represent 4% of OTC foreign exchange

turnover. FX futures contracts were introduced in 1972 at the Chicago Mercantile

Exchange and are actively traded relative to most other futures contracts.

Most developed countries permit the trading of FX derivative products (like currency

futures and options on currency futures) on their exchanges. All these developed

countries already have fully convertible capital accounts. A number of emerging

countries do not permit FX derivative products on their exchanges in view of controls on

the capital accounts. The use of foreign exchange derivatives is growing in many

emerging economies. Countries such as Korea, South Africa, and India have established

currency futures exchanges, despite having some controls on the capital account.

Foreign exchange trading

increased by 20% between 2007

and 2010 and has more than

doubled since 2004. The increase

in turnover is due to a number of

factors: the growing importance of

foreign exchange as an asset class,

the increased trading activity of

high-frequency traders, and the

emergence of retail investors as an

important market segment. The

growth of electronic execution

methods and the diverse selection

of execution venues have lowered

transaction costs, increased market liquidity, and attracted greater participation from


Top 10 currency traders [7]

% of overall volume, May 2011

Rank Name Market share

1 Deutsche Bank 15.64%

2 Barclays Capital 10.75%

3 UBS AG 10.59%

4 Citi 8.88%

5 JPMorgan 6.43%

6 HSBC 6.26%

7 Royal Bank of Scotland 6.20%

8 Credit Suisse 4.80%

9 Goldman Sachs 4.13%

10 Morgan Stanley 3.64%

http://en.wikipedia.org/wiki/Morgan_Stanley

http://en.wikipedia.org/wiki/Goldman_Sachs

http://en.wikipedia.org/wiki/Credit_Suisse

http://en.wikipedia.org/wiki/Royal_Bank_of_Scotland

http://en.wikipedia.org/wiki/HSBC

http://en.wikipedia.org/wiki/JPMorgan

http://en.wikipedia.org/wiki/Citi

http://en.wikipedia.org/wiki/UBS_AG

http://en.wikipedia.org/wiki/Barclays_Capital

http://en.wikipedia.org/wiki/Deutsche_Bank

http://en.wikipedia.org/wiki/Foreign_exchange_market#cite_note-6

http://en.wikipedia.org/wiki/Germany

http://en.wikipedia.org/wiki/United_Kingdom

http://en.wikipedia.org/wiki/Switzerland

http://en.wikipedia.org/wiki/United_States




http://en.wikipedia.org/wiki/Switzerland



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many customer types. In particular, electronic trading via online portals has made it

easier for retail traders to trade in the foreign exchange market. By 2010, retail trading is

estimated to account for up to 10% of spot FX turnover, or $150 billion per day

3. Market participants

Unlike a stock market, the foreign exchange market is divided into levels of access. At

the top is the inter-bank market, which is made up of the largest commercial banks and

securities dealers. Within the inter-bank market, spreads, which are the difference

between the bids and ask prices, are razor sharp and not known to players outside the

inner circle. The difference between the bid and ask prices widens (for example from 0-1

pip to 1-2 pips for a currencies such as the EUR) as you go down the levels of access.

This is due to volume. If a trader can guarantee large numbers of transactions for large

amounts, they can demand a smaller difference between the bid and ask price, which is

referred to as a better spread. The levels of access that make up the foreign exchange

market are determined by the size of the "line" (the amount of money with which they are

trading). The top-tier interbank market accounts for53% of all transactions. From there,

smaller banks, followed by large multi-national corporations (which need to hedge risk

and pay employees in different countries), large hedge funds, and even some of the retail

FX market makers. According to Galati and Melvin,” Pension funds, insurance

companies, mutual funds, and other institutional investors have played an increasingly

important role in financial markets in general, and in FX markets in particular, since the

early 2000s.” (2004) In addition, he notes, “Hedge funds have grown markedly over the

2001–2004 period in terms of both number and overall size”. Central banks also

participate in the foreign exchange market to align currencies to their economic needs.

A. Banks

The inter bank market caters for both the majority of commercial turnover and large

amounts of speculative trading every day. Many large banks may trade billions of dollars,

daily. Some of this trading is undertaken on behalf of customers, but much is conducted


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by proprietary desks, which are trading desks for the bank's own account. Until recently,

foreign exchange brokers did large amounts of business, facilitating interbank trading and

matching anonymous counterparts for large fees. Today, however, much of this business

has moved on to more efficient electronic systems. The broker squawk box lets traders

listen in on going interbank trading and is heard in most trading rooms, but turnover is

noticeably smaller than just a few years ago.

B. Commercial Companies

An important part of this market comes from the financial activities of companies seeking

foreign exchange to pay for goods or services. Commercial companies often trade fairly

small amounts compared to those of banks or speculators, and their trades often have

little short term impact on market rates. Nevertheless, trade flows are an important factor

in the long-term direction of a currency's exchange rate. Some multinational companies

can have an unpredictable impact when very large positions are covered due to exposures

that are not widely known by other market participants.

C. central banks

National central banks play an important role in the foreign exchange markets. They try

to control the money supply, inflation, and/or interest rates and often have official or

unofficial target rates for their currencies. They can use their often substantial foreign

exchange reserves to stabilize the market. Nevertheless, the effectiveness of central bank

"stabilizing speculation" is doubtful because central banks do not go bankrupt if they

make large losses, like other traders would, and there is no convincing evidence that they

do make a profit trading.

D. Forex fixing


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Forex fixing is the daily monetary exchange rate fixed by the national bank of each

country. The idea is that central banks use the fixing time and exchange rate to evaluate

behavior of their currency. Fixing exchange rates reflects the real value of equilibrium in

the forex market. Banks, dealers and online foreign exchange traders use fixing rates as a

trend indicator. The mere expectation or rumor of central bank intervention might be

enough to stabilize a currency, but aggressive intervention might be used several times

each year in countries with a dirty float currency regime. Central banks do not always

achieve their objectives. The combined resources of the market can easily overwhelm any

central bank. Several scenarios of this nature were seen in the 1992–93 ERM collapse

and in more recent times in Southeast Asia.

E. Hedge fund as speculators

About 70% to 90% of the foreign exchange transactions are speculative. In other words,

the person or institution that bought or sold the currency has no plan to actually take

delivery of the currency in the end; rather, they were solely speculating on the movement

of that particular currency. Hedge funds have gained a reputation for aggressive currency

speculation since 1996. They control billions of dollars of equity and may borrow billions

more, and thus may overwhelm intervention by central banks to support almost any

currency, if the economic fundamentals are in the hedge funds' favor.

F . Investment management firms

Investment management firms (who typically manage large accounts on behalf of

customers such as pension funds and endowments) use the foreign exchange market to

facilitate transactions in foreign securities. For example, an investment manager bearing

an international equity portfolio needs to purchase and sell several pairs of foreign

currencies topay for foreign securities purchases. Some investment management firms

also have more speculative specialist currency overlay operations, which manage clients'


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currency exposures with the aim of generating profits as well as limiting risk. Whilst the

number of this type of

Specialist firms is quite small, many have a large value of Assets under Management

(AUM), and hence can generate large trades.

G. Retail foreign exchange traders

Individual Retail speculative traders constitute a growing segment of this market with the

advent of retail forex platforms, both in size and importance. Currently, they participate

indirectly through brokers or banks. Retail brokers, while largely controlled and regulated

in the USA by the CFTC and NFA have in the past been subjected to periodic foreign

exchanges cams. To deal with the issue, the NFA and CFTC began (as of 2009) imposing

stricter requirements, particularly in relation to the amount of Net Capitalization required

of its members. As a result many of the smaller and perhaps questionable brokers are now

gone or have moved to countries outside the US. A number of the forex brokers operate

from the UK under FSA regulations where forex trading using margin is part of the wider

over-the-counter derivatives trading industry that includes CFDs and financial spread

betting. There are two main types of retail FX brokers offering the opportunity for

speculative currency trading:

Brokers

And

Dealers or Market makers

.

Brokers

Serve as an agent of the customer in the broader FX market, by seeking the best price in

the market for a retail order and dealing on behalf of the retail customer. They charge a

commission or mark-up in addition to the price obtained in the market.

Dealers or Market makers


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By contrast, typically act as principal in the transaction versus the retail customer, and

quote a price they are willing to deal at.

H. Non-bank foreign exchange companies

Non-bank foreign exchange companies offer currency exchange and international

payments to private individuals and companies. These are also known as foreign

exchange brokers butare distinct in that they do not offer speculative trading but rather

currency exchange with payments (i.e., there is usually a physical delivery of currency to

a bank account).It is estimated that in the UK, 14% of currency transfers/payments are

made via Foreign Exchange Companies. These companies' selling point is usually that

they will offer better exchange rates or cheaper payments than the customer's bank. These

companies differ from Money Transfer/Remittance Companies in that they generally

offer higher-value services.

I. Money transfer companies/remittance companies and bureau de

change

Money transfer companies/remittance companies perform high-volume low-value

transfers generally by economic migrants back to their home country. In 2007, the Aite

Group estimated that there were $369 billion of remittances (an increase of 8% on the

previous year). The four largest markets (India, China, Mexico and the Philippines)

receive $95billion. The largest and best known provider is Western Union with 345,000

agents globally followed by UAE Exchange


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Chapter-3.

CURRENCY

DERIVATIVES


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1. Foreign Exchange

The exchange of one country’s currency for currency of another country is called Foreign

Exchange.

Currencies are important to most people around the world because currencies need to be

exchanged in order to conduct foreign trade and business. An Indian Exporter will

receive funds in the foreign currency and would want to exchange the same in to rupees.

Similarly a French tourist in the US can't pay in Euros to see the Statue of Liberty

because it's not the locally accepted currency. As such, the tourist has to exchange the

Euros for the local currency, in this case the Dollar, at the current exchange rate.

The need to exchange currencies is the primary reason why the forex market is the

largest, most liquid financial market in the world. It dwarfs other markets in size, even

the stock market in terms of volumes.

2. Volumes in Currency Market

Average daily currency trading volumes exceed $4 trillion per day. This is about 10 to 15

times the size of daily trading volume on the world’s stock markets combined.

3. Currency market a 24 hour market

The market is open 24 hours a day, five and a half days a week, and currencies are traded

worldwide in the major financial centers of London, New York, Tokyo, Zurich,Frankfurt,

Hong Kong, Singapore, Paris and Sydney - across almost every time zone. This means

that when the trading day in the U.S. ends, the Forex market begins in Tokyo and Hong

Kong. As such, the Forex market can be extremely active any time of the day, with price

quotes changing constantly. Trading time in India is from 9:00 am to 5:00 pm.


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4. Major currencies in the world

The US dollar is by far the most widely traded currency despite its decline and shakiness

in the recent past. It is also widely used as a ‘vehicle’ currency in foreign exchange

transactions. For example, a trader wants to shift funds from the Indian Rupees to the

Egyptian Pound will first sell INR for USD and then sell USD for EGP. Even though

there are two transactions instead of one, this is the most preferred method of Exchange

as the USD/EGP market is more active and liquid than the INR/EGP.

Other major currencies include:

The Euro:

The euro is the official currency of 16 of the 27 member states of the European Union.

The second most traded currency in the world- the Euro has a strong international

presence like the US dollar and has emerged as one of the most premier currencies after

the US Dollar.

The Japanese Yen:

The Japanese Yen is the third most traded currency in the world. The Yen is very liquid

around the world even though it has a much smaller international presence than the US

Dollar and the Euro

The British Pound:

Until the World War II, the Pound was the currency of reference. The currency is heavily

traded against the Euro and the US Dollar, but it has a spotty presence against other

currencies.

The Swiss Franc:


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The Swiss Franc is the only currency of a major European country that belongs neither to

the European Monitory Union or the G-7 countries. From a foreign exchange point of

view the Swiss Franc closely resembles the patterns of the Euro but lacks its liquidity.

5. Currency Pairs

In the currency market, a currency trade consists of a simultaneous purchase and sale. In

the stock market, for instance, if you buy 100 shares of Tata Motors, you own 100 shares

and hope to see the price go up. When you want to exit that position, you simply sell

what you bought earlier.

But in currencies, the purchase of one currency involves the simultaneous sale of another

currency. To put it another way, if you’re looking for the dollar to go higher, the question

is “Higher against what?” The answer is another currency. In relative terms, if the dollar

goes up against another currency, that other currency also has gone down against the

dollar.

To make matters easier, Forex markets refer to trading currencies in pairs, with names

that combine the two different currencies being traded, or “exchanged,” against each

other.

Let’s look at some common pairs

Currency Pair Countries Long Name

EUR/USD Euro zone/U.S. Euro-dollar

USD/JPY U.S./Japan Dollar-yen

GBP/USD United Kingdom/U.S. Sterling-dollar

USD/INR U.S./India Dollar-rupee

6. Base currency & Term currency


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In foreign exchange markets, the Base currency is the first currency in a currency pair.

The second currency is called as the Term currency. Exchange rates are quoted in per unit

of the Base currency.

Let’s take an example:

1 USD= INR 50

Here the Rupee is being quoted against the Dollar. The Dollar is the Base currency and

the Rupee is Term currency. The USD is the currency being priced and the Rupee is the

currency which is used to express the price. The Base currency is always quoted first.

7. Appreciation and Depreciation of currency exchange

happen

A change in the rate of exchange of one currency to another is expressed as appreciation

or depreciation of one currency in terms of the other currency. It is also referred to as

strengthening or weakening of one currency vis-a–vis the other.

Whenever the Base currency is bought more than the Term currency, the base currency is

strengthened / appreciated and the Term currency has weakened / depreciated.

To put it in other words, if the numeric value of the exchange rate goes up, the base

currency is strengthened / appreciated and the term currency has weakened / depreciated.

Let’s look at an example:

1 USD =INR 40

Something costing 100$ will cost Rs.4000

If 1 USD= INR 45

Then something costing 100$ will now cost Rs.4500

A Bigger value of the exchange rate means that our purchasing power is lower; it is a

depreciation of the

Rupee and appreciation of the dollar.

Let’s look at another example


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1 USD= INR 45

Something costing 100$ will cost Rs.4500

If 1 USD=INR 40

Then something costing 100$ will now cost Rs.4000

A Lower value of the exchange rate means that our purchasing power is higher; it is an

appreciation of the Rupee or you can say the Rupee has strengthened and Dollar has

depreciated.

Bids and Offers are always for the Base currency:

Traders always think in terms of how much it costs to buy or sell the base currency.

When you’re in front of your trading screen you’ll see two prices for each currency pair.

The price on the left-hand side is called the bid and the price on the right-hand side is

called the offer. The “bid” is the price at which you can sell the base currency. The

“offer” is the price at which you can buy the base currency.

Let’s take an example

The quote for the Dollar Rupee might be as follows:

USD/INR

49.2225/50

Here the bid price is 49.2225 per Dollar and the offer price is 49.2250 per Dollar.

The price quotation of each bid and offer you see will have two components: the big

figure and the dealing price. The big figure refers to the first four digits of the overall

currency rate and is usually shown in a smaller font size. The dealing price refers to the

last two digits of the overall currency price and is displayed in a larger font size. In the

above example- the big figure is 49.22 and the dealing price is 25/50. Spread is the

difference between the bid and the ask rate

Tick Size

The tick size refers to the smallest possible price change in currency quote. For e.g. if the

bid for USD/INR currency contract is Rs 47.0025, then the next tick would be Rs

47.0050 or Rs 47.0000. Here tick size (one tick) for the currency quote is Rs. 0.0025.


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Calculating profit and loss using pips:

The last decimal place is called the pip. For most currencies, bids and offers are presented

to the fourth decimal place that is 1/10000th of the Term currency unit also called as pip.

Profit-and-loss calculations are pretty straightforward — they’re all based on position

size and the number of pips you make or lose. A pip is the smallest increment of price

fluctuation in currency prices. Pips can also be referred to as points; we use the two terms

interchangeably.

Let’s look at some currency quotes to understand pip better

USD/CHF = 1.2225

USD/EUR = 1.3225

In the USD/CHF if the price moves from 1.2225 to 1.2250, it has gone up by 25 pips. If it

goes from 1.2225 to 1.2200, it has gone down by 25 points.

8. How is Currency Markets classified?

Currency markets are classified based on the settlement date of the transaction:

Spot: Foreign exchange spot trading is buying one currency with a different

currency for immediate delivery. The standard settlement convention for Foreign

Exchange Spot trades is T+2 days, i.e., two business days from the date of trade

execution. An exception is the USD/CAD (US – Canadian Dollars) currency pair

which settles T+1. Rates for days other than spot are always calculated with

reference to spot rate.

Forward Outright: A foreign exchange forward is a contract between two

counterparties to exchange one currency for another on any date after spot.


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Settlement Day TD (Trading

day)

TD + 1 TD + 2 TD + 3 or any later day

Value Cash Value Tom Spot Forward Outright

For example

If April 1 is the TD. Then April 2 is tom and April 3 is spot. Any day after April 4

is forward. Also note that Saturday and Sunday are market holidays so will not be

considered.

Futures: To participate in the currency markets one needs to go through an

Authorized Dealer. Most of the trading is done Over the Counter. To encourage

retail participation and to do away with some of the disadvantages of the forward

markets the exchanges have introduced Currency Futures

Swap: The most common type of forward transaction is the swap. In a swap, two

parties exchange currencies for a certain length of time and agree to reverse the

transaction at a later date. These are not standardized contracts and are not traded

through an exchange. A deposit is often required in order to hold the position

open until the transaction is completed.

Option; A foreign exchange option (commonly shortened to just FX option) is a

derivative where the owner has the right but not the obligation to exchange money

denominated in one currency into another currency at a pre-agreed exchange rate on

a specified date. The options market is the deepest, largest and most liquid market

for options of any kind in the world.


http://en.wikipedia.org/wiki/Foreign_exchange_swap

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9. factors that determine Foreign exchange rates

Numerous factors determine exchange rates, and all of them are related to the trading

relationship between two countries. Exchange rates are relative, and are expressed as a

comparison of the currencies of two countries. The following are some of the principal

determinants of the exchange rate between two countries. These factors are in no

particular order; like many aspects of economics, the relative importance of these factors

is subject to much debate.

1. Inflation

A country with a consistently lower inflation rate exhibits a rising currency value, as its

purchasing power increases relative to other currencies. Those countries with higher

inflation typically see depreciation in their currency in relation to other currencies.

Inflation in the country would increase the domestic prices of the commodities. Increase

in prices would probably affect exports because the price may not be competitive. With

the decrease in exports the demand for the currency would also decline; this in turn

would result in the decline of external value of the currency.

Eg: In India, Inflation rate is high and a big worry as compared to other countries. This is

affecting growth rate and rupee value is depreciating.

2. Interest Rate

The interest rate has a great influence on the short – term movement of capital. When the

interest rate at a centre rises, it attracts short term funds from other centers. This would


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increase the demand for the currency at the centre and hence its value. Therefore, higher

interest rates attract foreign capital and cause the exchange rate to rise. On the other hand

when the interest rates fall the exchange rate weakens.

E.g.: In the month of March 2011, European countries had increased the interest rate to

1.25%.Hence EURINR (Euro Vs Indian Rupee) appreciated from 63.00 to 66.50 level.

Also, as soon as ECB (European central bank) announced no more interest rate hikes for

the month of June 2011, value of EURINR depreciated from 66.50 to 63.50

3. Political Factors

Political stability induced confidence in the investors and encourages capital inflow into

the country. This has the effect of strengthening the currency of the country. On the other

hand, where the political situation in the country is unstable, it makes the investors

withdraw their investments. The outflow of capital from the country would weaken the

currency GDP, Fiscal Deficit & IIP. Higher GDP and IIP data of the country indicates

growth in the country. Economy is strengthening are positively correlated with a strong

currency and would result in the currency strengthening.

E.g.: Increase in GDP and IIP numbers in India resulted in appreciation of INR currency

against all other four currencies

But High fiscal deficit in the country means less capacity to build up infrastructure and

this stabilize the growth rate. Due to this value of the currency depreciate.

E.g.: Debt problem in Greek and Portugal in European countries has not yet resolved due

to which country has been downgraded to negative ratings. EURINR is being depreciated

due to this risk factor.

4. Employment level


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Lower unemployment level in the country indicates good economy and higher growth

rate in the country. Economy is strengthening are positively correlated with a strong

currency and would result in the currency strengthening. Similarly, higher unemployment

level in the country indicates stable/poor economy and lower growth rate in the country.

Hence, would result in the currency weakening.

E.g.: Every week US unemployment rate appreciate/depreciate the value of US dollar and

provides indication for the growth in the country.

10. The Trading strategies used in Currency Trading

Hedging: Hedging means taking a position in the future market that is opposite to a

position in the physical market with a view to reduce or limit the risk associated with

unpredictable changes in the exchange rate.

Long hedger:

Underlying position: short in the foreign currency

Hedging position: long in currency futures

Short hedger:

Underlying position: long in the foreign currency

Hedging position: short in currency futures

Speculation:

Futures contracts can also be used by speculators who anticipate that the spot price in the

future will be different from the prevailing futures price. For speculators, who anticipate

a strengthening of the base currency will hold a long position in the currency contracts, in

order to profit when the exchange rates move up as per the expectation. A speculator who

anticipates a weakening of the base currency in terms of the terms currency, will hold a

short position in the futures contract so that he can make a profit when the exchange rate

moves down.


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Long position in a currency futures contract without any exposure in the cash market is

called a speculative position. Long position in futures for speculative purpose means

buying futures contract in anticipation of strengthening of the exchange rate (which

actually means buy the base currency (USD) and sell the term currency (INR) and you

want the base currency to rise in value and then you would sell it back at a higher price).

If the exchange rate strengthens before the expiry of the contract then the trader makes a

profit on squaring off the position, and if the exchange rate weakens then the trader

makes a loss on squaring off the position.

Hypothetical Example – Long positions in futures

On May 1, 2008, an active trader in the Currency Futures market expects INR will

depreciate against USD, caused by India’s sharply rising import bill and poor FII equity

flows. On the basis of his view about the USD/INR movement, he buys 1 USD/INR

August contract at the prevailing rate of Rs. 40.5800. He decides to hold the contract till

expiry and during the holding period USD/INR futures actually moves as per his

anticipation and the RBI Reference rate increases to USD/INR 42.46 on May 30, 2008.

He squares off his position and books a profit of Rs. 1880 (42.4600x1000 -

40.5800x1000) on 1 contract of USD/INR

Futures contract.

Observation: The trader has effectively analyzed the market conditions and has taken a

right call by going long on futures and thus has made a gain of Rs. 1,880.

Short position in a currency futures contract without any exposure in the cash market is

called a speculative transaction. Short position in futures for speculative purposes means

selling a futures contract in anticipation of decline in the exchange rate (which actually

means sell the Base currency (USD) and buy the Term currency (INR) and you want the

base currency to fall in value and then you would buy it back at a lower price). If the

exchange rate weakens before the expiry of the contract, then the trader makes a profit on

squaring off the position, and if the exchange rate strengthens then the trader makes loss.

Example – Short positions in futures


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On August 1, 2008, an active trader in the currency futures market expects INR will

appreciate against USD, caused by softening of crude oil prices in the international

market and hence improving India’s trade balance. On the basis of his view about the

USD/INR movement, he sells 1 USD/INR August contract at the prevailing rate of Rs.

42.3600. On August 6, 2008, USD/INR August futures contract actually moves as per his

anticipation and declines to 41.9975. He decides to square off his position and earns a

profit of Rs. 362.50 (42.3600x1000 –41.9975x1000) on squaring off the short position of

1 USD/INR August futures contract.

Observation: The trader has effectively analyzed the market conditions and has taken a

right call by going short on futures and thus has made a gain of Rs. 362.50 per contract

with small investment (a margin of 3%, which comes to Rs. 1270.80) in a span of 6 days.

11. ]Types of traders in the Derivatives Markets

One of the reasons for the success of financial markets is the presence of different

types of traders who add a great deal of liquidity to the market. Suppliers of

liquidity provide an opportunity for others to trade, at a price. The traders in the

derivatives markets are classified into three broad types, viz. Hedgers, speculators and

arbitrageurs, depending on the purpose for which the parties enter into the contracts.

Hedgers

Hedgers trade with an objective to minimize the risk in trading or holding the

underlying securities. Hedgers willingly bear some costs in order to achieve

protection against unfavorable price changes.

Speculators

Speculators use derivatives to bet on the future direction of the markets. They take

calculated risks but the objective is to gain when the prices move as per their expectation.


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Based on the duration for which speculators hold a position they are further be

classified as scalpers (very short time, may be defined in minutes), day traders

(one trading day) and position traders (for a long period may be a week, a month

or a year).

Arbitrageurs

Arbitrageurs try to make risk-less profit by simultaneously entering into transactions in

two or more markets or two or more contracts. They profit from market inefficiencies by

making simultaneous trades that offset each other thereby making their positions

risk-free. For example, they try to benefit from difference in currency rates in two

different markets. They also try to profit from taking a position in the cash market and the

futures market.


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Chapter-4.

EXCHANGE TRADED CURRENCY

FUTURES


1


1) Currency Future contract:

Currency Futures contracts are agreement to buy or sell an asset for a certain price at a

future time. Unlike forward contracts, which are traded in the over -the-counter market

with no standard contract size or standard delivery arrangements, currency futures

contracts are exchange traded and are more standardized. They are standardized in terms

of contract sizes, trading parameters, settlement procedures and are traded on a regulated

exchange. The contract size is fixed and is referred to as lot size.

Since currency futures contracts are traded through exchanges, the settlement of the

contract is guaranteed by the exchange or a clearing corporation and hence there is no

counter party risk. Exchanges guarantee the execution by holding an amount as security

from both the parties. This amount is called as Margin money. Futures contracts provide

the flexibility of closing out the contract prior to the maturity by squaring off the

transaction in the market.


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2) Difference between Currency Forwards and Exchange

Traded Futures?

Forward Contracts Future Contracts

Forward contracts are private and custom

made agreements between banks and its

clients (MNCs, exporters, importers, etc.)

are not as rigid in their stated terms and

conditions.

Future Contracts are exchange-traded and,

therefore, are standardized contracts. It’s

being traded on NSE,MCX and USE

platform

No marked to market is debited on daily

basis

Futures contracts are marked-to-market

daily, which means that daily changes are

settled day by day until the end of the

Contract.

High commission is charged by bank for

this transaction

Lesser brokerage is charged on hedging or

speculation by brokers

No market accessibility Global accessibility to the market on

terminal provided by the exchanges

Most of forward contracts are settled with

delivery or receipt of the asset

All futures contracts are settled using cash,

NOT the delivery of the commodity/asset.

Usually no initial payment is required. This

contract is customized to the needs of the

customers.

Initial margin payment is needed. This

contract is standardized to the needs of the

Customers.

Once the contract has been made, it is very

difficult to undo it till the expiry date is

over.

Client can square off his position anytime

before the expiry of contract


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Examples of Forward & Future Contracts

USDINR Spot rate: 46.00

When USDINR spot exchange rate as on 20th Feb 2011 was Rs 46.00 then the Forward

contract rates were as follows:

Feb 2011: Bid: 46.2032 – Offer: 46.2181

Mar 2011: Bid: 46.4525 – Offer: 46.4725

Apr 2011: Bid: 46.73 – Offer: 46.75

When USDINR spot exchange rate as on 20th Feb 2011 was Rs 46.00 then the Futures

contract rates on NSE (National Stock Exchange) were as follows:

Feb 2011: Bid: 46.21 – Offer: 46.2125

Mar 2011: Bid: 46.45 – Offer: 46.4525

Apr 2011: Bid: 46.72 - Offer: 46.7225

If client wants to buy one lot then gain\Loss as per below mentioned contracts will be

Forward

Price

Future

Price

Brokerage

@ 3%

Future

price

Min

brokerage

charged

Difference(Forward

price -

Future price)

Difference

per 1000

lots in Rs.

46.2181 46.2125 0.004621 46.22 0.01 -0.00440 -4.4

46.4725 46.4525 0.004645 46.46 0.01 0.01000 10

46.75 46.7225 0.004672 46.73 0.01 0.01750 17.5

If client wants to sell one lot then gain\Loss as per below mentioned contracts will be:

Forward

Price

Future

Price

Brokerage

@ 3%

Future

price

Min

brokerage

charged

Difference(Forward

price -

Future price)

Difference

per 1000

lots in Rs.

46.2181 46.2125 0.004621 46.22 0.01 -0.00440 -4.4

46.4725 46.4525 0.004645 46.46 0.01 0.01000 10

46.75 46.7225 0.004672 46.73 0.01 0.01750 17.5


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Contract Specifications of currency futures?

NSE Currency Futures:

USD-INR EUR-INR GBP-INR JPY-INR

Underlying USD-Indian

Rupee

Euro-Indian

Rupee

Pound Sterling-

Indian Rupee

Japanese Yen-

Indian Rupee

Trading

hours

9 a.m. to 5 p.m.

Size of the

contract

USD 1,000 Euro 1,000 GBP 1,000 Japanese Yen

1,00,000

Quotation The contract

would be

quoted

In rupee terms.

However, the

outstanding

positions would

Be in USD

terms.

The contract

would be

quoted

In rupee terms.

However, the

outstanding

positions would

Be in Euro

terms.

The contract

would be

quoted

In rupee terms.

However, the

outstanding

positions would

be in Pound

sterling terms.

The contract

would be

quoted in rupee

terms.

However, the

outstanding

positions

would be in

Japanese

Yen terms.

Settlement

mechanism

Cash settled in Indian Rupee

Settlement

price

The settlement

price would be

the Reserve

Bank Reference

Rate for

USDINR

on the date of

Expiry.

The settlement

price would be

the Reserve

Bank Reference

Rate for

EURINR

on the date of

Expiry.

GBPINR

Exchange rate

published by

the Reserve

Bank in press

release

captioned RBI

reference rate

for US dollar

GBPINR

Exchange rate

published by

the Reserve

Bank in press

release

captioned RBI

reference rate

for US dollar


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and Euro. and Euro

Last trading

day

Two working days prior to the last business day of the expiry month at

12:15pm

(Reference NSE circular No.025/2011)

Final

settlement

day

Last working day of a month (Last working day will be same as that

for Interbank settlements in Mumbai)

Initial

margin

The initial

margin so

computed

would be

subject to a

minimum of

1.75% on the

first day of

trading and 1%

thereafter.

The initial

margin so

computed

would be

subject to a

minimum of

2.80% on the

first day of

trading and 2%

thereafter.

The initial

margin so

computed

would be

subject to a

minimum of

3.20% on the

first day of

trading and 2%

thereafter.

The initial

margin so

computed

would be

subject to a

minimum of

4.50% on the

first day of

trading and

2.30%

thereafter.

Extreme

Loss margin

Extreme loss

margin of 1%

on the mark to

market value of

the gross open

positions

Extreme loss

margin of 0.3%

on the mark to

market value of

the gross open

positions

Extreme loss

margin of 0.5%

on the mark to

market value of

the gross open

positions

Extreme loss

margin of 0.7%

on the mark to

market value of

the gross open

positions

Calendar

spread

margin

The calendar

spread margin

shall be at a

value of Rs.

400 for a spread

of 1 month. Rs

500 for a spread

The calendar

spread margin

shall be at a

value of Rs.

700 for a spread

of 1 month. Rs

1000 for a

The calendar

spread margin

shall be at a

value of Rs.

1500 for a

spread of 1

month. Rs 1800

The calendar

spread margin

shall be at a

value of Rs.

600 for a spread

of 1 month.

Rs 1000 for a


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of 2 months. Rs

800 for a spread

of 3 months Rs

1000 for a

spread or 4

months or

more.

spread of 2

months Rs

1500 for a

spread of 3

months or

more.

for a spread of

2 months Rs

2000 for a

spread of 3

months or

more.

spread of 2

months Rs

1500 for a

spread of 3

months or

more.

Tenor of the

contract

The maximum maturity of the contract would be 12 months.

Available

contracts

All months maturities from 1 to 12 months would be made available

3) Advantages of Futures:

- Transparency and efficient price discovery. The market brings together divergent

categories of buyers and sellers.

- Elimination of Counterparty credit risk.

- Access to all types of market participants. (Currently, in the Foreign Exchange OTC

markets one side of the transaction has to compulsorily be an Authorized Dealer – i.e.

Bank). - Standardized products.

- Transparent trading platform.

4) Limitations of Futures:

- The benefit of standardization which often leads to improving liquidity in futures, works

against this product when a client needs to hedge a specific amount to a date for which

there is no standard contract.

- While margining and daily settlement is a prudent risk management policy, some clients

may prefer not to incur this cost in favor of OTC forwards, where collateral is usually

not demanded


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5) The Order Management conditions in currency trading

1. Price Conditions:-

Limit Price order is an order where you specify a particular price at which the order

should get executed. For e.g. let’s say the current market price of a USDINR is 45.0075

and you place an order to buy at Rs. 45.0025. This order is called a limit price. Market

price orders are orders for which the price is specified as 'MKT’ when the order is

entered. For such orders, the system determines the best available price.

Stop-Loss order facility allows the user to release an order into the system only after the

market price of the security reaches or crosses a certain pre-decided threshold price

which is called the trigger price. Trigger Price is the Price at which an order gets

triggered from the stop loss book. Limit Price is the Price of the orders after it gets

triggered from stop loss book.

2. Time conditions:-

A Day order, as the name suggests is an order that is valid for the day on which it is

entered. If the order is not executed during the day, the system cancels the order

automatically at the end of the day. By default, the system assumes that all orders entered

are Day orders.

For example let’s say that you have placed an order to buy 1 lot of USDINR at 45.0000.

During the trading session your order does not get executed as the price of the currency

was above 45.0075 the whole day. In such a scenario your order gets cancelled once

market closes and if you want the same order to be placed the next day then you need to

place a fresh order.


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Immediate or Cancel (IOC) order allows the user to buy or sell a security as soon as the

order is released into the system. If the order does not execute immediately then the order

is cancelled from the system. Partial match is possible for the order, and the unmatched

portion of the order is cancelled immediately.

3. Other conditions:-

By selecting PRO option broker can place order on his own behalf and by selecting CLI

options broker can place order on behalf of the client. In other words, PRO means

Proprietary order and CLI means client order.

6) Contract Specifications of currency futures contracts of

USD-INR

The contract specification of a USD-INR future contract that is floated by NSE is

given in Table below. In the contract, the USD is the base currency and the INR

is the quote currency. Contracts are available for a maximum period of 12 months.

Each month new contract is introduced. The market disseminates open price, high and

low prices, and last trading prices on a real-time basis. Since the final settlement

is done on T+2 days, the last day for trading on futures contract is two working

days prior to the final settlement.


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USD-INR contract specifications:

Underlying USD-Indian Rupee

Trading hours 9 a.m. to 5 p.m.

Size of the

contract

USD 1,000

Quotation The contract would be quoted in rupee terms. However, the

outstanding positions would be in USD terms.

Settlement

mechanism

Cash settled in Indian Rupee

Settlement price The settlement price would be the Reserve Bank Reference Rate for

USDINR on the date of expiry.

Last trading day Two working days prior to the last business day of the expiry

month at 12 noon

Final settlement

day

Last working day of a month (Last working day will be same as

that for Interbank settlements in Mumbai)

Initial margin The initial margin so computed would be subject to a minimum of

1.75% on the first day of trading and 1% thereafter.

Extreme Loss

margin

Extreme loss margin of 1% on the mark to market value of the

gross open positions

Calendar spread

margin

The calendar spread margin shall be at a value of Rs. 400 for a

spread of 1 month.

Rs 500 for a spread of 2 months.

Rs 800 for a spread of 3 months

Rs 1000 for a spread or 4 months or more.

Tenor of the

contract

The maximum maturity of the contract would be 12 months.

Available

contracts

All months maturities from 1 to 12 months would be made

available


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Permitted lot size :-

Permitted lot size for USDINR future contracts is 1000 US dollars. Members place

orders in terms of number of lots. Therefore, if a member wants to take a position

for 10000 USD, then the number of contracts required is 10000/1000 = 10 contracts.

Tick Size:-

Price steps in respect of all currency futures contracts admitted to dealing on the

Exchange have been specified to be Rs. 0.0025. For example, if the current price is INR

48.5000, a single tick movement will result the price to be either INR 48.5025 or 48.4975

for one USD.

Quantity Freeze:-

Quantity Freeze for Currency Futures Contracts is 10,001 lots or greater i.e. Orders

having quantity up to 10001 lots are allowed. In respect of orders, which have come

under quantity freeze, the members are required to confirm to the Exchange that

there is no inadvertent error in the order entry and that the order is genuine. On

such confirmation, the Exchange may approve such order. However, in exceptional

cases, the Exchange has discretion to disallow the orders that have come under

quantity freeze for execution for any reason whatsoever including non-availability

of turnover / exposure limits.

Base Price:-

Base price of the USDINR Futures Contracts on the first day is the theoretical futures

price. The base price of the contracts on subsequent trading days is the daily

settlement price of the USDINR futures contracts.


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Price Dissemination :-

The exchanges generally disseminate the open price, high price, low price, last-

traded prices and the total number of contracts traded in the day through its

trading system on a real-time basis. It also disseminates information about the best

ask and best bid price, the spread and the net open interest on each contract on a

real-time basis. (Open Interest means the total number of contracts of an

underlying security that have no t yet been offset and closed by an opposite

derivatives transaction nor fulfilled by delivery of the cash or underlying security

or option exercise. For calculation of open interest, only one side of the derivatives

contract is counted). In India, futures contracts are floated that mature every month

but the maximum period is 12 months. The spread for the nearest- maturity

contracts is generally just a single tick and they are more liquid than other contracts.

Price ranges of contracts :-

There are no daily price bands (circuit limits) applicable for Currency Futures

contracts. This means that the strike rate is allowed to change to any level within

a day. This is unlike in case of stocks, where there is circuit limit on price,

ranging from ± 5% to ± 20% depending on the stock category.

However, in order to prevent erroneous order entry by members, operating ranges

have been kept at +/ -3% of the base price for contracts with tenure up to 6

months and 5% for contracts with tenure greater than 6 months. In respect of orders,

which have come under price freeze, the members are required to confirm to the

exchange that there is no inadvertent error in the order entry and that the order is

genuine. On such confirmation, the exchange may take appropriate action. This is

done to take care of cases where an order is entered into the system at a pr ice, which is

not meant by the party, but wrongly given due to data entry errors. For example,

instead of placing an order to sell USD at the rate of 48.5000, the client may

enter 4.8500 in the system.


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Chapter-5

RESEARCH

METDOLOGY


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DEFINE RESEARCH OBJECTIVE

The primary object of the present project is to know about the currency market..

To know about the currency market in detail.

To know about hedging strategies.

BENEFITS OF THE STUDY

The project provided researcher the following benefits:

This project will helpful for those people who want to know the currency market.

This report will helpful for those people who do not aware about the currency

hedging strategies.

This report will helpful for those people who want to invest some money in

currency market.

This project will helpful for those people who want to know the currency future market.

DATA COLLECTION

The data collection is very important before conducting a survey. The data can be collected by

two ways:

Secondary Data

Secondary data is the data already collected by someone for his/her purpose of study.

In this project report, I used secondary source of data in the form of overall currency

futures strategies through various internet sites, etc.

Communication with guide in order to get the feedback about the methodology of

convincing the potential client and asking for the required investments.

Limitation of the Study

These limitations that the researcher faced during the study are as follows:

This report is based on secondary data.

In practical, only optimal hedging is possible.


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Chapter-6

Data analysis

&

Interpretation


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STRATEGIES USING CURRENCY FUTURES

1. SPECULATION IN FUTURES MARKETS

Speculators play a vital role in the futures markets. Futures are designed primarily

to assist hedgers in managing their exposure to price risk; however, this would not be

possible without the participation of speculators. Speculators, or traders, assume the price

risk that hedgers attempt to lay off in the markets. In other words, hedgers often depend

on speculators to take the other side of their trades ( i.e. act as counter party) and to add

depth and liquidity to the markets that are vital for the functioning of a futures market.

The speculators therefore have a big hand in making the market.

Speculation is not similar to manipulation. A manipulator tries to push prices in

the reverse direction of the market equilibrium while the speculator forecasts the

movement in prices and this effort eventually brings the prices closer to the market

equilibrium. If the speculators do not adhere to the relevant fundamental factors of the

spot market, they would not survive since their correlation with the underlying spot

market would be nonexistent.

2. LONG POSITION IN FUTURES

Long position in a currency futures contract without any exposure in the cash

market is called a speculative position. Long position in futures for speculative purpose

means buying futures contract in anticipation of strengthening of the exchange rate

(which actually means buy the base currency (USD) and sell the terms currency (INR)

and you want the base currency to rise in value and then you would sell it back at a

higher price). If the exchange rate strengthens before the expiry of the contract then the

trader makes a profit on squaring off the position, and if the exchange rate weakens then

the trader makes a loss.


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Payoff – Long Position in Futures

The graph above depicts the pay-off of a long position in a future contract, which does

demonstrate that the pay-off of a trader is a linear derivative, that is, he makes unlimited

profit if the market moves as per his directional view, and if the market goes against, he

has equal risk of making unlimited losses if he doesn’t choose to exit out his position.

Hypothetical Example – Long positions in futures

On May 1, 2008, an active trader in the currency futures market expects INR will

depreciate against USD caused by India’s sharply rising import bill and poor FII equity

flows. On the basis of his view about the USD/INR movement, he buys 1 USD/INR

August contract at the prevailing rate of Rs. 40.5800.

He decides to hold the contract till expiry and during the holding period USD/INR futures

actually moves as per his anticipation and the RBI Reference rate increases to USD/INR


1


42.46 on May 30, 2008. He squares off his position and books a profit of Rs. 1880

(42.4600x1000 - 40.5800x1000) on 1 contract of USD/INR futures contract.

3. SHORT POSITION IN FUTURES

Short position in a currency futures contract without any exposure in the cash market is

called a speculative transaction. Short position in futures for speculative purposes means

selling a futures contract in anticipation of decline in the exchange rate (which actually

means sell the base currency (USD) and buy the terms currency (INR) and you want the

base currency to fall in value and then you would buy it back at a lower price). If the

exchange rate weakens before the expiry of the contract, then the trader makes a profit on

squaring off the position, and if the exchange rate strengthens then the trader makes loss.

The graph above depicts the pay-off of a short position in a future contract which does

exhibit that the pay-off of a short trader is a linear derivative, that is, he makes unlimited

profit if the market moves as per his directional view and if the market goes against his

view he has equal risk of making unlimited loss if he doesn’t choose to exit out his

position.

Example – Short positions in futures


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On August 1, 2008, an active trader in the currency futures market expects INR will

appreciate against USD, caused by softening of crude oil prices in the international

market and hence improving India’s trade balance. On the basis of his view about the

USD/INR movement, he sells 1 USD/INR August contract at the prevailing rate of Rs.

42.3600.

On August 6, 2008, USD/INR August futures contract actually moves as per his

anticipation and declines to 41.9975. He decides to square off his position and earns a

profit of Rs. 362.50 (42.3600x1000 – 41.9975x1000) on squaring off the short position of

1 USD/INR August futures contract.

4. HEDGING USING CURRENCY FUTURES

Hedging: Hedging means taking a position in the future market that is opposite to a

position in the physical market with a view to reduce or limit risk associated with

unpredictable changes in exchange rate.

A hedger has an Overall Portfolio (OP) composed of (at least) 2 positions:

1. Underlying position

2. Hedging position with negative correlation with underlying position

Value of OP = Underlying position + Hedging position; and in case of a Perfect hedge,

the Value of the OP is insensitive to exchange rate (FX) changes.

Types of FX Hedgers using Futures

Long hedge:

• Underlying position: short in the foreign currency

• Hedging position: long in currency futures

Short hedge:

• Underlying position: long in the foreign currency

• Hedging position: short in currency futures


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The proper size of the Hedging position

• Basic Approach: Equal hedge

• Modern Approach: Optimal hedge

Equal hedge: In an Equal Hedge, the total value of the futures contracts involved is

the same as the value of the spot market position. As an example, a US importer who has

an exposure of £ 1 million will go long on 16 contracts assuming a face value of £62,500

per contract. Therefore in an equal hedge: Size of Underlying position = Size of Hedging

position.

Optimal Hedge: An optimal hedge is one where the changes in the spot prices are

negatively correlated with the changes in the futures prices and perfectly offset each

other. This can generally be described as an equal hedge, except when the spot-future

basis relationship changes. An Optimal Hedge is a hedging strategy which yields the

highest level of utility to the hedger.

Example 1: Long Futures Hedge Exposed to the Risk of Strengthening

USD

Unhedged Exposure: Let’s say on January 1, 2008, an Indian importer enters into a

contract to import 1,000 barrels of oil with payment to be made in US Dollar (USD) on

July 1, 2008. The price of each barrel of oil has been fixed at USD 110/barrel at the

prevailing exchange rate of 1 USD = INR 39.41; the cost of one barrel of oil in INR

works out to be Rs. 4335.10 (110 x 39.41). The importer has a risk that the USD may

strengthen over the next six months causing the oil to cost more in INR; however, he

decides not to hedge his position.


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On July 1, 2008, the INR actually depreciates and now the exchange rate stands at 1 USD

= INR 43.23. In dollar terms he has fixed his price, that is USD 110/barrel, however, to

make payment in USD he has to convert the INR into USD on the given date and now the

exchange rate stands at 1USD = INR43.23. Therefore, to make payment for one dollar, he

has to shell out Rs. 43.23. Hence the same barrel of oil which was costing Rs. 4335.10 on

January 1, 2008 will now cost him Rs. 4755.30, which means 1 barrel of oil ended up

costing Rs. 4755.30 - Rs. 4335.10 = Rs. 420.20 more and hence the 1000 barrels of oil

has become dearer by INR 4,20,200.

When INR weakens, he makes a loss, and when INR strengthens, he makes a profit. As

the importer cannot be sure of future exchange rate developments, he has an entirely

speculative position in the cash market, which can affect the value of his operating cash

flows, income statement, and competitive position, hence market share and stock price.

Hedged: Let’s presume the same Indian Importer pre-empted that there is good

probability that INR will weaken against the USD given the current macro


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economic fundamentals of increasing Current Account deficit and FII outflows and

decides to hedge his exposure on an exchange platform using currency futures.

Since he is concerned that the value of USD will rise he decides go long on currency

futures, it means he purchases a USD/INR futures contract. This protects the importer

because strengthening of USD would lead to profit in the long futures position, which

would effectively ensure that his loss in the physical market would be mitigated. The

following figure and Exhibit explain the mechanics of hedging using currency futures.

`


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Example 2: Short Futures Hedge Exposed to the Risk of Weakening

USD

Unhedged Exposure: Let’s say on March 1, 2008, an Indian refiner enters into a

contract to export 1000 barrels of oil with payment to be received in US Dollar (USD) on

June 1, 2008. The price of each barrel of oil has been fixed at USD 80/barrel at the

prevailing exchange rate of 1 USD = INR 44.05; the price of one barrel of oil in INR

works out to be is Rs. 3524 (80 x 44.05). The refiner has a risk that the INR may

strengthen over the next three months causing the oil to cost less in INR; however he

decides not to hedge his position.

On June 1, 2008, the INR actually appreciates against the USD and now the exchange

rate stands at 1 USD = INR 40.30. In dollar terms he has fixed his price, that is USD

80/barrel; however, the dollar that he receives has to be converted in INR on the given

date and the exchange rate stands at 1USD = INR40.30. Therefore, every dollar that he

receives is worth Rs. 40.30 as against Rs. 44.05. Hence the same barrel of oil that initially

would have garnered him Rs. 3524 (80 x 44.05) will now realize Rs. 3224, which means


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1 barrel of oil ended up selling Rs. 3524 – Rs. 3224 = Rs. 300 less and hence the 1000

barrels of oil has become cheaper by INR 3,00,000.

When INR strengthens, he makes a loss and when INR weakens, he makes a profit. As

the refiner cannot be sure of future exchange rate developments, he has an entirely

speculative position in the cash market, which can affect the value of his operating cash

flows, income statement, and competitive position, hence market share and stock price.

Hedged: Let’s presume the same Indian refiner pre-empted that there is good

probability that INR will strengthen against the USD given the current macroeconomic

fundamentals of reducing fiscal deficit, stable current account deficit and strong FII

inflows and decides to hedge his exposure on an exchange platform using currency

futures.

Since he is concerned that the value of USD will fall he decides go short on currency

futures, it means he sells a USD/INR future contract. This protects the importer because


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weakening of USD would lead to profit in the short futures position, which would

effectively ensure that his loss in the physical market would be mitigated. The following

figure and exhibit explain the mechanics of hedging using currency futures.


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Example 3 (Variation of Example 1): Long Futures Hedge Exposed to

the Risk of Contract Expiry and Liquidation on the Same Day


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Example 4: Retail Hedging – Long Futures Hedge Exposed to the Risk

of a stronger USD

On March 2008, a student decides to enroll for CMT-USA October 2008 exam for which

he needs to make a payment of USD 1,000 on September, 2008. On March, 2008

USD/INR rate of 40.26, the price of enrolment in INR works out to be Rs. 40,260. The

student has the risk that the USD may strengthen over the next six months causing the

enrolment to cost more in INR hence decides to hedge his exposure on an exchange

platform using currency futures.

Since he is concerned that the value of USD will rise, he decides go long on currency

futures; it means he purchases a USD/INR futures contract. This protects the student

because strengthening of USD would lead to profit in the long futures position, which

would effectively ensure that his loss in the physical market would be mitigated. The

following figure and Exhibit explain the mechanics of hedging using currency futures.


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Example 5: Retail Hedging – Remove Forex Risk while Investing

Abroad

Let’s say when USD/INR at 44.20, an active stock market investor decides to invest USD

200,000 for a period of six months in the S&P 500 Index with a perspective that the

market will grow and his investment will fetch him a decent return. In Indian terms, the

investment is about Rs. 8,840,000.

Let’s say that after six months, as per his anticipation, the market wherein he has invested

has appreciated by 10% and now his investment of USD 200,000 stands at USD 220,000.

Having earned a decent return the investor decides to square off all his positions and

bring back his proceeds to India.

The current USD/INR exchange rate stands at 40.75 and his investment of USD 220,000

in Indian term stands at Rs. 8,965,000. Thus fetching him a meager return of 1.41% as

compared to return of 10% in USD, this is because during the same period USD has

depreciated by 7.81% against the INR and therefore the poor return. Consequently, even

after gauging the overseas stock market movement correctly he is not able to earn the

desired overseas return because he was not able to capture and manage his currency

exposure.

Let’s presume the same Indian investor pre-empted that there is good probability that the

USD will weaken given the then market fundamentals and has decided to hedge his

exposure on an exchange platform using currency futures.

Since he was concerned that the value of USD will fall he decides go short on currency

futures, it means he sells a USD/INR futures contract. This protects the investor because

weakening of USD would lead to profit in 35

the short futures position, which would effectively ensure that his loss in the investment

abroad would be mitigated. The following figure and Exhibit explain the mechanics of

hedging using currency futures.


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Example 6: Retail Hedging – Remove Forex Risk while Trading in

Commodity Market

Gold prices on Exchanges in India have a very high correlation with the COMEX gold

prices. That is, Indian gold prices decrease with the decrease in COMEX prices and

increase with the increase in COMEX prices. But it doesn’t mean the increase and

decrease will be same in Indian exchanges in percentage terms as that in COMEX. This is

because in both the markets the quotation is in different currency, for COMEX gold is

quoted in USD and in India gold is quoted in INR. Hence any fluctuation in USD/INR

exchange rate will have an impact on profit margins of corporates/clients having

positions in Indian Gold Futures. By hedging USD/INR through currency futures, one

can offset the deviation caused in COMEX and Indian prices. The following example

explains the same.

Let’s say with gold trading on COMEX at USD 900/Troy Ounce (Oz) with USD/INR at

40.00, an active commodity investor, realizing the underlying fundamentals, decides that

it’s a good time to sell gold futures. On the basis of this perspective, he decides to sell 1

Indian Gold Future contract @ Rs. 11,580/10 gm.

Let’s say after 20 days, as per his expectation, gold prices did decline drastically on

COMEX platform and gold was now trading at USD 800/oz, a fall of 11.11%. However,

in India gold future was trading @ Rs. 11,317/10 gm, which is a profit of 2.27%. This is

because during the same period the INR has depreciated against the USD by 10% and the

prevalent exchange rate was 44.00.

Had the USD/INR exchange rate remained constant at 40.00, the price after 20 days on

the Indian exchange platform would have been Rs. 10,290 and thus profit realization

would have been the same 11%.


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Let’s presume the same Indian investor pre-empted that there is good probability that the

INR will weaken given the then market fundamentals and has decided to hedge his

exposure on an exchange platform using currency futures.

Since he was concerned that the value of USD will rise, he decides go long on currency

futures, it means he buys a USD/INR futures contract. This protects the investor because

strengthening of USD would lead to profit in the long futures position, which would

effectively ensure that his loss in the commodity trading would be mitigated.

5. TRADING SPREADS USING CURRENCY FUTURES.

Spread refers to difference in prices of two futures contracts. A good understanding of

spread relation in terms of pair spread is essential to earn profit. Considerable knowledge

of a particular currency pair is also necessary to enable the trader to use spread trading

strategy.

Spread movement is based on following factors:

Interest Rate Differentials

Liquidity in Banking System

Monetary Policy Decisions (Repo, Reverse Repo and CRR)

Inflation

Intra-Currency Pair Spread: An intra-currency pair spread consists of one long

futures and one short futures contract. Both have the same underlying but different

maturities.


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Inter-Currency Pair Spread: An inter–currency pair spread is a long-short

position in futures on different underlying currency pairs. Both typically have the same

maturity.

Example: A person is an active trader in the currency futures market. In September

2008, he gets an opportunity for spread trading in currency futures. He is of the view that

in the current environment of high inflation and high interest rate the premium will move

higher and hence USD will appreciate far more than the indication in the current quotes,

i.e. spread will widen. On the basis of his views, he decides to buy December currency

futures at 47.00 and at the same time sell October futures contract at 46.80; the spread

between the two contracts is 0.20.

Let’s say after 30 days the spread widens as per his expectation and now the October

futures contract is trading at 46.90 and December futures contract is trading at 47.25, the

spread now stands at 0.35. He decides to square off his position making a gain of Rs. 150

(0.35 – 0.20 = 0.15 x $1000) per contract.

6. ARBITRAGE

Arbitrage means locking in a profit by simultaneously entering into transactions in two or

more markets. If the relation between forward prices and futures prices differs, it gives

rise to arbitrage opportunities. Difference in the equilibrium prices determined by the

demand and supply at two different markets also gives opportunities to arbitrage.

Example – Let’s say the spot rate for USD/INR is quoted @ Rs. 44.325 and one month

forward is quoted at 3 paisa premium to spot @ 44.3550 while at the same time one

month currency futures is trading @ Rs. 44.4625. An active arbitrager realizes that there

is an arbitrage opportunity as the one month futures price is more than the one month

forward price. He implements the arbitrage trade where he;


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Sells in futures @ 44.4625 levels (1 month)

Buys in forward @ 44.3250 + 3 paisa premium = 44.3550 (1 month) with the

same term period

On the date of future expiry he buys in forward and delivers the same on

exchange platform

In a process, he makes a Net Gain of 44.4625-44.3550 = 0.1075

i.e. Approx 11 Paisa arbitrage

Profit per contract = 107.50 (0.1075x1000)


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Chapter -7

Findings


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FINDINGS

LONG POSITIONS IN FUTURES

The trader has effectively analyzed the market conditions and has taken a right call by

going long on futures and thus has made a gain of Rs. 1,880.

SHORT POSITION IN FUTURES

The trader has effectively analysed the market conditions and has taken a right call by

going short on futures and thus has made a gain of Rs. 362.50 per contract with small

investment (a margin of 3%, which comes to Rs. 1270.80) in a span of 6 days.

LONG FUTURES HEDGE EXPOSED TO THE RISK OF

STRENGTHENING USD

In the example, Following a 9.7% rise in the spot price for USD, the US dollars are

purchased at the new, higher spot price, but profits on the hedge foster an effective

exchange rate equal to the original hedge price.

SHORT FUTURES HEDGE EXPOSED TO THE RISK OF

WEAKENING USD

Following an 8.51% fall in the spot price for USD, the US dollars are sold at the new,

lower spot price; but profits on the hedge foster an effective exchange rate equal to the

original hedge price.


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LONG FUTURES HEDGE EXPOSED TO THE RISK OF

CONTRACT EXPIRY AND LIQUIDATION ON THE SAME DAY

The size of the exposure is USD 110000 and the desired value date is precisely the same

as the futures delivery date (June 30). Following a 9.5% rise in the spot price for USD

against INR, the US dollars are purchased at the new, higher spot price; but profits on the

hedge foster an effective exchange rate equal to the original futures price because on the

date of expiry the spot price and the future price tend to converge.

Retail Hedging – Long Futures Hedge Exposed to the Risk of a

stronger USD

Following a 14.25% rise in the spot price for USD (against INR), the US dollars are

bought at the new, higher spot price; but profits on the hedge foster an effective exchange

rate equal to the original hedge price.

Retail Hedging – Remove Forex Risk while Investing Abroad

Had the exchange rate been stagnant at 44.20 during the six-month investment period the

investment in Rupee terms would have grown from INR 884,00,000 to INR 9,724,000

fetching him a return of INR 8,84,000 in absolute terms. However, during the investment

period, the USD has depreciated by 7.81% and hence his investment has earned him a

return of only INR 125,000. Had he hedged his exposure using currency futures, he could

have mitigated a major portion of his risk as explained in the above example; he is not

able to mitigate his risk completely even with the basis remaining the same because

during the holding period his investment has grown from USD 2,00,000 to USD

2,20,000. The exhibit below gives the tabular representation of the portfolio with and

without currency hedging:


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Hence a hedging using currency future has provided him better return as compared to the

one without hedging. Also, it is not possible for every investor to gauge both the markets

correctly, as in this case the investor may be an intelligent and well informed stock

investor, but he may not be equally good when it comes to currency market; also it is not

necessary that both markets move in the direction of the investor’s advantage. So it’s

advisable that if an investor is taking a bet in one market, he will be better off if he can

mitigate the risk related to other markets.

ARBITRAGE

The discrepancies in the prices between the two markets have given an opportunity to

implement a lower risk arbitrage. As more and more market players will realize this

opportunity, they may also implement the arbitrage strategy and in the process will

enable market to come to a level of equilibrium.


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Chapter – 8

Suggestions

&

Recommendations


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SUGGESTIONS & RECOMMANDATIONS

In the long futures hedge exposed to the risk of strengthening USD, the investor

concerned that the value of USD will rise he should decides go long on currency

futures, it means he should purchase a USD/INR futures contract. It protects the

importer because strengthening of USD would lead to profit in the long futures

position, which ensure that his loss in the physical market would be mitigated.

In the short futures hedge exposed to the risk of weakening USD, investor

concerned that the value of USD will fall , so he should decides to go short on

currency futures, it means he should sell a USD/INR future contract. It protects the

importer because weakening of USD would lead to profit in the short futures

position.

When investor wants to do risk management in long future about the risk of

contract expiry and liquidation on the same day, he should make the use of hedging

strategy.

According to the example, he will get profit on the hedge which fosters an effective

exchange rate equal to the original futures price.

From the example of retail hedging, investor is concerned that the value of USD

will rise; he should go long on currency futures. He should purchase a USD/INR

future contract. It will protect the investor from the risk of invest because

strengthening of USD would lead to profit in the long futures position which

mitigate the loss of invest.


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While investing in abroad the investor have risk of increase the value of the

currency. So he should purchase a future contract to be safe against loss. It will help

the investor to provide him better return as compared to the one without hedging.

In the commodity market, the investor can apply the hedging strategy. While

trading in commodity market, hedging remove the forex risk.

Let’s presume the investor pre-empted that there is good probability that the INR

will weaken, he should decide to hedge his exposure on an exchange platform using

currency futures.

It is advisable that if an investor is taking a bet in one market, he will be better off if

he can mitigate the risk related to other markets.


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LIMITATIONS OF THE STUDY

In the currency future market, contract size are fixed (like 1000USD). So, hedger has

to buy compulsory 1000USD size lot. Here, equal hedging position is not possible or

negligible.

Costs increases with transaction size.

Exchange traded future come in limited currencies and maturities.

Daily marking-to-market can cause a cash flow mismatch.


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Chapter -9

CONCLUSION


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CONCLUSION

It must be noted that though the examples illustrate how a hedger can successfully

avoid negative outcomes by taking an opposite position in FX futures, it is also possible,

that on occasion the FX fluctuations may have been beneficial to the hedger had he not

hedged his position and taking a hedge may have reduced his windfall gains from these

FX fluctuations. FX hedging may not always make the hedger better-off but it helps him

to avoid the risk (uncertainty) and lets him focus on his core competencies instead.

Many people are attracted toward futures market speculation after hearing stories

about the amount of money that can be made by trading futures. While there are success

stories, and many people have achieved a more modest level of success in futures trading,

the keys to their success are typically hard work, a disciplined approach, and a dedication

to master their trade.

An investor should always remember the trade that he has initiated has the equal

probability of going wrong and must therefore apply meticulous risk management

practices to ensure the safety of his hard-earned capital. If you intend to follow this path,

this market is the place to be.


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GLOSSARY ITEMS

FX Foreign Exchange Forex (Foreign Exchange)

GATT General Agreement on Tariffs and Trade

EEC European Economic Community

INR Indian Rupee

LTP Last Trade Price

MTM Mark-To-Market

OTC Over-the-Counter

RBI Reserve Bank of India

TD Trading day

NSE National security Exchange

USD US Dollar

USD/INR US Dollar-Indian Rupee Forex Transaction

NSE-CDS National Stock Exchange – Currency derivative segment

SEBI The Securities & Exchange Board of India

GDP Gross Domestic Product

PRO Proprietary order

CLI Client order.


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BIBLIOGRAPHY

Websites:-


Documents

OVERVIEW OF CURRENCY MARKET & STRATEGIES USING IN CURRENCY FUTURES