Price Risk Management Using Currency

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A

Project report

On

Price risk management using currency futures

for

Greenback Forex Services Ltd.

In partial fulfillment of the requirements of

Masters of Management Studies

conducted by

University of Mumbai

through

Rizvi Institute of Management Studies and Research

under the guidance of

Prof. Vishal Singhi

Submitted by

Kaynat Chainwala

MMS

Batch: 20112013


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CERTIFICATE

This is to certify that Ms.Kaynat Chainwala, a student ofRizvi Management Institute, of MMS

III bearing Roll No. 32 and specializing in Finance has successfully completed the project titled

Price risk management using currencyfutures

under the guidance of Prof. Vishal Singhi in partial fulfillment of the requirement of Masters of

Management Studies by Rizvi Management Institutes for the academic year 20112013.

_______________

Prof. Vishal Singhi

Project Guide

_______________ ______________

Prof. Umar Farooq Dr. Kalim Khan

Academic Coordinator Director


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TABLE OF CONTENTS:

RESEARCH OBJECTIVE 5

EXECUTIVE SUMMARY 6

CURRENCY MARKETS

Current Status 7

Overview 9

Participants in Currency Markets 10

Factors that affect currency rates 12

CURRENCY/FOREX RISK MANAGEMENT

Currency risks 14

FOREX Risk Management- Process and Necessity 17

Hedging Strategies 18

Derivatives Instruments traded in India 19

Business Growth in Currency Derivatives in India 24

CURRENCY FUTURES

Introduction 25

Rationale 27

Market players 30

Major exchanges

NSE 33

MCX-SX 33

USE 34

Trading and volumes 35

Major contracts traded on the exchange 36

Futures terminology 37

Product specification 39


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Pricing futures 41

Cost of carry model 43

Hedging with currency futures 44

Currency futures payoffs 46

MANAGING CURRENCY RISK USING FUTURES

Using Purchasing Power Parity (PPP) 48

Using Interest Rate Parity (IRP) 49

Quantitative analysis

Open interest and volumes of contracts traded 50

Correlation between OI and volumes traded 51

Returns for the past year 52

Historical volatility 53

Research work 54

CONCLUSION 55

BIBLIOGRAPHY 56


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RESEARCH OBJECTIVE

The main objective of this study is to study risks and hedging techniques used to manage them.

A significant number of firms hedge their risk exposures, with wide variations in which risks get

hedged and the tools used for hedging. A significant number of firms hedge against risks, some

risks seem to be hedged more often than others.

In this report, we will look at the most widely hedged risksExchange rate risk.

The most widely hedged risk is Exchange rate risk because it not only affects the multinational

companies but also the domestic companies since their revenue are dependent on inputs from

foreign markets.

Derivatives have been used to manage risk for a very long time, but they were available only to a

few firms and at high cost, since they had to be customized for each user. The development of

options and futures markets in the 1970s and 1980s allowed for the standardization of derivative

products, thus allowing access to even individuals who wanted to hedge against specific risk.

The range of risks that are covered by derivatives grows each year, and there are very few

market-wide risks that you cannot hedge today using options or futures.

The introduction of currency futures in India has passed a journey of almost four years and many

changes have been implemented in the trading system in this regard. Currency futures have

significantly gained importance all over the world since the first currency futures contract was

traded in the year 1972. The futures market holds a great importance in the economy and,

therefore, it becomes imperative that we analyse this important market and seek answers to a few

basic questions. The main theme of this paper is to assess the speed in which the growth of

currency futures in India has accelerated. It also aims at examining the volatility of the currency

futures. In order to study the growth of the currency futures, the number of contracts traded and

open interest at NSE has been inclusively compared.


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If you dont invest in risk management, it doesntmatter what business youre in, its a risky

business.

INDIAN CURRENCY MARKETS

CURRENT SCENARIO:

When India remained largely unaffected by the US sub-prime crisis of 2007-08 that snowballed

into a global financial crisis, it was praised for not being exposed to complex debt instruments.

That was perhaps a good thing then.

But four years later, the scenario has changed. Now, India is more integrated with the global

economy. Besides, the interest rate outlook has turned more volatile.

The rupee crossed historic 56.40 levels recently against the dollar and depreciated against other

major currencies. The volatility in rupee movements is only set to increase on account of a host

of external and domestic forces.

The importance of currency risk management adopting new hedging methods and moving

beyond forward contracts has increased in this scenario. Bungling on currency riskmanagement can adversely affect profits, sales, cost, revenue and competitiveness of companies

involved in international business

HEDGING ERRORS

Indian companies mainly use forward contract derivatives from their banks to hedge currency

exchange risk. Exchange-traded currency futures and options are yet to become popular, in spite

of the fact that these were introduced by RBI and SEBI to provide a transparent hedging system,especially to small and medium scale units.

Indian companies went in for over-the-counter derivatives, duly encouraged by banks, only to

have their fingers burnt when the rupee rates moved against them.Such structures were

developed for speculation rather than for hedging, and now have been banned by RBI.


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present trend of the declining rupee can be converted into big opportunity, particularly by

expanding exports in new international markets. Currency risk management will play a crucial

role in translating this potential into reality.

The rupee will not appreciate in any significant way, unless our current account achieves surplus

position. The rupee-dollar exchange rates are a critical factor in exports, imports, international

loans, foreign remittances, tourism and overseas education. The depreciating rupee poses major

challenges for importers and those servicing unhedged foreign currency loans. Future business

decisions will be influenced by the external value of the rupee against major currencies,

including the dollar.

Contrary to what is generally believed, even dollar depreciation can hurt exporters because

foreign buyers, especially in Europe and the US, exert pressure on Indian exporters to cut prices.

What's more, export-oriented large companies may have hedged their short, medium and long-

term exposures at, say, 48-50 to a dollar, when the rupee was below 45.

Overview of CURRENCY MARKETS:

Globalization and integration of financial markets, coupled with progressive increase of cross-

border flow of capital, have transformed the dynamics of the Indian financial markets. This hasincreased the need for dynamic currency risk management. The steady rise in Indias foreign

trade, along with liberalization in foreign exchange regime, has led to large inflows of foreign

currency into the system in the form of FDI and FII investments. In order to provide a liquid,

transparent and vibrant market for foreign exchange rate risk management, Securities &

Exchange Board of India (SEBI) and Reserve Bank of India (RBI) have allowed trading in

currency futures on stock exchanges for the first time in India, initially based on the USDINR

exchange rate and subsequently on three other currency pairs EURINR, GBPINR and JPYINR.

The USDINR futures contract is being traded on MCX-SX with more than US $3.05 billion

average daily turnover. This would give Indian businesses another tool for hedging their foreign

exchange risks effectively and efficiently at transparent rates on an electronic trading platform.

The primary purpose of exchange traded currency derivatives is to provide a mechanism for

price risk management and consequently provide price curve of expected future prices to enable


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the industry to protect its foreign currency exposure. The need for such instruments increases

with increase of foreign exchange volatility.

Participants in Currency Markets:

The forex market is an OTC market without any centralized clearing house. It consists of two

tiers.

The interbank or wholesale market,

Client or retail market

4 broad categories of participants operate within these two tiers i.e. the participants in the foreign

exchange market comprise;

(i)Corporate

(ii)Commercial banks

(iii)Exchange brokers

(iv)Central banks

Corporates: The business houses, international investors, and multinational corporations may

operate in the market to meet their genuine trade or investment requirements. They

may also buy or sell currencies with a view to speculate or trade in currencies to the extent

permitted by the exchange control regulations. They operate by placing orders with the

commercial banks. The deals between banks and their clients form the retail segment of foreign

exchange market.

Commercial Banks:are themajor players in the market. They buy and sell currencies for their

clients. They may also operate on their own. When a bank enters a market to correct excess or

sale or purchase position in a foreign currency arising from its various deals with its customers, it

is said to do a cover operation. Such transactions constitute hardly 5% of the total transactions

done by a large bank. A major portion of the volume is accounted buy trading in currencies

indulged by the bank to gain from exchange movements. For transactions involving large


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Factors that affectcurrency rates:

Numerous factors determine exchange rates, and all 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.

1. Differentials in Inflation

As a general rule, a country with a consistently lower inflation rate exhibit a rising currency

value, as its purchasing power increases relative to other currencies. During the last half of the

twentieth century, the countries with low inflation included Japan, Germany and Switzerland,

while the U.S. and Canada achieved low inflation only later. Those countries with higher

inflation typically see depreciation in their currency in relation to the currencies of their trading

partners. This is also usually accompanied by higher interest rates.

2. Differentials in Interest Rates

Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest

rates, central banks exert influence over both inflation and exchange rates, and changing interest

rates impact inflation and currency values. Higher interest rates offer lenders in an economy a

higher return relative to other countries. Therefore, higher interest rates attract foreign capital

and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if

inflation in the country is much higher than in others, or if additional factors serve to drive the

currency down. The opposite relationship exists for decreasing interest rates - that is, lower

interest rates tend to decrease exchange rates.

3. Current-Account Deficit

The current account is the balance of trade between a country and its trading partners, reflectingall payments between countries for goods, services, interest and dividends. A deficit in the

current account shows the country is spending more on foreign trade than it is earning, and that it

is borrowing capital from foreign sources to make up the deficit. In other words, the country

requires more foreign currency than it receives through sales of exports, and it supplies more of

its own currency than foreigners demand for its products. The excess demand for foreign


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currency lowers the country's exchange rate until domestic goods and services are cheap enough

for foreigners, and foreign assets are too expensive to generate sales for domestic interests.

4. Public Debt

Countries will engage in large-scale deficit financing to pay for public sector projects and

governmental funding. While such activity stimulates the domestic economy, nations with large

public deficits and debts are less attractive to foreign investors. A large debt encourages

inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper

real dollars in the future.In the worst case scenario, a government may print money to pay part

of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a

government is not able to service its deficit through domestic means (selling domestic bonds,

increasing the money supply), then it must increase the supply of securities for sale to foreigners,

thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they

believe the country risks defaulting on its obligations. Foreigners will be less willing to own

securities denominated in that currency if the risk of default is great.

5. Terms of Trade

A ratio comparing export prices to import prices, the terms of trade is related to current accounts

and the balance of payments. If the price of a country's exports rises by a greater rate than that of

its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater

demand for the country's exports. This, in turn, results in rising revenues from exports, which

provides increased demand for the country's currency (and an increase in the currency's value). If

the price of exports rises by a smaller rate than that of its imports, the currency's value will

decrease in relation to its trading partners.

6. Political Stability and Economic Performance

Foreign investors inevitably seek out stable countries with strong economic performance in

which to invest their capital. A country with such positive attributes will draw investment funds

away from other countries perceived to have more political and economic risk. Political turmoil,

for example, can cause a loss of confidence in a currency and a movement of capital to the

currencies of more stable countries.


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CURRENCY /FOREX RISK MANAGEMENT

Currency risks:

The impact that unexpected exchange rates changes have on the value of the corporation.

Currency risk is very important to a corporation as it can have a major impact on its cash flows,

assets and liabilities, net profit and ultimately its stock market value. Assuming the corporation

has accepted that currency risk needs to be managed specifically and separately, it has three

initial priorities:

1. Define what kinds of currency risk the corporation is exposed to

2. Define a corporate Treasury strategy to deal with these currency risks

3. Define what financial instruments it allows itself to use for this purpose

Currency risk is simple in concept, but complex in reality. At its most basic, it is the possible

gain or loss resulting from an exchange rate move. It can affect the value of a corporation

directly as a result of an unhedged exposure or more indirectly. Different types of currency risk

can also offset each other. For instance, take a US citizen who owns stock in a German auto

manufacturer and exporter to the US. If the Euro falls against the US dollar, the US dollar value

of the Euro-denominated stock falls individual sees the US dollar value of their holding decline.

However, the German auto exporter should in fact benefit from a weaker Euro as this makes the

companys exports to the US cheaper, allowing them the choice of either maintaining US prices

to maintain margin or cutting them further to boost market share. Sooner or later, the stock

market will realize this and mark up the stock price of the auto exporter. Thus, the stock owner

may lose on the currency translation, but gain on the higher stock price. This is of course a very

simple example and life unfortunately is rarely that simple. The first step in successfullymanaging currency risk is to acknowledge that such risk actually exists and that it has to be

managed in the general interest of the corporation and the corporations shareholders. Indeed, at

its best, prudent currency hedging can be defined as the elimination of speculation. The real

speculation is in fact not managing currency risk.


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Translation risk is thus balance sheet currency risk. While most large multinational corporations

actively manage their transaction currency risk, many are less aware of the potential dangers of

translation risk. The actual translation process in consolidating financial statements is done either

at the average exchange rate of the period or at the exchange rate at the period end, depending on

the specific accounting regulations affecting the parent company. As a direct result, the

consolidated results will vary as either the average or the end-of-period exchange rate varies.

Thus, all foreign currency-denominated profit is exposed to translation currency risk as exchange

rates vary. In addition, the foreign currency value of foreign subsidiaries is also consolidated on

the parent companys balance sheet, and that value will vary accordingly. Translation risk for a

foreign subsidiary is usually measured by the net assets (assets less liabilities) that are exposed to

potential exchange rate moves.

Economic Risk:

The translation of foreign subsidiaries concerns the consolidated group balance sheet. However,

this does not affect the real economic value or exposure of the subsidiary. Economic risk

focuses on how exchange rate moves change the real economic value of the corporation,

focusing on the present value of future operating cash flows and how this changes in line with

exchange rate changes. More specifically, the economic risk of a corporation reflects the effect

of exchange rate changes on items such as export and domestic sales, and the cost of domestic

and imported inputs. As with translation risk, calculating economic risk is complex, but clearly

necessary to be able to assess how exchange rate changes can affect the present value of foreign

subsidiaries. Economic risk is usually applied to the present value of future operating cash flows

of a corporations foreign subsidiaries. However, it can also be applied to the parent companys

operations and how the present value of those change in line with exchange rate changes.

Summarizing this part, transaction risk deals with the effect of exchange rate moves on

transactional exposure such as accounts receivable/payable or dividends. Translation risk focuses

on how exchange rate moves can affect foreign subsidiary valuation and therefore the valuation

of the consolidated group balance sheet. Finally, economic risk deals with the effect of exchange

rate changes to the present value of future operating cash flows, focusing on the currency

of determination of revenues and operating expenses.


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Foreign Exchange Risk Management: Process & Necessity

Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on account of

sudden/unanticipated changes in exchange rates, quantified in terms of exposures. Exposure isdefined as a contracted, projected or contingent cash flow whose magnitude is not certain at the

moment and depends on the value of the foreign exchange rates. The process of identifying risks

faced by the firm and implementing the process of protection from these risks by financial or

operational hedging is defined as foreign exchange risk management.

Necessity of managing foreign exchange risk

A key assumption in the concept of foreign exchange risk is that exchange rate changes are not

predictable and that this is determined by how efficient the markets for foreign exchange are.

Research in the area of efficiency of foreign exchange markets has thus far been able to establish

only a weak form of the efficient market hypothesis conclusively which implies that successive

changes in exchange rates cannot be predicted by analyzing the historical sequence of exchange

rates.

However, when the efficient markets theory is applied to the foreign exchange market under

floating exchange rates there is some evidence to suggest that the present prices properly reflect

all available information.This implies that exchange rates react to new information in an

immediate and unbiased fashion, so that no one party can make a profit by this information and

in any case, information on direction of the rates arrives randomly so exchange rates also

fluctuate randomly. It implies that foreign exchange risk management cannot be done away with

by employing resources to predict exchange rate changes.

Some firms feel hedging techniques are speculative or do not fall in their area of expertise and

hence do not venture into hedging practices. Other firms are unaware of being exposed to foreign

exchange risks. There are a set of firms who only hedge some of their risks, while others are

aware of the various risks they face, but are unaware of the methods to guard the firm against the

risk. There is yet another set of companies who believe shareholder value cannot be increased by

hedging the firms foreign exchange risks as shareholders can themselves individually hedge

themselves against the same using instruments like forward contracts available in the market or

diversify such risks out by manipulating their portfolio.


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Hedging Strategies/ Instruments:

A derivative is a financial contract whose value is derived from the value of some other financial

asset, such as a stock price, a commodity price, an exchange rate, an interest rate, or even anindex of prices. The main role of derivatives is that they reallocate risk among financial market

participants, help to make financial markets more complete. This section outlines the hedging

strategies using derivatives with foreign exchange being the only risk assumed.

Derivatives market in India:

Derivatives markets have been in existence in India in some form or other for a long time. In the

area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and,

by the early 1900s India had one of the worlds largest futuresindustries. In 1952 the

government banned cash settlement and options trading and derivatives trading shifted to

informal forwards markets. In recent years, government policy has changed, allowing for an

increased role for market-based pricing and less suspicion of derivatives trading. The ban on

futures trading of many commodities was lifted starting in the early 2000s, and national

electronic commodity exchanges were created.

In the equity markets, a system of trading called badla involving some elements o f forwards

trading had been in existence for decades. However, the system led to a number of undesirable

practices and it was prohibited off and on till the Securities and Exchange Board of India (SEBI)

banned it for good in 2001. A series of reforms of the stock market between 1993 and 1996

paved the way for the development of exchange-traded equity derivatives markets in India. In

1993, the government created the NSE in collaboration with state-owned financial institutions.

NSE improved the efficiency and transparency of the stock markets by offering a fully

automated screen-based trading system and real-time price dissemination. In 1995, a prohibitionon trading options was lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-

traded derivatives. The report of the L. C. Gupta Committee, set up by SEBI, recommended a

phased introduction of derivative products, and bi-level regulation (i.e., self-regulation by

exchanges with SEBI providing a supervisory and advisory role). Another report, by the J. R.

Varma Committee in 1998, worked out various operational details such as the margining


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Derivatives Instruments Traded in India:

In the exchange-traded market, the biggest success story has been derivatives on equity products.

Index futures were introduced in June 2000, followed by index options in June 2001, and options

and futures on individual securities in July 2001 and November 2001, respectively.

Derivatives on stock indexes and individual stocks have grown rapidly since inception. In

particular, single stock futures have become equally popular to the index futures. In fact, NSE

has the highest volume (i.e. number of contracts traded) in the single stock futures globally,

enabling it to highest rank holder among world exchanges at point of time. While single stock

options were less popular than stock futures, they have witnessed a high growth rate since

starting of 2011 after they were changed to European style. On the other hand, index options are

hugely popular than index futures. Now a days, index options turnover share the 2/3rd of the

total F&O turnover. NSE launched interest rate futures in 2009 on 10 Year Notional Coupon-

bearing Govt. of India Security & the recently introduced (2011) 91-day Govt. of India T-Bill;

but in contrast to equity derivatives, there has been little trading in them. This particular segment

is still in its nascent stage.

Regulators permitted the exchanges to launch currency derivatives contracts to start with

USDINR currency pair in 2nd half of 2008. Later on three more currency pairs EURINR,

GBPINR & JPYINR is allowed in Feb. 2010. Currency options contracts were launched on Oct.

29th 2010 on USDINR only & so far now this is the only option contract available in the

segment. Since its launch forex derivatives have seen continuous activity & rising trading

volumes than interest rate derivatives and any other segments.

Exchange-traded commodity derivatives have been allowed for trading only since April 2003.

The number of commodities eligible for futures trading is 109 by 2011 on 21 recognized

exchanges. Of all the commodities, bullion contracts shares 40.75%, most of the total turnover.

Among all exchanges, MCX enjoys the biggest share of turnover of more than 82% of the total

traded value.


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A Derivative is a financial product that is derived out of the value of an underlying asset.

Derivatives are very popular and are widely used financial instruments.

Derivative products can be classified into the following main types:

1. Forwards

2. Futures

3.Options

4. Swaps

Out of these Futures & Options are actively traded on organized stock exchanges whereas

Forwards are traded in OTC Exchanges.

Forwards Contract:

A forward contract is the simplest of the Derivative products. It is a mutual agreement between

two parties, in which the buyer agrees to buy a quantity of an asset at a specific price from the

seller at a future date. The Price of the contract does not change before delivery. These types of

contracts are binding, which means both the buyer and seller must stay committed to the

contract. This means they are bound to deliver or take delivery of the product on which the

forward contract was agreed upon. Forwards contracts are very useful in hedging.

Important Character istics of Forwards Contracts:

1.They are Over the counter (OTC) contracts

2. Both the buyer and seller are bound by the contractual terms

3. The Price remains fixed

L imi tations of F orwards contracts:

1. Lack of centralized trading. Any two individuals can enter into a forwards contract

2. Lack of Liquidity


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An options contract is nothing but the right to buy or sell something at a specified price within a

period of time. The feature of the options contract for a buyer is that, the buyer has the right to

buy, but he may choose to buy or may even choose to cancel the contract. Hence the buyers

maximum loss is only the initial amount that was paid to gain the rights. Unlike buyers, the

options contracts for sellers are an obligation. If a seller enters into an agreement, he has to

deliver the asset on the specified date and the price agreed upon.Thus the loss for a seller could

bemuchworse.

The right to buy is called a "CALL" option while the right to sell is called a "PUT" option.

Please note that an option is only a right to do something. It is not an obligation to carry out the

action. For a buyer it is only a right and not an obligation, but for a seller it is an obligation.

For Example, you want to buy Gold. You form an options contract with a Gold merchant to buy

1000 grams of Gold at the rate of say Rs. 1000/- per gram of gold on December 1st 2008. The

total value of the contract would sum up to 10, 00, 000/- (10 lacs). As part of getting into the

contract you make an initial payment of say 2% of the contract value to the merchant. You make

a payment of Rs. 20 thousand (Rs. 20,000/-) and the contract gets formed. Now you are the

buyer and the merchant is the seller.

Swaps:

A Swap is an agreement between two parties to exchange future cash flows according to a

predefined formula. These streams of cash flow are called the "Legs" of the swap. Usually, when

the swap contract is formed at least one of these series of cash flows is determined by a random

or uncertain value like interest rate or equity price etc.

Most swap contracts are traded OTC which are tailor made for the counterparties. Some are also

traded in organized exchanges. The four generic types of swaps are:

1.Interest rate swaps

2. Currency swaps

3. Equity swaps &


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4. Commodity swaps

Business Growth in Currency Derivatives Segment:

Year Currency Futures Currency Options Total Averag

e Daily

Turnov

er

( cr.)

No. of

contracts

Turnover

( cr.)

No. of

contracts

Notional

Turnover

( cr.)

No. of

contract

s

Turnov

er

( cr.)

2012-

2013

12,55,98,

771

6,84,576.48 4,19,22,048 2,28,021.21 16,75,20,

819

9,12,59

7.69

3,04,19

9.2

2011-

2012

70,13,71,

974

33,78,488.9

2

27,19,72,15

8

12,96,500.9

8

97,33,44,

132

46,74,9

89.9

3,89,58

2.5

2010-

2011

71,21,81,

928

32,79,002.1

3

3,74,20,147 1,70,785.59 74,96,02,

075

34,49,7

87.7

2,87,48

2.3

2009-

2010

37,86,06,

983

17,82,608.0

4

- - 37,86,06,

983

17,82,6

08.0

1,48,55

0.6


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Currency Futures

A Powerful tool to manage currency risk:

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

underlying asset or an instrument at a certain date in the future, at a specified price. When the

underlying asset is a commodity, e.g. Oil or Wheat, the contract is termed a commodity futures

contract.

When the underlying is an exchange rate, the contract is termed a currency futurescontract. In

other words, it is a contract to exchange one currency for another currency at a specified date and

a specified rate in the future. Therefore, the buyer and the seller lock themselves into an

exchange rate for a specific value and delivery date. Both parties of the futures contract must

fulfill their obligations on the settlement date.

Internationally, currency futures can be cash settled or settled by delivering the respective

obligation of the seller and buyer. All settlements, however, unlike in the case of OTC markets,

go through the exchange.

Currency futures are a linear product, and calculating profits or losses on Currency Futures will

be similar to calculating profits or losses on Index futures. In determining profits and losses in

futures trading, it is essential to know both the contract size (the number of currency units being

traded) and also what the tick value is.

A tick is the minimum trading increment or price differential at which traders are able to enter

bids and offers. Tick values differ for different currency pairs and different underlying. For e.g.

in the case of the USD-INR currency futures contract the tick size shall be 0.25 paisa or 0.0025

Rupee. To demonstrate how a move of one tick affects the price, imagine a trader buys a contract

(USD 1000 being the value of each contract) at Rs.52.2500.One tick move on this contract willtranslate to Rs.52.2475 or Rs.52.2525 depending on the direction of market movement.

Purchase price: 52.2500 Purchase price: 52.2500

Price increases by 1 tick: .0025 Price decreases by 1tick: .0025

New price: 52.2525 New price: 52.2475


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Rationale for introducing Currency Futures:

Futures markets were designed to solve the problems that exist in forward markets. A futures

contract is an agreement between two parties to buy or sell an asset at a certain time in the future

at a certain price. But unlike forward contracts, the futures contracts are standardized and

exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain

standard features of the contract. A futures contract is standardized contract with standard

underlying instrument, a standard quantity and quality of the underlying instrument that can be

delivered, (or which can be used for reference purposes in settlement) and a standard timing of

such settlement. A futures contract may be offset prior to maturity by entering into an equal and

opposite transaction.

The standardized items in a futures contract are:

Quantity of the underlying

Quality of the underlying

The date and the month of delivery

The units of price quotation and minimum price change

Location of settlement

The rationale for introducing currency futures in the Indian context has been outlined in theReport of the Internal Working Group on Currency Futures (Reserve Bank of India, April 2008)

as follows:

The rationale for establishing the currency futures market is manifold. Both residents and non-

residents purchase domestic currency assets. If the exchange rate remains unchanged from the

time of purchase of the asset to its sale, no gains and losses are made out of currency exposures.

But if domestic currency depreciates (appreciates) against the foreign currency, the exposure

would result in gain (loss) for residents purchasing foreign assets and loss (gain) for non

residents purchasing domestic assets.

In this backdrop, unpredicted movements in exchange rates expose investors to currency risks.

Currency futures enable them to hedge these risks. Nominal exchange rates are often random

walks with or without drift, while real exchange rates over long run are mean reverting. As such,

it is possible that over a long run, the incentive to hedge currency risk may not be large.


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However, financial planning horizon is much smaller than the long-run, which is typically inter-

generational in the context of exchange rates. As such, there is a strong need to hedge currency

risk and this need has grown manifold with fast growth in cross-border trade and investments

flows. The argument for hedging currency risks appear to be natural in case of assets, and applies

equally to trade in goods and services, which results in income flows with leads and lags and get

converted into different currencies at the market rates. Empirically, changes in exchange rate are

found to have very low correlations with foreign equity and bond returns. This in theory should

lower portfolio risk. Therefore, sometimes argument is advanced against the need for hedging

currency risks. But there is strong empirical evidence to suggest that hedging reduces the

volatility of returns and indeed considering the episodic nature of currency returns, there are

strong arguments to use instruments to hedge currency risks.

Due to internationalization of Indian economy, exchange rate changes of rupee against USD are

exposing our corporate sector to a formidable business risk. Rupee touching the historic low

level of Rs 57.09 against USD caused adverse damage to companies having imports and foreign

currency loans. Unpredictable cycles of depreciation and appreciation resulted in additional risk

factors to already very risky international business.


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Due to global economic uncertainties, rupee touched 52 level in 2009 but recovered to 44 per

USD. Now bearish sentiments are more powerful and chances of such recovery in short term are

not bright. To meet challenges of rupees sudden and steep depreciation, innovative currency risk

hedging strategies have to be developed in consonance to the hedging policies of the company.

More dynamism has to be shown to meet the challenges of unpredictable exchange rate

fluctuations. Indian companies now have to track USD/ INR rates seriously because more than

85% of our exports and imports are invoiced in USD, further, majority of foreign currency

borrowing were also raised in USD.

ECB/FCCB EXPOSURE:

Indian corporates raised huge dollar denominated funds under ECB / FCCB schemes of RBI due

to rupee appreciation and availability of loans at cheap LIBOR rates for USD in 2011. During

such period, Indian companies mobilized huge USD funds to meet their requirements for capital

intensive imports, investment in infrastructure, refinancing high cost existing foreign currency

loans, overseas acquisition etc. via automatic and approval route as per RBI guidelines.

Foreign borrowing constitutes high percentage (40% to 90%) of loan portfolio of big companies.

Domestic loans became expensive due to RBI monetary policy. Companies raised funds costinginterest of 5%p.a to 7%p.a and converted to rupee equivalent when market rate of USD were at

the 44 45 per dollar. At that level, nobody forecasted that the exchange rates would fall to

56.09 in such a short span of time. Majority of borrowers either did not hedge or partially

hedged. Such situation has created huge burden of repayment of principal and interest on

borrowing which are due for payment in the upcoming months. In majority of cases foreign

currency loans will prove to be bad choice for Indian companies resulting in poor results next yr.


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Market players:

Hedgers

Presume Entity A is expecting a remittance for USD 1000 on 27 August 08. Wants to lock in

the foreign exchange rate today so that the value of inflow in Indian rupee terms is safeguarded.

The entity can do so by selling one contract of USDINR futures since one contract is for USD

1000.

Presume that the current spot rate is Rs.43 and USDINR 27 Aug 08 contract is trading at

Rs.44.2500. Entity A shall do the following:

Sell one August contract today. The value of the contract is Rs.44,250.

Let us assume the RBI reference rate on August 27, 2008 is Rs.44.0000. The entity shall sell on

August 27, 2008, USD 1000 in the spot market and get Rs. 44,000. The futures contract will

settle at Rs.44.0000 (final settlement price = RBI reference rate).

The return from the futures transaction would be Rs. 250, i.e. (Rs. 44,250 Rs. 44,000). As

may be observed, the effective rate for the remittance received by the entity A is Rs.44. 2500

(Rs.44,000 + Rs.250)/1000, while spot rate on that date was Rs.44.0000. The entity was able to

hedge its exposure.

Speculators

Bullish, buy futures

Take the case of a speculator who has a view on the direction of the market. He would like to

trade based on this view. He expects that the USD-INR rate presently at Rs.42, is to go up

in the next two-three months. How can he trade based on this belief? In case he can buy

dollars and hold it, by investing the necessary capital, hecan profit if say the Rupee

depreciates to Rs.42.50. Assuming he buys USD 10000, it would require an investment of

Rs.4,20,000. If the exchange rate moves as he expected in the next three months, then he

shall make a profit of around Rs.10000.


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Arbitrageurs

Arbitrage is the strategy of taking advantage of difference in price of the same or similar

product between two or more markets. That is, arbitrage is striking a combination of matching

deals that capitalize upon the imbalance, the profit being the difference between the market

prices. If the same or similar product is traded in say two different markets, any entity which

has access to both the markets will be able to identify price differentials, if any. If in one of the

markets the product is trading at higher price, then the entity shall buy the product in the

cheaper market and sell in the costlier market and thus benefit from the price differential

without any additional risk.

One of the methods of arbitrage with regard to USD-INR could be a trading strategy between

forwards and futures market. As we discussed earlier, the futures price and forward prices are

arrived at using the principle of cost of carry. Such of those entities who can trade both

forwards and futures shall be able to identify any mis-pricing between forwards and futures. If

one of them is priced higher, the same shall be sold while simultaneously buying the other

which is priced lower. If the tenor of both the contracts is same, since both forwards and

futures shall be settled at the same RBI reference rate, the transaction shall result in a risk less

profit.


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Major exchanges:

In India the Forex future currency trade can be carried out through recognized stock markets

Bombay Stock Exchange, National Stock Exchange and Multi Commodity Exchange. National

Stock Exchange has started Forex future currency trading from August 29, 2008. NSE is the first

exchange in India to have obtained an in principle approval from Security and Exchange Board

of India to set up currency derivatives segment. BSE is the third exchange in India to have

obtained an in principle approval from Security and Exchange Board of India after NSE and

MCX.

In brief the history of Trading in Currency Future contracts in India can be traced back to the

year 2008 when various stock exchanges started trading in currency futures on the following

dates:

National Stock Exchange started its operation on August 29, 2008

Multi Commodity Exchange started its operation on October 7, 2008

United Stock Exchange launched its operations on September 20, 2010.

(MCX got the approval from SEBI before BSE but it could start trading in Currency future after

BSE) This shows that trading in currency futures in India is not very old rather it is at the stage

of infancy.

NSE: All the trades done at NSE are cleared and settled by National Security Clearing

Corporation. NSCCL is a separate and independent entity. The following data shows the

increasing trade of currency futures at NSE

MCX: MCX-SX started live operations on October 7, 2008 by launching monthly

contracts in the USDINR currency pair under the regulatory framework of Securities and

Exchange Board of India (SEBI), and Reserve Bank of India (RBI). Consequently, the

stock exchange expanded its currency derivatives offerings to Euro-Indian Rupee

(EURINR), Pound Sterling-Indian Rupee (GBPINR) and Japanese Yen-Indian Rupee

(JPYINR). The currency futures trading will be through MCX Stock Exchange, the new

company that MCX has recently floated. Presently all future contracts on MCX-SX are


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cash settled. There will be no physical contracts. All trade on MCX-SX takes place on its

nationwide electronic trading platform that can be accessed from dedicated terminals at

locations of the members of the exchange. All participants on the MCXSX trading

platform have to participate only through trading members of the Exchange. Participants

have to open a trading account and deposit stipulated cash/collaterals with the trading

member. MCX-SX stands in as the counterparty for each transaction; so participants need

not worry about default. In the event of a default, MCX-SX will step in and fulfills the

obligations of the defaulting party, and then proceed to recover dues and penalties from

them.

Those who entered either by buying (long) or selling (short) a futures contract can close their

contract obligations through squaring-off their positions at any time during the life of that

contract by taking opposite position in the same contract. A long (buy) position holder has to

short (sell) the contract to square off his/her position or vice versa. The participants will be

relieved of their contract obligations to the extent they square off their positions. All contracts

that remain open at expiry are settled in Indian rupees in cash at the reference rate specified by

RBI.

USE: The United Stock Exchange of India (USE) is the fourth pan India exchange to be

launched for trading financial instruments specifically currency futures and currency

options. USE has Bombay Stock Exchange as a strategic partner. USE represents the

commitment of ALL 21 Indian public sector banks, private banks and corporate houses to

build an institution of standing. USE launched its operations on 20 Sept 2010. USE began

operations in the future contracts in each of the following currency pairs:

-Indian Rupee (USD-INR)

-Indian Rupee (EUR-INR)

-Indian Rupee (GBP-INR)

Yen-Indian Rupee (JPY-INR)

There would be 12 contracts i.e. one for each of the next 12 months in each of the above

currency pair. Outright contracts as well as calendar spread contracts are available in each pair

for trading.


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Trading and volumes:

Exchange-trading of the rupee, in India, started in 2010. At a point in time, turnover in exchange-

traded currency futures did seem to haveovertaken the OTC forward market. The USD-INR

futures contract on MCX-SX, NSE, and USE with a contract size of USD 1000 occupied the

firstthree ranks for volume in the world in 2010 and 2011. The USD-INR options contract on the

NSE ranked fourth while the EUR-INR futures on the NSE also featured in the top 20 forex

futures contracts in the world.

Volumes have also seen a rising trend here in India which shows the increased participation in

this new emerging asset class. Combined volumes in currency futures have increased at a CAGR

of 132% from 2009 to 2011 in NSECDS and MCX-SX exchanges after it opened up for trading

on Indian bourses in 2008. Depth has increased in all currency futures pairs as well

MCX-SX, whose application for a full-fledged stock exchange was recently approved by SEBI,

currently offers trading in only currency futures.

It has witnessed a steady and significant growth in currency futures turnover and open interest

and continued to maintain its leadership in currency futures with a market share of 43.57 per cent

in the last fiscal (FY11-12).

The average daily turnover has increased from Rs 324.78 crore during its first month of

operations to Rs 13,530.47 crore at the end of July 2012.
http://ajayshahblog.blogspot.in/2009/09/currency-futures-liquidity-ahead-of.htmlhttp://www.futuresindustry.org/files/css/magazineArticles/article-1383.pdfhttp://www.futuresindustry.org/files/css/magazineArticles/article-1383.pdfhttp://ajayshahblog.blogspot.in/2009/09/currency-futures-liquidity-ahead-of.html


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Major Contracts traded on the exchange:


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Futures terminology:

Some of the common terms used in the context of currency futures market are given below:

SPOT PRICE :The price at which an asset trades in the spot market. The transaction in

which securities and foreign exchange get traded for immediate delivery. Since the

exchange of securities and cash is virtually immediate, the term, cash market, has also

been used to refer to spot dealing. In the case of USDINR, spot value is T + 2.

FUTURE PRICE :The price at which the future contract is traded in the future market.

CONTRACT CYCLE :The period over which a contract trades. The currency future

contracts in Indian market have one month, two month, and 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 SETTLEMENT DATE :The last business day of the month

will be termed the value date /final settlement date of each contract. The last business

day would be taken to the same as that for inter bank settlements in Mumbai. The rules

for inter bank settlements, including those for known holidays and would be those aslaid down by Foreign Exchange Dealers Association of India (FEDAI).

EXPIRY DATE :It is the date specified in the futures contract. This is the last day on

which the contract will be traded, at the end of which it will cease to exist. The last

trading day will be two business days prior to the value date / final settlement date.

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

Also called as lot size. In case of USDINR it is USD 100

BASIS:In the context of financial futures, basis can be defined as the futures price minus

the spot price. There will be a different basis for each delivery month for each contract.


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In a normal market, basis will be positive. This reflects that futures prices normally

exceed spot prices.

COST OF CARRY :The relationship between futures prices and spot prices can be

summarized in terms of what is known as the cost of carry. This measures the storage

cost plus the interest that is paid to finance or carry the asset till delivery less the

income earned on the asset. For equity derivatives carry cost is the rate of interest.

INITIAL MARGIN :When the position is opened, the member has to deposit the margin

with the clearing house as per the rate fixed by the exchange which may vary asset to

asset. Or in another words, the amount that must be deposited in the margin account at

the time a future contract is first entered into is known as initial margin.

MARKING TO MARKET :At the end of trading session, all the outstanding contracts

are reprised at the settlement price of that session. It means that all the futures contracts

are daily settled, and profit and loss is determined on each transaction. This procedure,

called marking to market, requires that funds charge every day.The funds are added or

subtracted from a mandatory margin (initial margin) that traders are required to maintain

the balance in the account.

MAINTENANCE MARGIN:Members account are debited or credited on a daily

basis. In turn customers account are also required to be maintained at a certain level,

usually about 75 percent of the initial margin, is called the maintenance margin.


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Product Specifications:

Symbol USDINR

Instrument Type FUTCUR

Unit of trading 1 (1 unit denotes 1000 USD)

Underlying USD

Quotation/PriceQuote Rs. per USD

Tick size 0.25 paise or INR 0.0025

Trading hours Monday to Friday 9:00 a.m. to 5:00 p.m.

Contract trading cycle 12 month trading cycle.

Last trading dayTwo working days prior to the last business day of the expiry month at

12:15pm.

Final settlement day

Last working day (excluding Saturdays) of the expiry month.

The last working day will be the same as that for Interbank Settlements

in Mumbai.

Base priceTheoretical price on the 1st day of the contract. On all other days, DSP

of the contract.

Price operating rangeTenure up to 6 months Tenure greater than 6 months

+/-3 % of base price +/- 5% of base price

Position limits

Clients Trading Members Banks

Higher of 6% of

total open interest

or USD 10 million

Higher of 15% of the

total open interest or

USD 50 million

Higher of 15% of the

total open interest or

USD 100 million

Minimum initial

margin1.75% on first day & 1% thereafter.


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Extreme loss margin 1% of MTM value of gross open position.

Calendar spreads

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 of 4 months

or more

SettlementDaily settlement :T + 1

Final settlement :T + 2

Mode of settlement Cash settled in Indian Rupees

Daily settlement price

(DSP)

DSP shall be calculated on the basis of the last half an hour weighted

average price of such contract or such other price as may be decided by

the relevant authority from time to time.

Final settlement

price(FSP)RBI reference rate

PRICING FUTURESCOST OF CARRY MODEL

Pricing of futures contract is very simple. Using the cost-of-carry logic, we calculate the

fair value of a futures contract. Every time the observed price deviates from the fair value,

arbitragers would enter into trades to capture the arbitrage profit. This in turn would push the

futures price back to its fair value. The cost of carry model used for pricing futures is given

below:

F=Se^(r-rf)T

where:

r=Cost of financing (using continuously compounded interest rate)

rf= one year interest rate in foreign

T=Time till expiration in years

E=2.71828


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The relationship between F and S then could be given as

F =Se^(r rf )T

This relationship is known as interest rate parity relationship and is used in international finance.

To explain this, let us assume that one year interest rates in US and India are say 7% and 10%

respectively and the spot rate of USD in India is Rs. 56.0775.

From the equation above the one year forward exchange rate should be

F = 56.0775 * e^(0.10-0.07 )*1=57.78

It may be noted from the above equation, if foreign interest rate is greater than the domestic rate

i.e. rf > r, then F shall be less than S. The value of F shall decrease further as time T increase. If

the foreign interest is lower than the domestic rate, i.e. rf < r, then value of F shall be greater than

S. The value of F shall increase further as time T increases.

HEDGING WITH CURRENCY FUTURES

Exchange rates are quite volatile and unpredictable, it is possible that anticipated profit in foreign

investment may be eliminated, rather even may incur loss. Thus, in order to hedge this foreign

currency risk, the traders oftenly use the currency futures. For example, a long hedge (I.e..,

buying currency futures contracts) will protect against a rise in a foreign currency value whereas

a short hedge (i.e., selling currency futures contracts) will protect against a decline in a foreign

currencys value.

It is noted that corporate profits are exposed to exchange rate risk in many situation. For

example, if a trader is exporting or importing any particular product from other countries then he

is exposed to foreign exchange risk. Similarly, if the firm is borrowing or lending or investing for

short or long period from foreign countries, in all these situations, the firms profit will be

affected by change in foreign exchange rates. In all these situations, the firm can take long or

short position in futures currency market as per requirement.

The general rule for determining whether a long or short futures position will hedge a potential

foreign exchange loss is:


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Loss from appreciating in Indian rupee= Short hedge

Loss form depreciating in Indian rupee= Long hedge

The choice of underlying currency

The first important decision in this respect is deciding the currency in which futures contracts are

to be initiated. For example, an Indian manufacturer wants to purchase some raw materials from

Germany then he would like future in German mark since his exposure in straight forward in

mark against home currency (Indian rupee). Assume that there is no such future (between rupee

and mark) available in the market then the trader would choose among other currencies for the

hedging in futures. Probably he has only one option rupee with dollar. This is called cross hedge.

Choice of the maturity of the contract

The second important decision in hedging through currency futures is selecting the currency

which matures nearest to the need of that currency. For example, suppose Indian importer import

raw material of 100000 USD on 1st september 2012. And he will have to pay 100000 USD on

1st December2012. And he predicts that the value of USD will increase against Indian rupees

nearest to due date of that payment. Importer predicts that the value of USD will increase more

than 58.0000.

What he will do to protect against depreciating Indian rupee? Spot value of 1 USD is 55.66.

Solution:He should buy ten contract of USDINR 28102012 at the rate of 56.0775. Value of the

contract is (56.0775*1000*100) =5607750. (Value of currency future per USD*contract size*No

of contract).

For that he has to pay 5% margin on 5607750 i.e.he will have to pay Rs.280387.5 at present.

And suppose on settlement day the spot price of USD is 58.0000. On settlement date payoff of

importer will be (58.0000-56.0775) =1.9225 per USD. And (1.9225*100000) =192250.Rs.

Choice of the number of contracts (hedging ratio)


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Another important decision in this respect is to decide hedging ratio HR. The value of the futures

position should be taken to match as closely as possible the value of the cash market position. As

we know that in the futures markets due to their standardization, exact match will generally not

be possible but hedge ratio should be as close to unity as possible. We may define the hedge ratio

HR as follows:

HR= VF / Vc

Where, VFis the value of the futures position and Vc is the value of the cash position.

Suppose value of contract dated 28th January 2009 is 56.0775

And spot value is 55.66

HR=56.0775/55.66=1.007

Hedging against Indian Rupee appreciation

Lets assume an Indian IT exporter receives an export order worth EUR100,000 from a European

telecom major with the delivery date being in three months. At the time of placing the contract,

the Euro is worth 64.05 Indian Rupees in the Spot market, while a Futures contract for an expiry

date that matches the order payment date is trading at INR64. This puts the value of the order,

when placed, at INR6,405,000. However, if the domestic exchange rate appreciates significantly

(to INR63.20) by the time the order is paid for (which is one month after the delivery date), the

firm will receive only INR6,320,000 rather than INR6,405,000.

To insure against such losses, the firm can, at the time it receives the order, enter into 100 Euro

Futures contracts of EUR1,000 each to sell at INR64 per Euro, which involves contracting to sell

a foreign Currency on expiry date at the agreed exchange rate. If on the payment date the

exchange rate is INR63.20, the exporter will receive only INR6,320,000 on selling the Euro in

the Spot market, but gains INR80,000 (ie 64 - 63.20 * 100 * 1,000) in the Futures market.

Overall, the firm receives INR6,400,000 and protects itself against the sharp appreciation of the

domestic Currency against the Euro.

In the short term, firms can make gains or losses from hedging. The basic purpose of hedging is


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to protect against excessive losses. Firms also tend to benefit from knowing exactly how much

they will receive from the export deals and can avoid the uncertainty associated with future

exchange rate movements.

Hedging against Indian Rupee depreciation

An organic chemicals dealer in India places an import order worth EUR100,000 with a German

manufacturer. Lets assume the current Spot rate of the Euro is INR64.05 and at this rate the

value of the order is INR 6,405,000. The importer is worried about the sharp depreciation of the

Indian Rupee against the Euro during the months until the payment is due. So, the importer buys

100 Euro Futures contracts (EUR1, 000 each) at INR64 per Euro. At expiry, the Rupee has

depreciated to INR65 and the importer has to pay INR6,500,000, gaining INR100,000 (ie

INR65-64 * 100 * 1,000) from the Futures market and the resulting outflow would be only

INR6,400,000.

In the short term, firms can make gains or losses from hedging. The basic purpose of hedging is

to protect against excessive losses. Firms also tend to benefit from knowing exactly how much

they will pay for the import order and avoid the uncertainty associated with future exchange rate

movements.


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CURRENCY FUTURES PAYOFFS

A payoff is the likely profit/loss that would accrue to a market participant with change in the

price of the underlying asset. This is generally depicted in the form of payoff diagrams which

show the price of the underlying asset on the X-axis and the profits/losses on the Y-axis. Futures

contracts have linear payoffs. In simple words, it means that the losses as well as profits for the

buyer and the seller of a futures contract are unlimited

Payoff for buyer of futures: Long futures

The payoff for a person who buys a futures contract is similar to the payoff for a person who

holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside.

Take the case of a speculator who buys a two-month currency futures contract when the USD

stands at say Rs.53.19. The underlying asset in this case is the currency, USD. When the value o

dollar moves up, i.e. when Rupee depreciates, the long futures position starts making profits, and

when the dollar depreciates, i.e. when rupee appreciates, it starts making losses.

Payoff for buyer of future:

The figure shows the profits/losses for a long futures position. The investor bought futures

when the USD was at Rs.56.07. If the price goes up, his futures position starts making

P

R

O

L

O

USD

0

56.07


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profit. If the price falls, his futures position starts showing losses.

Payoff for seller of futures: Short futures

The payoff for a person who sells a futures contract is similar to the payoff for a person

who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited

downside. Take the case of a speculator who sells a two month currency futures contract

when the USD stands at say Rs.56.07. The underlying asset in this case is the currency,

USD. When the value of dollar moves down, i.e. when rupee appreciates, the short futures

position starts 25 making profits, and when the dollar appreciates, i.e. when rupee

depreciates, it starts making losses. The Figure below shows the payoff diagram for the

seller of a futures contract.

Payoff for seller of future:

The figure shows the profits/losses for a short futures position. The investor sold futures

when the USD was at 56.07. If the price goes down, his futures position starts making

profit. If the price rises, his futures position starts showing losses .

P

R

O

L

O

USD

0

56.07


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Managing currency risk through currency Futures:

Understanding currency risk

Case: (When firm has foreign currency payable in future)

ABC, an Indian company, imports machinery from US firm for $ 5 million. Due date for

payment is January 22, 2011. Present exchange rate is Rs. 47/$ (as on January 22, 2010)

Inflation in India = 6%

Inflation in US= 1%

Interest rate in India = 8%

Interest rate in US= .5%

Situation: - ABC company needs to pay $ 5 million on January 22, 2011. Since the payment willbe made in future and exchange rate does not remain constant, there is uncertainty with the

actual cash outflow. USD may appreciate or depreciate in future. If USD appreciates cash

outflow in terms of rupee will me more which leads to risk.

Risk: Volatility of exchange rate (especially when USD appreciates)

Problem 1: How to eliminate the risk.

Problem 2: How to forecast the forward rate

Solution 1: In this situation, ABC needs to go long hedge by buying currency futures for $ 5

million for 1 year. Since contract size for USD future is $1000, number of contract will be

5000000/1000=5000 to get perfect hedge.

Solution 2: There two basic methods to calculate spot and future exchange rate.

(a) Purchasing power parity (PPP)

(b) Interest rate parity (IRP)

Determination of Exchange rate as per Purchasing Power Parity:-

PPP theory follows law of one price, which states that the price of identical goods should be

same all over the world. Exchange rate of currency is being adjusted if the inflation rate is

different in two countries.


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Absolute form of PPP

Case 2: Suppose 1 kg apple costs $5 in USA and Rs 220 in India, then as per this theory the

exchange rate will be 220/5 = Rs 44/$

Relative form of PPP

According to this theory, exchange rate is determined by the inflation of one country over

inflation of another country. It states that the percentage change in the exchange rate should

equal the percentage in the ratio of the price indices of the two countries.

Spot exchange rate at time t = value of country A currency in terms of country B at the

beginning of the period * (Inflation rate of country A/ Inflation rate of country B) t

Determination of Exchange rate as per Interest Rate Parity

For currencies which are fully convertible, the rate of exchange for any date other than spot is a

function of spot and the relative interest rates in each currency. The assumption is that, any funds

held will be invested in a time deposit of that currency. Hence, the forward rate is the rate which

neutralizes the effect of differences in the interest rates in both the currencies. The forward rate is

a function of the spot rate and the interest rate differential between the two currencies, adjusted for

time. In the case of fully convertible currencies, having no restrictions on borrowing or lending

of either currency the forward rate can be calculated as follows;

As per this IRP, interest rate difference between two countries is equal to the percentage

difference between the forward exchange rate and the spot exchange rate.

Forward exchange rate for settlement at period N= Current spot exchange rate*(1+domestic

country interest rate)/ (1+foreign country interest rate)

Here the Spot rate is $1 = Rs. 47

Interest rate in India = 8%

Interest rate in US= .5%

One year forward rate for $ will be 47*(1.08/1.005) ^1=50.51

Therefore, the country with a higher interest rate would have a lower forward exchange rate.


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Correlation between open interest and no. of contracts traded at NSE and

MCX-SX:

Null hypothesis: no significant correlation between open interest and contracts traded

Alternate hypothesis: significant correlation between open interest and contracts traded

Inference: A linear correlation is found

Alternate hypothesis is accepted with extreme significance

No. of points: 230

Contract considered: 29 august 2012

Correlation coefficient: 0.8984

In order to understand Growth trajectory of the currency futures, open interest and no. of

contracts traded at NSE and MCX-SX have been compared, explained and statistically

supported. A correlation between the two was calculated and result depicted that they have a

significant relationship with correlation coefficient of 0.8984 which concludes growth in both the

variables.

0

1000000

2000000

3000000

4000000

5000000

6000000

7000000

Open Interest

total vol


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ii)Returns for past 1 year on major exchanges

Returns on $-rupee contracts havent been that great in the last 1 year, more or less the same on

both the leading currency futures exchanges.

Returns on MCX SX -0.00069%

Returns on NSE -0.00071%

-0.03

-0.02

-0.01

0

0.01

0.02

0.03

0.04

Returns for 2011-12

returns on mcx sx

returns on nse


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47

(iii)Historical volatility

Annualized historical volatility in 2003- 3.4

Annualized historical volatility in 2008- 6.5

Annualized historical volatility in 2012- 9.2( as shown in the graph)

Over the years, there has been a trend increase in Dollar-Rupee volatility, measured by the

percentage movement in a month. The Rupee used to fluctuate an average of 1% (or 45 paise)

earlier, but the monthly fluctuation is now averaging 5% (about 225-250 paise). Moreover, the

volatility is likely to remain above 3% (135-150 paise) in the future.

The main reason behind the structural increase in volatility is the growth of India's Current

Account, including exports and imports of both goods and services, and India's Capital Account,

which is witness to a high degree of volatility in portfolio investment flows. This has led to a

huge increase in the daily turnover in the Dollar-Rupee market, to such an extent that it is now

increasingly difficult for the RBI to contain the volatility on a daily basis. As the economy

continues to grow and open up, it is unlikely that forex volatility is going to decrease.

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

44.00

46.00

48.00

50.00

52.00

54.00

56.00

58.00

Sep'11

Oct'11

Nov'11

Nov'11

Dec'11

Jan'12

Jan'12

Feb'12

Feb'12

Mar'12

April'12

April'12

May'12

May'12

June'12

July'12

July'12

closing

price

Annualized Volatility 2011-12

closing price

90 day Hvol

20 day Hvol


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48

Research work:

I have taken the case of an exporter who is expecting payment of $100000 every month starting

from January 2011.In this piece of work I have taken 30 paise as the threshold i.e. if the currency

movement breaches 30 paise mark in a day I will cover that contract that day itself. Here I have

taken 2 case scenarios to see the difference in returns due to proportion covered under hedging.

1. if 50 % of the contract is covered undered futures and 50% is managed actively.

2. If 25% of the contract is covered undered futures and 75% is managed actively.

Here I have taken different time frames to see the impact of currency fluctuations on the

exporters income. If the exporter starts receiving payment from January 2011 or march

2011 or june 2011 then the probable returns he may receive are given in the following

table:

When 25 % is hedged When 50 % is hedged

Jan 2011 0.40% 1.77%

March 2011 4.28% 1.26%

June 2011 3.13% 3.28%

This table shows that Hedging is a very crucial strategy for both importers and exporters but it is

very important on the part of trader as well that he is actively involved to make gains which are

offset by losses due to hedging, thereby getting higher returns. It even throws light on the fact

that putting a portion aside for active management gives higher returns than fully hedged but

then the investor has to monitor the market on a daily basis.

Having said that hedging is important for preventing losses rather than making gains, which is its

very definition. So for a trader who is involoved active foreign trade, hedging comes to be of

great help.


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49

Conclusion:

The Indian currency futures market has experienced an impressive growth since its introduction.

The upward trend of the volumes and open interest for currency futures in NSE explains the

whole story in detail. The growth of USD-INR currency futures since August 2008 led to the

introduction of three other currency futures in January 2010. The GBP-INR, JPY-INR and the

USD-INR currency futures have recorded a growth and thus confirmed that the introduction of

currency futures have been a good step taken by the Government.

The correlation between the open interest and the contracts traded has been the maximum in this

case. It is +0.87 thus signifying the growth of the USD-INR currency futures.

Although currency futures has reduced volatility asymmetric and have led to enhancement in thequality of transactions and information , the fact that the currency market just plus 4 years old

does to some extent cloud the conclusion as volatility has increased substantially in 2011-12 to

June 2012 period due to global crises and rising CAD(Current Account Deficit) in India.

The growth of currency futures in India and the volatility pattern in the Indian exchange market

has proved the influence of currency futures as a hedging instrument in India. Although currency

futures has reduced volatility and has led to enhancement in the quality and speed of market

transactions, the fact that the currency futures market just 4 plus years old does to some extent

cloud the conclusion as volatility has increased substantially in 2011-12 to June 2012 period due

to various global issues (Eurozone crisis) and domestic issues such as rising Current Account

Deficit (CAD).


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Bibliography

Books:

FUTURES, OPTIONS AND OTHER DERIVATIVES by JOHN. C. HULL

Articles:

The introduction of currency derivatives on exchanges has provided investors new asset class to

dabble withNirmal Bang

Currency futurestaxes, levy and liquidityMint

NCFMCurrency Future Module

Currency futures traded on the NSE- Dharen Kumar Pandey

Websites:

www.nseindia.com

www.mcx-sx.com

Documents

Price Risk Management Using Currency