Currency Derivatives
Objectives
How to the read the quotes
Evolution of Foreign Exchange Market
Factors affecting the Currency Market
Current scenario
Currency Futures – Opportunities & Advantages
Currency options
Currency Futures specifications
Foreign Exchange
Price of one currency viewed in relation to another currency is called a exchange rate…
What you see above are quotes to buy/sell three currency pairs.
Currencies are pairs, in the above example, Euro against US Dollar or GBP against US Dollar
Interpret the quotes
There are two ways to quote currency pairs in the FX market: direct quote and indirect quote
Direct quote in US Dollars: Number of US Dollar required to buy 1 unit of foreign currency. eg.
GBP/USD or EUR/USD1.2437 USD required to buy 1 USD.
Indirect quote in US Dollars: Number of units of foreign currency that can be bought with 1 US Dollar
eg. USD/JPY or 1 USD can buy 78.00 JPY
Direct Quote & Indirect Quote
This is a direct quote in US Dollars
The currency that comes on left,
here Euro, becomes the base
currency. Hence, in EUR/USD, the
question is how many Dollars for 1
Euro
One would require 1.2435 US
Dollars to buy 1 unit of Euro
This is an indirect quote in US Dollars
USD is on the left, hence it is 1 unit of
USD.
One US Dollar can buy 55.5450 Indian
Rupees
Direct Quote & Indirect Quote
If a client sells EUR/USD, he sells at
the bid rate, i.e., 1.2434.
Once a client sells EUR/USD, he
becomes long on the US Dollar and
short on Euro. Remember, the quote
means 1.2434 US Dollar is required
to buy 1 Euro.
If a client sell EUR/USD @ 1.2434
and after an hour EUR/USD @
1.2420, then the client makes 14
pips
If a client buys USD/JPY, he buys at the
offer rate, i.e., 78.03
Once a client buys USD/JPY, we
becomes long on USD and short on JPY
If a client buys USD/JPY @ 78.03 and
after an hour USD/JPY @ 78.33, then
the client makes 30 pips
How much money do I make….
Evolution of FX market
Foreign Exchange Market is mainly a decentralized global market where
trading of currencies takes place. Also known as fx/forex or currency market.
Came into being in 1970s when countries shifted from fixed exchange rate
system to floating exchange rate system
Trades mainly in OTC market, where participants negotiate directly amongst
themselves (96% - OTC; 4% - Exchanges).
Main participants include – banks, large corporate, hedge funds, central banks
and financial institutions
Retail participation (HNIs) is primarily through dedicated currency funds, as
ticket size is usually quite large in OTC markets
Evolution contd….
Trading in currencies started as a mechanism
To facilitate international trade and investment, and
To hedge foreign exchange risk
But soon emerged as the largest “alternative investment” asset class in the
world, because of its unique features:
Continuous trading opportunity : i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday
Standardization of underlying contract (trading on relative value between two currencies)
Huge trading volume leading to high liquidity
Variety of factors that affect exchange rates (sheer sensitivity to different news make it known as
“adults” market in trading circle)
Geographical dispersion (it is said – currency market never sleeps)
Higher leverage and hence opportunity to make higher profit /loss
How big is the pond
Today, trading volume in currency market far exceeds any other asset class.
Main trading centre are – Tokyo, Singapore, London and New York
Most active pairs are – EUR/USD, USD/JPY, GBP/USD, known as G3
currencies , followed by G10 currencies (AUD/USD, USD/CAD etc)
Of late, EM currencies are gaining momentum because of liberalized policies
and higher growth potential
Asset Class Approx. ADV (in USD billion)
Currencies 4700
Fixed Income 2300
Commodities 1200-1300
Equities 300-350 ADV = Average Daily Volume
India – Forex Market
INR trades in a managed floating exchange rate regime
INR is fully convertible on India’s current account but not on capital account
Forex transaction mainly confined to banks and network of dealers/brokers,
known as OTC market.
Entities having underlying exposure can only access OTC market
Suitable for large entities having bigger exposure and greater access to banks
Total volume – approx USD 32-34 billion all combined (spot + forwards +
swaps)
What is Currency Futures (CF)?
Launched in August 2008 in consultation with SEBI and RBI.
Futures are standardized version of forward contracts with fixed expiry and
size
Unlike OTC market where forward points are quoted separately, forward
points are in-built in futures price
Trades on regulated exchanges
Aims to provide higher access to SMEs, HNIs and retail investors.
Futures are cash settled contracts – No delivery possible
Why Currency Futures (CF)?
Average daily volume of more than 25,000 cr.
One of the fastest growing futures market presently in India
Activity in exchange traded options is buzzing.
Average daily volume of more than 4,000 cr.
Why Currency Options?
Why Currency Futures (CF)?
Daily average volatility of 0.6-1.00%, hence better control over portfolio
Lower Exchange margin requirement
Minimum Initial Margin requirement: 3-4%
Kotak Securities Total Margin Charged – 5% to 6%
Hence, higher leverage of 18-20 times
Better risk-reward ratio
No STT (Securities Transaction Tax)
Only cost involved – Brokerage + Stamp Duty + SEBI fee + exchange trans. charges
Brokerage: 0.02% or 10 per lot, whichever is higher (can be negotiated on volume)
Stamp duty: 0.002%
SEBI fee: 0.0002%
Opportunity to churn in profit at minimum of 5 ticks (tick size – 0.0025 paise)
What affects the currency movement?
Long Term
Interest rate differential (Change in interest rate - monetary policy)
GDP growth – Higher GDP growth potential entails stronger currency
Medium Term
Change in macro-economic indicators (Worsening of trade balance, current account deficit and
fiscal deficit adversely affects the currency)
Short Term
Capital flows (FIIs, FDI or corporate flow) – Higher inflow leads to stronger currency
Performance of equity markets (Nifty & Rupee has inverse relationship)
Movement in currencies of peer countries like Korea, Taiwan (EMs in Asia), or movement in
crosses like EURUSD, USDJPY etc (overall risk sentiment in the market)
Central bank intervention – RBI intervenes sometimes to stem volatility and maintain fair value
Key economic data announcements like inflation, IIPs etc.
Equity market & Rupee
Nifty Index and USD/INR has inverse relationship (co-relation of plus 60%)
On few days, this relationship may not work because of currency market positioning
India’s macros: CAD and Rupee
A widening Current Account Deficit is negative for Indian Rupee
Oil & Gold command a lion share of imports… Petro, jewelry & engg. goods
command a lion share of exports
India’s macros: FII inflows
Monthly FII inflows (debt/equity combined) (Rs crore)
Inflows dried in 2011, except for an LTRO lead push during Q1 2012
India’s macros: Capital Account
and Rupee
Stress in BOP made Rupee one of the weak FX in the world…
Since July of 2011, INR depreciated @ 25%...
Rupee & the world markets
Stress in the Eurozone causing spike in Spanish yields (%) and decline in
equities
Supporting factors for Rupee
Monthly QaINTBWREER
91.273
104.21
Line, QaINTBWREER, Cvalue(Last), (S1, S2)
30/04/2012, 93.4
Value
92
96
100
104
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
1990 2000 2010
INR 36 currency REER
Weekly QINR=, QLCOc1
Price
USD
.1234
44
45
46
47
48
49
50
51
52
53
54
5555.1700
Value
USD
Bbl
.123
-40
-20
0
20
40
60
80
-13.001
Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
2009 2010 2011 2012 [Delayed]
Annual change in Brent crude (%-
red) & USD/INR (black)
Supporting factors for Rupee
Indian gold imports- USD Bn IIP (yellow) & Non-oil, non-gold
imports (blue)
India imported 655 tons in FY12 v/s
969 tons in FY11
Currency Futures - Opportunities
Directional Views
Taking directional call on different currency pairs against INR
Price view on cross currency pairs like EUR/USD, USD/JPY GBP/USD
through combination of futures contracts
Hedging current exposure
Importers and exporters can hedge their short term exposure
Borrowers can hedge FCY loans for interest or principal payments
Hedge for offshore investment by Resident Indians
Trade & Capital Flows
Remittances for trade or services or capital transactions
Arbitrage
Arbitrage opportunity between exchange, OTC and off-shore market, if any