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Home > Knowledge Center > Currency Derivatives

Knowledge Center

Currency Derivatives

What is Currency Derivatives

A currency derivative is a contract between the seller and the buyer, whose value is to be derived from the underlying asset, the currency amount. A derivative based on currency exchange rates is a future contract which stipulates the rate at which a given currency can be exchanged for another currency as at a future date. Currency futures are standardised foreign exchange contracts traded on approved stock exchanges to buy or sell one currency against another on a specified date in the future at a specified price (exchange rate).

Introduction of Currency Derivatives

Players in the Currency Future Market

Hedgers

Currency futures are widely used as hedging tools by financial institutions, banks, exporters, importers etc. 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 currency risk arising from exchange rate fluctuations that is faced by exporters and importers needs to be properly managed.

For example, an exporting firm is expecting to receive dollar inflows. If the rupee appreciates against the dollar, then there will be a negative impact on the profitability of these companies. If a company has un-hedged exposures in foreign currency on account of borrowings, and the rupee depreciates against the borrowed currency, there could be a loss requiring disclosure. Though this is not a direct business loss, it adds to the liability and as such impacts the balance sheet. It is possible that subsequently the rupee might appreciate or regain the lost ground; but, what is relevant is the rate as on the day of the closure of the books. The deficit on the date is considered a notional loss as the liability has not crystallised and there is no outflow of rupees.

Speculators

All those interested in taking a view on appreciation (or deprecation) of exchange rate in the long term and short term can participate in the currency futures.

Speculation: Bullish, buy futures

Speculation: Bearish, sell futures

For example, if one expects deprecation of Indian rupee against the US dollar, then he can hold on long position in USD-INR contracts for returns. Contrarily, he can sell the contracts if he sees the appreciation of the Indian Rupees.

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.

Basics of Currency Future Trading

The forex market is where one currency is traded for another. The average traded turnover in global forex and related markets is in trillion of US dollars. The spot exchange rates refer to the current prevailing rate at which the currency can be bought or sold for another. Forwards exchange rates are those quoted and traded for future delivery of underlying currencies and payment.
The forwards rates are different from the spot rates depending on the market sentiments and expected future conditions. Typically, the pricing of forward contract is determined by prevailing spot rate and interest rate differential of perspective countries for a specified date in future.

Forward Rate =Spot Rate+/- Forward points (i.e. benefit/disadvantage for holding a currency for a specified period of time)

The forward contracts are customised bilateral agreement between two counter parties agreeing to buy and sell the underlying on a specified future date at a specified rate.
A currency future contracts is a standardised version of a forward contract traded on a regulated exchange it is an agreement to buy or sell the underlying currency, on a specified date in future on a specified rate.
Currency futures can be bought and sold on the MCX-SX through the member of exchange, after opening a trading account and depositing stipulated cash/collaterals with the trading member.
Initially, monthly futures contract for a maximum maturity of 12 months will be available on USDINR. The final settlement price would be the Reserve Bank Reference Rate on the date of expiry.

Future contracts	Forwards contracts
Are traded on an exchange.	Are not traded on an exchange.
Use a Clearing House which provides protecton for both parties.	Are private and are negotiated between the parties with no exchange guarantees.
Require a margin to be paid.	Involve no margin payments.
Are used for heading and speculating.	Are used for hedging and physical delivery.
Are standardised and published.	Are dependent on the negotiated contract conditions.
Are transparent – futures contracts are reported by the exchange.	Are not transparent as they are all private deals.

Currency Futures & Risk Management Strategies

How to Trade on MCX-SX

All trades 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 MCX-SX trading platforms have to participate only through the trading member of the Exchange. Participants have to open a trading account and deposit stipulated cash/collaterals with the trading member.
Clearing house/corporation of MCX-SX stands in as the counter party for each transaction; so participants need not worry about the default. In event of a default clearing house/corporation fulfils all obligations and recovers dues and penalties from the defaulter.
Contracts can be squared of anytime during the Exchange’s working hours and during the life of the contract.
All contracts are open on expiry will be settled in Indian Rupees in cash at the reference rate specified by the RBI.

Underlying	Rate of exchange between one USD and INR
Trading Hours(Monday to Friday)	9:00 a.m to 5:00 p.m
Contract Size	USD 1000
Tick Size	0.25 paise or 0.0025
Trading Period	Maximum expiration period of 12 months
Contract Months	12 near calendar months
Final Settlement date / Value date	Last working day of the month(subject to holiday calendars)
Last Trading Day	Two working days prior to final Settlement Date
Settlement	Cash Settled
Final Settlement Price	The reference rate fixed by RBI two working days prior to the final settlement date will be used for final settlement

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