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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
Currency derivatives can be described as contracts between the sellers and buyers, whose values are to be derived from the underlying assets, the currency amounts. These are basically risk management tools in forex and money markets. They are used for hedging risks and act as insurance against unforeseen and unpredictable currency and interest rate movements. It is not completely risk free. Market risks can't be avoided, but have to be managed. The currency derivative serves the purpose of financial risk management.
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 is an exchange rate, the contract is termed a “currency futures contract. The origin of futures can be traced back to 1851 when the Chicago Board of Trade (CBOT) introduced standardized forward contracts The Chicago Mercantile Exchange (CME) first conceived the idea of a currency futures exchange and it launched the same in 1972. The Chicago Mercantile Exchange, or CME, provides the most popular currency futures.
    Players in the Currency Future Market
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.
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.
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
Possible Scenario: Indian Rupee will depreciate against USD Dollar due to country’s rising import cost and slowing down of foreign equity inflows. However, INR may appreciate after some period when conditions in domestic and global market change in favour.
Example 1
Suppose an edible oil importer wants to import edible oil worth USD 100,000 and places his import order on July 15, 2008 with the delivery date being 4 months ahead. At the time when the contracts is placed in the spot market, one USD was worth, say INR 44.50. But, suppose the Indian Rupee depreciates to INR 44.75 per USD when the payment is due in Oct 08, the value of the payment for the importer goes up to INR 4,475,000 rather than 4,445,000. The heading strategy for the importer thus would be:
Thus, through heading in futures market the importer covers up to RS 20,000 of loss due to depreciation of Indian Rupees over the contract period.
Contrarily, if an expoter takes a reserve view on the exchange rate movement , he can lock in the exchange rate by selling the USD-INR contracts.
Example 2
A jeweller who is exporting gold jewellery worth USD 50,000 wants protection against the Indian Rupee appreciation in Dec’08 i.e. when he receives his payments. He wants to lock in the exchange rate for the above transaction. His strategy would be:
The net receipt in INR for hedged transaction would be: 50,000*44.35+15,000=2,232,500
Had he not participated in futures market he would have got only INR 2,217,500. Thus he kept his sales unexposed to foreign exchange rate risk.
    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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