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Currency derivatives
1. Summer Internship Project
(In Religare Securities Limited)
A REPORT ON
“Fundamentals of Derivatives with special reference to
Currency Derivatives”
Submitted to,
Dr. V.J. Byra Reddy
Asst. Dean,
IBA, Bangalore.
Submitted by,
Yogesh Moule
(FPB1113/072)
INDUS BUSINESS ACADEMY
(BATCH 2011-13)
2. Fundamentals of Derivatives with special reference to Currency Derivatives.
DECLARATION
I hereby declare that I had a wonderful experience in doing this project titled
“Fundamentals of Derivatives with special reference to Currency Derivatives” at
“Religare Securities Ltd., Nasik” submitted in partial fulfillment of the
requirements for the prestigious degree of PGDM.
I hereby declare that the project done by me is true to my knowledge. The project
duration was of four months (10/05/2012 to 10/09/2012).The information
collected by me is authentic and is done through data analysis and interpretation.
The content of this report is based on information collected from different
sources and research reports.
I further declare that this project report has not been submitted to any other
university or institute for the award of any degree or diploma.
Date: 30/09/2012 Yogesh Moule
Place: BangaloreIndus Business Academy
INDUS BUSINESS ACADEMY FPB1113/072 Page1
3. Fundamentals of Derivatives with special reference to Currency Derivatives.
CERTIFICATE BY MENTOR
This is to certify that the Dissertation titled “Fundamentals of Derivatives
with special reference to Currency Derivatives”by Yogesh Moulebearing
the Reg. No. FPB1113/072has been prepared under my guidance and supervision.
This work has been satisfactory and is recommended for consideration towards
partial fulfillment for the PGDM program of the Indus Business Academy,
Bangalore. This has not been submitted earlier to any other University or
Institution for the award of any degree/ diploma/ certificate.
Date: 30/09/2012 Dr. V.J.Byra Reddy
Place: Bangalore (Signature by Mentor)
INDUS BUSINESS ACADEMY FPB1113/072 Page2
4. Fundamentals of Derivatives with special reference to Currency Derivatives.
CERTIFICATE BY DIRECTOR
This is to certify that the Dissertation titled “Fundamentals of
Derivatives with special reference to Currency Derivatives” by Yogesh
Moule bearing the Reg. No. FPB1113/072has been prepared under the
guidance of Prof. Byra Reddy.This work has been satisfactory and is
recommended for consideration towards partial fulfillment for the
PGDM program of the Indus Business Academy, Bangalore. This has
not been submitted earlier to any other University or Institution for the
award of any degree/ diploma/ certificate.
Date: 30/09/2012 Dr. Subhash Sharma
Place: Bangalore (Signature of Director)
INDUS BUSINESS ACADEMY FPB1113/072 Page3
5. Fundamentals of Derivatives with special reference to Currency Derivatives.
INDUS BUSINESS ACADEMY FPB1113/072 Page4
6. Fundamentals of Derivatives with special reference to Currency Derivatives.
ACKNOWLEDGEMENT
I take this opportunity to express my heartfelt gratitude to all the
people who have extended their assistance and provided me the information during
the tenure of the project. I am greatly indebted to them for their guidance and
support throughout the project and for sparing their valuable time with me.
I earnestly express to Mr. Vinay Pandey&Mr. Kiran Ahiray for
giving me this opportunity to work with Religare Securities Ltd. and also very
much thankful to the staff of the office for their invaluable guidance, keen interest,
cooperation, inspiration and of course moral support throughout my internship
tenure .
This report could not have been completed without the guidanceMr.
Manish Jain, CEO, INDUS BUSINESS ACADEMY,Dean Dr. Subhash Sharma
and the entire faculty at IBA. Special thanks to my project guide Dr. V.J. Byra
Reddy (Asst. Dean, Academics) for his expert guidance and support
throughoutthis project.
Yogesh Moule
(FPB1113/072)
INDUS BUSINESS ACADEMY FPB1113/072 Page5
7. Fundamentals of Derivatives with special reference to Currency Derivatives.
Table of Contents
1. EXECUTIVE SUMMARY .................................................................................................... 7
2. OBJECTIVES AND SCOPE ...................................................................................................... 9
Objectives of the study: .............................................................................................................. 9
Scope of the study ....................................................................................................................... 9
3. COMPANY PROFILE ............................................................................................................. 10
Vision: ....................................................................................................................................... 11
Leadership Team - Board of Directors ..................................................................................... 12
RELIGARE PRODUCT OFFERINGS .................................................................................... 13
4. RESEARCH METHODOLOGY.............................................................................................. 14
Type of the study ...................................................................................................................... 14
Primary data .............................................................................................................................. 14
Secondary Data: ........................................................................................................................ 14
5. INTRODUCTION TO DERIVATIVES............................................................................... 15
Three types of investors trade in derivatives markets ............................................................... 21
Types of Derivatives: ................................................................................................................ 23
6. CURRENCY DERIVATIVES ............................................................................................. 35
Factors Affecting Exchange Rates: ........................................................................................... 38
Currency Futures ....................................................................................................................... 42
NSE's Currency Derivatives Segment: ..................................................................................... 46
Base Currency/ Terms Currency: .............................................................................................. 50
7. FINDINGS, SUGGESTIONS & CONCLUSION ................................................................ 54
8. BIBLIOGRAPHY ................................................................................................................. 64
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8. Fundamentals of Derivatives with special reference to Currency Derivatives.
1. EXECUTIVE SUMMARY
A derivative is a collective name used for a broad class of financial instruments that
derive their value from other financial instruments (known as the underlying), events or
conditions. The Derivatives Market is meant as the market where exchange of derivatives takes
place. Derivatives are one type of securities whose price is derived from the underlying assets.
The value of these derivatives is determined by the fluctuations in the underlying assets. These
underlying assets are most commonly stocks, bonds, currencies, interest rates, commodities and
market indices.
Derivatives allow financial institutions and other participants to identify, isolate and
manage separately the market risks in financial instruments and commodities for the purpose of
hedging, speculating, arbitraging price differences and adjusting portfolio risks. Derivatives offer
the possibility of large rewards; many individuals have a strong desire to invest in derivatives.
Derivatives like forwards, futures, options, swaps etc. are extensively used in many developed
and developing countries of the world.Financial markets are, by nature, extremely volatile and
hence the risk factor is an important concern for financial agents. To reduce this risk, the concept
of derivatives comes into the picture.
There are mainly three categories of traders in the Derivative market, those areHedgers
whouses futures or options market to reduce or eliminate the risk associatedwith price of an
asset.Speculatorsuse futures and options contracts to get extra leverage in betting onfuture
movements in the price of an asset. They can increase both the potentialgains and potential losses
by usage of derivatives in a speculative venture.Arbitrageursare in business to take advantage
of a discrepancy between prices intwo different markets.
The main objectives of the study are: To study the fundamental terms used in derivatives
market, to know in detail about what is currency derivatives, to know the price fluctuations
happening in currency derivatives market.
The main findings of the study are: most of investors go through broker’s suggestion
because they don’t have much knowledge and also they don’t know how to trade in derivatives,
about 44% of the investors are professional who knows the derivative market very well. And
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9. Fundamentals of Derivatives with special reference to Currency Derivatives.
second highest majority lies in employees, though there is huge scope from government for
derivatives still people hesitate to invest in derivatives, they even don’t know about many
strategies that they can apply to minimize their risk. Currency derivatives are getting popular
now-a-days due to their attractive return on investments.
The main conclusion of the study are: the challenges of building awareness and educating
the people about derivatives, active marketing of the product have all required significant efforts in
paving the way for a vibrant derivatives market. The market has made enormous progress in terms
of technology, transparency and the trading activity.
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10. Fundamentals of Derivatives with special reference to Currency Derivatives.
2. OBJECTIVES AND SCOPE
Objectives of the study:
To study the concept of derivatives and the purpose for which financial
institutions adopt derivatives.
To understand the potentiality of the derivatives as an investment avenues.
To study the growth of Currency derivatives in Indian Capital Market.
To study the performance of Currency derivative as compared to NSE’s
NIFTY.
Scope of the study:
From its inception, trading in Currency derivative has started gaining interest
among the investors. It is been seen as an investment & risk reducing tool by
individual investors as well as corporate or institutional investors.
As its only been 4 years from when the trading in Currency derivative has
started, there is a huge scope in this type of Derivative segment.
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11. Fundamentals of Derivatives with special reference to Currency Derivatives.
3. COMPANY PROFILE
Religare is a financial services company in India, offering a wide range of financial products
and services targeted at retail investors, high net worth individuals and corporate and
institutional clients. Religare is promoted by the promoters of Ranbaxy Laboratories Limited.
Religare operate from six regional offices and 25 sub-regional offices and have a presence in
330 cities and towns controlling 979 locations which are managed either directly by Religare or
by our Business Associates all over India, the company has a representative office in London.
While the majority of Religare offices provide the full complement of its services yet it has
dedicated offices for investment banking, institutional brokerage, portfolio management
services and priority client services.
Religare Enterprises Limited is the holding company & its principal subsidiaries include:
Religare Securities Limited (―RSL‖)
Religare Finvest Limited (―RFL‖)
Religare Commodities Limited (―RCL‖)
Religare Insurance Broking Limited (―RIBL‖)
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12. Fundamentals of Derivatives with special reference to Currency Derivatives.
Vision:
"To be the leading emerging markets financial services group driven by
innovation, delivering superior value for all stakeholders globally"
With the worldwide economic rebalancing, emerging markets are increasingly becoming the
drivers of the global economy, offering more opportunities and calling for more capital. Religare
is positioned right in the center of this emerging paradigm. We are focused on tapping these
opportunities and growing along with our key stakeholders.
This vision animates Three Pillar Strategy that seeks to maximize value from our vast presence
in India and to build a financial services franchise that connects the most promising emerging
markets globally.
Religare‟s Three Pillar Strategy:
An Integrated Indian Financial Services Platform that leverages the robust Indian
growth story, providing solid breadth and depth to the financial services sector, resulting
in rapid growth of profit pools.
An Emerging Markets Capital Markets Platform that intermediates the flow of capital
into and out of emerging markets based on its global reach and an on-the-ground
understanding of how emerging markets function.
A Global Asset Management Platform that brings together niche asset managers with
proven track record and capabilities in the alternatives space.
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13. Fundamentals of Derivatives with special reference to Currency Derivatives.
Leadership Team - Board of Directors
Mr. Sunil Godhwani
Chairman & Managing Director
Religare Enterprises Limited.
Mr. Sunil Godhwani, Chairman and Managing Director, Religare Enterprises Limited (REL), is
the driving force behind the group and its vision. Sunil brings to the table strong leadership
skills, vigor and a passion for excellence. He believes in nurturing a culture that is
entrepreneurial, result oriented, customer focused and based on teamwork. He has given strategic
direction to Religare’s growth since his joining in 2001 and has been a key force in giving birth
to Religare’s current shape and form globally.
Mr. Shachindra Nath
Group Chief Executive Officer
Religare Enterprises Limited
Mr. Anil Saxena
Director & Group CFO
Mr. Ravi Mehrotra
Director
Mr. Harpal Singh
Non-Executive Director
Mr. Stuart D Pearce
Director
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14. Fundamentals of Derivatives with special reference to Currency Derivatives.
RELIGARE PRODUCT OFFERINGS
Religare has divided its product and service offering under three broad client interface
categories:
―Retail Spectrum‖, ―Wealth Spectrum‖ and ―Institutional Spectrum‖ as per following details :-
Retail Spectrum Wealth Spectrum Institutional Spectrum
Caters to a large number of retail To provide customized To forge and build strong
clients by offering all products wealth advisory services relationships with
under one roof through our to high net worth corporate and institutional
branch network individuals clients
and online mode To provide
customized
wealth advisory services to high
net worth individuals
Equity and Commodity Wealth Advisory Institutional
Trading Services EquityBroking
Personal Financial Portfolio Investment Banking
Services ManagementServi Merchant Banking
o Distribution of ces
mutual funds International o Transaction Advisory
o Distribution of Equity o Services
insurance Priority Client
o Distribution of
EquityServices
savings products
Personal Credit
Arts Initiative
o Personal loan
services
o Loans against shares
Online Investment
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15. Fundamentals of Derivatives with special reference to Currency Derivatives.
4. RESEARCH METHODOLOGY
Type of the study:
This is a descriptive study; analysis is made on the basis of primary data
and secondary data.
Primary data:
Data is collected by interviews and direct discussions with clients,
employees and staff in the office.
Secondary Data:
1. NCFM modules
2. Journals and Books
3. Websites of Religare Securities Ltd., NSE, BSE, MCX, NCDEX, etc.
Data collected form NSE, BSE and other stock exchanges through Internet along
with the previous reports and journals and NCFM course modules.
In this project I have used Secondary data most of which was obtained from
internal records of the Company. Usage of Secondary data enjoys some advantages
but it suffers some limitations too.
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16. Fundamentals of Derivatives with special reference to Currency Derivatives.
5. INTRODUCTION TO DERIVATIVES
Derivatives are financial instruments whose price is determined by some underlying
variables. Derivatives can be traded directly between the two parties as well as through
exchanges. There are different types of derivatives based on the type of assets that it deals in
such as commodity, equity, bond, interest rate, index and so on. Mainly there are four types of
derivatives that are traded – Future, Forward, Options and Swaps. In case of stock market
derivative trading essentially means trading in future contracts and options. In derivative trading,
stocks are bought in the form of contracts and in a lot.
Due to their great flexibility, derivatives are used by many different types of investors. A
good toolbox of derivatives allows the modern investor the full range of investment strategy:
speculation, hedging, arbitrage and all combinations thereof. When one reads about derivatives
offering the sophisticated management of risk - this is not just marketing hype. They truly do
offer the fund management, the insurance and pension industries additional ways to achieve their
investment targets.
The biggest advantage of derivative trading is that one can buy huge amount of stock by
paying only a part of the total value of the stock. As in derivative trading one have to buy the
stocks in a lot the price of the lot is relatively lower than the total amount stock one get. So, this
means there is a chance of making profit even by investing a comparatively less money.
Derivative trading also lets short sell the stocks. That means one can sell the stocks even
before one actually own them. This is beneficial when one has an idea that the price of a
particular stock is going to reduce. In derivative trading one can first sell the stock at a higher
price and then buy the equal number of stocks when the price has gone down. In that way one
can make profit in derivative trading even if the price is going down.
Derivatives are used for risk management, investing, and speculative purposes. Important
institutional users are: banks, brokers, dealers, B/Ds, mutual funds, investment companies,
insurers, producers, and other organizations which have financial interests and exposures.
Derivatives allow financial institutions and other participants to identify, isolate and manage
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17. Fundamentals of Derivatives with special reference to Currency Derivatives.
separately the market risks in financial instruments and commodities for the purpose of hedging,
speculating, arbitraging price differences and adjusting portfolio risks.
Evolution of derivatives in Indian capital markets
The precursor to exchange based derivatives in India was a kind of ―forward trading‖ in
securities in the form to call options (teji), put options (mandi) and straddles (fatak) etc. The
Securities Contracts Regulation Act, 1956 (SCRA) was enacted, inter-alia, to prevent undesirable
speculation in securities.
The contracts for ―clearing‖ commonly known as ―forward trading‖ were banned by the
Central Government through a notification issued on 27th, June1969 in exercise of the powers
conferred under Section 16 of the SCRA. As the prohibition of forward trading in securities led
to a decline of traded volumes on stock markets, the Stock Exchange, Mumbai (BSE), evolved in
1972 an informal system of ―forward trading‖, which allowed carry forward between two
settlement periods, which resulted in substantial increase in the turnover of the exchange.
However, this also created several problems and there were payment crises from time to time and
frequent closure of the market. Later SCRA amended the bye-laws of stock exchanges to
facilitate performance of contracts in ―specified securities‖. In pursuance of this policy the stock
exchanges at Bombay, Calcutta and Ahmadabad introduced a system of trading in ―specified
shares‖ with carry forward facility after amending their bye-laws and regulations.
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Types of Derivatives Products which are legally permitted To Be Traded In
Indian Markets.
Equity Derivatives (Index/stock future/options)-Legally permitted to be traded
Through stock exchanges approved by SEBI.
Commodity Trading – Commodity futures are permitted. Commodity futures are
Permitted only for trading in commodities approved by the Government in
Commodity Exchanges, which are recognized by Forward Markets
Commission.OptionContracts in commodities trading are not permitted.
Foreign Exchange Derivatives- Forward Contracts as approved by RBI permitted to be
transacted by Banks and other approved foreign-exchange dealers.
OTC rupee derivatives in the form of Forward Rate Agreements (FRAs/Interest
Rate Swaps (IRS) – These were introduced by RBI in India in July 1999 in terms powers
vested with it Foreign Exchange Management Act, 2000. These derivatives enable banks,
primary dealers (PDs) and all- India financial institutions (FIs) to hedge interest rate risk
for their own balance sheet management and for market making purposes. Banks
/PDs/FIs can undertake different types of plain vanilla FRAs/IRS. Swaps having
explicit/implicit option features such as caps/floors/collars are not permitted now.
Exchange Traded Interest Rate Derivatives – were introduced by RBI/SEBI during
June, 2003. These can be traded through stock exchanges by primary dealers subject to
conditions stipulated by RBI/ OTC Rupee derivatives are presently not permitted.
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19. Fundamentals of Derivatives with special reference to Currency Derivatives.
Derivatives products traded in the Indian markets are as under;
Commodities Futures for Coffee, Oil Seeds, Oil (Castor, Palmolein), Pepper, Cotton, Jute
and Jute Goods are traded in the Commodities Futures. Forward Markets Commission
regulates the trading of commodities futures.
Index futures based on Sensex and Nifty Index are also traded under the supervision of
SEBI.
RBI has permitted Banks, FIs and PDs to enter into forward rate agreement(FRAs)/
interest rate swaps in order to facilitate hedging of interest rate risks and ensuring orderly
development of the derivatives market; NSE become the first exchange to launch trading
in options on individual securities. Trading in options on individual securities
commenced from July 2, 2001. Options contracts are American style and cash settled and
are available on 41 securities stipulated by the Securities & Exchange Board of India
(SEBI).
NSE commenced trading in futures on individual securities on November9, 2001. The
futures contracts are available on 41 securities stipulated by the Securities &Exchange
Board of India (SEBI).BSE also has started trading in individual stock options & futures
(both index & Stocks) around the same time as NSE.
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20. Fundamentals of Derivatives with special reference to Currency Derivatives.
Calendar of Introduction of Derivatives Products in Indian Financial Market:
OTC Exchange Traded
1980s - Currency Forwards June 2000 – Equity Index futures
1997s - Long term FC – June 2001 – Equity Index Options
Rupee swaps July 2001 - Stock Options
July 1999 - Interest rate June 2000 - Interest Rate Futures
swaps and FRAs Nov 2002- RBI Working Group on Rupee
July 2003 - FC – Rupee Derivatives
options March 2003- RBI Working group on
credit derivatives
Product Specifications BSE-30 Sensex Futures
Contract Size – Rs. 50 times the Index
Tick Size – 0.1 points or Rs. 5
Expiry day – last Thursday of the month
Settlement basis – cash settled
Contract cycle – 3 months
Active contracts – 3 nearest months
Product Specification S&P CNX Nifty Futures
Contract Size – Rs. 200 times the Index
Tick Size – 0.05 points or Rs. 10
Expiry day – last Thursday of the month
Settlement basis – cash settled
Contract cycle- 3 months
Active contracts – nearest months
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21. Fundamentals of Derivatives with special reference to Currency Derivatives.
The following factors have been driving the growth of financial derivatives:
Over the last 3 decades, Derivatives market has seen a phenomenal growth. Large
varieties of Derivative contracts have been launched at exchanges across the world. Some of the
factors driving the growth of financial Derivatives are:
Increased volatility in asset prices in financial market
Increased integration of national financial market with the international market
Market improvement in communication facilities and sharp decline in their costs
Development of more sophisticated risk management tools, providing economic
agents a wider choice of risk management strategies, and
Innovations in the derivatives markets, which optimally combine the risks and returns
over a large number of financial assets, leading to higher returns, reduced risk as well
as trans-actions costs as compared to individual financial assets.
ECONOMIC FUNCTION OF DERIVATIVE MARKET
In spite of the fear and criticism with which the derivative markets are commonly looked
at, these markets perform a number of economic functions
Prices in an organized Derivatives market reflect the perception of market
participants about the future and lead the prices of underlying to the perceived to the
perceived future level. The prices of Derivatives coverage with the prices of the
underlying at the expiration of the derivative contract. The derivatives help in
discovery of future as well as current prices.
The derivatives market helps to transfer risks from those who have them but may not
like them to those who have an appetite for them.
Derivatives, due to their inherent nature, are linked to the underlying cash markets.
With the introduction of derivatives, the underlying market witness higher trading
volumes because of participation by more players who would not otherwise
participate for lack of an arrangement to transfer risk.
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22. Fundamentals of Derivatives with special reference to Currency Derivatives.
Speculative traders shift to a more controlled environment of derivatives market. In
the absence of an organized derivatives market, speculators trade in the underlying
cash markets. Margining, monitoring and surveillance of the activities of various
participants become extremely difficult in these kinds of mixed markets.
An important incidental benefit that flows from derivatives trading is that it acts as a
catalyst for new entrepreneurial activity. The derivatives have a history of attracting
many bright, creative well-educated people with an entrepreneurial attitude. They
often energize others to create new business, new products and new employment
opportunities, the benefit of which is immense.
Derivatives markets help increase savings and investment in the long run. Transfer of
risk enables market participants to expand their volume of activity. Derivatives thus
promote economic development to the extent the later depends on the rate of savings
and investment.
Three types of investors trade in derivatives markets:
Hedgers:
Hedgers are those who protect themselves from the risk associated with the price of an
asset by using derivatives. In Hedging, financial derivatives act as a financial instrument to
transfer risk. A person keeps a close watch upon the prices discovered in trading and when the
comfortable price is reflected according to his wants, he sells futures contracts. Since one can
take either a long position or a short position in the futures contract, there are two basic hedge
positions.
For example, from another perspective, the farmer and the miller both reduce a risk and
acquire a risk when they sign the futures contract: The farmer reduces the risk that the price of
wheat will fall below the price specified in the contract and acquires the risk that the price of
wheat will rise above the price specified in the contract (thereby losing additional income that he
could have earned). The miller, on the other hand, acquires the risk that the price of wheat will
fall below the price specified in the contract (thereby paying more in the future than he otherwise
would) and reduces the risk that the price of wheat will rise above the price specified in the
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23. Fundamentals of Derivatives with special reference to Currency Derivatives.
contract. In this sense, one party is the insurer (risk taker) for one type of risk, and the
counterparty is the insurer (risk taker) for another type of risk.
The benefits of hedging are:
1. It is uncomplicated to handle.
2. The risk is minimized for both parties.
3. The trades can take the risk, without actually buying the future stock.
Speculators:
Speculators wish to bet on future movements in the price of an asset. Derivatives can be
used to acquire risk, rather than to insure or hedge against risk. Thus, some individuals and
institutions will enter into a derivative contract to speculate on the value of the underlying asset,
betting that the party seeking insurance will be wrong about the future value of the underlying
asset. Speculators will want to be able to buy an asset in the future at a low price according to a
derivative contract when the future market price is high, or to sell an asset in the future at a high
price according to a derivative contract when the future market price is low.
They are the second major group of futures players. These participants
includeIndependent floor traders and investors. They handle trades for their personal clients or
brokerage firms. Buying a futures contract in anticipation of price increases is known as .going
long. Selling a futures contract in anticipation of a price decrease is known as .going short.
While profits could be extremely high, potential for losses are also large.
Arbitrageurs:
Arbitrageurs are in business to take advantage of a discrepancy between prices in two
different markets. Arbitrage is a risk-less profit realized by simultaneous trading in two or more
markets.
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24. Fundamentals of Derivatives with special reference to Currency Derivatives.
In commodity market Arbitrators are the person who takes the advantage of a
Discrepancy between prices in two different markets. If he finds future prices of Commodity
edging out with the cash price, he will take offsetting positions in both the markets to lock in a
profit. Moreover the commodity futures investor is not charged interest on the difference
between margin and the full contract value
Types of Derivatives:
FORWARD:
A forward contract or simply a forward is a non-standardized contract between two
parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast
to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a
forward contract. The party agreeing to buy the underlying asset in the future assumes a long
position, and the party agreeing to sell the asset in the future assumes a short position. The price
agreed upon is called the delivery price, which is equal to the forward price at the time the
contract is entered into.
The forward price of such a contract is commonly contrasted with the spot price, which is
the price at which the asset changes hands on the spot date. The difference between the spot and
the forward price is the forward premium or forward discount, generally considered in the form
of a profit, or loss, by the purchasing party.
Forwards, like other derivative securities, can be used to hedge risk (typically currency or
exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality
of the underlying instrument which is time-sensitive. The promised asset may be currency,
commodity, instrument etc. It is the oldest type of all the derivatives. A forward contract is
traded in an OTC market. The contract price of a forward contract is not transparent, as it is not
publicly disclosed. A forward contract is less liquid and counterparty risk is high due to its
customized nature.
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FUTURES:
A futures contract is a standardized contract between two parties to buy or sell a
specified asset of standardized quantity and quality at a specified future date at a price agreed
today (the futures price). The contracts are traded on a futures exchange. Futures contracts are
not "direct" securities like stocks, bonds, rights or warrants. They are still securities, however,
though they are a type of derivative contract. The party agreeing to buy the underlying asset in
the future assumes a long position, and the party agreeing to sell the asset in the future assumes a
short position.
The price is determined by the instantaneous equilibrium between the forces of supply
and demand among competing buy and sell orders on the exchange at the time of the purchase or
sale of the contract.In many cases, the underlying asset to a futures contract may not be
traditional "commodities" at all – that is, for financial futures, the underlying asset or item can be
currencies, securities or financial instruments and intangible assets or referenced items such as
stock indexes and interest rates.The future date is called the delivery date or final settlement date.
The official price of the futures contract at the end of a day's trading session on the exchange is
called the settlement price for that day of business on the exchange.
Futures traders are traditionally placed in one of two groups: hedgers, who have an
interest in the underlying asset (which could include an intangible such as an index or interest
rate) and are seeking to hedge out the risk of price changes; and speculators, who seek to make a
profit by predicting market moves and opening a derivative contract related to the asset "on
paper", while they have no practical use for or intent to actually take or make delivery of the
underlying asset. In other words, the investor is seeking exposure to the asset in a long futures or
the opposite effect via a short futures contract.
Future contract get expires at every last Thursday of every month.
If you buy October month expiry future contract then you have to sell it within last Thursday of
October month.
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Major Advantages of Futures Trading over Stock Trading:
Margin is available:
In future trading you get margin to buy (but can hold only up to maximum of 3 months),
while in stock trading you must have that much of amount in your account to buy.
Possible to do short selling:
You can short sell futures- You can sell futures without buying them which is called short
selling and later buy within your expiry period, to cover up your positions.
This is not possible in stocks. You can’t sell stocks before buying them in delivery (you can
do in intraday). You can short sell futures and can cover off within your expiry period.
Brokerages are low:
Brokerages offered for future trading are less as compared to stock delivery trading.
Futures contracts, or simply futures, (but not future or future contracts) are exchange
traded derivatives. The exchange's clearing house acts as counterparty on all contracts, sets
margin requirements, and crucially also provides a mechanism for settlement.
OPTIONS:
An option is a contract between a buyer and a seller that gives the buyer of the option the right,
but not the obligation, to buy or to sell a specified asset (underlying) on or before the option's
expiration time, at an agreed price, the strike price.
In return for granting the option, the seller collects a payment (the premium) from the
buyer. Granting the option is also referred to as "selling" or "writing" the option. The buyer will
exercise his right only if it is favorable to him. If it is not, he will not exercise his right because
he has no obligation. Thus, the underlying asset moves from to another only when the option is
exercised. When it moves from one counterpart to another, its price (in cash) must move in the
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opposite direction. The amount of price in cash is fixed at the time of contract and is called the
strike price or exercise price.
A call option gives the buyer of the option the right but not the obligation to buy the
underlying at the strike price.
A put option gives the buyer of the option the right but not the obligation to sell the
underlying at the strike price.
If the buyer chooses to exercise this right, the seller is obliged to sell or buy the asset at
the agreed price. The buyer may choose not to exercise the right and let it expire. The underlying
asset can be a piece of property, a security (stock or bond), or a derivative instrument, such as a
futures contract.
The theoretical value of an option is evaluated according to several models. These
models, which are developed by quantitative analysts, attempt to predict how the value of an
option changes in response to changing conditions. Hence, the risks associated with granting,
owning, or trading options may be quantified and managed with a greater degree of precision,
perhaps, than with some other investments. Exchange-traded options form an important class of
options which have standardized contract features and trade on public exchanges, facilitating
trading among independent parties. Over-the-counter options are traded between private parties,
often well-capitalized institutions that have negotiated separate trading and clearing
arrangements with each other.
Option styles:
Naming conventions are used to help identify properties common to many different types
of options. Mainly include:
European option - an option that may only be exercised on expiration.
Americanoption - an option that may be exercised on any trading day on or before
expiration.
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The basic trades of traded stock options:
These trades are described from the point of view of a speculator. If they are combined
with other positions, they can also be used in hedging. An option contract in US markets usually
represents 100 shares of the underlying security.
Long call:
A trader who believes that a stock's price will increase might buy the right to purchase
the stock rather than just buy the stock. He would have no obligation to buy the stock, only the
right to do so until the expiration date. If the stock price at expiration is above the exercise price
by more than the premium paid, he will profit. If the stock price at expiration is lower than the
exercise price, he will let the call contract expire worthless, and only lose the amount of the
premium.
Long put:
A trader who believes that a stock's price will decrease can buy the right to sell the stock
at a fixed price. He will be under no obligation to sell the stock, but has the right to do so until
the expiration date. If the stock price at expiration is below the exercise price by more than the
premium paid, he will profit. If the stock price at expiration is above the exercise price, he will
let the put contract expire worthless and only lose the premium paid.
Short call:
A trader, who believes that a stock price will decrease, can sell the stock short or instead
sell, or "write," a call. The trader selling a call has an obligation to sell the stock to the call buyer
at the buyer's option. If the stock price decreases, the short call position will make a profit in the
amount of the premium. If the stock price increases over the exercise price by more than the
amount of the premium, the short will lose money, with the potential loss unlimited.
Short put:
A trader who believes that a stock price will increase can buy the stock or instead sell a
put. The trader selling a put has an obligation to buy the stock from the put buyer at the put
buyer's option. If the stock price at expiration is above the exercise price, the short put position
will make a profit in the amount of the premium. If the stock price at expiration is below the
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exercise price by more than the amount of the premium, the trader will lose money, with the
potential loss being up to the full value of the stock.
SWAPS:
A swap is a derivative in which two counterparties exchanges certain benefits of one
party's financial instrument for those of the other party's financial instrument. The benefits in
question depend on the type of financial instruments involved. Specifically, the two
counterparties agree to exchange one stream of cash flows against another stream. These streams
are called the legs of the swap. The swap agreement defines the dates when the cash flows are to
be paid and the way they are calculated. Usually at the time when the contract is initiated at least
one of these series of cash flows is determined by a random or uncertain variable such as an
interest rate, foreign exchange rate, equity price or commodity price.
The cash flows are calculated over a notional principal amount, which is usually not
exchanged between counterparties. Consequently, swaps can be used to create unfunded
exposures to an underlying asset, since counterparties can earn the profit or loss from movements
in price without having to post the notional amount in cash or collateral.
Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on
changes in the expected direction of underlying prices.
Swap market
Most swaps are traded over-the-counter (OTC), "tailor-made" for the counterparties.
Some types of swaps are also exchanged on futures markets such as the Chicago Mercantile
Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board Options Exchange,
Intercontinental Exchange and Frankfurt-based Eurex AG.
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Types of swaps:
The five generic types of swaps, in order of their quantitative importance, are: interest
rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps. There are also
many other types.
a. Interest rate swaps:
A is currently paying floating, but wants to pay fixed. B is currently paying fixed but wants to
pay floating. By entering into an interest rate swap, the net result is that each party can 'swap'
their existing obligation for their desired obligation. Normally the parties do not swap payments
directly, but rather, each sets up a separate swap with a financial intermediary such as a bank. In
return for matching the two parties together, the bank takes a spread from the swap payments.
The most common type of swap is a ―plain Vanilla‖ interest rate swap. It is the exchange
of a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15
years. The reason for this exchange is to take benefit from comparative advantage some
companies may have comparative advantage in fixed rate markets while other companies have a
comparative advantage in floating rate markets. When companies want to borrow they look for
cheap borrowing i.e. from the market where they have comparative advantage. However this
may lead to a company borrowing fixed when it wants floating or borrowing floating when it
wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate
loan into a floating rate loan or vice versa.
b. Currency swaps
A currency swap involves exchanging principal and fixed rate interest payments on a
loan in one currency for principal and fixed rate interest payments on an equal loan in another
currency. Just like interest rate swaps, the currency swaps also are motivated by comparative
advantage.
c. Commodity swaps
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A commodity swap is an agreement whereby a floating (or market or spot) price is
exchanged for a fixed price over a specified period. The vast majority of commodity swaps
involve crude oil.
d. Equity Swap
An equity swap is a special type of total return swap, where the underlying asset is a
stock, a basket of stocks, or a stock index. Compared to actually owning the stock, in this case
you do not have to pay anything up front, but you do not have any voting or other rights that
stock holders do have.
e. Credit default swaps
A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a
series of payments to the seller and, in exchange, receives a payoff if a credit instrument -
typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event that
triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having
its credit rating downgraded. A CDS contract has been compared with insurance, because the
buyer pays a premium and, in return, receives a sum of money if one of the events specified in
the contract occur. Unlike an actual insurance contract the buyer is allowed to profit from the
contract and may also cover an asset to which the buyer has no direct exposure.
WARRANT:
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In finance, a warrant is a security that entitles the holder to buy stock of the issuing
company at a specified price, which can be higher or lower than the stock price at time of issue.
Warrants and Options are similar in that the two contractual financial instruments allow
the holder special rights to buy securities. Both are discretionary and have expiration dates. The
word Warrant simply means to "endow with the right", which is only slightly different to the
meaning of an Option.
Structure and features
Warrants have similar characteristics to that of other equity derivatives, such as options,
for instance:
Exercising: A warrant is exercised when the holder informs the issuer their intention to
purchase the shares underlying the warrant. The warrant parameters, such as exercise
price, are fixed shortly after the issue of the bond. With warrants, it is important to
consider the following main characteristics:
Premium: A warrant's "premium" represents how much extra you have to pay for your
shares when buying them through the warrant as compared to buying them in the regular
way.
Gearing (leverage): A warrant's "gearing" is the way to ascertain how much more
exposure you have to the underlying shares using the warrant as compared to the
exposure you would have if you buy shares through the market.
Expiration Date: This is the date the warrant expires. If you plan on exercising the
warrant you must do so before the expiration date. The more time remaining until expiry,
the more time for the underlying security to appreciate, which, in turn, will increase the
price of the warrant (unless it depreciates). Therefore, the expiry date is the date on which
the right to exercise no longer exists.
Restrictions on exercise: Like options, there are different exercise types associated with
warrants such as American style (holder can exercise anytime before expiration) or
European style (holder can only exercise on expiration date).
Warrants are longer-dated options and are generally traded over-the-counter.
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Types of warrants
A wide range of warrants and warrant types are available. The reasons you might invest in one
type of warrant may be different from the reasons you might invest in another type of warrant.
Equity warrants: Equity warrants can be call and put warrants.
o Callable warrants: give you the right to buy the underlying securities
o Put able warrants: give you the right to sell the underlying securities
Covered warrants: A covered warrants is a warrant that has some underlying backing,
for example the issuer will purchase the stock before hand or will use other instruments
to cover the option.
Basket warrants: As with a regular equity index, warrants can be classified at, for
example, an industry level. Thus, it mirrors the performance of the industry.
Index warrants: Index warrants use an index as the underlying asset. Your risk is
dispersed—using index call and index put warrants—just like with regular equity
indexes. It should be noted that they are priced using index points. That is, you deal with
cash, not directly with shares.
Wedding warrants: are attached to the host debentures and can be exercised only if the
host debentures are surrendered
Detachable warrants: the warrant portion of the security can be detached from the
debenture and traded separately.
Naked warrants: are issued without an accompanying bond, and like traditional
warrants, are traded on the stock exchange.
Other Categorization of Derivatives Products:
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We can also categorize derivative products based on the mode or the place of trading.
1. Exchange traded derivatives: Derivatives traded on the regulated exchange are highly
standardized, (example – exchange traded future & options). Options & futures contracts are
standardized. In other words, the parties to the contracts do not decide the terms of
futures/option contract; but they merely accept terms of contracts standardized by the
Exchange. Exchange traded derivatives offer the maximum protection to the investor thanks
to various regulatory measures enforced by SEBI to provide for fairness and transparency in
trading.
2. Over the counter derivatives: Encompass tailored financial derivatives, such as swaps,
swaptions, caps and collars that are traded in the offices of the world’s leading financial
institutions. These are individually agreed between two counter-parties.
Commodities:A Strong Investment Option:
Commodities, a known avenue for investment, had always generated economic interest
especially among investors. In recent years, commodities have emerged as an asset class on their
own, and are currently perceived to be in the Peers of stocks and shares, bonds, other securities
and real estate. On many occasions, commodities have outperformed other asset classes and are
becoming distinctive in the investment basket of tactical investors. They are also part of the asset
diversification strategy of investors.
Indian Commodity market having its roots dating back a century ago got its new global
face with the development of national commodity exchanges and has now become the best place
to park the investment money. With India being a franchiser of global commodity market, there
is renewed interest in derivatives trading. The organized Indian Commodity Market is at its
nascent stage and a large potential to provide enormous opportunities to the investors and other
market participants.
Commodity Derivative Exchanges:
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The commodity market is a market, where commodities are bought and sold.
The main function of the commodity exchange is assurance of regular communication
between buyers and sellers, when transactions are carried out with available batches
of goods.
Commodity Markets and Commodity Futures are a mechanism for hedging.
In the commodity futures exchanges the peak value of trading have touched Rs
15,000 crore on some days with the average around of Rs 6,000 crore.
Open interests in certain commodities such as gold, silver, rubber, pepper, Soya are
also substantial.
The modern commodity markets have their roots in the trading of agricultural
products
For centuries, sugar has been a highly valued and widely traded commodity.
The main advantages of a call option are protection against higher prices, limited
liability with no margin deposits, and the potential to benefit from lower cash prices.
The National Commodity Derivatives Exchange (NCDEX) has emerged as the largest
commodity futures exchange.
The Government of India recognized three nation-wide multi commodity exchanges
to promote a healthy, competitive futures market. It was rightly presumed that there is
room for multiple players to grow in size and stature in the huge commodity economy
of India.
Operational Definitions:
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Currency:Any form of money issued by a government or central bank and used as legal tender
and a basis for Forex trade.
Currency Pair:The two currencies that make up a foreign exchange rate are known as Currency
Pair. For Example, USDINR
Cash Market: It isthe market in the actual financial instrument on which a futures or options
contract is based.
Stock Exchange:An association or a company or any other body corporate that provide the
trading platform for currencies.
Derivative contract:A derivative is a product whose value is derived from the value of one or
more underlying variable or asset in a contractual manner. The underlying asset can be equity,
foreign exchange, commodity or any other asset. The price of derivative is driven by the spot
price.
Long position:A position that appreciates in value if market prices increase. When the base
currency in the pair is bought, the position is said to be long.
Short position:An investment positions that benefit from a decline in market price. When the
base currency in the pair is sold, the position is said to be short.
Lot:A unit to measure the amount of the deal. The value of the deal always corresponds to an
integer number of lots.
6. CURRENCY DERIVATIVES
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Foreign exchange rate is the value of a foreign currency relative to domestic currency. The
exchange of currencies is done in the foreign exchange market, which is one of the biggest
financial markets. The participants of the market are banks, corporations, exporters, importers
etc. A foreign exchange contract typically states the currency pair, the amount of the contract,
the agreed rate of exchange etc.
Exchange Rate
A foreign exchange deal is always done in currency pairs, for example, US Dollar - Indian
Rupee contract (USD - INR); British Pound - INR (GBP- INR), Japanese Yen - U.S. Dollar
(JPY- USD), U.S. Dollar - Swiss Franc (USD-CHF) etc. Some of the liquid currencies in the
world are USD, JPY, EURO, GBP, and CHF and some of the liquid currency contracts are
on USD-JPY, USD-EURO, EURO-JPY, USD-GBP, and USD-CHF. The prevailing exchange
rates are usually depicted in a currency table like the one given below:
Currency Table:
Date: 28 June 2009 Time: 15:15 hours
USD .JPY EUR IIIIR GBP
USD 1.000 95.318 0.711 48.053 0.606
JPY 0.010 1.000 0.007 0.504 0.006
EUR 1.406 134.033 1.000 67.719 0.852
INR 0.021 1.984 0.015 1.000 0.013
GBP 1.651 157.43 1.174 79.311 1.000
In a currency pair, the first currency is referred to as the base currency and the second
currency is referred to as the 'counter/terms/quote' currency. The exchange rate tells the worth of
the base currency in terms of the terms currency, i.e. for a buyer, how much of the terms
currency must be paid to obtain one unit of the base currency. For example, a USD-INR rate
of Rs. 48.0530 implies that Rs. 48.0530 must be paid to obtain one US Dollar. Foreign
exchange prices are highly volatile and fluctuate on a real time basis. In foreign exchange
contracts, the price fluctuation is expressed as appreciation/depreciation or the
strengthening/weakening of a currency relative to the other. A change of USD-INR rate from
Rs. 48 to Rs. 48.50 implies that USD has strengthened/ appreciated and the INR has
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weakened/depreciated, since a buyer of USD will now have to pay more INR to buy 1USD
than before.
Fixed Exchange Rate Regime and Floating Exchange Rate Regime:
There are mainly two methods employed by governments to determine the value of domestic
currency vis-a-vis other currencies: fixed and floating exchange rate.
Fixed exchange rate regime:
Fixed exchange rate, also known as a pegged exchange rate, is when a currency's value is
maintained at a fixed ratio to the value of another currency or to a basket of currencies or to
any other measure of value e.g. gold. In order to maintain a fixed exchange rate, a government
participates in the open currency market. When the value of currency rises beyond
the permissible limits, the government sells the currency in the open market, thereby
increasing its supply and reducing value. Similarly, when the currency value falls beyond
certain limit, the government buys it from the open market, resulting in an increase in its
demand and value. Another method of maintaining a fixed exchange rate is by making it illegal
to trade currency at any other rate. However, this is difficult to enforce and often leads to a
black market in foreign currency.
Floating exchange rate regime:
Unlike the fixed rate, a floating exchange rate is determined by a market mechanism through
supply and demand for the currency. A floating rate is often termed "self-correcting", as any
fluctuation in the value caused by differences in supply and demand will automatically
be corrected by the market. For example, if demand for a currency is low, its value will
decrease, thus making imported goods more expensive and exports relatively cheaper. The
countries buying these export goods will demand the domestic currency in order to make
payments, and the demand for domestic currency will increase. This will again lead to
appreciation in the value of the currency. Therefore, floating exchange rate is self correcting,
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requiring no government intervention. However, usually in cases of extreme appreciation or
depreciation of the currency, the country's Central Bank intervenes to stabilize the
currency. Thus, the exchange rate regimes of floating currencies are more technically called a
managed float.
Factors Affecting Exchange Rates:
There are various factors affecting the exchange rate of a currency. They can be classified as
fundamental factors, technical factors, political factors and speculative factors.
Fundamental factors:
The fundamental factors are basic economic policies followed by the government in relation
to inflation, balance of payment position, unemployment, capacity utilization, trends in import
and export, etc. Normally, other things remaining constant the currencies of the countries
that follow sound economic policies will always be stronger. Similarly, countries having
balance ofpayment surplus will enjoy a favorable exchange rate. Conversely, for countries
facing balance of payment deficit, the exchange rate will be adverse.
Technical factors:
Interest rates: Rising interest rates in a country may lead to inflow of hot money in the
country, thereby raising demand for the domestic currency. This in turn causes appreciation in
the value of the domestic currency.
Inflation rate: High inflation rate in a country reduces the relative competitiveness of the
export sector of that country. Lower exports result in a reduction in demand of the domestic
currency and therefore the currency depreciates.
Exchange rate policy and Central Bank interventions: Exchange rate policy of the country
is the most important factor influencing determination of exchange rates. For example, a country
may decide to follow a fixed or flexible exchange rate regime, and based on this, exchange
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rate movements may be less/more frequent. Further, governments sometimes participate in
foreign exchange market through its Central bank in order to control the demand or supply of
domestic currency.
Political factors:
Political stability also influences the exchange rates. Exchange rates are susceptible to political
instability and can be very volatile during times of political crises.
Speculation:
Speculative activities by traders worldwide also affect exchange rate movements. For example,
if speculators think that the currency of a country is over valued and will devalue in near
future, they will pull out their money from that country resulting in reduced demand for that
currency and depreciating its value.
Quotes
In currency markets, the rates are generally quoted in terms of USD. The price of a currency in
terms of another currency is called 'quote'. A quote where USD is the base currency is referred
to as a 'direct quote' (e.g. 1 USD - INR 48.5000) while a quote where USD is referred to as the
terms currency is an 'indirect quote' (e.g. 1INR = 0.021USD).
USD is the most widely traded currency and is often used as the vehicle currency. Use of
vehicle currency helps the market in reduction in number of quotes at any point of time, since
exchange rate between any two currencies can be determined through the USD quote for
those currencies. This is possible since a quote for any currency against the USD is readily
available. Any quote not against the USD is referred to as 'cross' since the rate is calculated
via the USD.
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For example, the cross quote for EUR-GBP can be arrived through EUR-USD quote * USD-
GBP quote (i.e. 1.406 * 0.606 = 0.852). Therefore, availability of USD quote for all currencies
can help in determining the exchange rate for any pair of currency by using the cross-rate.
Tick-Size:
Tick size refers to the minimum price differential at which traders can enter bids and offers.
For example, the Currency Futures contracts traded at the NSE have a tick size of Rs. 0.0025.
So, if the prevailing futures price is Rs. 48.5000, the minimum permissible price movement can
cause the new price to be either Rs. 48.4975 or Rs. 48.5025. Tick value refers to the amount of
money that is made or lost in a contract with each price movement.
Spreads:
Spreads or the dealer's margin is the difference between bid price (the price at which a dealer is
willing to buy a foreign currency) and ask price (the price at which a dealer is willing to sell a
foreign currency). the quote for bid will be lower than ask, which means the amount to be paid
in counter currency to acquire a base currency will be higher than the amount of counter
currency that one can receive by selling a base currency. For example, a bid-ask quote for
USDINR of Rs. 47.5000 - Rs. 47.8000 means that the dealer is willing to buy USD by
paying Rs. 47.5000 and sell USD at a price of Rs. 47.8000. The spread or the profit of the
dealer in this case is Rs. 0.30.
Spot Transaction and Forward Transaction:
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The spot market transaction does not imply immediate exchange of currency, rather the
settlement (exchange of currency) takes place on a value date, which is usually two business
days after the trade date. The price at which the deal takes place is known as the spot rate
(also known as benchmark price). The two-day settlement period allows the parties to confirm
the transaction and arrange payment to each other.
A forward transaction is a currency transaction wherein the actual settlement date is at a
specified future date, which is more than two working days after the deal date. The date of
settlement and the rate of exchange (called forward rate) is specified in the contract. The
difference between spot rate and forward rate is called forward margin". Apart from forward
contracts there are other types of currency derivatives contracts, which are covered in
subsequent chapters.
Foreign Exchange Spot (cash) market
The foreign exchange spot market trades in different currencies for both spot and
forwarddelivery. Generally they do not have specific location, and mostly take place primarily
bymeans of telecommunications both within and between countries.It consists of a network of
foreign dealers which are often banks, financial institutions, large concerns, etc. The large banks
usually make markets in different currencies.
In the spot exchange market, the business is transacted throughout the world on acontinual basis.
So it is possible to transaction in foreign exchange markets 24 hours aday. The standard
settlement period in this market is 48 hours, i.e., 2 days after theexecution of the transaction.The
spot foreign exchange market is similar to the OTC market for securities. There is nocentralized
meeting place and any fixed opening and closing time. Since most of thebusiness in this market
is done by banks, hence, transaction usually do not involve aphysical transfer of currency, rather
simply book keeping transfer entry among banks.Exchange rates are generally determined by
demand and supply force in this market.The purchase and sale of currencies stem partly from the
need to finance trade in goodsand services. Another important source of demand and supply
arises from theparticipation of the central banks which would emanate from a desire to influence
thedirection, extent or speed of exchange rate movements.
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Currency Futures:
Derivatives are financial contracts whose value is determined from one or more underlying
variables, which can be a stock, a bond, an index, an interest rate, an exchange rate etc. The
most commonly used derivative contracts are forwards and futures contracts and options.
There are other types of derivative contracts such as swaps, swaptions, etc. Currency
derivatives can be described as contracts between the sellers and buyers whose values are
derived from the underlying which in this case is the Exchange Rate. Currency derivatives are
mostly designed for hedging purposes, although they are also used as instruments for
speculation.
Currency markets provide various choices to market participants through the spot market or
derivatives market. Before explaining the meaning and various types of derivatives contracts,
let us present three different choices of a market participant. The market participant may enter
into a spot transaction and exchange the currency at current time.
The market participant wants to exchange the currency at a future date. Here the market
participant may either:
Enter into a futures/forward contract, whereby he agrees to exchange the currency in the
future at a price decided now, or,
Buy a currency option contract, wherein he commits for a future exchange of currency,
with an agreement that the contract will be valid only if the price is favorable to the
participant.
Forward Contracts:
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Forward contracts are agreements to exchange currencies at an agreed rate on a specified
future date. The actual settlement date is more than two working days after the deal date. The
agreed rate is called forward rate and the difference between the spot rate and the forward
rate is called as forward margin. Forward contracts are bilateral contracts (privately
negotiated), traded outside a regulated stock exchange and suffer from counter-party risks
and liquidity risks. Counter Party risk means that one party in the contract may default on
fulfilling its obligations thereby causing loss to the other party.
Futures Contracts
Futures contracts are also agreements to buy or sell an asset for a certain price at a future
time. Unlike forward contracts, which are traded in the over-the-counter market with no
standard contract size or standard delivery arrangements, futures contracts are exchange
traded and are more standardized. They are standardized in terms of contract sizes, trading
parameters, settlement procedures and are traded on a regulated exchange. The contract size is
fixed and is referred to as lot size.
Since futures contracts are traded through exchanges, the settlement of the contract is
guaranteed by the exchange or a clearing corporation and hence there is no counter party risk.
Exchanges guarantee the execution by holding an amount as security from both the parties.
This amount is called as Margin money. Futures contracts provide the flexibility of closing
out the contract prior to the maturity by squaring off the transaction in the market. Table
3.1draws a comparison between a forward contract and a futures contract.
Comparison of Forward and futures Contracts:
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45. Fundamentals of Derivatives with special reference to Currency Derivatives.
ForwardContract FuturesContract
NatureofContract Non- Standardizedcontract
standardized/Customized
contract
Trading InformalOver-the-Countermarket; Tradedonanexchange
Privatecontractbetweenparties
Settlement Single - Pre-specified Dailysettlement,known
inthe contract asDaily mark tomarket
settlement and Final
Settlement.
Risk Counter-Partyrisk is present since Exchangeprovidesthe
noguaranteeisprovided guaranteeof settlementand
hence nocounter partyrisk.
Hedging using Currency Futures:
Hedging in currency market can be done through two positions, viz. Short Hedge and Long
Hedge. They are explained as under:
Short-Hedge:
A short hedge involves taking a short position in the futures market. In a currency market,
short hedge is taken by someone who already owns the base currency or is expecting a future
receipt of the base currency.
Long Hedge:
A long hedge involves holding a long position in the futures market. A Long position holder
agrees to buy the base currency at the expiry date by paying the agreed exchange rate. This
strategy is used by those who will need to acquire base currency in the future to pay any
liability in the future.
Speculation in Currency Futures:
Futures contracts can also be used by speculators who anticipate that the spot price in the future
will be different from the prevailing futures price. For speculators, who anticipate a
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46. Fundamentals of Derivatives with special reference to Currency Derivatives.
strengthening of the base currency will hold a long position in the currency contracts,in order to
profit when the exchange rates move up as per the expectation. A speculator who anticipates a
weakening of the base currency in terms of the terms currency, will hold a short position in the
futures contract so that he can make a profit when the exchange rate moves down.
Speculation in Futures Market
Suppose the current USD-INR spot rate is INR 48.0000 per USD. Assume that the current 3-
months prevailing futures rate is also INR 48.0000 per USD. Speculator ABC anticipates that
due to decline in India's exports, the USD (base currency) Is going to strengthen against INR
after 3 months. ABC forecasts that after three months the exchange rate would be INR 49.50
per USD. In order to profit,ABC has two options:
Option A: Buy 1000 USD in the spot market, retain it for three months, and sell them after 3
months when the exchange rate increases: This will require an investment of Rs. 48,000 on the
part of ABC (although he will earn some Interest on Investing the USD). On maturity date,If
the USD strengthens as per expectation (i.e. exchange rate becomes INR 49.5000 per
USD),ABC will earn Rs. (49.50 - 48)*1000, i.e. Rs. 1500 as profit.
Option B: ABC can take a long position in the futures contract - agree to buy USD after 3
months@ Rs. 48.0000 per USD: In a futures contract,the parties will just have to pay only the
margin money upfront. Assuming the margin money to be 10% and the contract size Is USD
1000, ABC will have to Invest only Rs. 4800 per contract.With Rs. 48,000, ABC can enter
into 10 contracts. The margin money will be returned once the contract expires.
After 3 months, if the USD strengthens as per the expectation, ABC will earn the difference
on settlement. ABC will earn (Rs 49.5000 - 48.0000) * 1000,i.e. Rs. 1500 per contract. Since
ABC holds 'long' position In 10 contracts, the total profit will be Rs. 15000.However, if the
exchange rate does not move as per the expectation, say the USD depreciates and the exchange
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47. Fundamentals of Derivatives with special reference to Currency Derivatives.
rate after 3 months becomes Rs. 47.0000 per USD, then in option A, ABC will lose only Rs.
(48-47) * 1000 = Rs. 1000, but In option B,ABC will lose Rs. 10000 (Rs. 1000 per contract *
10 contracts).
Thus taking a position in futures market, rather than in spot market, give speculators a chance
to make more money with the same investment (Rs.48,000). However,if the exchange rate does
not move as per expectation, the speculator will lose more in the futures market than in the
spot market. Speculators are willing to accept high risks in the expectation of high
returns.Speculators prefer taking positions in the futures market to the spot market because of
the low investment required in case of futures market. In futures market, the parties are required
to pay just the margin money upfront, but in case of spot market, the parties have to invest the
full amount, as they have to purchase the foreign currency.
NSE's Currency Derivatives Segment:
The phenomenal growth of financial derivatives across the world is attributed to the
fulfillment of needs of hedgers, speculators and arbitrageurs by these products. In this chapter
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48. Fundamentals of Derivatives with special reference to Currency Derivatives.
we look at contract specifications, participants, the payoff of these contracts, and finally at
how these contracts can be used by various entities at the NSE.
Contract specification:
Underlying Rate of exchangebetweenone USD andINR
TradingHours(MondaytoFriday) 09:00a.m.to 05:00p.m.
ContractSize USD1000
Tick Size 0.25paise orINR 0.0025
TradingPeriod Maximumexpirationperiodof12 months
ContractMonths 12 near calendarmonths
Final Settlementdate/Value date Last workingday ofthe month(subject to
holidaycalendars)
LastTradingDay Two workingdays priortoFinalSettlementDate
Settlement Cashsettled
Final SettlementPrice The reference rate fixed by RBI two
workingdays priorto the finalsettlement
datewillbeused for final settlement
Basisoftrading
The NEAT-CDSsystemsupports an
orderdrivenmarket,whereinordersmatchautomatically. Ordermatchingis
essentiallyon thebasisof security,itspriceand time.All quantityfieldsare
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49. Fundamentals of Derivatives with special reference to Currency Derivatives.
incontractsand pricein Indianrupees.The exchangenotifiesthecontractsize and
ticksize for eachof thecontractstradedon thissegmentfromtimetotime.Whenany
orderentersthe tradingsystem,itisan activeorder.Ittriestofindamatchon
theoppositeside of thebook.If itfindsa match,a tradeis generated.Ifitdoes
notfinda match,theorderbecomespassive and sits in
therespectiveoutstandingorderbookinthesystem.
Corporatehierarchy
Inthetradingsoftware,atradingmemberhas thefacilityof
definingahierarchyamongstusers of
thesystem.Thishierarchycomprisescorporatemanager,branchmanagerand
dealer.
1) Corporatemanager:The term'Corporatemanager'is
assignedtoauserplacedatthe highestlevelina tradingfirm.Such a usercan
performall thefunctionssuchas orderand
traderelatedactivities,receivingreportsfor all branchesof
thetradingmemberfirmand also all dealersof
thefirm.Additionally,acorporatemanagercan definelimitsfor thebranchesand
dealersofthe firm.
2) Branch manager: The branch manager is a term assigned to a user who is placed under
the corporate manager. Such a user can perform and view order and trade related activities
for all dealers under that branch. Additionally, a branch manager can define limits for the
dealers under that branch.
3) Dealer: Dealers are users at the lower most level of the hierarchy. A dealer must be
linked either with the branch manager or corporate manager of the firm. A Dealer can
perform view order and trade related activities only for oneself and does not have access to
information on other dealers under either the same branch or other branches.
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50. Fundamentals of Derivatives with special reference to Currency Derivatives.
Cases given below explain activities possible for specific user categories:
Corporate manager of the clearing member
Corporate manager of the clearing member has limited rights on the trading system. A
corporate manager of the clearing member can perform following functions:
On line custodian/ 'give up' trade confirmation/ rejection for the participants
Limit set up for the trading member I participants
View market information like trade ticker, Market Watch etc.
View net position of trading member I Participants
Corporate Manager of the trading member
This is the top level of the trading member hierarchy with trading right. A corporate manager
of the trading member can broadly perform following functions:
Order management and trade management for self
View market infonmation
Set up branch level and dealer level trading limits for any branch/ dealer of the
trading member
View, modify or cancel outstanding orders on behalf of any dealer of the
tradingmember
View, modify or send cancel request for trades on behalf of any dealer of the trading
member
View day net positions at branch level and dealer level and cumulative net position
atfirm level.
Branch manager of trading member
The next level in the trading member hierarchy with trading right is the branch
manager. One or more dealers of the trading member can be a branch manager
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51. Fundamentals of Derivatives with special reference to Currency Derivatives.
for the trading member. A branch manager of the trading member can broadly
perform the following functions:
Ordermanagementand trademanagementofself
View marketinformation
Set up dealerleveltradinglimitsfor any dealerlinkedwiththebranch
View, modify or cancel the outstanding orders on behalf of any dealers linked with the
branch
View, modify or send cancel request for trades on behalf of any dealer of the dealer
linked with the branch
View day net positions at branch level and dealer level
FOREIGN EXCHANGE QUOTATIONS
Foreign exchange quotations can be confusing because currencies are quoted in terms of other
currencies. It means exchange rate is relative price. For example, If one US dollar is worth of Rs.
45 in Indian rupees then it implies that 45Indian rupees will buy one dollar of USA, or that one
rupee is worth of 0.022 US dollar which is simply reciprocal of the former dollar exchange rate.
Base Currency/ Terms Currency:
In foreign exchange markets, the base currency is the first currency in a currency pair.The
second currency is called as the terms currency. Exchange rates are quoted in per unit of the base
currency. That is the expression Dollar-Rupee, tells you that the Dollar isbeing quoted in terms
of the Rupee. The Dollar is the base currency and the Rupee is theterms currency.Exchange rates
are constantly changing, which means that the value of one currency interms of the other is
constantly in flux. Changes in rates are expressed as strengtheningor weakening of one currency
vis-à-vis the second currency. Changes are also expressed as appreciation or depreciation of one
currency in terms of the second currency. Whenever the base currency buys more of the terms
currency, thebase currency has strengthened / appreciated and the terms currency has weakened
/depreciated.For example,if Dollar – Rupee moved from Rs. 43.00 to Rs. 43.25 the Dollar has
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52. Fundamentals of Derivatives with special reference to Currency Derivatives.
appreciated and the Rupee has depreciated. And if it moved from 43.0000 to 42.7525 the Dollar
has depreciated and Rupee has appreciated.
It has been observed that in most futures markets, actual physical delivery of the
underlying assets is very rare and hardly has it ranged from 1 percent to 5 percent. This is
because most of futures contracts in different products are predominantly speculative
instruments. For example, X purchases American Dollar futures and Y sells it. It leads to two
contracts, first, X party and clearing house and second Y party and clearing house. Assume next
day X sells same contract to Z, then X is out of the picture and the clearing house is seller to Z
and buyer from Y, and hence, this process is goes on.
REGULATORY FRAMEWORK FOR CURRENCYFUTURES
With a view to enable entities to manage volatility in the currency market,
RBI on April 20, 2007 issued comprehensive guidelines on the usage of foreign currency
forwards, swaps and options in the OTC market. At the same time, RBI also set up an Internal
Working Group to explore the advantages of introducing currency futures. With the expected
benefits of exchange traded currency futures, it was decided in a joint meeting of RBI and SEBI
on February 28, 2008, that an RBI-SEBI Standing Technical Committee on Exchange Traded
Currency and Interest Rate Derivatives would be constituted.
To begin with, the Committee would evolve norms and oversee the implementation of
Exchange traded currency futures. The Terms of Reference to the Committee was as under: 1. to
coordinate the regulatory roles of RBI and SEBI in regard to trading of Currency and Interest
Rate Futures on the Exchanges.2.To suggest the eligibility norms for existing and new
Exchanges for Currency and Interest Rate Futures trading.3.To suggest eligibility criteria for the
members of such exchanges.
Currency futures were introduced in recognized stock exchanges in India in August 2008. The
currency futures market is subject to the guidelines issued by the Reserve Bank of India (RBI)
and the Securities Exchange Board of India (SEBI) from time to time. Amendments were also
made to the Foreign Exchange Management Regulations to facilitate introduction of the
currency futures contracts in India. Earlier persons resident in India had access only to the
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53. Fundamentals of Derivatives with special reference to Currency Derivatives.
over-the-counter (OTC) products for hedging their currency risk, which included - forwards,
swaps, options. Introduction of exchange traded currency futures contracts has facilitated
efficient pricediscovery, counterparty risk management, wider participation (increased
liquidity) and lowered the transaction costs etc.
Membership
Categories of membership (NSE)
Members are admitted in the Currency Derivatives Segments in the following categories:
Only Trading Membership of NSE
Membership in this category entitles a member to execute trades on his own account as well as
account of his clients in the Currency Derivatives segment. However, clearing and settlement
of trades executed through the Trading Member would have to be done through a Trading-cum
Clearing Member or Professional Clearing Member on the Currency Derivatives Segment of
the Exchange (Clearing and settlement is done through the National Securities Clearing
Corporation Ltd. - NSCCL, a wholly owned subsidiary of the NSE). The exchange assigns a
unique trading member ID to each trading member. Each trading member can have more than
one user and each user is assigned a unique User-ID.
Orders by trading members on their own account are called proprietary orders and orders
entered by the trading members on behalf of their clients are called client orders. Trading
Members are required to specify in the order, whether they are proprietary orders or clients
orders.
Both Trading Membership of NSE and Clearing Membership of NSCCL
Membership in this category entitles a member to execute trades on his own account as well as
on account of his clients and to clear and settle trades executed by themselves as well as by
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54. Fundamentals of Derivatives with special reference to Currency Derivatives.
other trading members who choose to use clearing services of the member in the Currency
Derivatives Segment.
Professional Clearing Membership of NSCCL
These members are not trading members. Membership in this category entitles a member to
clear and settle trades of such members of the Exchange who choose to clear and settle
their trades through this member. SEBI has allowed banks to become clearing member
and/or trading member of the Currency Derivatives Segment of an exchange.
Self Clearing Membership of NSCCL
Membership in this category entitles a member to clear and settle transactions on its own
account or on account of its clients only. A Self-Clearing member is not entitled to clear or settle
transactions in securities for any other trading member(s). Self clearing membership may be
availed jointly with trading membership on Currency Derivatives segment and would be
separately registered with SEBI. New members and existing SEBIregistered members on other
segments of National Stock Exchange may apply for self clearing membership jointly with
trading membership of Currency Derivatives segment,subject to fulfillment of prescribed
eligibility criteria. Further,existing trading members on Currency Derivatives Segment may also
apply for self clearingmembership,subject to fulfillment of prescribed eligibility criteria.
Who cannot become a member?
Further to the capital and network requirements, no entity will be admitted as a member/partner
or director of the member if:
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