Currency Futures: A Powerful tool to manage currency risk Finally long outstanding financial reform has seen light

of day. It was Friday, August 29, 2008 when the Finance Minister P Chitambaram inaugurated Currency futures trading in NSE at 08.45 AM. Nearly 300 members and 11 banks have participated in the first day of trading in currency futures market. Approximately 70,000 contract valuing $ 65.8 million were traded on the first day. East India securities were the first trader to stuck deal for its client Budge Budge Refineries limited by buying 50 November contract at Rs. 44.15. The reason for introduction of currency future was to stabilize rupee and to minimize the loss of the corporate and traders arises due to volatility in the foreign exchange market. Though it has been introduced as a hedging tool, the experience and fact says that 85% of world wide trade in currency futures is done by speculators (who makes the forex market more volatile) and only 15% of the trade is done by hedgers to reduce the loss. Average daily traded volume of Forex market globally is $4 trillian, out of which the share of Exchange traded futures is only 7-8% and balance is OTC traded Forward contract. In India also the currency future trading has not picked as expected due to lesser publicity and awareness. Though it is catching up among retailers, yet corporate still prefer forward market because of customized product and ease of trading. Considering the small size of the market and huge participation by the speculators, it has not been able to manage risk up to expectation. But as the volume and participation increases it will certainly bring stability in foreign exchange market and will help in managing risk. Risk Management Risk management is the logical development and execution of a plan to deal with potential losses Mark Dorfman Liberalization has brought rapid growth in international trade and overseas investment. Export and import all over the world has gone many fold. Increased trading has increased foreign currency exposure to both exporting and importing firms, especially when trade is denominated in foreign currency. Increased foreign currency exposure and exchange rate volatility has made these firms and foreign investors vulnerable to risk. Foreign exchange risk management has become now much more important than it was earlier.

Chart 1 : Indian Rupee Exchange Rate

Source: www.tradingeconomics.com/Economics/Currency.aspx Following two techniques are helpful for the Firms to reduce or eliminate currency risk. (i) Market specific tools or External technique (ii) Firm specific tools or Internal technique Market specific tools: It is also known as external technique, under which risk reduction is done through Hedging with the help of derivative instruments. Hedging involves taking exactly opposite position of the underlying position by using various financial derivative products. Long hedge: It is applied by going long on derivative product when underlying position is short. Short hedge: It is applied by going short on derivative product, when underlying position is long. Financial Derivatives Derivatives are financial instruments the value of which is derived from underlying assets. The underlying assets can be Equity, Commodity and Foreign Exchange etc. Thus derivatives do not have value of their own. Initially derivatives products were being used as hedging devices against fluctuation in commodity prices. The main purpose was to transfer the risk from one party to another. Growing instability brought financial derivatives into spotlight in the post 1970. Gradually the financial derivatives have grown tremendously over the period of time. World over futures and options on stock indices have gained more popularity than on individual stocks. Not only institutional investors, who are majors of index-linked derivatives but also small investors find these useful due ease of use.

Derivatives Products for hedging: Forwards:A forward contract is a tailor made customized contract between two parties, where settlement takes placement on a specific date in the future at todays pre-agreed price. Futures: - A Future contract is a buy or sell agreement of an asset between two parties at a specific date in future at a specific rate. Future contracts are standardized exchangetraded contracts. When the underlying asset is an exchange rate it is known as currency future contract. Benefits of trading in futures :- Now the question arises is, since we have already well organized forward currency derivative which is traded on OTC, then what is the need of having another derivative market. Following comparison will make the reader understand as to how futures (currency) derivative market is better than forward currency derivative market. Table 1: Difference between Forward and Futures currency markets Futures Exchange Traded Forwards OTC Traded

Standardized contracts in terms of Privately negotiated derivative contract underlying assets, size and maturity of which is custom-tailored to meet specific the contract. needs of counter-parties. It is regularized by SEBI It is not regulated by any regulatory authority. No Counterparty risk as Clearing House Counterparty risk exists as there is no takes counter guarantee for all the Clearing House. contract. Initial Margin is to be deposited with Not required exchange Marking to market is done at the end of Not required every trading day Only two parties (buyer and seller) are Three parties (buyer, seller and clearing involved house) are involved Underlying asset is required Not required Sourse: Compiled by the authors Options :Option is a type of contract between two people where one person grants the other person the right to buy or sell a specific asset at a specific price within a specific time period, without an obligation . The person, who has received the right, must pay for this right as premium, is known as option buyer. The person who has sold the right, and received the premium, is known as option writer.

Options are of two types:Call option: It gives the buyer the right but not the obligation to buy a given quantity of underlying assets, at a given price on or before a given future date. Put option : It gives the buyer the right but not the obligation to sell a given quantity of underlying assets, at a given price on or before a given future date. Option may be of American style or European style. In American style option the holder has the right to exercise his right any time before the maturity or on maturity. In European style option the holder can exercise his right only on maturity. Warrants: Options generally have a lives of up to one year,( In India it three months only) Options with a life of more than a year is called warrants and are generally traded overthe-counter. Leaps : Leaps means Long-Term Equity Anticipation Securities. It has a maximum life period of three years. Baskets: Basket options are options on portfolio of underlying assets. Equity index options are a form of basket options. Swaps: Under Swaps two parties agree to exchange cash flows in the future according to a prearranged formula. The two commonly used Swaps are: Interest rate swaps: Interest rate swaps involves swapping only the interest related cash flows between the parties in the same currency. Currency swaps: Under Currency Swaps both the parties agrees swapping both principal and interest related cash flows. Purpose of Trading in derivative: The purpose of trading in any derivative market can be any of the following three: Speculation- When derivative products are used to bet on future movements in the price of an asset. Hedging - When derivative products are used to eliminate the price risk of an assets Arbitrage- When derivative products are used to take advantage of a discrepancy between prices in two different markets. Box 1: Derivatives markets in India: Derivatives markets in India: The first step towards development of derivatives markets in India is the appointment of LC Gupta committee by SEBI in Nov 1996. SEBI accepted the recommendations of the committee on May 11, 1998 and approved the phased introduction of derivatives. Chronology of derivatives market in India 14 December 1995-NSE asked SEBI for permission to trade index futures. 18November1996-Formed LC Gupta committee to design a policy framework for index futures. 07 July 1999RBI gives permission for OTC forward rate agreements and Interest Rate Swaps.

24 May 2000-

SIMEX chose Nifty For trading futures and options on an Indian index. 25 May 2000SEBI give permission to NSE and BSE to do index futures trading. 09 June 2000Trading of BSE Sensex Futures commenced at BSE. 12 June 2000Trading of Nifty Futures commenced at NSE. 25 September 2000-Nifty Futures trading commenced at SGX 04 June 2001Index options introduced 02 July 2001Stock options introduced 09 November 2001-Stock futures introduced 29 August 2008- Currency futures introduced 31 August 2009- Interest Rate futures introduced

Source:http://www.geocities.com/kstability/content/derivatives/India.html (ii) Firm specific tools or Internal technique Invoicing in domestic currency Netting and offsetting by matching Outflows and Inflows Risk sharing adjustment with other party Leading and Lagging of receivable/payable Managing currency risk through currency Futures Understanding currency risk Case : (When firm has foreign currency payable in future) ABC, an Indian company, imports machinery from US firm for $ 5 million. Due date for payment is January 22, 2011. Present exchange rate is Rs. 47/$ (as on January 22, 2010) Inflation in India = 6% Inflation in US= 1% Interest rate in India = 8% Interest rate in US= .5% Situation:- ABC company needs to pay $ 5 million on January 22, 2011. Since the payment will be made in future and exchange rate does not remain constant, there is uncertainty with the actual cash outflow. USD may appreciate or depreciate in future. If USD appreciates cash outflow in terms of rupee will me more which leads to risk. Risk: Volatility of exchange rate (especially when USD appreciates) Problem 1: How to eliminate the risk. Problem 2: How to forecast the forward rate Solution 1: In this situation, ABC needs to go long hedge by buying currency futures for $ 5 million for 1 year. Since contract size for USD future is $1000, number of contract will be 5000000/1000=5000 to get perfect hedge. Solution 2: There two basic methods to calculate spot and future exchange rate. (a) Purchasing power parity (PPP) (b) Interest rate parity (IRP)

Determination of Exchange rate as per Purchasing Power Parity:-PPP theory follows law of one price, which states that the price of identical goods should be same all over the world. Exchange rate of currency is being adjusted if the inflation rate is different in two countries. Absolute form of PPP Case 2: Suppose 1 kg apple costs $5 in USA and Rs 220 in India, then as per this theory the exchange rate will be 220/5 = Rs 44/$ Relative form of PPP According to this theory, exchange rate is determined by the inflation of one country over inflation of another country. It states that the percentage change in the exchange rate should equal the percentage in the ratio of the price indices of the two countries. Spot exchange rate at time t = value of country A currency in terms of country B at the beginning of the period * (Inflation rate of country A/ Inflation rate of country B)^t Calculation of future exchange rate as per Relative PPP Here the Spot rate is $1 = Rs. 47 Inflation in India = 6% Inflation in US= 1% The value of $ will be 47*( 1.06/1.01)^1=49.32 Therefore, the currency with the higher inflation rate is expected to depreciate relative to the currency with the lower rate of inflation. Determination of Exchange rate as per Interest Rate Parity As per this IRP, interest rate difference between two countries is equal to the percentage difference between the forward exchange rate and the spot exchange rate. Forward exchange rate for settlement at period N= Current spot exchange rate*(1+domestic country interest rate)/( 1+foreign country interest rate) Here the Spot rate is $1 = Rs. 47 Interest rate in India = 8% Interest rate in US= .5% One year forward rate for $ will be 47*( 1.08/1.005)^1=50.51 Therefore, the country with a higher interest rate would have a lower forward exchange rate. Box 2: Introduction of currency futures in India Important dates of Currency Futures Market 1972:- First trading of Currency Futures in Chicago Mercantile Exchange. June 7, 2007:- First trading of Rupee Futures in Dubai gold and commodities exchange. Nov, 2007:- Internal working group of RBI submitted its recommendation for currency Futures trading in Exchanges.

April, 2008 :- Raghuram Rajan committee repot on Financial sector reforms have also suggested to start currency Futures trading. May 29, 2008:-Standing committee of RBI and SEBI submitted its report on currency Futures trading in Exchanges. August 06, 2008:- Circular Issued for currency Futures trading in stock exchanges. August 07, 2008:- Joint panel of RBI and SEBI have decided to introduce currency Futures trading in stock exchanges. August 14, 2008:- Application invited from traders for membership August 27, 2008:- Mock trading conducted under the guidance of FEDAI and NSE at 04.30-05.30 PM August 29, 2008:- Actual trading kicked off at NSE October 1,2008:- Trading kicked off at BSE October 7,2008:- Trading started started at MCX Box 3: Features of currency futures of NSE :Features of currency futures of NSE : Size of one contract will be $1000. Maximum maturity will be 12 months; hence 12 contracts will be open at all the time. Contract will expire on last business of every month and New month contract will open on the first business day of next month. Contract will be in Rupee- Dollar only and settlement will be in rupee only. Tick size is kept as 0.25 Paise.( A tick size is minimum increment by which trader can enter bid or ask price) Market timing will be 09.00-05.00PM Settlement price will be RBIs reference rate on the last trading day ( RBI offers rupee reference rate for four currency i.e. USD, Euro, Yen & sterling. Gross open position of a trader is limited to a maximum of $25 million or 15% of the total open interest. Gross open position of a bank which is acting as a trading cum clearing member is limited to a maximum of $100 million or 15% of the total open interest. No Security Transaction Tax (STT) will applicable on the trading from August 29 to September 30, 2008. However, members need to contribute Rs.500 lump sum (one time) for investors protection fund. Membership for the traders for currency futures in NSE i. Separate membership is required to be taken by the traders for trading in rupee futures as it is different from the membership of equity derivative market or cash market. ii. Trading member should have a net worth of Rs. 1 Crore (INR 10 million) and for trading cum clearing membership it is Rs. 10 Crore. Also the liquid net worth for trading cum clearing members should be Rs. 50 Lakhs ( INR 5 million ). iii. For margin requirement Cash, Bank guarantee, receipt of Fixed Deposit and stock of group 1 securities can be considered.

iv.

Requirements of the banks are different if they wanted to act as a trading cum clearing member. a. Total capital and reserve should be at least Rs. 500 crore. b. Capital Adequacy Ratio should at least be 10%. c. Non performing Assets should be 3% or less. d. Should have three years profit records.

Deposit requirement for the members of NSE Existing Members Fresh members Trading member Rs. 10 Lakh (INR 1 Rs. 15 Lakh (INR 1.5 Million) Million) Trading cum clearing Rs. 10 Lakh (INR 1 Rs. 20 Lakh (INR 2 member Million) Million) Source: Business standard (Mumbai edition) Dated 14 August 2008 (Sebi has also given approval to BSE and Multi Commodities Exchange for currency futures trading. Deposit requirement for the members in BSE is relatively low and also refundable) Who can Trade currency futures market ? Corporate i.e. Exporter or Importer for hedging their exposure. Banks Individual Investors ( Indian resident only, FII and NRIs are not permitted to trade in Currency futures ) Hedge fund Retail forex brokers Central banker Margin requirement:-Trader need to pay 5% of the total Contract amount. Suppose somebody purchases USD1000 futures at the rate of Rs. 42.44 , total contract amount is Rs. 42440 and hence margin requirement will be 5% of Rs. 42440 i.e. Rs.2122 Limitations of currency futures : Though mark to market is done everyday, final settlement can be done only at the last trading day of the month at the reference rate of RBI. Gross open position of a trader is limited to a maximum of USD25 million or 15% of the total open interest. This is not sufficient for large Exporter- Importer. If some body needs USD for one time only then also he or she will have to open the account with the broker and will have to pay brokerage fee and other charges. Market timing is only 9.00AM to 5.00PM. Whereas, the world wide market remains open around the clock. Therefore one may require foreign currency any time for making payments or for hedging purpose. Perfect hedge is not possible because of quantity and time standardization. Basis risk due to imperfect correlation of spot and future rate. Intermediate cash flow due to margin requirement and maintenance of margin.

Acknowledgements: www.nseindia.com www.bseindia.com www.businessmapsofindia.com/investment-industry/types-of-derivatives.html-17k/18k www.icai.org/resourse_file/10907p976-981.pdf www.managementparadise.com/forums/archive/index. www.rediff.com/money/2007/mar/15bspec.html www.papers.ssrn.com/sol3/Delivery.cfm http://www.geocities.com/kstability/content/derivatives/India.html www.livemint.com/2008/08/25143320/mcx-gets-sebi www.indianmba.com/faculty www.economictimes.com www.businessstandard.com www.tradingeconomics.com/Economics/Currency.aspx http://www.geocities.com/kstability/content/derivatives/India.html Derivative Markets Vol.I : ICFAI Press Book Business standard (Mumbai edition) Dated 14 August 2008

Abhay Kumar Faculty Finance INC, Nashik 9371533461