A STUDY ON THE

MECHANISM OF CURRENCY
DERIVATIVES- HEDGING AND
MACROECONOMIC
INDICATORS
Presented by: Debangan Das
INTRODUCTION

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 OVERVIEW OF THE
PROJECT
What to expect?

Currency derivatives
• Why Currency derivatives? What is hedging?
• Economic indicators that impacts them.
• Hedging strategies using options.

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WHAT ARE DERIVATIVES?

• In the Indian context the

Securities Contracts
(Regulation) Act, 1956
[SC(R)A] defines
• "derivative" to include,
• A contract which derives its
value from the prices, or
index of prices, of
underlying securities.

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BASICS OF THE TOPIC
FX Derivative and the most popular traded pair

Foreign currency derivative Share of different currency pairs

• A foreign currency derivative is a financial

derivative whose pay-off depends on the
foreign exchange rates of two (or more)
currencies.
• commonly used for hedging foreign exchange
risk or for currency speculation and arbitrage
• their value is derived from an underlying
asset, a foreign currency

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MAJOR CURRENCY PAIRS

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PLACES TO TRADE

• In India, forex trading is primarily an OTC

Market, wherein trades are conducted between
two known counterparties. There are two distinct
segments of OTC foreign exchange market.
One segment is called as “interbank” market
and the other is called as “merchant” market.
• Trading also happens in stock exchanges and the
volume of trade is gradually shifting from OTC to
exchanges.

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FUTURES AND Hedging strategies and
macro-economic

OPTIONS indicators.

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PLAYERS IN THE CURRENCY DERIVATIVE
SEGMENT (USING FUTURES AND OPTIONS)
• Hedgers: These types of participants have a real exposure to foreign currency risk on
account of their underlying business and their objective is to remove the FX risk using
currency futures. The exposure could be because of imports/ exports of goods/services,
foreign investments or foreign expenditure on account of travel, studies or any other type
of need resulting in FX exposure.

• Speculators: This set of market participants does not have a real exposure to foreign
currency risk. These participants assume FX risk by taking a view on the market direction
and hope to make returns by taking the price risk.

• Arbitrageurs: This set of market participants identify mispricing in the market and use it
for making profit. They have neither exposure to risk and nor do they take the risk.
Arbitrageurs lock in a profit by simultaneously entering opposite side transactions in two or
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EXAMPLE OF ACTIVE ARBITRAGE

• Example – Let’s say the spot rate for USDINR is quoted @ Rs. 67.80 and one month
forward is quoted at 30 paisa premium to spot @ 68.10 while at the same time one month
currency futures is trading @ Rs. 68.25. Assume that both the futures contract and the
forward contract expires on the same day. An active arbitrager realizes that there is an
arbitrage opportunity as the one month futures price is more than the one month forward
price. He implements the arbitrage trade where he;

• Sells in futures @ 68. 25 levels (1 month)

• Buys in forward @ 68.10 (1 month) with the same term period
• On the date of expiry, he/she takes delivery in his/her forwards position and delivers the
• same on exchange platform (for his/her futures position).
• In the process, he/she makes a Net Gain of 68.25 – 68.10 = Rs 0.15 or 15 paise per USD
i.e. approx 15 paise arbitrage. This results into a profit per contract of Rupees 150 (= Rs
0.15 x 1000 units per USDINR lot).
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USING CURRENCY FUTURES FOR HEDGING
VARIOUS KINDS OF FX EXPOSURES

Some of the common purposes/ transactions, in addition to import/export,

which could use currency futures for the purpose of hedging, are as
follows:

• Payment in foreign currency for travel abroad, for education, for medical
treatment,
• payment for employees based abroad, etc.
• Payment of loan availed in foreign currency
• Investment in assets outside India or repatriation of capital invested
outside India
• Payment of loan installments in INR by a person earning in foreign
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OPTIONS

• As the word suggests, option means a choice or an alternative.

• It is a contract between two parties to buy or sell a given amount of asset
at a
• pre‐ specified price on or before a given date.
• The right to buy the asset is called call option and the right to sell the
asset is called put option.
• The price which option buyer pays to option seller to acquire the right is
called as option price or option premium.
• The asset which is bought or sold is also called as an underlying or
underlying asset.

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GLOBAL INDICATORS THAT DETERMINES THE
CURRENCY STRENGTH OF AN ECONOMY
• There are two types of indicators we need to be aware of:
• Leading indicators often change prior to large economic adjustments
and, as such, can be used to predict future trends.
• Lagging indicators, however, reflect the economy’s historical
performance and changes to these
are only identifiable after an economic trend or pattern has already been
established.

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LEADING INDICATORS
Potential to forecast the direction where the economy is headed fiscal
policymakers and governments make use of them to implement or alter programs in order to
ward off a recession or other negative economic events

• 1. Stock Market

• a strong market may suggest that earnings estimates

are up and therefore that the overall economy is
preparing to thrive. Conversely, a down market may
indicate that company earnings are expected to
decrease and that the economy is headed toward a
recession.
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 STOCK
MARKET IN
INDIA
(SNAPSHOT)

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 NSE
SNAPSHOT

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2. MANUFACTURING ACTIVITY
Indian context

• This influences the GDP (gross domestic product) strongly; an increase

in which suggests more demand for consumer goods and, in turn, a
healthy economy. Moreover, since workers are required to manufacture
new goods, increases in manufacturing activity also boost employment
and possibly wages as well.

• The Nikkei India Manufacturing PMI increased unexpectedly to 54.3 in

February 2019 from 53.9 in a month earlier and beating market
expectations of 53.5. The latest reading pointed to the strongest pace of
expansion in the manufacturing sector since December 2017.

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NIKKEI PMI

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3. INVENTORY LEVELS
Understanding

• High inventory levels can reflect two very different things: either that
demand for inventory is expected to increase or that there is a current
lack of demand.
• In the first scenario, businesses purposely bulk up inventory to prepare
for increased consumption in the coming months. If consumer activity
increases as expected, businesses with high inventory can meet the
demand and thereby increase their profit. Both are good things for the
economy.
• In the second scenario, however, high inventories reflect that company
supplies exceed demand. Not only does this cost companies money, but
it indicates that retail sales and consumer confidence are both down,
which further suggests that tough times are ahead.

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INVENTORY LEVELS
Indian context
• The stocks of goods held by firms in India increased by 380.27 INR Billion in the fourth quarter
of 2018. Changes in Inventories in India averaged 395.54 INR Billion from 2004 until 2018,
reaching an all-time high of 731.25 INR Billion in the first quarter of 2015 and a record low of
184.29 INR Billion in the second quarter of 2004.

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4. RETAIL SALES
Understanding in the Indian context

• Retail sales are particularly important metrics and function hand in hand
with inventory levels and manufacturing activity.
• strong retail sales directly increase GDP, which also strengthens the
home currency. When sales improve, companies can hire more
employees to sell and manufacture more product, which in turn puts
more money back in the pockets of consumers.
• One downside to this metric, though, is that it doesn’t account for how
people pay for their purchases. For example, if consumers go into debt to
acquire goods, it could signal an impending recession if the debt
becomes too steep to pay off. However, in general, an increase in retail
sales indicates an improving economy.

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RETAIL SALES

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5. BUILDING PERMITS
Understanding in Indian context

• Building permits offer foresight into future real estate supply levels. A
high volume indicates the construction industry will be active, which
forecasts more jobs and, again, an increase in GDP.

• But just like with inventory levels, if more houses are built than
consumers are willing to buy, it takes away from the builder’s bottom
line. To compensate, housing prices are likely to decline, which, in turn,
devalues the entire real estate market and not just “new” homes.

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HOUSING MARKET
A decline in housing prices can suggest that supply exceeds demand, that existing prices are
unaffordable, and/or that housing prices are inflated and need to correct as a result of a housing
bubble. In any scenario, declines in housing have a negative impact on the economy for several key
reasons:
• They decrease homeowner wealth.
• They reduce the number of construction jobs needed to build new homes, which thereby
• increases unemployment.
• They reduce property taxes, which limits government resources.
• Homeowners are less able to refinance or sell their homes, which may force them into
foreclosure.
• When you look at housing data, look at two things: changes in housing values and changes in
sales.
• When sales decline, it generally indicates that values will also drop. For example, the collapse of
• the housing bubble in 2007 had dire effects.

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HOUSING IMPACT
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 • Unlike leading indicators, lagging
indicators shift after the economy changes.
LAGGING Although they do not typically tell us
where the economy is headed, they
INDICATORS indicate how the economy changes over
time and can help identify long-term
trends.

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1. CHANGES IN THE GROSS DOMESTIC
PRODUCT (GDP)
GDP is typically considered by economists to be the most important measure of
the economy’s current health.

When GDP increases, it’s a sign the economy is strong

In fact, businesses will adjust their expenditures on inventory, payroll, and other
investments based on GDP output.

The rule of thumb is that when the GDP drops for more than two quarters, a
recession is at hand.
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GDP
Indian context

The Indian economy advanced 6.6 percent year-on-year in the last three
months of 2018, below a downwardly revised 7 percent expansion in the
previous period and market expectations of 6.9 percent.

It is the lowest growth rate in five quarters as weak consumer demand and
government spending held back expansion. GDP Annual Growth Rate in
India averaged 6.21 percent from 1951 until 2018, reaching an all-time
high of 11.40 percent in the first quarter of 2010 and a record low of -5.20
percent in the fourth quarter of 1979.

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GDP
Indian context

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 • If the economy is operating efficiently, earnings
should increase regularly to keep up with the average
cost of living.
• When incomes decline, however, it is a sign that
employers are either cutting pay rates, laying workers
off, or reducing their hours. Declining incomes can
2. INCOME also reflect an environment where investments are not
performing as well.
AND WAGES • Indian Context: Wages in India increased to 272.19
INR/Day in 2014 from 255.65 INR/Day in 2013.
• Wages in India averaged 146.00 INR/Day from 1965
until 2014, reaching an all time high of 272.19
INR/Day in 2014 and a record low of 3.87 INR/Day in
1965.

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INCOME AND WAGES
Indian context

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GROSS
NATIONAL
INCOME
• Gross National Product in
India increased to 13954956 INR
Tens Of Million in 2018 from
12865461 INR Tens Of Million
in 2017.
• Gross National Product in
India averaged 10996192.88 INR
Tens Of Million from 2011 until
2018, reaching an all time high of
13954956 INR Tens Of Million
in 2018 and a record low of
8659505 INR Tens Of Million in
2011.

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GDP PER CAPITA
Indian context

The Gross Domestic Product per capita in India was last recorded at
1963.55 US dollars in 2017.

The GDP per Capita in India is equivalent to 16 percent of the world's

average. GDP per capita in India averaged 693.96 USD from 1960 until
2017, reaching an all-time high of 1963.55 USD in 2017 and a record low
of 304.20 USD in 1960.

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3. UNEMPLOYMENT RATE
Indian context

The unemployment rate is very important and measures the number of people looking for
work as a percentage of the total labor force. In a healthy economy, the unemployment rate
will be anywhere from 3% to 5%.

When unemployment rates are high, however, consumers have less money to spend, which
negatively affects retail stores, GDP, housing markets, and stocks, to name a few. Government
debt can also increase via stimulus spending and assistance programs, such as unemployment
benefits and food stamps.

Unemployment Rate in India increased to 6.10 percent in 2018 from 3.52 percent in 2017.
Unemployment Rate in India averaged 4.12 percent from 1983 until 2018, reaching an all
time high of 8.30 percent in 1983 and a record low of 3.41 percent in 2014.

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4. CONSUMER PRICE INDEX (INFLATION)

The consumer price index (CPI) reflects the increased cost of living, or
inflation. The CPI is calculated by measuring the costs of essential goods and
services, including vehicles, medical care, professional services, shelter,
clothing, transportation, and electronics. Inflation is then determined by the
average increased cost of the total basket of goods over a period.

Deflation is a condition in which the cost of living decreases. Although this

sounds like a good thing, it is an indicator that the economy is in very poor
shape. Deflation occurs when consumers decide to cut back on spending and
is often caused by a reduction in the supply of money. This forces retailers to
lower their prices to meet a lower demand.

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CPI
Indian context

Consumer Price Index CPI in India decreased to 139.60 Index Points in

February from 139.90 Index Points in January of 2019.

Consumer Price Index CPI in India averaged 118.21 Index Points from
2011 until 2019, reaching an all time high of 140.80 Index Points in
November of 2018 and a record low of 86.81 Index Points in February of
2011.

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5. CURRENCY STRENGTH
Indian context

A strong currency increases a country’s purchasing and selling power with other nations. The
country with the stronger currency can sell its products overseas at higher foreign prices and import
products more cheaply.

However, there are advantages to having a weak INR as well. When the INR is weak, India can
draw in more tourists and encourage other countries to buy Indian goods. In fact, as the INR drops,
the demand for Indian products increases.

Indian context: The USDINR decreased 0.2230 or 0.32% to 69.1370 on Friday March 15 from
69.3600 in the previous trading session. Historically, the Indian Rupee reached an all time high of
74.33 in October of 2018 and a record low of 7.19 in March of 1973.

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CURRENCY STRENGTH

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INTEREST RATES

Interest rates are another important lagging indicator of economic growth. They represent the
cost of borrowing money and are based around the repo rate, which represents the rate at which
money is lent from one bank to another.

Indian context: The Reserve Bank of India lowered unexpectedly its benchmark interest rate by
25bps to 6.25 percent on February 7th and shifted its stance to "neutral", in an attempt to boost a
slowing economy as inflation rate remains well below its mid-point 4 percent target. Interest Rate
in India averaged 6.65 percent from 2000 until 2019, reaching an all time high of 14.50 percent in
August of 2000 and a record low of 4.25 percent in April of 2009.

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8. BALANCE OF TRADE
Indian context

Trade surpluses are generally desirable, but if the trade surplus is too high,
a country may not be taking full advantage of the opportunity to purchase
other countries’ products. That is, in a global economy, nations specialize
in manufacturing specific products while taking advantage of the goods
other nations produce at a cheaper, more efficient rate.
Trade deficits, however, can lead to significant domestic debt.

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8. BALANCE OF TRADE
Indian context

Indian context: India trade deficit fell to USD 14.73 billion in January of 2019 from a downwardly
revised USD 15.67 billion a year earlier. Exports rose 3.74 percent to USD 26.36 billion, mainly
driven by sales of chemicals (15.56 percent); drugs and pharmaceuticals (15.2 percent); readymade
garments (9.33 percent); gems and jewellery (6.67 percent) and engineering goods (1.07
percent). Imports were flat at USD 41.09 billion after falling 2.44 percent in December, the biggest
drop since August of 2016. Purchases fell for metaliferrous ores (-48.87 percent); pearls, precious
and semi-precious stones (-36.51 percent); transport equipment (-21.43 percent); vegetable oil (-
19.89 percent); and oil (-3.59 percent) but jumped 38.16 percent for gold. From April to January,
the country's trade gap increased to USD 155.93 billion from USD 136.25 billion a year earlier.
Balance of Trade in India averaged -2544.12 USD Million from 1957 until 2019, reaching an all time
high of 258.90 USD Million in March of 1977 and a record low of -20210.90 USD Million in October
of 2012.

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9. VALUE OF COMMODITY SUBSTITUTES TO INR

• Gold and silver are often viewed as substitutes to the INR. When the economy suffers
or the value of the INR declines, these commodities increase in price because more
people buy them as a measure of protection.
• However, the prices of Gold and silver are largely dependent on the Global prices.

Global context real time: Gold increased 7.72 USD/t oz. or 0.60% to 1,301.30 on Friday
March 15 from 1,296.03 in the previous trading session. Historically, Gold reached an all
time high of 1898.25 in September of 2011 and a record low of 34.83 in January of 1970.

Silver increased 0.19 USD/t. oz or 1.23% to 15.35 on Friday March 15 from 15.18 in the
previous trading session. Historically, Silver reached an all time high of 49.45 in January
of 1980 and a record low of 3.55 in February of 1991.

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REFERENCES

• NISM Currency derivatives workbook.

• https://link.springer.com/chapter/10.1057/9781137318886_5
• https://www.investopedia.com/terms/i/inthemoney.asp
• https://www.thebalance.com/call-and-put-options-definitions-and-examples-1031124
• https://tradingeconomics.com/
• http://www.economywatch.com/economic-statistics/country/India/year-2018/
• https://www.motilaloswal.com/markets/currencies-overview.aspx
• www.nseindia.com

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THANK YOU
Debangan Das 9674340267

Debangan.das@emkayglobal.com

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