Currency Futures Niv

8/8/2019 Currency Futures Niv

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CURRENCY FUTURES

Acontract to make or take delivery of a standard quantity of a specific foreign currency at a specified future

date and at a price agreed on an Exchange.

Currency futures in India

Currency futures trading were started in Mumbai August 29, 2008. With over 300 trading members including 11

banks registered in this segment, the first day saw a very lively counter, with nearly 70,000 contracts being traded.

The first trade on the NSE was by East India Securities Ltd.

Amongst the banks, HDFC Bank carried out the first trade. The largest trade was by Standard Chartered Bank constituting 15,000 contracts. Banks contributed 40 percent of

the total gross volume.

Traded in BSE, NSE and MCX exchange

Currency Futures

Standardized foreign exchange derivative contract

Traded on a recognized exchange

Underlying is the exchange ratesTraded in limited number of currencies



Price and date of delivery-predetermined

A currency future, also FX future or foreign exchange future, is a futures contract to exchange one currency for

another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date;. Typically, one

of the currencies is the US dollar. The price of a future is then in terms of US dollars per unit of other currency. This

can be different from the standard way of quoting in the spot foreign exchange markets. The trade unit of each

contract is then a certain amount of other currency, for instance ½125,000. Most contracts have physical delivery, so

for those held at the end of the last trading day, actual payments are made in each currency. However, most

contracts are closed out before that. Investors can close out the contract at any time prior to the contract's delivery

date.

History

Currency futures were first created at the Chicago Mercantile Exchange (CME) in 1972, less than one year after the

system of fixed exchange rates was abandoned along with the gold standard. Some commodity traders at the CMEdid not have access to the inter-bank exchange markets in the early 1970s, when they believed that significant

changes were about to take place in the currency market. They established the International Monetary Market

(IMM) and launched trading in seven currency futures on May 16, 1972. Today, the IMM is a division of CME. In

the fourth quarter of 2009, CME Group FX volume averaged 754,000 contracts per day, reflecting average daily notional value of approximately $100 billion. Currently most of these are traded electronically [1]



Example

Contract Best Bid Best Offer Spread LTP

USD/INR 240/210

Feb end

2010

48.6525 48.6550 0.0025 48.6550

If A has to sell 100 contracts of USDINR expiring on 24/02/09, he will sell at the Best Bid rate48.6525.

If A has to buy 100 contracts of USDINR expiring on 24/02/09, he will buy at the Best Offer rate 48.6550.

Eg:Category Description=Underlying Rate of exchange between 1 USD and INR

Contract Size =USD 1000

Contract months =12 near calendar months

Expiry =12:00 noon of Last Trading day of the monthMin Price Fluctuations =0.25 psor INR 0.0025



1 Contract = USD 1000

USDINR = 48.5925

Contract Value = 1000*48.5925 = 48592.50 INR

If there is 1 tick movement then gain/loss:

Tick Value = 1,000 x 0.0025 = INR 2.50/contract

Margin requirementInitial, Calendar, Extreme Loss, Marked to Market

FEATURES

y Settlement =Cash settled in INR. No physical delivery of the underlying currency

y

Settlement Price =RBI Reference Rate of Last Trading Day.y Last Trading Day =Two Business days before the Final Settlement day of the contract

y Final Settlement Day =Last Business day of the month for interbankForex settlement (as per FEDAI

guidelines).

y Position Limits =Client Level: The gross open positions of the client across all contracts should not

exceed 6% of the total open interest or 10 million USD, whichever is higher.

y Trading Member level: The gross open positions of the trading member across all contracts should not

exceed 15% of the total open interest or 50* million USD whichever is higher. (*In case of a Bank it is

USD100 million)



y

Only USD-INR contracts are allowed to be traded.y Standardized contract size - $1000.

y The contracts quoted and settled in Indian Rupees.

y The maturity of the contracts shall not exceed 12 months.

y Settled on specified future date called as settlement date.

y Only resident Indians are allowed to trade in currency futures.

y Future price= Spot Price + Cost of Carry

HEDGING

Hedge means, ´To minimize loss or riskµ. It means taking a position in the futures market that is opposite to a

position in the physical market with a view to reduce or limit risk associated with unpredictable changes in the

exchange rate.

Hence, it entails two positions:²Underlying Position²Hedging Position i.e. position opposite from the underlying

position.



HOW TO HEDGE?

Example:

The Importer enters into a contract on 1st June to make a payment for USD on 25thNovember, 09. He is of the

view that Rupee will depreciate.

The importer will buy November CF Contract: 1 USD = Rs. 4025thNovember OTC market ongoing rate = Rs.

42The importer will book actual import at Rs. 42.

The importer will wind up the futures contract at Rs. 42. Thereby generating a profit of Rs. 2.

Effective rate of import = Rs. 42 ²Rs. 2 (profit on CF) = Rs. 40(This is very simplified example, just to introduce

the concept.)

Imperfections in hedging with Currency Futures

Maturity mismatch ²Mismatch in maturity date of futures contract and date of cash transaction

Size mismatch ²Mismatch between size of futures contract and size of cash transaction

Hedging with currency futures may not result inperfect hedge

Final delivery of the foreign currency will take place only through the banking system

Uses



Hedging

Investors use these futures contracts to hedge against foreign exchange risk. If an investor will receive a cashflow

denominated in a foreign currency on some future date, that investor can lock in the current exchange rate by

entering into an offsetting currency futures position that expires on the date of the cashflow.

For example, Jane is a US-based investor who will receive ½1,000,000 on December 1. The current exchange rate

implied by the futures is $1.2/½. She can lock in this exchange rate by selling ½1,000,000 worth of futures contracts

expiring on December 1. That way, she is guaranteed an exchange rate of $1.2/½ regardless of exchange rate

fluctuations in the meantime.

Speculation

Currency futures can also be used to speculate and, by incurring a risk, attempt to profit from rising or falling

exchange rates.

For example, Peter buys 10 September CME Euro FX Futures, at $1.2713/½. At the end of the day, the futures

close at $1.2784/½. The change in price is $0.0071/½. As each contract is over ½125,000, and he has 10 contracts,

his profit is $8,875. As with any future, this is paid to him immediately.

Eligibility for trade in Currency Futures

Only 'persons resident in India' may trade in Currency Futures to hedge an exposure to foreign exchange rate risk

or otherwise. Any resident Indian or company including banks and financial institutions can participate in the



Currency Futures market. At present Foreign Institutional Investors and Non-Resident Indians are not permitted to

participate in the Currency Futures market.

Benefits of trading in Currency Futures

y

Currency Futures trading is in a fully regulated and transparent market place.y It does not require one to have an underlying exposure in foreign currency.

y If the Client has an underlying exposure in the foreign currency, Currency Futures can be used effectively to

hedge the same. It allows hedge for near 12 calendar months.

y Currency Futures provide investors with access to a new asset class for their portfolio, i.e., Forex.

y Margin trading in Currency Futures allows leverage of funds as it involves buying Currency Futures without

having to pay for the entire value of the contract.

y Daily settlement of Marked to Market pay-in and pay-out encourages disciplined trading.

y Smaller and more affordable contract lot size enables a large number of players to enter the market.

y All the trades are done on the recognized stock exchanges guaranteed by the clearing corporations and hence

the risks associated with counter party default are eliminated



y .Electronic Trading platform is made available for Currency Futures Trading. Without access to a computer,

one can also do trades by calling Axis Bank Dealing Room and placing orders with the dealers who will inturn

place orders on the Exchange trading platform on the Client's behalf.

y Currency Futures are cash settled and offer convenience to trade.

y

Hedging Currency Risks Hedging currency risk is the act of reducing or negating the risks that arise out of changes in the prices of one

currency against another. In simpler words, if you had a certain amount payable in dollars in two months time

and had planned accordingly for it, only to find out that the dollar has appreciated with respect to your home

currency, you'd be shelling out much more when the payable actually became due. The strategies that help incountering this risk of unexpected increase in payables in decrease in receivables come under the 'hedging

currency risks' purview. Know more on foreign exchange hedging.

V arious Options for Hedging Currency Risks There are many ways to hedge foreign currency risks. You can use any of the below mentioned foreign

currency hedging methods to hedge foreign exchange risks and also for other risks, like for hedging interest

rate risks.

I nternal Hedging Strategies



Internal tactics like leading and lagging can ensure that you utilize the exchange rate movements to ensure

that you always pay less and earn more. That is, when you can lead payments (pay them in advance) when you

expect the home currency to depreciate with respect to the foreign currency. Similarly netting the payments

and receipts that are in the same foreign currency will also help reduce the exposure.

Forward Transacti ons

Hedging currency risks with forward transaction is a relatively easy to implement hedging strategy. In this, the

currency payment or receipt is locked in at a particular exchange rate for a pre-specified rate in the future,

irrespective of what the actual market exchange rate at that time is. The idea behind forward contracts is that

as the exchange rate is locked on both sides, both, the creditor and the lender do not have to worry about

fluctuations in the income and expenditure respectively.

Currency F utures

Currency futures are the same as forward contracts and are just for locking in an exchange rate for a pre-set

date of the transaction in the future. The advantage that currency futures have over currency forwards is that

as these are exchange traded, counter-party risk is eliminated. It also helps that currency futures are more

transparent in their pricing and are more easily available to all market participants. Know more on futures

trading.



Currency Swaps

These exchange rate transactions are real time transactions where one thing is just exchanged for another.

These swaps can also be used for hedging interest rate risks where two parties can exchange their fixed and

floating interest rate obligations with each other.

Currency Opti ons

Currency options are financial instruments that give the owner the right but not the obligation to buy or sell a

specific foreign currency at a predetermined exchange rate. While a call option gives the holder the right to

buy the currency at an agreed price, a put option gives him the right to sell it at an agreed price, irrespective of

an unfavorable market price for the same. Know more on options trading.

These were some of the traditional methods for hedging currency risks. Here are some of the newer strategies

to achieve the same, that some companies like the UBS have brought forward for their customers. Know

more on currency hedging for importers.

Cancellable Forward

Some companies allow for cancellable forwards which are instruments that allow a regular currency cash flow

to be hedged on a monthly rolling basis. The instrument requires no payment of premiums and gives better

rates than those in the forward markets, but on the downside, the cash flows are not guaranteed and are



always less favorable than the spot rates.

R ange R eset Forward

This is an instrument based on market expectations and is perfect for you if you think that the exchange rates

between two currencies is going to be within a certain band or range. As long as the exchange rates remain in

your predetermined range, you can effectively hedge currency risk by getting a favorable forward rate. This is

a perfect plan to help protect against a worst case scenario and also does not require premiums. The flip side

is that, if the prices fall below or shoot above your expected range, you may have to shell out a price that is

actually more unfavorable that even the worst case scenario.

R isk R eversal

This hedging currency strategy provides protection against losses in the complete sense of the word.

Unfortunately, this strategy limits participation in a favorable market with a cap and sometimes has rates that

are worse than the actual forward rates being quoted in the market. Once again, the benefits are that you do

not have to pay premiums, you are completely protected against the worst possible scenario and you have the

option to restructure your risk reversal at anytime.

Kick I nt o Forward

Last but not the least, this hedging currency strategy, gives hedging protection for downside risk and



conditional participation for upside price movements. While you benefit up to the kick-in level with no initial

premiums, full hedging cover and restructuring facility, you are in for a worse off rate if the kick-in level is

actually reached.

While much more can be written on the subject of foreign currency hedging, I think I shall stop this 'hedging

currency risk' article here. Hedging is a very important step in financial planning and if done well, serves well

in the long run financial management.

Long Hedge

y The long hedge is a hedging strategy used by manufacturers and producers to lock in the price of a product or

commodity to be purchased some time in the future. Hence, the long hedge is also known as input hedge.

y The long hedge involves taking up a long futures position. Should the underlying commodity price rise, the

gain in the value of the long futures position will be able to offset the increase in purchasing costs.

y Long Hedge Example

y In May, a flour manufacturer has just inked a contract to supply flour to a supermarket in September. Let's

assume that the total amount of wheat needed to produce the flour is 50000 bushels. Based on the agreed

selling price for the flour, the flour maker calculated that he must purchase wheat at $7.00/bu or less in order

to breakeven.



y At that time, wheat is going for $6.60 per bushel at the local elevator while September Wheat futures are

trading at $6.70 per bushel, and the flour maker wishes to lock in this purchase price. To do this, he enters a

long hedge by buying some September Wheat futures.

y With each Wheat futures contract covering 5000 bushels, he will need to buy 10 futures contracts to hedge his

projected 50000 bushels requirement.

y In August, the manufacturing process begins and the flour maker need to purchase his wheat supply from the

local elevator. However, the price of wheat have since gone up and at the local elevator, the price has risen to

$7.20 per bushel. Correspondingly, prices of September Wheat futures have also risen and are now trading at

$7.27 per bushel.

Loss in Cash Market...

y Since his breakeven cost is $7.00/bu but he has to purchase wheat at $7.20/bu, he will lose $0.20/bu. At

50000 bushels, he will lose $10000 in the cash market.

y So for all his efforts, the flour maker might have ended up with a loss of $10000.

... Is Offset by Gain in Futures Market.

y Fortunately, he had hedge his input with a long position in September Wheat futures which have since gained

in value.

y Value of September Wheat futures purchased in May = $6.70 x 5000 bushels x 10 contracts = $335000



y Value of September Wheat futures sold in August = $7.27 x 5000 bushels x 10 contracts = $363500

y Net Gain in Futures Market = $363500 - $335000 = $28500

y Overall profit = Gain in Futures Market - Loss in Cash Market = $28500 - $10000 = $18500

y Hence, with the long hedge in place, the flour maker can still manage to make a profit of $18500 despite

rising Wheat prices.

y Basis Risk

y The long hedge is not perfect. In the above example, while cash prices have risen by $0.60/bu, futures prices

have only gone up by $0.57/bu and so the long futures position have only managed to offset 95% of the rise

in price. This is due to the strengthening of the basis.

Cash September Futures Basis

May $6.60 $6.70 -$0.10

August $7.20 $7.27 -$0.07

Net -$0.60/bu +$0.57/bu +$0.03 (Stengthened by $0.03)

y The basis tracks the relationship between the cash market and the futures market. Hedgers should pay

attention to the basis when deciding when to enter the hedge as they are said to have taken up a position in

the basis once a hedge is in place. See basis.



y Long Hedge Example with Futures

y Joe Parcell and V ern Pierce, Department of Agricultural Economics

y This guide details the placing of an input (long) hedge in the futures market for use in reducing the price risk

associated with buying an input used in your business. For example, a swine producer knows he/she will be

buying a pen of feeder-pigs two months from now. To feed the pen of weaner pigs, the producer will need

5,000 bushels of corn (one full contract at the Chicago Board of Trade) during the next four months to use in

the production of feed. Corn is an input into the production of swine. Currently, the local cash corn price is at

$2.35/bushel, and the producer believes that the corn price may rise during the next few months exposing

him to the risk of higher prices. The producer calculates his cost of production and knows that the

$2.35/bushel will allow for profit potential. What can the producer do? The producer can purchase the grain

now; however, he/she will have to pay storage on the grain for the next few months, increasing the price

above $2.40/bushel. Alternatively, the producer could enter the futures market and offset any potential loss in

value (increase in price) with a gain in the futures market.

H ow d o I Place a Hedge?

y Placing a hedge can be a simple process. First, knowing your cost of production helps you know when to

place a hedge. To place a hedge, you need to contact a broker with whom you place your order. Most large



communities have a broker who will take your order for a set fee (as is common when placing any

futures/options market order). The broker can be helpful in informing you on how to appropriately place and

exit your hedging position. The broker has a stake, i.e., commission, in making sure your experience with

hedging is a good one. After you have placed the order with the broker, the broker will contact a brokerage

house at the commodity exchange and relay the order. On the trading floor of the trading commission, open

out-cry is used in matching market supply and demand forces. If you want to place a long hedge, there will

likely be either someone wanting to place a short hedge or a speculator willing to offset your risk. The

speculator is using a process known as arbitrage.

Wh at Can Happen W it h t h e L ong F utures Hedge?

y Any of seven scenarios can arise between the cash and futures price. The only scenario not discussed below is

that of the cash and futures prices not changing while the hedge is placed. In this scenario, the producer

purchases the input for the same price as when the hedge was placed. The costs of hedging would then simply

be commissions. The other scenarios are discussed below. Because the cash and futures markets typically

trend in the same direction over time the scenario of the cash and futures moving in opposite directions is not

discussed. One final note, even though a loss may be shown from taking a futures position, the final price

must be compared to purchasing the grain in advance, and paying storage costs.

A. Cash and Futures Price both Increases



y 1. Cash Price Increases Faster than the Futures Price (Basis Strengthens)

y Table 1 is used to describe the actions you might take as a hedger and the outcomes of those actions in

placing an input hedge in which the cash price increases by more than the futures price during the hedging

period. In this scenario basis is said to strengthen. Following from table 1, suppose today you could purchase

corn for $2.35/bushel and the relevant futures contract is trading for $2.50/bushel (basis is $0.15 under).

Knowing that you will need the corn at a later date and you want to protect against a price increase, you take a

long position in the futures market at this time. Over the next few months the local cash price increases to

$2.60/bushel and the futures price increases to $2.65/bushel. At this time you decide you need to purchase

corn for the production of feed. You purchase the corn in the cash market for $2.60/bushel and sell back

your futures position for $2.65/bushel. Therefore, the cost of the grain to you is $2.60/bushel less

$0.15/bushel gained from the futures position plus any commission costs (a typical commission might be $25

for entry into the futures and $25 for exit, $50/round-turn or @ $0.01/bushel). Instead of paying

$2.60/bushel, you pay $2.46/bushel. The net price you receive is exactly equal to the original cash price plus

the basis gain or loss plus commission.

2. Futures Price Increases Faster than the Cash Price (Basis Weakens)


placing an input hedge in which the futures price increases by more than the cash price during the hedging

period. In this scenario basis is said to weaken. Following from table 2, suppose today you could purchase





period. In this scenario basis is said to weaken. Following from table 3, suppose today you could purchase



long position in the futures market at this time. Over the next few months the local cash price decreases to

$2.20/bushel and the futures contract price decreases to $2.40/bushel. At this time you decide you need to

purchase corn for the production of feed. You purchase the corn in the cash market for $2.20/bushel and sell

back your futures position for $2.40/bushel. Therefore, the cost of the grain to you is $2.20/bushel plus

$0.10/bushel lost from the futures position plus commission costs ($0.01/bushel). Instead of paying

$2.20/bushel you pay $2.31/bushel.

2. Futures Price Decreases Faster than the Cash Price (Basis Strengthens)


placing an input hedge in which the futures price decreases by more than the cash price during the hedging

period. In this scenario basis is said to strengthen. Following from table 4, suppose today you could purchase



long position in the futures market at this time. Over next few months the local cash price decreases to

$2.20/bushel and the futures contract price decreases to $2.25/bushel. At this time you decide you need to

purchase corn for the production of feed. You purchase the corn in the cash market for $2.20/bushel and sell



back your futures position for $2.25/bushel. Therefore, the cost of the grain to you is $2.20/bushel plus

$0.25/bushel lost from the futures position plus any commission costs (assume $0.01/bushel). Instead of

paying $2.20/bushel you pay $2.46/bushel because basis strengthened.

y 3. Futures Price Decreases at the same rate as the Cash Price

y Under this scenario the price you pay is exactly equal to the price you would have paid earlier with the

exception of commissions ($0.01/bushel). The next price you receive is equal to the original cash price plus

the commission since there was no change in the basis.

Table 1. Long Hedge Example using Futures with Cash Price Increase (basis strengths)

Corn Example - Cash Price Increases faster than Futures Price Cash Futures Basis

Today: $2.35/bu.Buy corn contract at

$2.50/bu.

-

$0.15/bu.(under)

Later: buy corn in local

market at $2.60/bu.

Sell corn contract back at

$2.65/bu.

-

$0.05/bu.(under)

ResultsCash paid price $2.60/bu.

Plus Commission $0.01/bu$0.10 basis loss



Less futures gain $0.15/bu.

----------------------------

Net buying price $2.46/bu.

Table 2. Long Hedge Example using Futures with Cash Price Increase (basis weakens)

Corn Example - Futures Price Increases faster than Cash Price

Cash Futures Basis


$2.50/bu.

-

$0.15/bu.(under)


market at $2.45/bu.


$2.65/bu.

-

$0.20/bu.(under)

Results

Cash paid price $2.45/bu.

Plus Commission $0.01/buLess futures gain $0.15/bu.

---------------------------


-$0.05 basis gain



Table 3. Long Hedge Example using Futures with Cash Price Decreases (basis weakens)

Corn Example - Cash Price Decreases faster than Futures

Cash Futures Basis


$2.50/bu

-$0.15/bu.

(under)


market at $2.20/bu.


$2.40/bu.

-

$0.20/bu.(under)

Results


Plus Commission $0.01/bu

Plus futures loss $0.10/bu.

-----------------------------


-$0.05 basis gain

Table 4. Long Hedge Example using Futures with Cash Price Decrease (basis strengths)

Corn Example - Futures Price Decreases faster than Cash Price

Cash Futures Basis




$2.50/bu

-$0.15/bu.

(under)


market at $2.20/bu.


$2.25/bu.

-

$0.05/bu.(under)

Results


Plus Commission $0.01/bu

Plus futures loss $0.25/bu.

-----------------------------


$0.10 basis loss

y Short Hedge Example with Futures

y Joe Parcell and V ern Pierce, Department of Agricultural Economics

y This guide details the placing of an output (short) hedge in the futures market for use in reducing the price

risk associated with selling an output used in your business. For example, a cattle producer knows he/she will

be selling a pen of cattle two months from now. The producer knows that by selling live cattle for over

$62/cwt. he/she can insure a satisfactory profit. Currently, the local live cattle price is $64/cwt., and the

producer believes that the fed price may drop during the next few months. By knowing the cost of

production of these animals, the producer knows that the $64/cwt. will allow for a satisfactory profit. What



can the producer do? The producer cannot sell the cattle now because the cattle are too light; however, the

producer could enter the futures market and off-set any loss in value (decrease in price) with a gain in the

futures market.

H ow d o I Place a Hedge?

y Placing a hedge can be a simple process. First, knowing your cost of production helps you know when to

place a hedge. To place a hedge, you need to contact a broker with whom you place an order. Most large

communities have a broker who will take your order for a set fee (as is common when placing any futures

market order). The broker can be helpful in informing you on how to appropriately place and exit your

hedging position. The broker has a stake, i.e., commission, in making sure your experience with hedging using

futures is a good one. After you have placed the order with the broker, the broker will contact a brokerage

house at the commodity exchange and relay the order. On the trading floor of the trading commission open

out-call is used in matching market supply and demand forces. If you want to place a short hedge, there will

always be either someone wanting to place a long hedge or a speculator willing to off-set your risk. This

process is known as arbitrage and is discussed in more detail in an accompanying risk management guide in

this series.

Wh at Can Happen W it h t h e S h ort F utures Hedge?



y Any of seven scenarios can arise between the cash and futures price. The only scenario not discussed below is

that of the cash and futures prices not changing while the hedge is placed. In this scenario, the producer sells

the output for the same price as when the hedge was placed. The costs of hedging would then simply be

commissions. The other scenarios are discussed below. Because the cash and futures markets typically trend

in the same direction over time the scenario of the cash and futures moving in opposite directions is not

discussed.

A. Cash and Futures Price both Decrease

y 1. Cash Price Decreases Faster than the Futures Price (Basis Weakens)


placing an output hedge in which the cash price decreases by more than the futures price during the hedging

period. In this scenario basis is said to weaken. Following from table 1, suppose today you could sell live

cattle for $64/cwt. and the relevant futures contract is trading for $65/cwt. (basis is $1.00 under). Knowing

that you will sell cattle at a later date and you want to protect against a price decrease, you take a short

position in the futures market at this time. Over the next few months the local cash price decreases to

$60/cwt. and the futures price decreases to $63/cwt. At this time you decide the cattle need to go to market.

You sell cattle in the cash market for $60/cwt. and buy back your futures position for $63/cwt. Therefore,

the revenue from selling cattle is $60/cwt. plus $2/cwt. gain from the futures position less any commission

costs (a typical commission might be $30 for entry into the futures and $30 for exit, $60/round-turn or @



$0.15/cwt.). Instead of selling for $60/cwt. you sell for $61.85/cwt. The net price you receive is exactly equal

to the original cash price plus the basis gain or loss less commission.

2. Futures Price Decreases Faster than the Cash Price (Basis Strengthens)


placing an output hedge in which the futures price decreases by more than the cash price during the hedging

period. In this scenario basis is said to strengthen. Following from table 2, suppose today you could sell live

cattle for $64/cwt. and the relevant futures contract is trading for $65/cwt. (basis is $1.00 under). Knowing

that you will sell cattle at a later date and you want to protect against a price decrease, you take a short

position in the futures market at this time. Over the next few months the local cash price decreases to

$60/cwt. and the futures price decreases to $60/cwt. At this time you decide the cattle need to go to market.


the revenue from selling cattle is $60/cwt. plus $5/cwt. gain from the futures position less any commission

costs Instead of selling for $60/cwt. you sell for $64.85/cwt. Again the net price you receive is exactly equal

to the original cash price plus the basis gain or loss less commission.

3. Futures Price Decreases at the same rate as the Cash Price




exception of commissions ($0.15/cwt). Following with the first two examples, there is no basis change here

and the net price is simply equal to the original cash price less commission.

B. Cash and Futures Price both Increases

y 1. Cash Price Increases Faster than the Futures Price (Basis Weakens)

y Table 3 is used to describe the actions you might take as a hedger would take and the outcomes of those

actions in placing an output hedge in which the cash price increases by more than the futures price during the

hedging period. In this scenario basis is said to strengthen. Following from table 3, suppose today you could

sell live cattle for $64/cwt. and the relevant futures contract is trading for $65/cwt. (basis is $1.00 under).

Knowing that you will sell cattle at a later date and you want to protect against a price decrease, you take a

short position in the futures market at this time. Over the next few months the local cash price increases to

$67/cwt. and the futures price increases to $66/cwt. At this time you decide the cattle need to go to market.


the revenue from selling cattle is $67/cwt. less $1/cwt. lost from the futures position less any commission.

Instead of selling for $67/cwt. you sell for $65.85/cwt.

y 2. Futures Price Increases Faster than the Cash Price (Basis Weakness)



y Table 4 is used to describe the actions a hedger would take and the outcomes of those actions in placing an

output hedge in which the futures price increased by more than the cash price during the hedging period. In

this scenario basis is said to weaken. Following from table 4, suppose today you could sell live cattle for

$64/cwt. and the relevant futures contract is trading for $65/cwt. (basis is $1.00 under). Knowing that you

will sell cattle at a later date and you want to protect against a price decrease, you take a short position in the

futures market at this time. Over the next few months the local cash price increases to $67/cwt. and the

futures price increases to $69/cwt. At this time you decide the cattle need to go to market. You sell cattle in

the cash market for $67/cwt. and buy back your futures position for $69/cwt. Therefore, the revenue from

selling cattle is $67/cwt. less $4/cwt. lost from the futures position less any commission. Instead of selling for

$67/cwt. you sell for $62.85/cwt.

y 3. Futures Price Increases at the same rate as the Cash Price


exception of commissions ($0.15/cwt). Again, there is no change in the basis in this example so the net price

received is exactly equal to the original price less commissions.

Table 1. Short Hedge Example using Futures with Cash Price Decreases (Basis Weakens)

Live Cattle Example - Cash Price Decreases faster than Futures

Cash Futures Basis



Today: $64/cwt.Sell live cattle contract at

$65/cwt.

-$1.00/cwt.

(under)

Later: sell cattle in local

market at $60/cwt.

Buy live cattle contract back at

$63/cwt.

-$3.00/cwt.

(under)

Results

Selling price $60.00/cwt.

Less Commission $0.15/cwt.Plus futures gain $2.00/cwt.

----------------------------

Net selling price $61.85/cwt.

-$2.00 basis

loss

Table 2. Short Hedge Example using Futures with Cash Price Decrease (Basis Strengths)

Live Cattle Example - Futures Price Decreases faster than Cash

Price

Cash Futures Basis

Today: $64/cwt. Sell live cattle contract at -$1.00/cwt.



$65/cwt. (under)

Later: sell cattle in localmarket at $60/cwt.

Buy live cattle contract back at$60/cwt.

-$0.00/cwt.

Results


Less Commission $0.15/cwt.

Plus futures gain $5.00/cwt---------------------------


$1.00 basis

gain

Table 3. Short Hedge Example using Futures with Cash Price Increase (Basis Strengths)

Live Cattle Example - Cash Price Increases faster than Futures

Price

Cash Futures Basis


$65/cwt.

-$1.00/cwt.

(under)


market at $67/cwt.


$66/cwt.

$1.00/cwt.

(over)



Results



Less futures loss $1.00/cwt.

-----------------------------


$2.00 basisgain

Table 4. Short Hedge Example using Futures with Cash Price Increase (Basis Weakens)

Live Cattle Example - Futures Price Increases faster than Cash

Price

Cash Futures Basis


$65/cwt.

-$1.00/cwt.

(under)


market at $67/cwt.


$69/cwt.

-$2.00/cwt.

(under)

Results



Less futures gain $4.00/cwt.

-$1.00 basis

loss



-----------------------------




Arbitrage

Defn: It means locking in a profit by simultaneously entering into transactions in two or more markets where

there is price differential of the same underlying.

In simple terms one can understand by an example of a commodity selling in one market at price x and the same

commodity selling in another market at price x + y. Now this y, is the difference between the two markets is the

arbitrage available to the trader. The trade is carried simultaneously at both the markets so theoretically there is

no risk. (This arbitrage should not be confused with the word arbitration, as arbitration is referred to solving of

dispute between two or more parties. )

The person who conducts and takes advantage of arbitrage in stocks, commodities, interest rate bonds,

derivative products, Forex is known as an arbitrageur.

An arbitrage opportunity exists between different markets because there are different kind of players in the

market, some might be speculators, others jobbers, some market-markets, and some might be arbitrageurs.

In India, there is a good amount of Arbitrage opportunities between NCDEX, MCX in commodities.

In the Indian Stock Market, there are a good amount of Arbitrage opportunities between NSE, Cash and Future

market and BSE, Cash and Future market.

Some Characteristics:

If the relation between forward prices and futures price differs, it gives rise to arbitrage opportunities.

If there is price differential between two exchanges, it gives rise to arbitrage opportunities



We can categorize arbitrage in the real world into three groups:

Pure arbitrage, where, in fact, you risk nothing and earn more than the riskless rate.

Near arbitrage, where you have assets that have identical or almost identical cash flows, trading at different prices,

but there is no guarantee that the prices will converge and there exist significant constraints on the investors forcing

convergence.

Speculative arbitrage, which may not really be arbitrage in the first place. Here, investors take advantage of what

they see as mispriced and similar (though not identical) assets, buying the cheaper one and selling the more

Expensive one.

ARBITRAGEExplained

USDINR Spot = INR 44.325 1 Month Forward Premium= 3 paisa

1 month USDINR Outright Forward Rate = INR 44.355

1 month USDINR Currency Futures = INR 44.4625

BUY OUTRIGHT FORWARDS ANDSELL FUTURES.

NETGAIN = (44.4625 ²44.355) INR = 10.75 PS ARBITRAGE

Profit per contract = 1000*0.1075 = 107.50 INR

(Example assumes that both outright and futures contracts are coterminous.



BENEFITS

No requirement of an underlying to trade in currency futures.

No requirement of a non-fund based limit

MTM Settlement

Minimal cost of trading ²Fees for corporate clients and individual clients tailored to suit their requirements²(Govt.

/Exchange taxes, charges, levies extra, as applicable)

To see how spot and futures currency prices are related, note thatholding the foreign currency enables the investor

to earn the risk-freeinterest rate (Rf) prevailing in that country while the domestic currencyearn the domestic

riskfree rate (Rd). Since investors can buy currencyat spot rates and assuming that there are no restrictions on

investing atthe riskfree rate, we can derive the relationship between the spot andfutures prices.

I nterest rate parity relates the differential between futures and spotprices to interest rates in the domestic and

foreign market.

Futures Price = (1+ Rd)

Spot Price (1+ Rf)

Example using the formula:



Assume that the one-year interest rate in the United States is 5% andthe one-year interest rate in Germany is 4%.

Furthermore, assume thatthe spot exchange rate is $0.65 per Deutsche Mark.

The one-year futures price, based upon interest rate parity, should beas follows:

Futures Price = (1.05) = $0.6525

$ 0.65 (1.04)

Documents

Currency Futures Niv