Financial Risk Management

PROJECT REPORT

Currency Futures Growth in India – A Realty Check

Under guidance of Prof. P.C.Biswal

Group – V

Anuj Khera 24NMP06Dinesh Gangwar 24NMP13Jagdeeswara Reddy S 24NMP14

Parwaz Alam Khan 24NMP19

Anil Kumar Bharadwaj 24NMP29

NATIONAL MANAGEMENT PROGRAMME (NMP – XXIV)

MANAGEMENT DEVELOPMENT INSTITUTE

GURGAON-122 001

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Acknowledgment

We would like to show our greatest appreciation to Prof. P.C. Biswal. We can’t say thank you

enough for his tremendous support and help. We feel motivated and encouraged every time we attend

his meeting. Without his encouragement and guidance this project would not have materialized.

The guidance and support received from all the members who contributed and who are

contributing to this project, was vital for the success of the project. We are grateful for their constant

support and help.

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Table of Contents

1.Introduction on Currency Futures ............................................................................................................ 3

1.1 Need for Currency Futures ................................................................................................................. 4

1.2 Currency futures benefits to investors as: ......................................................................................... 5

2. History of Currency Futures ..................................................................................................................... 5

3. Currency future derivatives in India ......................................................................................................... 6

3.1 Rationale behind Currency futures in India ....................................................................................... 6

3.2 Exchanges engaged in Currency future in India ................................................................................. 7

3.3 CURRENCY FUTURE CONTRACT FORMAT .......................................................................................... 7

3.4 Distinctive attribute of Currency Futures ........................................................................................... 8

4. Benefits of currency trading in India ........................................................................................................ 9

5. Currency Futures Vs Currency Forwards ............................................................................................... 10

6. Trends in Currency Future in India ......................................................................................................... 12

7. Risks of trading in Currency Futures ...................................................................................................... 15

8. Opportunities ......................................................................................................................................... 16

9. Currency Futures – the road ahead ....................................................................................................... 16

10. Conclusion ........................................................................................................................................... 17

11. References ........................................................................................................................................... 18

1. Introduction on Currency Futures

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Currency Futures are standardized contracts to buy or sell a currency at a future

date at a rate determined in advance. The contracts are traded on regulated exchanges

in accordance with the guidelines specified in the RBI-SEBI Standing Technical

Committee Report on Exchange Traded Currency Futures, 2008.

Currencies are the money of different countries, and currency trading is the buying

and selling of these currencies. There are almost as many different currencies as there

are countries, but the most popular currencies for trading are the US Dollar, the Euro,

the British Pound (Sterling), and the Japanese Yen. The currency markets are some of

the most popular day trading markets, and they therefore have some of the highest

volume (number of contracts) and liquidity. This high volume and liquidity makes the

currency markets attractive to all types of traders, including individual day traders,

trading companies, financial and non financial companies, banks, and governments.

Globalization and integration of financial markets, coupled with progressive

increase of cross-border flow of capital, have transformed the dynamics of Indian

financial markets. This has increased the need for dynamic currency risk

management. The steady rise in India’s foreign trade along with liberalization in

foreign exchange regime has led to large inflow of foreign currency into the

system in the form of FDI and FII investments.

In order to provide a liquid, transparent and vibrant market for foreign exchange

rate risk management, Securities & Exchange Board of India (SEBI) and Reserve Bank

of India (RBI) have allowed trading in currency futures on stock exchanges for the first

time in India, initially based on the USDINR exchange rate and subsequently on three

other currency pairs – EURINR, GBPINR and JPYINR.

1.1 Need for Currency Futures

Financial markets are, by nature, extremely volatile and hence the risk factor is an

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important concern for financial agents. To reduce this risk, the concept of derivatives

comes into the picture. Derivatives are products whose values are derived from one or

more basic variables called bases. These bases can be underlying bases or reference

rates. A currency futures contract allows for three things:

Hedging Participants with exposure in currency can use futures to manage risk

arising from unfavourable exchange rate movements

Speculation/Investment Participants with a view on the Forex market can trade

futures to profit from these views, just like stocks or commodities or any other

asset class

Arbitrage Entities with access to both Exchange traded Futures and OTC

markets, or different exchanges can exploit arbitrage arising due to pricing

differences.

1.2 Currency futures benefits to investors as:

Importers/Exporters may have some obligations in Forex market, trading in

Currency Futures will help them hedge their positions. Similarly, any investor can

trade in Currency Futures with or with no obligations.

The counter-party risk is eliminated as the clearing corporation guarantees the

trades.

By ensuring that the best price is available to all categories of market

participants, transactions are executed on a price time priority

In Currency Futures, mark to market (MTM) obligations are settled on a daily

basis, unlike a forward contract, which is an agreement to transact at a forward

price on a future date and no money changes hands except on the maturity date.

2. History of Currency Futures

Currency futures were first created at the Chicago Mercantile Exchange (CME) in

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1972, less than one year after the system of fixed exchange rates was abandoned

along with the gold standard. Some commodity traders at the CME did 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.

3. Currency future derivatives in India

The Currency Future in India was first time traded at NSE on August 29, 2008.

Thereafter MCX was subsequently allowed to deal in currency future from October 31,

2008.

3.1 Rationale behind Currency futures in India

The OTC transaction was happening with the help of electronic trading and

efficient risk management systems, Exchange traded currency future has helped to get:

Transparency and efficiency in price discovery

Elimination of counterparty credit risk

Access to all types of market participants,

Standardized products

Transparent trading platform.

Banks are also allowed to become members of this segment on the Exchange

and this provides them new opportunity in this market segment.

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3.2 Exchanges engaged in Currency future in India

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3.3 CURRENCY FUTURE CONTRACT FORMAT

The stock exchange expanded its currency derivatives offerings to Euro-Indian

Rupee (EURINR), Pound Sterling-Indian Rupee (GBPINR) and Japanese Yen-Indian

Rupee (JPYINR) which started initially with USDINR.

Each of these currency contracts has a life of 12 months from the month in which

it is launched as shown

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3.4 Distinctive attribute of Currency Futures

Standardized currency futures shall have the following attributes:-

Only USD-INR INR/USD, INR/EUR, INR/JPY and INR/GBP contracts are

allowed to be traded.

For USD, EUR and GBP, the lot size will be 1,000 foreign currency; for JPY it will

be 1,00,000 JPY (since quotation is for 100 Japanese Yen; lot size on trading

system shall be 1,000 JPY)

The contracts shall be quoted and settled in Indian Rupees.

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The maturity of the contracts shall not exceed 12 months.

The settlement price shall be the Reserve Bank‘s Reference Rate on the last

trading day.

Permission

Currency futures are permitted in US Dollar - Indian Rupee or any other currency

pairs, as may be approved by the Reserve Bank from time to time.

Only persons resident in India‘ may purchase or sell currency futures to hedge an

exposure to foreign exchange rate risk.

4. Benefits of currency trading in India

Easy Accessibility - Small investors would get an easy access to currency futures

trading on the popular exchanges

Easy Affordability - Margins are very low and the contract size is very small

Low Transaction Cost - As opposed to the high pay-out of commissions in

overseas forex trading, currency futures carries low costs for investors

Transparency - It is possible for you to verify trade details on NSE if you have a

doubt that the broker has tried to cheat you

Counter-party default risk - All the trades done on the recognized exchanges are

guaranteed by the clearing corporations and hence it eliminates the risks

associated with counter party default. NSCCL (National Securities Clearing

Corporation Limited) carries out all the notation, clearing and settlement process

of currency futures trading

Standardized Contracts - Exchange Traded currency futures are standardized in

respect of lot size ($1000) and maturity (12 monthly contracts). Retail investors

with their limited resources would find it tremendously beneficial to take positions

in standardised USD INR futures contracts.

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Moreover, the currency futures market is used by some companies for hedging.

These companies either purchase currency futures for their future payables, or

sell the futures on currencies for their future receipts.

Speculators may also buy or sell futures on a foreign currency as a protection

against the strengthening or weakening of the US dollar. So, speculators may be

able to earn profit from the rise or fall of these exchange rates.

5. Currency Futures Vs Currency Forwards

Till August 2008, Resident Indians had the following over-the-counter (OTC) products:

Currency forwards Swaps and options.

These are used by companies, institutions and residents to hedge their risks.

With the introduction of currency futures by SEBI and RBI and the inauguration of

trading of currency futures on NSE in August 2008, only persons resident in India will

have the option of trading in currency futures on recognized stock exchanges.

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Difference between Currency Futures and OTC Market

The below data apparently gives an indication that the reduction in the share of the

OTC currency forward market in the total currency derivatives market may be attributed

to the rise in the share of Exchange traded currency futures, there can be several other

market and economic factors for the same.

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Share of currency futures turnover to the OTC currency forward turnover

6. Trends in Currency Future in India

Currency futures trading started in India on August 29, 2008 on National Stock

Exchange. This was the first time currency derivatives got listed on an exchange in

India. Till this time, the currency futures trading took place over the counter and were

unorganized. With the entry of the National Stock Exchange in the picture, currency

trading became more organized with the NSE acting as a counter party to all the

transactions.

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The dominant exchanges in the Currency future market are NSE and MSX-NX. The

above pie-chart shows that the market share of MCX-NX is increasing and it is taking

the position of NSE in this field, although both the players are holding almost half share

with them.

From the contracts traded in NSE and MCX-SX, we can see that the currency

future market is in growing phase. The high fold increase in the currency future trading

is a testimony of the growth. The high in Indian rupee/dollar futures demonstrates the

increased demand among the global members and their commercial and investor

clients to manage their exchange rate risk or gain exposure to the Indian rupee. This

also reflects towards the increasing economy of India.

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Turnover of currency futures is consistently increasing since the introduction year 2008

onwards till date as seen below

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In the above chart we see even though there is fluctuation in the exchange rate

currency futures trading is consistently increasing, giving the better hedging option to

the investors.

7. Risks of trading in Currency Futures

Trading in Currency futures comes with high levels of risk. Even a small adverse

fluctuation in the exchange rate may result in loss of the entire deposit of someone

trading in currency. Only people having an in-depth knowledge of the working of this

market or have done a thorough homework about the risks involved are advised to trade

in this market.

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8. Opportunities

There is lot of scope for facilitating the currency futures trading through:

Introduction of Options trading ·

FII participation.

NRI participation which would add more volumes and liquidity.

Positions larger than $5 million - a tiny limit when compared with the size of

exposure that is found in a trillion dollar economy‖.

9. Currency Futures – the road ahead

Currency futures today are offered only for rupee-dollar contracts for longer

periods (12 contracts) than the existing forward contracts (3 contracts – 3

months, 6 months and 12 months).

Liberalization in terms of changes in the contract size, variable lot sizes and

extended trading hours could help encourage larger participation. The rupee

futures have a contract size of $1,000. The position limit for a client is higher of

6% of the total open interest or $ 5 million. For the trading member it is higher of

15% of the total open interest or $25 million. If the trading member is a bank it is

higher of 15% of the total open interest or $ 100 million. Hence till the total open

interest rises, a participant cannot increase his open interest beyond present

proportion/limits.

Foreign institutional investors (FIIs) are excluded from the market and their

inclusion as participants can help in stepping up volumes significantly.

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10. Conclusion

With the current trend of growing market of currency futures, it is bound to have

rapid growth rate. However, it does not seem to be going well with its pace in India as

industry due to lack of awareness among retail investors and knowledge gap faced by

the brokers.

India is one of the countries which have achieved greater turnover of the

currency futures market in comparison to the currency forward market. The currency

futures has a rosy future ahead, given the industry provides good support in terms of

making it popular and more conversant with retail investors.

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11. References

www.mcx-sx.com

www.nseindia.com

www.useindia.com

www.moneycontrol.com

www.sebi.gov.in

http://www.ccilindia.com

www.rbi.org.in

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