A PROJECT REPORT ON

Hedging through currency derivatives in india

Submitted in Partial Fulfillment for the Award of the Diploma of Post Graduate Diploma in Management (2011-2013)

SUBMITTED TO
MS. PARUL PURI

SUBMITTED BYSumit Anoop Bihari PGDM-PGD11109

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DEPARTMENT OF MANAGEMENT

INSTITUTE OF MANAGEMENT STUDIES, NOIDA

A UGC Recognized Institute A-8B, Plot C, Sector-62, Noida

DECLARATION
I, Sumit Anoop Bihari, bearing Roll No PGD11109 Class PGDM 2nd year of the Institute of Management Studies, Noida hereby declare that the Project Report-PG407 entitled is an original work and the same has not been submitted to any other Institute for the award of any other diploma. The suggestions as approved by the faculty were duly incorporated.

SIGNATURE OF FACULTY GUIDE-

SIGNATURE OF STUDENT-

MS. PARUL PURI

Sumit Anoop Bihari

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DEPARTMENT OF MANAGEMENT

INSTITUTE OF MANAGEMENT STUDIES, NOIDA

A UGC Recognized Institute

ACKNOWLEDGEMENT
This study of Hedging through currency derivatives in India could not have been possible with my efforts only. I would like to express my deep gratitude to my faculty guide MS. PARUL PURI and DR. VANDANA MATHUR who gave me the guidance in various ways to make the project a reality. Above all, I would like to express my deep gratitude to my family for providing me moral support and help.

Sumit Anoop Bihari ROLL NO- PGD11109

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EXECUTIVE SUMMARY
Derivatives market is one of the most important classes of financial instrument that are central to todays financial and trade markets. They offer various types of risk protection and allow innovative investment strategies In India the derivative market was small and domestic just a few years back since then it has grown impressively and had reached to a sizable position for example on an average providing 3500 crores of volumes in on the national stock exchange in daily currency derivative trade. Given the derivative market global nature users can trade around the clock and make use of currency derivatives that offers exposure to the investors in almost any underlying currency across all markets. The currency derivatives market is growing at a fast pace and providing all different investing horizons to the investors like hedging speculation arbitrage investment. There are two competing segments in the currency market the off-exchange or the over the counter segment and the on exchange segment from a customer perspective, OTC trading is approximately less expensive than on exchange. By and large the currency derivatives market is safe and efficient risk are particularly well controlled in the exchange segment where central counterparties operates very efficiently and mitigate the risk of all participants. The currency derivatives market has successfully developed under an effective regulatory regime in India. All three prerequisites for a well functioning market, safety efficiently and innovation are fulfilled while there is no need for structural changes in framework under which OTC players and exchanges operate today, improvements are possible. At the end, currency derivatives market opens a new window for the investors in India to go beyond to the stereotype equity and commodity market and enjoy the currency market.

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CONTENTS:1 INTRODUCTION 6-14

2 3 8 9 10 11 12 13

LITREATURE REVIEW FOREIGN EXCHANGE MARKET OVERVIEW RESEARCH METHODOLOGY DATA ANALYSIS FINDINGS CONCLUSION SUGGESTION REFERENCES

15-17 18-28 29 30-40 41 42 43 44

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INTRODUCTION
By far the most significant event in finance during the past decade has been the extraordinar y development and expansion of financial derivativesThese instruments enhances the ability to differentiate risk and allocate it to those investors most able and willing to take it- a process that has undoubtedly improved national productivity growth and standards of livings The past decades has witnessed the multiple growths in the volume of international trade and business due to the wave of globalization and liberalization all over the world. As a result, the demand for the

international money and financial instruments increased significantly at the global level. In this respect, changes in the interest rates, exchange rate and stock market prices at the different financial market have increased the financial risks to the corporate world. It is therefore, to manage such risks; the new financial instruments have been developed in the financial markets, which are also popularly known as financial derivatives. The Underlying Securities for Derivatives are : Commodities: Castor seed, Grain, Pepper, Potatoes, etc. Precious Metal : Gold, Silver Short Term Debt Securities : Treasury Bills Interest Rates Common shares/stock Stock Index Value : NSE Nifty Currency : Exchange Rate

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TYPES OF FINANCIAL DERIVATIVES

Financial derivatives are those assets whose values are determined by the value of some other assets, called as the underlying. Presently there are Complex varieties of derivatives already in existence and the markets are innovating newer and newer ones continuously. For example, various types of financial derivatives based on their different properties like, plain, simple or straightforward, composite, joint or hybrid, synthetic, leveraged, mildly leveraged, OTC traded, standardized or organized exchange traded, etc. are available in the market. Due to complexity in nature, it is very difficult to classify the financial derivatives, so in the present context, the basic financial derivatives which are popularly in the market have been described. In the simple form, the derivatives can be classified into different categories which are shown below :

DERIVATIVES

Financials

Commodities

Basics

Complex

1. Forwards 2. Futures 3. Options

1. Swaps 2.Exotics (Non STD)

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4. Warrants and Convertibles

One form of classification of derivative instruments is between commodity derivatives and financial derivatives. The basic difference between these is the nature of the underlying instrument or assets. In commodity derivatives, the underlying instrument is commodity which may be wheat, cotton, pepper, sugar, jute, turmeric, corn, crude oil, natural gas, gold, silver and so on. In financial derivative, the underlying instrument may be treasury bills, stocks, bonds, foreign exchange, stock index, cost of living index etc. It is to be noted that financial derivative is fairly standard and there are no quality issues whereas in commodity derivative, the quality may be the underlying matters.

Another way of classifying the financial derivatives is into basic and complex. In this, forward contracts, futures contracts and option contracts have been included in the basic derivatives whereas swaps and other complex derivatives are taken into complex category because they are built up from either forwards/futures or options contracts, or both. In fact, such derivatives are effectively derivatives of derivatives.

Derivatives are traded at organized exchanges and in the Over The Counter ( OTC ) market : Derivatives Trading Forum

Organized Exchanges

Over The Counter

Commodity Futures

Forward Contracts
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Financial Futures Options (stock and index) Stock Index Future

Swaps

Derivatives traded at exchanges are standardized contracts having standard delivery dates and trading units. OTC derivatives are customized contracts that enable the parties to select the trading units and delivery dates to suit their requirements.

A major difference between the two is that of counterparty riskthe risk of default by either party. With the exchange traded derivatives, the risk is controlled by exchanges through clearing house which act as a contractual intermediary and impose margin requirement. In contrast, OTC derivatives signify greater vulnerability.

DERIVATIVES INTRODUCTION IN INDIA

The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. SEBI set up a 24 member committee under the chairmanship of Dr. L.C. Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India, submitted its report on March 17, 1998. The committee recommended that the derivatives should be declared as securities so that regulatory framework applicable to trading of securities could also govern trading of derivatives.

To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE-30 (Sensex) index. The trading in index options commenced in June 2001 and the trading in
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options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001.

HISTORY OF CURRENCY DERIVATIVES

Currency futures were first created at the Chicago Mercantile Exchange (CME) in 1972.The contracts were created under the guidance and leadership of Leo Melamed, CME Chairman Emeritus. The FX contract capitalized on the U.S. abandonment of the Bretton Woods agreement, which had fixed world exchange rates to a gold standard after World War II. The abandonment of the Bretton Woods agreement resulted in currency values being allowed to float, increasing the risk of doing business. By creating another type of market in which futures could be traded, CME currency futures extended the reach of risk management beyond commodities, which were the main derivative contracts traded at CME until then. The concept of currency futures at CME was revolutionary, and gained credibility through endorsement of Nobel-prize-winning economist Milton Friedman. Today, CME offers 41 individual FX futures and 31 options contracts on 19 currencies, all of which trade electronically on the exchanges CME Globex platform. It is the largest regulated marketplace for FX trading. Traders of CME FX futures are a diverse group that includes multinational corporations, hedge funds, commercial banks, investment banks, financial managers, commodity trading advisors (CTAs), proprietary trading firms; currency overlay managers and individual investors. They trade in order to transact business, hedge against unfavorable changes in currency rates, or to speculate on rate fluctuations.

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UTILITY OF CURRENCY DERIVATIVES

Currency-based derivatives are used by exporters invoicing receivables in foreign currency, willing to protect their earnings from the foreign currency depreciation by locking the currency conversion rate at a high level. Their use by importers hedging foreign currency payables is effective when the payment currency is expected to appreciate and the importers would like to guarantee a lower conversion rate. Investors in foreign currency denominated securities would like to secure strong foreign earnings by obtaining the right to sell foreign currency at a high conversion rate, thus defending their revenue from the foreign currency depreciation. Multinational companies use currency derivatives being engaged in direct investment overseas. They want to guarantee the rate of purchasing foreign currency for various payments related to the installation of a foreign branch or subsidiary, or to a joint venture with a foreign partner. A high degree of volatility of exchange rates creates a fertile ground for foreign exchange speculators. Their objective is to guarantee a high selling rate of a foreign currency by obtaining a derivative contract while hoping to buy the currency at a low rate in the future. Alternatively, they may wish to obtain a foreign currency forward buying contract, expecting to sell the appreciating currency at a high future rate. In either case, they are exposed to the risk of currency fluctuations in the future betting on the pattern of the spot exchange rate adjustment consistent with their initial expectations. The most commonly used instrument among the currency derivatives are currency forward contracts. These are large notional value selling or buying contracts obtained by exporters, importers, investors and speculators from banks with denomination normally exceeding 2 million USD. The contracts guarantee the future conversion rate between two currencies and can be obtained for any customized amount and any date in the future. They normally do not require a security deposit since their purchasers are mostly large business firms and investment institutions, although the banks may require compensating deposit balances or lines of credit. Their transaction costs are set by spread between bank's buy and sell prices.
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Exporters invoicing receivables in foreign currency are the most frequent users of these contracts. They are willing to protect themselves from the currency depreciation by locking in the future currency conversion rate at a high level. A similar foreign currency forward selling contract is obtained by investors in foreign currency denominated bonds (or other securities) who want to take advantage of higher foreign that domestic interest rates on government or corporate bonds and the foreign currency forward premium. They hedge against the foreign currency depreciation below the forward selling rate which would ruin their return from foreign financial investment. Investment in foreign securities induced by higher foreign interest rates and accompanied by the forward selling of the foreign currency income is called a covered interest arbitrage.

INTRODUCTION TO CURRENCY DERIVATIVES

Each country has its own currency through which both national and international transactions are performed. All the international business transactions involve an exchange of one currency for another. For example, If any Indian firm borrows funds from international financial market in US dollars for short or long term then at maturity the same would be refunded in particular agreed currency along with accrued interest on borrowed money. It means that the borrowed foreign currency brought in the country will be converted into Indian currency, and when borrowed fund are paid to the lender then the home currency will be converted into foreign lenders currency. Thus, the currency units of a

country involve an exchange of one currency for another. The price of one currency in terms of other currency is known as exchange rate. The foreign exchange markets of a country provide the mechanism of exchanging different currencies with one and another, and thus, facilitating transfer of purchasing power from one country to another.

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With the multiple growths of international trade and finance all over the world, trading in foreign currencies has grown tremendously over the past several decades. Since the exchange rates are continuously changing, so the firms are exposed to the risk of exchange rate movements. As a result the assets or liability or cash flows of a firm which denominated in foreign currencies undergo a change in value over a period of time due to variation in exchange rates. This variability in the value of assets or liabilities or cash flows is referred to exchange rate risk. Since the fixed exchange rate system has been fallen in the early 1970s, specifically in developed countries, the currency risk has become substantial for many business firms. As a result, these firms are increasingly turning to various risk hedging products like foreign currency futures, foreign currency forwards, foreign currency options, and foreign currency swaps.

INTRODUCTION TO CURRENCY FUTURE

A futures contract is a standardized contract, traded on an exchange, to buy or sell a certain underlying asset or an instrument at a certain date in the future, at a specified price. When the underlying asset is a commodity, e.g. Oil or Wheat, the contract is termed a commodity futures contract. When the underlying is an exchange rate, the contract is termed a currency futures contract. In other words, it is a contract to exchange one currency for another currency at a specified date and a specified rate in the future. Therefore, the buyer and the seller lock themselves into an exchange rate for a specific value or delivery date. Both parties of the futures contract must fulfill their obligations on the settlement date Currency futures can be cash settled or settled by delivering the respective obligation of the seller and buyer. All settlements however, unlike in the case of OTC markets, go through the exchange. Currency futures are a linear product, and calculating profits or losses on Currency Futures will be similar to calculating profits or losses on Index futures. In determining profits and losses in futures trading, it is essential to know both the contract size (the number of currency units being traded) and also what the tick value is. A tick is the minimum trading increment or price differential at which traders are able to enter bids and offers. Tick values differ for different currency pairs and different underlying. For e.g. in the case of the USD-INR currency futures contract the tick size shall be 0.25
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paise or 0.0025 Rupees. To demonstrate how a move of one tick affects the price, imagine a trader buys a contract (USD 1000 being the value of each contract) at Rs.42.2500. One tick move on this contract will translate to Rs.42.2475 or Rs.42.2525 depending on the direction of market movement.

Purchase price: Price increases by one tick: New price: Purchase price: Price decreases by one tick: New price:

Rs .42.2500 +Rs. 00.0025 Rs .42.2525 Rs .42.2500 Rs. 00.0025 Rs.42. 2475

The value of one tick on each contract is Rupees 2.50. So if a trader buys 5 contracts and the price moves up by 4 tick, she makes Rupees 50. Step 1: Step 2: Step 3: 42.2600 42.2500 4 ticks * 5 contracts = 20 points 20 points * Rupees 2.5 per tick = Rupees 50

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LITERATURE REVIEW
Abe de Jong , Frans de Roon and Chris Veld (December 6, 1995) : An Empirical Analysis of the Hedging Effectiveness of Currency Futures , this study shows the hedging effectiveness for futures positions which are not adjusted during the hedge period. For this purpose an out-of-sample approach is used. Three models are used to determine hedge ratios and hedging effectiveness. These are the minimumvariance model of Ederington (1979), the "-t model of Fishburn (1977), which is a model in which the disutility of a loss is minimized, and the Sharpe-ratio model ofHoward and D'Antonio (1984, 1987) Dr. Sumeet Gupta (7 December 2011) : Currency Derivatives in India & its hedging using minimum variance hedging model , Futures market provides for hassle free operations with minimum transaction cost and specially beneficial for small SME and corporate which have issues obtaining limits with their bankers will be helpful to understand through minimum variance hedging model. Anuradha Sivakumar and Runa Sarkar (December 2008): Corporate Hedging for Foreign Exchange Risk in India, The paper concludes by pointing out that the onus is on Reserve Bank of India, the apex bank of the country, and its Working Group on Rupee Futures to realize the need for rupee futures in India and the convertibility of the rupee. Mohan Rakesh (2007), What are the key objectives of financial market development? From our point of view, the basic aim of financial market development must be to aid economic growth and development. The primary role of financial markets, broadly interpreted, is to intermediate resources from savers to investors, and allocate them in an efficient manner among competing uses in the economy, thereby contributing to growth both through increased investment and through enhanced efficiency in resource use Goyal Ashima (2010), The paper analyzes the changing INR trends over the reform period, in the context of fundamental determinants of exchange rates. In the early reform years the chief concern was to limit appreciation from inflows, and from higher domestic inflation, given the trade deficit. So short-term nominal depreciation maintained a long-term real fix. But with two-way nominal variation, more objectives canbe accommodated. We ask how the exchange rate contributed to three possible policy objectivesmaintaining a real competitive exchange rate, neutralizing inflationary oil shocks,deepening foreign exchange markets and encouraging hedging. Depreciation allowed just before oi lprices crashed compromised the second objective. Inadequate commitment to two-way movement, prior to the crisis,
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induced firms to take large currency exposures based on expected appreciation. After the crisis, capital flows were allowed to drive the exchange rate, aggravating inflation and acting against Dr.Hiren Mania (July 3rd 2010) Hedging of Foreign Exchange Risk by Corporate in India This research paper attempts to evaluate the various alternatives available to the Indian corporate for hedging financial risks. By studying the use of hedging instruments by major Indian firms from different sectors, the paper concludes that forwards and options are preferred as short term hedging instruments while swaps are preferred as long term hedging instruments. The high usage of forward contracts by Indian firms as compared to firms in other markets underscores the need for rupee futures in India.

Dua Pami and Ranjan Rajeev (2010) Exchange Rate Policy and Modelling in India

Growing

international trade and the resultant financial integration of the world economy have led to the study of and debate over an optimal exchange rate policy. Presenting a comprehensive overview of various regimes and their evolution, this book traces the reforms in India's foreign exchange policy over the last two decades. The book undertakes a nuanced analysis of: the key facets of India's exchange rate policy and the structure of the foreign exchange market; the global recession of 20089 and the crisis-related movements and fluctuations in exchange rate; the pattern of capital flows with an emphasis on cautious capital account liberalization and measures regulating large capital inflows; and the modelling and forecasting of the exchange rate in the framework of developing economies within a managed- float regime. Rthig, Andreas: Since financial derivatives are key instruments for risk taking as well as risk reduction, it is only straightforward to examine their role in currency crises. This paper addresses this issue by investigating the impact of currency futures trading on the underlying exchange rates. After a discussion of trading mechanisms and trader types, the linkage between futures trading activity and spot market turbulence is modelled using a VAR-GARCH approach for the exchange rates of Australia, Canada, Japan, Korea and Switzerland in terms of the US dollar. The empirical results indicate that there is a positive relationship between currency futures trading activity and spot volatility. Moreover, in the case of four out of the total of five currencies discussed in this paper, futures trading activity adds significantly to spot volatility.

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DHAREN KUMAR PANDEY (8 December 2011): The introduction of currency futures in India has passed a journey of almost one and a half year and many changes have been implemented in the trading system in this regard. The main theme of this paper is to assess the speed in which the growth of currency futures in India has accelerated. It also aims at analyzing the volatility of the currency futures. In order to study the growth of the currency futures, the number of contracts traded and open interest at NSE and MCX have been inclusively compared. Attempt has been made to check whether the daily returns of the NSE and MCX on currency futures are normally distributed distributed. For this purpose the changes in the daily value of Rupee as compared to Dollar has been calculated for every month separately and the data have been used for the Kolmogorov Smirnov Test to test the hypothesis that the returns are normally distributed. With the measure of skewness and kurtosis it has been found that the returns are normally distributed and, thus, the null hypothesis is accepted. The currency futures have received a good response from investors as well as the hedgers. initially currency futures were started for USD-INR contracts but recently trading in Euro-INRYen-INR and Pound-INR contracts have been introduced in January 2010.Average turnover of these instruments in the National Stock Exchange and MCX Stock Exchange (MCXSX) in December was nine times higher than a year earlier. These exchanges are currently clocking an average daily turnover of over Rs 20,000 crore in currency products while it was just Rs 2,400 crore in January last year. The risk involved is comparatively low in this case and currency futures has proved to be a good tool for hedging the risk involved in the currency of a country (currency risk). It is hoped that the currency futures market will develop more faster and it will be a good choice for all the market participants in the near future and it will find its way in the Indian economy Shinhua Liu ( August 2007 ) : By incorporating new information generated by currency derivatives trading, underlying exchange rates should be less forecastable than previously and the underlying currency markets should, therefore, be more efficient. This hypothesis was tested, for the first time, for the period 1982 through 1997 on a clean sample of three major types of currency derivatives launched in two prominent markets. Various statistical tests indicate that following the introduction of the derivative contracts, the underlying exchange rates became more random and the currencies involved tended thus to be priced more efficiently, which supports the hypothesis.

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OVERVIEW OF THE FOREIGN EXCHANGE MARKET IN INDIA

During the early 1990s, India embarked on a series of structural reforms in the foreign exchange market. The exchange rate regime, that was earlier pegged, was partially floated in March 1992 and fully floated in March 1993. The unification of the exchange rate was instrumental in developing a market-determined exchange rate of the rupee and was an important step in the progress towards total current account convertibility, which was achieved in August 1994. Although liberalization helped the Indian Forex market in various ways, it led to extensive fluctuations of exchange rate. This issue has attracted a great deal of concern from policy-makers and investors. While some flexibility in foreign exchange markets and exchange rate determination is desirable, excessive volatility can have an adverse impact on price discovery, export performance, sustainability of current account balance, and balance sheets. In the context of upgrading Indian foreign exchange market to international standards, a well- developed foreign exchange derivative market (both OTC as well as Exchange-traded) is imperative. With a view to enable entities to manage volatility in the currency market, RBI on April 20, 2007 issued comprehensive guidelines on the usage of foreign currency forwards, swaps and options in the OTC market. At the same time, RBI also set up an Internal Working Group to explore the advantages of introducing currency futures. The Report of the Internal Working Group of RBI submitted in April 2008, recommended the introduction of Exchange Traded Currency Futures. Subsequently, RBI and SEBI jointly constituted a Standing Technical Committee to analyze the Currency Forward and Future market around the world and lay down the guidelines to introduce Exchange Traded Currency Futures in the Indian market. The Committee submitted its report on May 29, 2008. Further RBI and SEBI also issued circulars in this regard on August 06, 2008. Currently, India is a USD 34 billion OTC market, where all the major currencies like USD, EURO, YEN, Pound, Swiss Franc etc. are traded. With the help of electronic trading and efficient risk management systems, Exchange Traded Currency Futures will bring in more transparency and efficiency in price discovery, eliminate counterparty credit risk, provide access to all types of market participants, offer standardized products and provide transparent trading platform. Banks are also allowed to become members of this segment on the Exchange, thereby providing them with a new opportunity.
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CURRENCY DERIVATIVE PRODUCTS

Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. We take a brief look at various derivatives contracts that have come to be used. FORWARD : The basic objective of a forward market in any underlying asset is to fix a price for a contract to be carried through on the future agreed date and is intended to free both the purchaser and the seller from any risk of loss which might incur due to fluctuations in the price of underlying asset. A forward contract is customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price. The exchange rate is fixed at the time the contract is entered into. This is known as forward exchange rate or simply forward rate. FUTURE : A currency futures contract provides a simultaneous right and obligation to buy and sell a particular currency at a specified future date, a specified price and a standard quantity. In another word, a future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Future contracts are special types of forward contracts in the sense that they are standardized exchange-traded contracts. SWAP : Swap is private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolio of forward contracts. The

currency swap entails swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. There are a various types of currency swaps like as fixed-to-fixed currency swap, floating to floating swap, fixed to floating currency swap.

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In a swap normally three basic steps are involve___ (1) Initial exchange of principal amount (2) Ongoing exchange of interest (3) Re - exchange of principal amount on maturity.

OPTIONS : Currency option is a financial instrument that give the option holder a right and not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period ( until the expiration date ). In other words, a foreign currency option is a contract for future delivery of a specified currency in exchange for another in which buyer of the option has to right to buy (call) or sell (put) a particular currency at an agreed price for or within specified period. The seller of the option gets the premium from the buyer of the option for the obligation undertaken in the contract. Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer dated options are called warrants and are generally traded OTC.

NEED FOR EXCHANGE TRADED CURRENCY FUTURES

With a view to enable entities to manage volatility in the currency market, RBI on April 20, 2007 issued comprehensive guidelines on the usage of foreign currency forwards, swaps and options in the OTC market. At the same time, RBI also set up an Internal Working Group to explore the advantages of introducing currency futures. The Report of the Internal Working Group of RBI submitted in April 2008, recommended the introduction of exchange traded currency futures. Exchange traded futures as compared to OTC forwards serve the same economic purpose, yet differ in fundamental ways. An individual entering into a forward contract agrees to transact at a forward price on a future date. On the maturity date, the obligation of the individual equals the forward price at which the contract was executed. Except on the maturity date, no money changes hands. On the other hand, in the case of an exchange traded

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Further, in an Exchange traded scenario where the market lot is fixed at a much lesser size than the OTC market, equitable opportunity is provided to all classes of investors whether large or small to participate in the futures market. The transactions on an Exchange are executed on a price time priority ensuring that the best price is available to all categories of market participants irrespective of their size. Other advantages of an Exchange traded market would be greater transparency, efficiency and accessibility.

RATIONALE FOR INTRODUCING CURRENCY FUTURE

Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. A futures contract is standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. The standardized items in a futures contract are: Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change Location of settlement

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The rationale for introducing currency futures in the Indian context has been outlined in the Report of the Internal Working Group on Currency Futures (Reserve Bank of India, April 2008) as follows; The rationale for establishing the currency futures market is manifold. Both residents and nonresidents purchase domestic currency assets. If the exchange rate remains unchanged from the time of purchase of the asset to its sale, no gains and losses are made out of currency exposures. But if domestic currency depreciates (appreciates) against the foreign currency, the exposure would result in gain (loss) for residents purchasing foreign assets and loss (gain) for non residents purchasing domestic assets. In this backdrop, unpredicted movements in exchange rates expose investors to currency risks. Currency futures enable them to hedge these risks. Nominal exchange rates are often random walks with or without drift, while real exchange rates over long run are mean reverting. As such, it is possible that over a long run, the incentive to hedge currency risk may not be large. However, financial planning horizon is much smaller than the long-run, which is typically intergenerational in the context of exchange rates. As such, there is a strong need to hedge currency risk and this need has grown manifold with fast growth in cross-border trade and investments flows. The argument for hedging currency risks appear to be natural in case of assets, and applies equally to trade in goods and services, which results in income flows with leads and lags and get converted into different currencies at the market rates. Empirically, changes in exchange rate are found to have very low correlations with foreign equity and bond returns. This in theory should lower portfolio risk. Therefore, sometimes argument is advanced against the need for hedging currency risks. But there is strong empirical evidence to suggest that hedging reduces the volatility of returns and indeed considering the episodic nature of currency returns, there are strong arguments to use instruments to hedge currency risks.

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USES OF CURRENCY FUTURES

H ed gi n g: Presume Entity A is expecting a remittance for USD 1000 on 27 August 08 wants to lock in the foreign exchange rate today so that the value of inflow in Indian rupee terms is safeguarded. The entity can do so by selling one contract of USDINR futures since one contract is for USD 1000. Presume that the current spot rate is Rs.43 and USDINR 27 Aug 08 contract is trading at Rs.44.2500. Entity A shall do the following:Sell one August contract today. The value of the contract is Rs.44,250. Let us assume the RBI reference rate on August 27, 2008 is Rs.44.0000. The entity shall sell on August 27, 2008, USD 1000 in the spot market and get Rs. 44,000. The futures contract will settle at Rs.44.0000 (final settlement price = RBI reference rate). The return from the futures transaction would be Rs. 250, i.e. (Rs. 44,250 Rs. 44,000). As may be observed, the effective rate for the remittance received by the entity A is Rs.44. 2500 (Rs.44,000 + Rs.250)/1000, while spot rate on that date was Rs.44.0000. The entity was able to hedge its exposure. Speculation: Bullish, buy futures Take the case of a speculator who has a view on the direction of the market. He would like to trade based on this view. He expects that the USD-INR rate presently at Rs.42, is to go up in the next two-three months. How can he trade based on this belief? In case he can buy dollars and hold it, by investing the necessary capital, he can profit if say the Rupee depreciates to Rs.42.50. Assuming he buys USD 10000, it would require an investment of Rs.4,20,000. If the exchange rate moves as he expected in the next three months, then he shall make a profit of around Rs.10000. This works out to an annual return of around 4.76%. It may please be noted that the cost of funds invested is not considered in computing this return. A speculator can take exactly the same position on the exchange rate by using futures contracts. Let us see how this works. If the INR- USD is Rs.42 and the three month futures trade at Rs.42.40. The minimum contract size is USD 1000. Therefore the speculator may buy 10 contracts. The exposure shall be the same as above USD 10000. Presumably, the margin may be around Rs.21, 000. Three months later if the Rupee depreciates to Rs. 42.50 against USD, (on the day of expiration of the contract), the futures price shall converge to the spot price (Rs. 42.50) and he
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makes a profit of Rs.1000 on an investment of Rs.21, 000. This works out to an annual return of 19 percent. Because of the leverage they provide, futures form an attractive option for speculators.

Speculation: Bearish, sell futures Futures can be used by a speculator who believes that an underlying is over-valued and is likely to see a fall in price. How can he trade based on his opinion? In the absence of a deferral product, there wasn't much he could do to profit from his opinion. Today all he needs to do is sell the futures. Let us understand how this works. Typically futures move correspondingly with the underlying, as long as there is sufficient liquidity in the market. If the underlying price rises, so will the futures price. If the underlying price falls, so will the futures price. Now take the case of the trader who expects to see a fall in the price of USD-INR. He sells one two-month contract of futures on USD say at Rs. 42.20 (each contact for USD 1000). He pays a small margin on the same. Two months later, when the futures contract expires, USD-INR rate let us say is Rs.42. On the day of expiration, the spot and the futures price converges. He has made a clean profit of 20 paise per dollar. For the one contract that he sold, this works out to be Rs.2000

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 Arbitrage: Arbitrage is the strategy of taking advantage of difference in price of the same or similar product between two or more markets. That is, arbitrage is striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. If the same or similar product is traded in say two different markets, any entity which has access to both the markets will be able to identify price differentials, if any. If in one of the markets the product is trading at higher price, then the entity shall buy the product in the cheaper market and sell in the costlier market and thus benefit from the price differential without any additional risk. One of the methods of arbitrage with regard to USD-INR could be a trading strategy between forwards and futures market. As we discussed earlier, the futures price and forward prices are arrived at using the principle of cost of carry. Such of those entities who can trade both forwards and futures shall be able to identify any mis-pricing between forwards and futures. If one of them is priced higher, the same shall be sold while simultaneously buying the other which is priced lower. If the tenor of both the contracts is same, since both forwards and futures shall be settled at the same RBI reference rate, the transaction shall result in a risk less profit .

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TRADING PROCESS AND SETTLEMENT PROCESS

Like other future trading, the future currencies are also traded at organized exchanges. The following diagram shows how operation take place on currency future marke

TRADER ( BUYER )

TRADER ( SELLER )

Purchase order

Sales order

MEMBER ( BROKER )

Transaction on the floor (Exchange)

MEMBER ( BROKER )

Informs CLEARING HOUSE

It has been observed that in most futures markets, actual physical delivery of the underlying assets is very rare and it hardly ranges from 1 percent to 5 percent. Most often buyers and sellers offset their original position prior to delivery date by taking an opposite positions. This is because most of futures contracts in different products are predominantly speculative instruments. For example, X purchases American Dollar futures and Y sells it. It leads to two contracts, first, X party and clearing house and second Y party and clearing house. Assume next day X sells same contract to Z, then X is out of the picture and the clearing house is seller to Z and buyer from Y, and hence, this process is goes on.

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REGULATORY FRAMEWORK FOR CURRENCY FUTURES

With a view to enable entities to manage volatility in the currency market, RBI on April 20, 2007 issued comprehensive guidelines on the usage of foreign currency forwards. swaps and options in the OTC market. At the same time, RBI also set up an Internal Working Group to explore the advantages of introducing currency futures. The Report of the Internal Working Group of RBI submitted in April 2008, recommended the introduction of exchange traded currency futures. With the expected benefits of exchange traded currency futures, it was decided in a joint meeting of RBI and SEBI on February 28, 2008, that an RBI-SEBI Standing Technical Committee on Exchange Traded Currency and Interest Rate Derivatives would be constituted. To begin with, the Committee would evolve norms and oversee the implementation of Exchange traded currency futures. The Terms of Reference to the Committee was as under: 1. To coordinate the regulatory roles of RBI and SEBI in regard to trading of Currency and Interest Rate Futures on the Exchanges. 2. To suggest the eligibility norms for existing and new Exchanges for Currency and Interest Rate Futures trading. 3. To suggest eligibility criteria for the members of such exchanges. 4. To review product design, margin requirements and other risk mitigation measures on an ongoing basis. 5. To suggest surveillance mechanism and dissemination of market information. 6. To consider microstructure issues, in the overall interest of financial stability.

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COMPARISION OF FORWARD AND FUTURES CURRENCY CONTRACT

BASIS Size

FORWARD Structured as per requirement of the parties Standardized

FUTURES

Delivery date Method of transaction

Tailored on individual needs

Standardized

Established by the bank or broker through electronic media

Open auction among buyers and seller on the floor of recognized exchange.

Participants

Banks, brokers, forex dealers, multinational companies, institutional investors, arbitrageurs, traders, etc.

Banks, brokers, multinational companies, institutional investors, small traders, speculators, arbitrageurs, etc.

Margins

None as such, but compensating bank balanced may be required

Margin deposit required

Maturity

Tailored to needs: from one week to 10 years

Standardized

Settlement

Actual delivery or offset with cash settlement. No separate clearing house

Daily settlement to the market and variation margin requirements

Market place

Over the telephone worldwide and computer networks

At recognized exchange floor with worldwide communications Open to any one who is in need of hedging facilities or has risk capital to speculate Actual delivery has very less even below one percent Highly secured through margin deposit.

Accessibility Limited to large customers banks, institutions, etc. Delivery More than 90 percent settled by actual delivery Secured Risk is high being less secured

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RESEARCH METHODOLOGY
TYPE OF RESEARCH In this project Descriptive research methodologies were used.The research methodology adopted for carrying out the study was at the first stage theoretical study is attempted and at the second stage observed online trading on NSE/BSE.

SOURCE OF DATA COLLECTION Secondary data were used such as various books, report submitted by RBI/SEBI committee and NCFM/BCFM modules. OBJECTIVES OF THE STUDY The basic idea behind undertaking Currency Derivatives project is to gain knowledge about currency future market. To study the basic concept of Currency future To study the exchange traded currency future To understand the ways of considering currency future price. To analyze different currency derivatives products.

LIMITATION OF THE STUDY

The analysis was purely based on the secondary data. So, any error in the secondary data might also affect the study undertaken. The currency future is new concept and topic related book was not available in library and market.

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DATA ANALYSIS

INTEREST RATE PARITY PRINCIPLE

For currencies which are fully convertible, the rate of exchange for any date other than spot is a function of spot and the relative interest rates in each currency. The assumption is that, any funds held will be invested in a time deposit of that currency. Hence, the forward rate is the rate which neutralizes the effect of differences in the interest rates in both the currencies. The forward rate is a function of the spot rate and the interest rate differential between the two currencies, adjusted for time. In the case of fully convertible currencies, having no restrictions on borrowing or lending of either currency the forward rate can be calculated as follows; Future Rate = (spot rate) {1 + interest rate on home currency * period} / {1 + interest rate on foreign currency * period}

For example, Assume that on January 10, 2002, six month annual interest rate was 7 percent p.a. on Indian rupee and US dollar six month rate was 6 percent p.a. and spot ( Re/$ ) exchange rate was 46.3500. Using the above equation the theoretical future price on January 10, 2002, expiring on June 9, 2002 is: the answer will be Rs.46.7908 per dollar. Then, this theoretical price is compared with the quoted futures price on January 10, 2002 and the relationship is observed.

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PRODUCT DEFINITIONS OF CURRENCY FUTURE ON NSE/BSE

Underlying Initially, currency futures contracts on US Dollar Indian Rupee (US$-INR) would be permitted. Trading Hours The trading on currency futures would be available from 9 a.m. to 5 p.m. Size of the contract The minimum contract size of the currency futures contract at the time of introduction would be US$ 1000. The contract size would be periodically aligned to ensure that the size of the contract remains close to the minimum size. Quotation The currency futures contract would be quoted in rupee terms. However, the outstanding positions would be in dollar terms. Tenor of the contract The currency futures contract shall have a maximum maturity of 12 months. Available contracts All monthly maturities from 1 to 12 months would be made available Settlement mechanism The currency futures contract shall be settled in cash in Indian Rupee.

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Settlement price The settlement price would be the Reserve Bank Reference Rate on the date of expiry. The methodology of computation and dissemination of the Reference Rate may be publicly disclosed by RBI. Final settlement day The currency futures contract would expire on the last working day (excluding Saturdays) of the month. The last working day would be taken to be the same as that for Interbank Settlements in Mumbai. The rules for Interbank Settlements, including those for known holidays and subsequently declared holiday would be those as laid down by FEDAI. The contract specification in a tabular form is as under: Underlying Trading Hours (MondaySize to Friday) Contract Tick Size Trading Period Contract Months Final Settlement date/ Rate of exchange between one USD and INR a.m. to 05:00 p.m. 09:00 USD 1000 0.25 paisa or INR 0.0025 Maximum expiration period of 12 months 12 near calendar months Last working day of the month (subject to holiday calendars) Two working days prior to Final Settlement Date settled Cash The reference rate fixed by RBI two

Value date Day Last Trading Settlement Final Settlement Price

working days prior to the final settlement date will be used for final settlement

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CURRENCY FUTURES PAYOFFS A payoff is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. This is generally depicted in the form of payoff diagrams which show the price of the underlying asset on the X-axis and the profits/losses on the Y-axis. Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. Options do not have linear payoffs. Their pay offs are non-linear. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. However, currently only payoffs of futures are discussed as exchange traded foreign currency options are not permitted in India. Payoff for buyer of futures: Long futures The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who buys a two-month currency futures contract when the USD stands at say Rs.43.19. The underlying asset in this case is the currency, USD. When the value of dollar moves up, i.e. when Rupee depreciates, the long futures position starts making profits, and when the dollar depreciates, i.e. when rupee appreciates, it start making losses. Figure 4.1 shows the payoff diagram for the buyer of a futures contract. Payoff for buyer of future: The figure shows the profits/losses for a long futures position. The investor bought futures when the USD was at Rs.43.19. If the price goes up, his futures position starts making profit. If the price falls, his futures position starts showing losses.

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P R O
43.19

F 0 USD I L T O S S
D

Payoff for seller of futures: Short futures The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells a two month currency futures contract when the USD stands at say Rs.43.19. The underlying asset in this case is the currency, USD. When the value of dollar moves down, i.e. when rupee appreciates, the short futures position starts 25 making profits, and when the dollar appreciates, i.e. when rupee depreciates, it starts making losses. The Figure below shows the payoff diagram for the seller of a futures contract

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Payoff for seller of future: The figure shows the profits/losses for a short futures position. The investor sold futures when the USD was at 43.19. If the price goes down, his futures position starts making profit. If the price rises, his futures position starts showing losses\

P R O
43.19

F 0 USD I L T O S S
D

PRICING FUTURES COST OF CARRY MODEL Pricing of futures contract is very simple. Using the cost-of-carry logic, we calculate the fair value of a futures contract. Every time the observed price deviates from the fair value, arbitragers would enter into trades to capture the arbitrage profit. This in turn would push the futures price back to its fair value. The cost of carry model used for pricing futures is given below: F=Se^(r-rf)T where:
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r=Cost of financing (using continuously compounded interest rate) rf= one year interest rate in foreign T=Time till expiration in years E=2.71828 The relationship between F and S then could be given as F Se^(r rf )T - = This relationship is known as interest rate parity relationship and is used in international finance. To explain this, let us assume that one year interest rates in US and India are say 7% and 10% respectively and the spot rate of USD in India is Rs. 44.

From the equation above the one year forward exchange rate should be F = 44 * e^(0.10-0.07 )*1=45.34

It may be noted from the above equation, if foreign interest rate is greater than the domestic rate i.e. rf > r, then F shall be less than S. The value of F shall decrease further as time T increase. If the foreign interest is lower than the domestic rate, i.e. rf < r, then value of F shall be greater than S. The value of F shall increase further as time T increases.

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HEDGING WITH CURENCY FUTURES

Exchange rates are quite volatile and unpredictable, it is possible that anticipated profit in foreign investment may be eliminated, rather even may incur loss. Thus, in order to hedge this foreign currency risk, the traders oftenly use the currency futures. For example, a long hedge (I.e.., buying currency futures contracts) will protect against a rise in a foreign currency value whereas a short hedge (i.e., selling currency futures contracts) will protect against a decline in a foreign currencys value. It is noted that corporate profits are exposed to exchange rate risk in many situation. For example, if a trader is exporting or importing any particular product from other countries then he is exposed to foreign exchange risk. Similarly, if the firm is borrowing or lending or investing for short or long period from foreign countries, in all these situations, the firms profit will be affected by change in foreign exchange rates. In all these situations, the firm can take long or short position in futures currency market as per requirement. The general rule for determining whether a long or short futures position will hedge a potential foreign exchange loss is: Loss from appreciating in Indian rupee= Short hedge Loss form depreciating in Indian rupee= Long hedge

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The choice of underlying currency The first important decision in this respect is deciding the currency in which futures contracts are to be initiated. For example, an Indian manufacturer wants to purchase some raw materials from Germany then he would like future in German mark since his exposure in straight forward in mark against home currency (Indian rupee). Assume that there is no such future (between rupee and mark) available in the market then the trader would choose among other currencies for the hedging in futures. Which contract should he choose? Probably he has only one option rupee with dollar. This is called cross hedge.

Choice of the maturity of the contract The second important decision in hedging through currency futures is selecting the currency which matures nearest to the need of that currency. For example, suppose Indian importer import raw material of 100000 USD on 1st November 2008. And he will have to pay 100000 USD on 1st February 2009. And he predicts that the value of USD will increase against Indian rupees nearest to due date of that payment. Importer predicts that the value of USD will increase more than 51.0000. So what he will do to protect against depreciating in Indian rupee? Suppose spots value of 1 USD is 49.8500. Future Value of the 1USD on NSE as below:

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Price Watch Contract USDINR 261108 USDINR 291208 USDINR 280109 USDINR 250209 USDINR 270309 USDINR 280409 USDINR 270509 USDINR 260609 USDINR 290709 USDINR 270809 USDINR 280909 USDINR 281009 USDINR 261109 Order Book Best Best Best Best LTP Volume Open Buy Qty Buy Price Sell Price Sell Qty Interest 464 49.8550 49.8575 712 49.8550 58506 43785 189 1 100 100 1 25 1 2 1 1 1 49.6925 49.8850 50.1000 49.9225 50.0000 49.0000 48.0875 48.1625 48.2375 48.3100 48.3825 49.7000 49.9250 50.2275 50.5000 51.0000 51.0000 50.5000 53.1900 612 49.7300 2 49.9450 1 50.1925 5 49.9125 5 50.5000 5 47.1000 - 50.0000 - 49.1500 1 50.3000 - 51.2000 2 50.9900 - 50.9275 176453 5598 3771 311 6 111830 16809 6367 892 278 506 116 44 2215 79 2 -

Volume As On 26-NOV-2008 17:00:00 Hours IST No. of Contracts 244645 Archives As On 26-Nov-2008 12:00:00 Hours IST Underlying USDINR RBI reference rate 49.8500

Rules, Byelaws & Regulations Membership Circulars List of Holidays

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Solution: He should buy ten contract of USDINR 28012009 at the rate of 49.8850. Value of the contract is (49.8850*1000*100) =4988500. (Value of currency future per USD*contract size*No of contract). For that he has to pay 5% margin on 5988500. Means he will have to pay Rs.299425 at present.And suppose on settlement day the spot price of USD is 51.0000. On settlement date payoff of importer will be (51.0000-59.8850) =1.115 per USD. And (1.115*100000) =Rs. 111500.

Choice of the number of contracts (hedging ratio) Another important decision in this respect is to decide hedging ratio HR. The value of the futures position should be taken to match as closely as possible the value of the cash market position. As we know that in the futures markets due to their standardization, exact match will generally not be possible but hedge ratio should be as close to unity as possible. We may define the hedge ratio HR as follows:

HR= VF / Vc Where, VF is the value of the futures position and Vc is the value of the cash position. Suppose value of contract dated 28th January 2009 is 49.8850. And spot value is 49.8500. HR=49.8850/49.8500=1.001.

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FINDINGS
Cost of carry model and Interest rate parity model are useful tools to find out standard future price and also useful for comparing standard with actual future price. also a very help full in Arbitraging. New concept of Exchange traded currency future trading is regulated by higher authority and regulatory. The whole function of Exchange traded currency future is regulated by SEBI/RBI, and they established rules and regulation so there is very safe trading is emerged and counter party risk is minimized in currency Future trading. And also time reduced in Clearing and Settlement process up to T+1 days basis. Larger exporter and importer has continued to deal in the OTC counter, even exchange traded currency future is available in markets. There is a limit of USD 100 million on open interest applicable to trading member who are banks. And the USD 25 million limit for other trading members so larger exporter and importer might continue to deal in the OTC market where there is no limit on hedges. In India RBI and SEBI has restricted other currency derivatives except Currency future, at this time if any person wants to use other instrument of currency derivatives in this case he has to use OTC. And its

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CONCLUSIONS
By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivativesThese instruments enhances the ability to differentiate risk and allocate it to those investors most able and willing to take it- a process that has undoubtedly improved national productivity growth and standards of livings. The currency future gives the safe and standardized contract to its investors and individuals who are aware about the forex market or predict the movement of exchange rate so they will get the right platform for the trading in currency future. Because of exchange traded future contract and its standardized nature gives counter party risk minimized. Initially only NSE had the permission but now BSE and MCX has also started currency future. It is shows that how currency future covers ground in the compare of other available derivatives instruments. Not only big businessmen and exporter and importers use this but individual who are interested and having knowledge about forex market they can also invest in currency future. Exchange between USD-INR markets in India is very big and these exchange traded contract will give more awareness in market and attract the investors.

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SUGGESTIONS
Currency Future need to change some restriction it imposed such as cut off limit of 5 million USD, Ban on NRIs and FIIs and Mutual Funds from Participating. Now in exchange traded currency future segment only one pair USD-INR is available to trade so there is also one more demand by the exporters and importers to introduce another pair in currency trading. Like POUND-INR, CAD-INR etc. In OTC there is no limit for trader to buy or short Currency futures so there demand arises that in Exchange traded currency future should have increase limit for Trading Members and also at client level, in result OTC users will divert to Exchange traded currency Futures. In India the regulatory of Financial and Securities market (SEBI) has Ban on other Currency Derivatives except Currency Futures, so this restriction seem unreasonable to exporters and importers. And according to Indian financial growth now its become necessary to introducing other currency derivatives in Exchange traded currency derivative segment.

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REFERNCES
NCFM: Currency future Module. BCFM: Currency Future Module. NSE BSE) Security and portfolio analysis ( KEVIN Financial Markets and services ( E GORDON AND K NATRAJAN)

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