Currency Derivatives Trading

A Currency market is a market in which one Currency is traded for another. The Spot exchange rate refers to the prevailing exchange rate at which a Currency can be bought or sold for another. The Forward exchange rate refers to the exchange rate for the future delivery of the underlying Currencies. A Currency Futures contract, traded on Exchanges, is a standardised version of a Forward contract. The only difference between a Forward contract and the Futures contract is that the Forward contract is an over-thecounter (OTC) product. The main advantages of Currency Futures over Forwards are price transparency, elimination of counter-party credit risk and greater accessibility for all. The Futures contract is an agreement to buy or sell the underlying Currency, on a specified date in the future, and at a specified price. The underlying asset for a Currency Futures contract is a Currency. The Exchanges clearing house acts as a central counter-party for all trades and thus provides a performance guarantee. Currency Futures can be bought and sold on the Currency Exchanges through members of the Exchange. MCXSX, NSE and USE all offer Currency Futures in India. Before trading, the investor/trader/speculator needs to open a trading account and deposit the stipulated cash and/or collaterals with the trading member. The average daily turnover in global Forex and related markets is trillions of US Dollars

Currency Hedging Scenario's

Exchange Traded Currency Futures are used to hedge against the risk of rate volatilities in the Forex markets. Below we give two illustrations to explain the concept and mechanism of hedging. Hedging against Indian Rupee appreciation Lets assume an Indian IT exporter receives an export order worth EUR100,000 from a European telecom major with the delivery date being in three months. At the time of placing the contract, the Euro is worth 64.05 Indian Rupees in the Spot market, while a Futures contract for an expiry date that matches the order payment date is trading at INR64. This puts the value of the order, when placed, at INR6,405,000. However, if the domestic exchange rate appreciates significantly (to INR63.20) by the time the order is paid for (which is one month after the delivery date), the firm will receive only INR6,320,000 rather than INR6,405,000. To insure against such losses, the firm can, at the time it receives the order, enter into 100 Euro Futures contracts of EUR1,000 each to sell at INR64 per Euro, which involves contracting to sell a foreign Currency on expiry date at the agreed exchange rate. If on the payment date the exchange rate is INR63.20, the exporter will receive only INR6,320,000 on selling the Euro in the Spot market, but gains INR80,000 (ie 64 - 63.20 * 100 * 1,000) in the Futures market. Overall, the firm receives INR6,400,000 and protects itself against the sharp appreciation of the domestic Currency against the Euro. In the short term, firms can make gains or losses from hedging. The basic purpose of hedging is to protect against excessive losses. Firms also tend to benefit from knowing exactly how much they will receive from the export deals and can avoid the uncertainty associated with future exchange rate movements. Hedging against Indian Rupee depreciation An organic chemicals dealer in India places an import order worth EUR100,000 with a German manufacturer. Lets assume the current Spot rate of the Euro is INR64.05 and at this rate the value of the order is INR 6,405,000. The importer is worried about the sharp depreciation of the Indian Rupee against the Euro during the months until the payment is due. So, the importer buys 100 Euro Futures contracts (EUR1, 000 each) at INR64 per Euro. At expiry, the Rupee has depreciated to INR65 and the importer has to pay INR6,500,000, gaining INR100,000 (ie INR65-64 * 100 * 1,000) from the Futures market and the resulting outflow would be only INR6,400,000. In the short term, firms can make gains or losses from hedging. The basic purpose of hedging is to protect against excessive losses. Firms also tend to benefit from knowing exactly how much they will pay for the import order and avoid the uncertainty associated with future exchange rate movements.

Illustrations
Illustration 1

A vegetable oil importer wants to import oil worth USD100,000 and places his import order on 15 July 2009, with the delivery date being four months later. At the time of placing the contract one US Dollar is worth 44.50 Indian Rupees in the Spot market. Lets assume the Indian Rupee depreciates to INR44.75 per USD by the time the payment is due in October 2009, then the value of the payment for the importer goes up to INR4,475,000, rather than the original INR4,450,000. The hedging strategy for the importer, thus, would be: Current Spot rate (15 July 2009) Buy 100 USD - INR October 2009 contracts on 15 July 2009 Sell 100 USD - INR October 2009 contracts in October 2009, profit/loss (Futures market) Purchases in Spot market at 44.75 total cost of hedged transaction 44.5000 (1,000 * 44.5500) * 100 (assuming the October 2009 contract is trading at 44.5500 on 15 July 2009) 44.7500 1000 * (44.75 44.55) * 100 = 20,000 44.75 * 100,000 100,000 * 44.75 20,000 = INR4,455,000

Illustration 2 A jeweller who is exporting gold jewellery worth USD50,000 wants protection against possible Indian Rupee appreciation in December 2009, ie when he receives his payment. He wants to lock in the exchange rate for the above transaction. His strategy would be: One USD - INR contract size Sell 50 USD - INR December 2009 contracts (on 15 July 2009) Buy 50 USD - INR December 2009 contracts in December 2009 USD1,000 44.6500 44.3500

Sell USD50,000 in Spot market at 44.35 in December 2009 (assuming that the Indian Rupee depreciated initially , but later appreciated to 44.35 per USD by the end of December 2009, as foreseen by the exporter) Profit/loss from Futures (December 2009 contract) 50 * 1000 *(44.65 44.35) = 0.30 *50 * 1000 = Rs 15,000

The net receipt in INR for the hedged transaction would be: 50,000 *44.35 + 15,000 = 2,217,500 + 15,000 = INR2,232,500. Had he not participated in the Futures market, he would have got only INR2,217,500 However, he kept his sales unexposed to Forex rate risk.