Final Report

June 10, 2014 A STUDY ON CURRENCY DERIVATIVES AN INVESTMENT OPTION OR A NEW
HEDGING TOOL.

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A STUDY ON CURRENCY DERIVATIVES AN
INVESTMENT OPTION OR A NEW HEDGING TOOL.

BY:
N.SINDHU SRI
ID: 13A2HP003

INSTITUTE OF MANAGEMENT TECHNOLOGY
HYDERABAD
10
Th
JUNE, 2014
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A REPORT ON
Training undertaken at
FAIRWEALTH SECURITIES PRIVATE LIMITED
Titled
A STUDY ON CURRENCY DERIVATIVES AN
INVESTMENT OPTION OR A NEW HEDGING TOOL
By
N.SINDHU SRI, 13A2HP003
A report submitted in partial fulfilment of the requirements
of PGDM Program of IMT Hyderabad.

Approved by:
Dr.KaushikBhattacharyajee Mr.SumanAdepu

JUNE 9, 2014

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COPYRIGHT NOTICE
Information and images contained within this report are copyright and intellectual property
of N.Sindhu Sri @2014.
No part of this report may be reproduced in any manner without the permission of the
publisher.

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Cover Letter
To: Dr. Kaushik Bhattacharjee and Mr. Suman Adepu
Subject: Summer Internship Report
Date: 10th June 2014
I am pleased to submit my Summer Internship Report which helps in knowing
the economic factors which currency fluctuations and their impact on Indian
Rupee. Also compare costs incurred for trading with banks and brokerage firms
and compare those charges.
I would like to mention my sincere and heartfelt gratitude towards my faculty
guide Dr. Kaushik Bhattacharjee and company guide Mr. Suman Adepu for
their support throughout the completion of the report which made the task quite
easy for me.

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Acknowledgement
I take this opportunity to express my profound gratitude and deep regards to
my Professor Mr.Kaushik Bhattacharjee for his exemplary guidance, monitoring
and constant encouragement throughout the course of this thesis. The
blessing, help and guidance given by him time to time shall carry me a long
way in the journey of life on which I am about to embark.
I also take this opportunity to express a deep sense of gratitude to my
Company Mentor Mr.Suman Adepu, Partner, Fair wealth Securities* for his
cordial support, valuable information and guidance, which helped me in
completing this task through various stages.
I am obliged to staff members of Fairwealth, for the valuable information
provided by them in their respective fields. I am grateful for their cooperation
during the period of my project.

*Details of Fairwealth Securities Pvt Ltd are given at the end.
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SUMMARY
There are many factors which lead to the rapid currency fluctuations. The
objective of this project is to see the economic factors affecting the currency
fluctuations. Also see how changes in other currencies have an impact on Indian
Rupee. In addition to this, the project also compares the charges of FOREX
transactions by Banks and Brokerage firms.
So basically, project deals with currency fluctuations, which shows how
important it is to hedge, so as to reduce risk involved in these currency
fluctuations. Also, for hedging, how brokerage firms like Fairwealth offers less
charges compared to banks.

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Table of Contents
Cover Letter iv
Acknowledgement v
Summary Vi
Technical Terms and Abbreviations 1
1. Introduction 2
1.1 Derivatives introduction in India 2
1.2 Types of Derivatives 2
1.2.1. Forwards Contract 2
1.2.2. Futures Contract 3
1.2.3. Options Contract 3
1.2.2. Swaps Contract 3
1.3 Major players of derivatives market 4
1.4 Foreign Exchange Rate 4
2 Factors affecting currency fluctuations 6
2.1 Interest rate 7
2.1.1 Major announcements 7
2.1.2 Analyzing forecasts 8
2.2 Inflation 8
2.3 Retail sales 9
2.4 Unemployment 10
2.5 Consumer Price Index 11
2.6 Producer Price Index 12
2.7 GDP 14
3. Subprime Crisis 14
4. Regression Analysis 17
4.1 Unites States 17
4.2 Europe countries trading in EURO 20
4.3 Japan 23
5. Exchange traded future cost versus OTC traded forward cost 25
5.1 Charges of brokerage firms 25
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5.2 Charges of banks 28
5.3 Advantages of Banks over Brokerage firms 30
6. Questionnaire Responses 31
7. Conclusions and recommendations 37
8. References 38

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LIST OF TABLES
S.no. Name Page no.
1. The lot size and the contract value 25
2. The costs charged by a broking firm 25
3.
The brokerage charged by the broking firms for
different amounts.
26
4. Fee charged by SEBI for different investments. 26
5. The costs charged by a broking firm when taken
highest brokerage value.
27
6. The different charges charged by banks. 28
7. The difference between charges charged by
broking firms and banks.
29

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LIST OF FIGURES

S.no Name Page No.
1. Derivatives contract in India 2
2. Comparison of Indian Interest rate with USD-INR 7
3. Comparison of US Inflation rate with USD-INR 8
4. Comparison of US Retail sales with USD-INR 10
5. Comparison of US Unemployment rate with USD-INR 11
6. Comparison of US CPI with USD-INR 11
7. Comparison of US PPI with USD-INR 13
8. Comparison of US GDP with USD-INR 14
9. Customers with less credit rating were given loans 15
10. Many defaults are made by credit risk customers. 15
11. Regression output for US in 2009 17
17. Regression output for Euro Area in 2009 20
22. Regression output for Japan in 2009 23
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TECHNICAL TERMS OR ABBREVIATIONS
1. USD US Dollar
2. INR Indian Rupee
3. EURO European currency
4. YEN Japanese currency which is Yen
5. LOT 1 lot is equal to 1000 USD
6. FOREX Market Decentralized market for trading of currencies.
7. Exchange Traded Future Cost Cost incurred through trading with brokerage
firms.

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1. INTRODUCTION

1.1. 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.
1.2. TYPES OF DERIVATIVES:
Derivative contracts are of several types. The most common types are forwards, futures,
options and swap.

Figure 1: Derivative contracts in India.
1.2.1. Forwards Contract:
A forward contract is a customized contract between the buyer and the seller where
settlement takes place on a specific date in future at a price agreed today. The price to be
paid/received is decided at the time of entering into the contract. Although the delivery is
made in the future, the price is determined on the initial trade date.
One of the parties to a forward contract assumes a long position (buyer) and agrees to buy the
underlying asset at a certain future date for a certain price. The other party to the contract
known as seller assumes a short position and agrees to sell the asset on the same date for the
same price. The specified price is referred to as the deliver price. The terms like price and
date are decided on mutual agreement of both the parties.
Derivatives
Currency Commodity Equity
1. Futures
2. Forwards
3. Currency swaps
1. Forwards
2. Futures
1. Futures
2. Options
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This forwards contract is over the counter and not any type of exchange. This is basically
between any two financial institutions of a financial institute and its client.
Forward contracts are bilateral contracts, and hence, they are exposed to the counter party
risk. There is risk of non-performance of obligation either of the parties, so these are riskier
than to futures contracts. Each contract is custom designed, and hence, is unique in terms of
contract size, expiration date, the asset type, quality etc.
1.2.2. Futures Contract:
Futures contract is an agreement between two parties to buy or sell a specified quantity of an
asset at a specified price and at a specified time and place. Future contracts are normally
traded on an exchange which sets the certain standardized norms for trading in futures
contracts.
Futures contract required to have standard contract terms. These contracts are regulated by
regulatory authorities like SEBI. The main use of the future by the commercial users is to
hedge corresponding cash and forward positions.
1.2.3. Options Contract:
Options are derivative contract that give the right, but not the obligation to either buy or sell a
specific underlying security for a specified price on or before a specific date. The person who
buys an option is normally called the buyer or holder. Conversely, the seller is known as the
seller or writer
Options are of two types calls and puts. Calls give the buyer the right but not the obligation
to buy a given quantity of the underlying asset, at a given price on or before a given future
date. Puts give the buyer the right, but not the obligation to sell a given quantity of the
underlying asset at a given price on or before a given date.
In options, the owner has limited liability. Owners of options have no voting rights.
1.2.4. Swaps Contract:
A swap is an agreement between two or more people or parties to exchange sets of cash flows
over a period in future. Swaps are agreements between two parties to exchange assets at
predetermined intervals. Swaps are generally customerised transactions. The swaps are
innovative financing which reduces borrowing costs, and to increase control over interest rate
risk and FOREX exposure. Swaps are useful in avoiding the problems of unfavourable
fluctuation in FOREX market. The parties that agree to the swap are known as counter
parties.
Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes
in the expected direction of underlying prices. Contrary to a future, a forward or an option,
the notional amount is usually not exchanged between counterparties. Consequently, swaps
can be in cash or collateral.
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The two commonly used swaps are interest rate swaps and currency swaps.
Interest rate swaps which entail swapping only the interest related cash flows between the
parties in the same currency.
Currency swaps entail swapping both principal and interest between the parties, with the cash
flows in one direction being in a different currency than the cash flows in the opposite
direction.

1.3. MAJOR PLAYERS OF DERIVATIVES MARKET:
There are three major players in the financial derivatives trading:
1. Hedgers: Hedgers are traders who use derivatives to reduce the risk that they face from
potential movements in a market variable and they want to avoid exposure to adverse
movements in the price of an asset. Hedging is done with an objective to minimize the
risk in trading or holding the underlying securities. Hedgers have to bear some cost in
order to achieve protection against sudden price changes.
2. Speculators: Speculators are traders who buy/sell the assets only to sell/buy them back
profitably at a later point in time. They want to assume risk. They use derivatives to bet
on the future direction of the price of an asset and take a position in order to make a quick
profit. They assume the changes in markets and try to invest or take back their investment
based on their speculation.
3. Arbitrageurs: Arbitrageurs are traders who simultaneously buy and sell the same or
different(but related) assets in an effort to profit from unrealistic price differentials. They
attempts to make profits by locking in a riskless trading by simultaneously entering into
transaction in two or more markets. They try to earn riskless profit from discrepancies
between futures and spot prices and among different futures prices.

1.4. FOREIGN EXCHANGE RATE:
At some point either when travelling or making an overseas purchase, most people would
have in some way participated in the FX market. However, it is more than
currency conversion. Increasingly many are now turning to the FX market for the purposes of
speculation or dealing at prices formerly only available to financial institutions.
As defined in The Economist's Guide to Financial Markets, foreign exchange, more
popularly referred to as "FOREX" is a worldwide decentralized over-the-counter financial
market for the trading of currencies, wherein financial centres around the globe serves as
anchors of trading between a wide range of different types of buyers and sellers 24 hours a
day, five days a week.
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Foreign exchange rate is value of foreign currency relative to domestic currency. This is done
in Foreign Exchange market, which is one of the biggest financial markets. The participants
in this market are Banks, corporations, exporters, importers etc. In currency pair, first
currency is called base currency and second one is quote currency. Exchange rate tells the
worth of base currency in terms of quote currency.
There are many risks influenced by both external and internal factors to the business and
suitable measures should be adopted to manage and reduce such risks. Successful business
firms are those which manage these risks effectively. The best way for this is hedging.
Hedging is done with an objective to minimize the risk in trading or holding the underlying
securities. Hedgers have to bear some cost in order to achieve protection against sudden price
changes.
Currency Derivatives is a transferable contract that specifies the price at which a currency can
be bought or sold at a future date. Currency contracts allow investors to hedge against foreign
exchange risk.
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. 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.
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.

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2. FACTORS AFFECTING CURRENCY FLUCTUATIONS

This study aims to explore the macro economic factors influencing currency fluctuations and
how Indian rupee is getting affected with these fluctuations. There are many factors that can
cause currency changes and fluctuations. Exchange rates can be unpredictable. It is important
to know why such changes occur. The exchange rate can often be used as an indicator to
determine the health of an economy.
Exchange rates are determined by supply and demand. For example, if there was greater
demand for American goods then there would tend to be an appreciation (increase in value)
of the dollar. A higher currency makes a country's exports more expensive and imports
cheaper in foreign markets and a lower currency makes a country's exports cheaper and its
imports more expensive in foreign markets.
Exchange rate matters on a smaller scale as well: it impacts the real return of an investor's
portfolio, profitability of firms, and growth of specific sectors amongst various other
determinants of the economy.
Exchange rate affects trading relationships between two nations. The exchange rate of
currency determines the real return of portfolio that holds the bulk of its investment.
There are many factors which after getting released affect the currency and cause
fluctuations. They are
1. Interest rate
2. Inflation
3. Retail Sales
4. Unemployment
5. Consumer Price Index
6. Production Price Index
7. GDP
We will see in detail how these factors are affecting the currency fluctuations.

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2.1. INTEREST RATE:
The biggest influence that drives the foreign-exchange market is interest rate changes made
by any of the eight global central banks. They possess the power to move the market
immediately and with full force. Surprise rate changes often make the biggest impact on
traders.
In general, if interest rate is increased, it is a positive sign for domestic currency. Because,
due to increase in interest rate, people from different countries wish to invest in our country.
So they will convert their currency into our currency. The demand for domestic currency
increases and hence the value of our domestic currency appreciates.

Figure 2: Comparison of Indian Interest rate with USD-INR
But this is not the only case because if it would have been so easy then people with this
knowledge can make huge profits. There is also a disadvantage here because people from our
country will try to invest as much as possible in banks by reducing their spending. Hence
companies lose their sales and they suffer some loss. This in turn reduces economy of our
country.
It is possible to predict a rate decision by:
1. Watching for major announcements
2. Analyzing forecasts
2.1.1. Major announcements: Major announcements from central bank heads tend to play a
vital role in interest rate moves. Any time a board of directors from any of the central banks
is scheduled to talk publicly, it will usually give an insight.
For example, on July 16, 2008, Federal Reserve Chairman Ben Bernanke gave his semi-
annual monetary policy testimony before the House Committee. In his statement and
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answers, he was adamant that the U.S. dollar was in good shape and that the government was
determined to stabilize it even though fears of a recession were influencing all other markets.
This session was widely followed by traders, and because it was positive, it was anticipated
that the Federal Reserve would raise interest rates. Hence the demand for dollar was
increased and people invested in dollar. This resulted in a $440 profit for traders who acted
on the announcement.
2.1.2. Analyzing forecasts: The second useful way to predict interest rate decisions is
through analyzing predictions. Because interest rates moves are usually well anticipated,
brokerages, banks and professional traders will already have a consensus estimate as to what
the rate is.
Traders should take four or five of these forecasts (which should be very close numerically)
and average them in order to gain a more accurate prediction.
In 2007, the interest rate of The US was around 4.25%. But gradually after the recession
occurred, the interest rate fell to around 0.25%. Hence the value of dollar depreciated thereby
increasing the value of Rupee. During 2008-2009 the value of USDINR reached 39 rupees
also. So change in interest rate can affect the currency a lot.
2.2. INFLATION:
Inflation is a bad sign for domestic currency. Inflation is nothing but paying more amount for
same basket of goods. This in turn means decrease in value of money. Let us take a situation
where income of an individual increases whereas the production of goods remain same.
Hence the individual will be willing to pay more for the same good which he used to get for
less in past. So the demand for good increases thereby increasing its value. Hence inflation
occurs.
Here the value of the money we pay decreases as we are paying more to get the same
product. Hence the currency depreciates. Also the demand for export of goods decreases as
they are quoted a high price. This also leads to decrease in value of currency.

Figure 3: Comparison of US inflation rate and USD-INR.
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Relatively high rate of inflation reduces a country's competitiveness in international markets
and weakens its ability to sell in foreign markets.
During the last half of the twentieth century, the countries with low inflation included Japan,
Germany and Switzerland, while the U.S. and Canada achieved low inflation only later.
Those countries with higher inflation typically see depreciation in their currency in relation to
the currencies of their trading partners.
Inflation is also usually accompanied by higher interest rates. If inflation is consistently rising
in any one country, the central bank is going to want to control that and they do that through
raising interest rates. This increase in interest rates welcomes foreign investors as said above.
Hence the demand for the currency increases and capital comes into the country. This lowers
the price of imported goods for the citizens of that country.[3]
There is also a problem with this as foreign investment is unstable and people can take back
their money at any point of time. This reduce the value of currency all of sudden. This has
happened in countries like Brazil where foreign investors caused the currency value to
increase when they invested in Brazilian companies in the early 2000s. This initially created a
positive effect for Brazil, but now that foreign investors are withdrawing their money
causing a 40 percent drop in foreign investments in the first six months of 2012. The
government is slashing interest rates in the hopes of increasing cheaper loans and returning to
its days of strong growth.
In 2011, inflation rate is around 3% and it fell to 1.7% in 2012. Here there is decrease in
inflation rate. Hence there will be demand for domestic currency which increases the value of
currency. So this can be one of the reason for the USD-INR to increase from Rs.51.1 in 2011
to Rs.54.7 in 2012.
2.3. RETAIL SALES:
Increase in retail sales means there is increase in consumer spending. Because with increase
in spending of consumers, sales of company increases. This increase in consumer spending
can be due to increase in their income. Hence, their increase in income increases demand for
goods as consumers will be willing to buy goods at a higher price with increase in income.
Hence companies make profit as most of their goods are sold with their increase in
demand.[4]
So with increase in consumer spending thereby companies making profit, the economy of the
country increases to an extent. With increase in economy of the country, foreign investors
will get attracted towards investing in our country. Hence demand of our currency increases
which increase the value of domestic currency.
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Figure 4: Comparison of US Retail sales and USD-INR
Normally, with increase in retail sales currency value also increases. But in US from 2008-
2010, there was major affect of recession. So irrespective of economic factors value of USD
kept on decreasing.
2.4. UNEMPLOYMENT:
Employment levels have an immediate impact on economic growth. As unemployment
increases, consumer spending falls because jobless workers have less money to spend on
nonessentials. Those still employed worry for the future and also tend to reduce spending and
save more of their income.
An increase in unemployment signals a slowdown in the economy and possible devaluation
of a country's currency because of declining confidence and lower demand. If demand
continues to decline, the currency supply builds and further exchange rate depreciation is
likely. One of the most anticipated employment reports is the U.S. Non-Farm Payroll (NFP),
a reliable indicator of U.S. employment issued the first Friday of every month.
Also government has to pay unemployment claims for unemployed person with social
security number. This also reduces the money from government. This all reduces economy of
the country thereby decreasing the value of currency.
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Figure 5: Comparing US unemployment rate and USD-INR.
Employment growth is a good indicator for the overall health of the economy. Positive
employment growth will attract more investors and create a stronger dollar. Unnaturally high
unemployment causes the dollar to drop because the government loses tax revenue that could
help with the deficit. It also takes consumer purchasing power away, which causes the
economy to suffer.
In 2011, the unemployment rate of US is 9% on an average. It decreased to 8% on an average
in 2012. This can also be one of the reasons for appreciation in value of USD-INR from
Rs.51.1 in 2011 to Rs.54.7 in 2012.
2.5. CONSUMER PRICE INDEX:
The Consumer Price Index or CPI is a fundamental economic indicator that has become one
of the most closely watched inflation measures used by forex traders. The level of the CPI is
commonly used by economists and fundamental traders to assess the level of inflation
prevailing in a country's economy that relates to the cost of goods and services to a typical
consumer. [5].

Figure 6: Comparison of US Consumer Price Index and USD-INR.
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The Consumer Price Index indicator is a weighted average of the price changes seen in a
certain basket of consumer services and goods. The weights for each item are determined
based on the item's importance in the economy. The index usually includes items such as:
food, transportation, housing, recreation, medical care, clothing, and education.
The changes seen in the CPI can have a large effect on an economy. When the CPI of an
economy is rising strongly, it tends to discourage consumers from saving and reduces their
purchasing power. Also, benchmark interest rates tend to increase in a rising CPI
environment as central banks move to fight inflationary pressures. This results in a
contraction in borrowing for expansion purposes.
On the other hand, a declining CPI that is typical of deflationary periods tends to signal an
economic slowdown in a country. Benchmark interest rates set by central banks also usually
come down during such low or negative inflationary periods in order to make borrowing less
costly.
Basically, if the CPI or Core CPI number for a country comes out above the market's
expectations, then that tends to increase the value of that country's currency relative to other
currencies. On the other hand, if the CPI or Core CPI comes out below the market's
expectations, then that will tend to reduce the value of that country's currency relative to
others.
In addition to deviations of the most recent number from expectations causing FOREX
market volatility, revisions to previous numbers can also have a significant market impact.
The CPI and Core CPI are some of the most closely observed of all of the fundamental
indicators for an economy. Nevertheless, the forex market tends to focus on the Core CPI
data for a country, if available, since it tends to better indicate the underlying trend in
inflation by excluding the especially volatile of food and energy elements.
2.6. PRODUCER PRICE INDEX:
Producer price changes in the United States are measured with the Producer Price Index. This
important economic indicator is computed by taking a weighted average of the price changes
observed in physical goods measured at the wholesale or producer level.
If production increases, it means the industry is growing. Due to this growth, exports of a
country increases. The demand for domestic currency increases. This strengthens the value of
domestic currency.
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Figure 7: Comparing US Production and USD-INR.
Furthermore, U.S. Core PPI excludes the more volatile price changes often seen in food and
energy commodities since their price fluctuations can obscure the underlying trend in
wholesale inflation.
The PPI was formerly known as the Wholesale Price Index until its name was changed in
1978, and the indicator currently includes changes in the prices of all goods manufactured in
the United States. In addition, the U.S. PPI currently uses as a benchmark a fixed basket of
goods prices from 1982 that is given an initial value of 100. This basket is then used to
measure subsequent price increases.
The weight for each item included in the index is determined based on the item's importance
in the economy. The index usually includes items such as: food, transportation, housing,
recreation, medical care, clothing and education. The changes seen in the PPI can have a
large effect on the U.S. economy. When the PPI of an economy is rising strongly, it tends to
result in future inflation in the prices of consumer goods that discourage consumers from
saving and also reduces their purchasing power.
In addition, benchmark interest rates tend to rise in an increasing PPI environment as central
banks act to combat inflationary pressures. This tends to cause a contraction in borrowing for
the purpose of expansion.
On the other hand, a declining PPI that is typical of deflationary periods tends to signal an
upcoming economic slowdown in a country. Benchmark interest rates set by central banks
also usually come down during such low or negative inflationary periods in order to make
borrowing less costly.
In addition to deviations of the most recent PPI number from expectations causing forex
market volatility, revisions to previous numbers can also have a significant market impact.
2.7. GROSS DOMESTIC PRODUCT:
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The Gross Domestic Product is the total market value of all goods and services in a country.
GDP is an excellent and commonly used indicator to measure a countrys economic growth.
With increase in GDP, the national currency will appreciate as well.
Figure 8: Comparing US GDP and USD-INR.
Between early 2011 to mid-2013, the real GDP of the U.S. increased from 15,052 to 15,679
billion dollars. This is a reason why the U.S Dollar appreciated against most currencies
during that period.
3. SUBPRIME CRISIS:
The subprime crisis that began in August 2007 has been called the worst financial crisis since
the Great Depression The subprime mortgage crisis of 200710 stemmed from an earlier
expansion of mortgage credit, including to borrowers who previously would have had
difficulty getting mortgages, which both contributed to and was facilitated by rapidly rising
home prices. Prior to 2006, the housing market seemed to be going up for long time. Noticing
this trend, borrowers thought that everything was fine and refinancing will solve any future
problems.
Historically, potential homebuyers found it difficult to obtain mortgages if they had below
average credit ratings. Unless protected by government insurance, lenders often denied such
mortgage requests. Banks offered loans to those with less credit ratings at high interest rate.
rates are higher, the lower the credit score and smaller the down-payment.
By definition subprime mortgage is giving loans to borrowers who typically are not qualified
because of their higher risks: income level, work status, and credit history. This also puts the
borrowers into a higher rate category than the prime rate.
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Figure 9:Customers with less credit rating were given loans.
In 2006-2007, the housing market moderately cooled down. Many unable to refinance
because of higher interest rate of Adjustable Rate Mortgages. Massive defaults and
foreclosures soon followed.

Figure 10: Many defaults are made by credit risk customers.
There are many contributing factors that cause the subprime mortgage crisis: slump of the
housing market, role of borrowers, role of financial institutions, etc. The most visible of them
all is the housing market crisis. In March 2007, the U.S value subprime mortgage is about
$1.3 trillion; $7.5 million of that is bad.
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Crisis situation began in mid-2004 after the interest rate hike by the Fed (U.S.). Due to the
increased interest rates, the floating interest rate borrowers got impacted by the fact that the
monthly instalment payment increased. The situation finally resulted in overleveraging the
payment potential of the borrowers. The ultimate impact started to show by way of default in
payment of loans and thus subprime crisis situation arose.
Banks were out of money after too many defaults (6.5 to 17%). So it started issuing bonds. Now
people took bonds and invested them in other banks. The money which people got from
banks through bonds was kept in equity market.
Later banks in which people invested realized the value of bonds has reduced as the value of
houses got reduced, then it immediately asked people to pay back the money they borrowed.
So people started taking back their amount from equity market which all of a sudden reduced
the share prices. Hence there was a big recession.
Consumer power of the people reduced, business investments reduced as they couldnt get
money from banks. Unemployment rate increased from 4.9% to 9.5%.
The sub-prime mortgage crisis went on to affect major global investment banks as well.
Shares in Bear Stearns came under pressure in May 2007 because of the banks exposure to
the U.S. subprime market. In June, Merrill Lynch seized and sold $ 800 millions of bonds
used as collateral for loans made to Bear Stearns hedge funds that were used to bet on the
sub-prime mortgage market.
In July 2007, General Electric decided to sell the WMC Mortgage sub-prime lending business
it bought in 2004. Goldman Sachs also announced financial support for one of its struggling
hedge funds hit by the defaulting sub-prime mortgages.
Given the dominance of U.S. financial markets in there developed and developing
economies, the sub-prime mortgage market crisis affected markets and institutions all over
the globe.
On July 27, 2007, worries about the sub-prime crisis hit global stock markets and the main
Dow Jones stock index lost 4.2 per cent in five sessions, its worst weekly decline in five
years. The fall continued in August.
On August 3, 2007, the Dow Jones Index ended the session almost 2.1% lower. The same
day, Londons main FTSE 100 stock index closed down 1.2% with French and German
markets also declining. On August 9, French bank BNP Paribas suspended three investment
funds worth USD 2 billion, citing problems in the U.S. sub-prime mortgage sector.
The Dutch bank NIBC announced losses of USD 137 million from asset-backed securities in
the first half of year 2007.
The European Central Bank (ECB) pumped USD 500 billion into the European banking
market to allay fears about a sub-prime credit crunch.
To control the situation, the Central Banks across the globe tried to maintain liquidity in the
market and injected funds. In addition, they also tried to maintain the purchasing power by
way of reducing the interest rates.
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To sum up, though the crisis seems over, the impact it may have on various financial
institutions worldwide cant be assessed considering the diverse portfolio under mortgage
finance.
4. REGRESSION ANALYSIS
4.1. UNITED STATES:
Here we find regression for interest rate and inflation of US, EURO and YEN with dollar
index for previous 5 years.
Euro contributes to about 57% of the value of dollar index. Yen contributes to 14% of the
value of dollar index.
US 2009

Figure 11: Regression output for US in 2009
Here in 2009, correlation between interest rate and inflation with dollar index of 2009 is just
14%. This is because in 2009, big recession occurred which affected US Dollar a lot. So these
economic factors had a very less affect on the currency fluctuations and recession affected
US Dollar more than these factors. Many companies went into bankruptcy like Lehman
Brothers etc.
From 2010,
There has been increase in correlation from 2010 slowly. As economy started to recover after
recession, again the economic factors started making an impact on currency fluctuations.
Hence we will see how the correlation values increased from 2010 to 2013. This again started
increasing the value of US Dollar. USD-INR increased from 39 in 2009 to almost 65 in 2013.
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Figure 15: Regression output for US in 2013.
As we can see correlation increased from 14% in 2009 to almost 50% in 2013.
To understand it clearly, we will check regression output for an year before recession. In
2006, correlation is almost 86% with a significance level of <0.003.


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4.2. EUROPE COUNTRIES TRADING IN EURO:
Countries which are trading in EURO in Europe are Austria, Belgium, Cyprus, Estonia,
Finland, France, Germany, Greece, Ireland, Italy, Latvia, Luxembourg, Malta, The
Netherlands, Portugal, Slovakia, Slovenia and Spain.

Figure 17: Regression output for EURO AREA in 2009.
A period of time in which several European countries faced the collapse of financial
institutions, high government debt and rapidly rising bond yield spreads in government
securities. The European sovereign debt crisis started in 2009, with the collapse of Iceland's
banking system, and spread to primarily to Greece, Ireland and Portugal during 2009. The
debt crisis led to a crisis of confidence for European businesses and economies.
The European debt crisis is the shorthand term for Europes struggle to pay the debts it has
built up in recent decades. Five of the regions countries Greece, Portugal, Ireland, Italy,
and Spain have, to varying degrees, failed to generate enough economic growth to make
their ability to pay back bondholders the guarantee it was intended to be. It was regarded as
the most serious financial crisis at least since the 1930s.
The global economy has experienced slow growth since the U.S. financial crisis of 2008-
2009, which has exposed the unsustainable fiscal policies of countries in Europe and around
the globe. When growth slows, so do tax revenues making high budget deficits
unsustainable. The result was that the new Prime Minister George Papandreou, in late 2009,
was forced to announce that previous governments had failed to reveal the size of the nations
deficits.
In truth, Greeces debts were so large that they actually exceed the size of the nations entire
economy, and the country could no longer hide the problem.

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So due to this European Debt Crisis, the correlation between interest rate and inflation with
dollar index is very less. This is because there can be various other factors due to the crisis
which affected this correlation other than these economic factors.

Figure 18: Regression output for EURO AREA in 2010.
Crisis was from 2009 to early 2011. So again economy started to develop from 2012. Hence
the correlation value also increases from 2012.

Figure 19: Regression output of EURO AREA in 2011.
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4.3. JAPAN:
Japan has a managed float as a floating mechanism which means Japan always tries to
manage its currency. Japan is an export oriented country. So they always try to make their
currency weaker so as to attract exports.
Hence there will be less impact of the economic factors on the dollar index. As soon as there
is increase in value of YEN, Japan takes some measures to reduce the value of YEN. Hence
there is very less correlation between Interest rate and inflation with dollar index.

Figure 22: Regression output for Japan in 2009


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5. EXCHANGE TRADED FUTURE COST VERSUS OTC
TRADED FORWARD COST:
USD REF Rate Contract Value (INR) TENOR (in Months)
Units
1000 60 60000 1
1

Table 1. The lot size and the contract value
If we take the value of USD as 60 approximately then the entire contract value is Rs.60,000.
5.1. CHARGES OF BROKERAGE FIRMS -

Table 2: The costs charged by a broking firm
Exchange traded Futures cost is the cost incurred by a client when traded in futures with a
stock broking company like Fairwealth. They charge a brokerage of 0.03-0.05% depending
on the customer with an average of 0.04%.

EXCHANGE TRADED FUTURES COST
Range
Brokerage 0.03-0.05% 0.04%
Service Tax on brokerage 12.36% 0.00494%
Stamp Duty on turnover 0.002% 0.002%
Net Brokerage for Futures (%) 0.04694%
Net Brokerage for Futures (INR) 28.17
SEBI Fee (Per Crore) 20 0
Margin (MTM Additional) 2.75% 1650
Interest Cost on Margin(Monthly basis) 1.00% 16.5

Total Futures transaction Cost (ONE-way) 44.67
Squaring-up/Cancellation Brokerage % 0.04694%
Squaring-up/Cancellation Brokerage INR 28.1664
Total Cancellation/Squaring-Up Cost 28.1664

Total cost for 2-way transaction(INR) 72.83
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The brokerage is different for different investments. As the amount invested increases the
brokerage decreases. The brokerage costs for different investments are given in the table
below.
Brokerage
Volume %
0 0.04%
20000000 0.03%
50000000 0.02%
100000000 0.01%
0.005%

Table 3: The brokerage charged by the broking firms for different amounts.
There are two taxes applicable on the brokerage. They are service tax and stamp duty.
Service tax is charged by Central Government and Stamp duty is charged by State
Government. Service tax on brokerage is 12.36% at present and it is charged on brokerage i.e
12.36% of 0.04% (which is the average brokerage charged by Fairwealth) which goes to
0.00494% and the Stamp Duty is 0.002%.
Now Net brokerage is the brokerage plus the service tax and stamp duty. So the net brokerage
goes to (0.04+0.00494+0.002) which is 0.04694%. As out contract amount is 60000
approximately, the net brokerage value in INR goes to (60000*0.04694) which is 28.17 INR.
The SEBI fee also varies according to our investment. But basically SEBI charges Rs 20 for
each crore invested for trading. So this goes on as a multiple of 20 for every increase in
investment of 1 crore. SEBI fees as per our investment are given in the table below.
SEBI FEES
0 0
10000000 20
20000000 40
30000000 60
40000000 80
50000000 100
60000000 120
70000000 140

Table 4: Fee charged by SEBI for different investments.
Next comes the margin. Margin is the percentage of amount of the total contract value to be
invested to continue trading. Suppose if we are planning to enter into a contract with a
contract value of Rs.1,00,000, then we have to pay an amount of 2.75% of the total contract
value which is Rs.2,750. As our contract value here is Rs.60,000, the margin we have to pay
HEDGING TOOL.

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is (2.75% of 60,000) which is Rs.1,650. There will be interest cost on margin charged which
is 1% of the margin amount. This accounts to Rs.16.5.
One time transaction cost is nothing but one time cost incurred at the time of entering the
contract. For banks it is settlement by actual delivery of FOREX. For exchange traders like
brokerage firms it is the settlement on last trading day without entering into counter contract
like selling.
Here the one way transaction cost incurred is (16.5+28.17) which is Rs.44.67.
Two way transaction cost is the cost incurred in entering into counter contract that is selling
also. For banks the charges may be pre settlement charges or squaring up or cancellation of
contract charges. So here the 28.17 INR charged in one way transaction is incurred again as
this is two way. Hence the total two way transaction cost is (44.67+28.17) which is Rs. 72.83.
The above cost is when we have taken average for brokerage. Even if we take highest
brokerage value i.e 0.05% instead of average which is 0.04%, still the cost of investment is
very less compared to banks. This is shown below
EXCHANGE TRADED FUTURES COST
Range
Brokerage 0.03-0.05% 0.05%
Service Tax on brokerage 12.36% 0.00618%
Stamp Duty on turnover 0.002% 0.002%
Net Brokerage for Futures (%) 0.05818%
Net Brokerage for Futures (INR) 34.91
Margin (MTM Additional) 2.75% 1650
Interest Cost on Margin(Monthly basis) 1.00% 16.5

Total Futures transaction Cost (ONE-way) 51.41
Squaring-up/Cancellation Brokerage % 0.05818%
Squaring-up/Cancellation Brokerage INR 34.908
Total Cancellation/Squaring-Up Cost 34.908

Total cost for 2-way transaction(INR) 86.32

Table 5: The costs charged by a broking firm when taken highest brokerage value.

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5.2. CHARGES OF BANKS
BANK/OTC TRADED FORWARD COST Range Avg Avg %
Margin Loaded on Bid-Ask Spread (Spot & Forward)
0.5-
35paise Same N.A
Margin deposited with Bank (Balance/FD etc) 5-15% 6000 10%
Loan Interest on Margin (p.a) OUTFLOW 10-14% 720 12%
FD Interest on Margin deposited(p.a) INFLOW 3.5-6.5% 360 6%
Opportunity Cost/Interest on Margin (NET OUTFLOW) p.a 360 6%
Total Opportunity/Interest Cost (Monthly wise) 0.500% 30 0.50%
Forward Contract Charges 500-2000 500
Service Tax on Charges 12.36% 61.8
Stamp Duty (State) Optional 50 0 Optional
Net Forward Contract fee(One way) 611.8 561.8 0.936333%
Pre-Settlement/Squaring-up/Cancellation Charges
Cancellation fee 561.8
Margin Load cost on Bid-Ask Spread (0.5-35paise) 0.5 500 0.8333%
Cancellation Charges (Fee + Margin load) 1.7697% 1061.8

Total charges for 2-Way Transaction 1623.6

Table 6: The different charges charged by banks.
Spread is the profit made by the bank. They buy the rupee at low price and sell that rupee at a
higher price. The difference in that price is spread and bank gets most of its profit through
this spread only. Margin deposited with the bank is around 5-15%. This depends on
customers and it can reach to 18 or 20% at times. This is the information given by banks. If
the margin is taken from the same bank as loan, then the interest rate charged is 10-14%. So
on an average it charges (12% of 6000) which is 720. If the amount which you invest in
securities in bank will be invested in Fixed deposit account, then your opportunity cost is
approximately (6% of 6000) since return on FD is 3.5 to 6.5%. This is nothing but the
customers opportunity cost in selecting investment in securities rather than in FD.
Forward contract charges are around 500-2000. We will take the least possible amount which
is 500 as contract charges. Service tax on charges is again (12.36% of 500) which is
Rs.61.80. Stamp duty here is optional. So to see the least charges we will neglect this stamp
duty. So the least one way cost incurred to invest in any securities in bank is the futures
contract charges and service tax on that charge i.e (500+61.80) which is Rs.561.80. If stamp
duty is taken into consideration, then the one way cost incurred goes to Rs.611.80.
For two way transaction, margin load cost exists as an extra cost which is 0.5 times the lot
size on which trading is done. It is (0.5*1000) which is Rs.500.The cancellation fee is
HEDGING TOOL.

30

Rs.500. Hence the total two way transaction cost is (500+561.80) which is Rs.1061.80. The
total two way transaction cost is (561.80+1061.80) which is Rs.1623.60.
So, the difference in the costs incurred in investment in brokerage firms and banks is shown
in the below table -
HEDGING Diff 0.04%
One Way (Settlement on last day) 547.13 FUTURES
2-Way in Ex & 1 Way in OTC
(Actual Delivery)
518.97 FUTURES
2-Way in EX & 2-Way in OTC (Cancellation)
1580.77 FUTURES

Table 7: The difference between charges charged by broking firms and banks.
One way settlement cost difference between broking firms and banks is (591.80-44.67) which
is Rs.547.13.
Difference between two way cost of exchange trading firms and one way transaction cost is
(591.80-72.83) which is Rs.518.97.
Difference between two way transaction cost of both broking firms and banks is (1653.60-
72.83) which is Rs.1580.77.
5.3. ADVANTAGES OF BANKS OVER BROKERAGE FIRMS:
1. Customers donot have to pay margin amount as they can cover it from their OD account.
So they need not have any liquid cash for trading.
2. To avoid paying Mark to Mark. Mark to Mark is nothing but you can spontaneously see
what is your profit or loss in your account.
3. People consider investing in banks as secure because a minimum amount is guaranteed by
RBI. But even in brokerage firms, Minimum amount is guaranteed by Exchange which is
unknown to many people.
4. If there are any relations with banks, customers get competitive prices for which they trade
in banks.

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31

6. QUESTIONNAIRE RESPONSES
1.

Among the responses I collected, traders are 73% male and 27% female. So this says mostly
men are active in trading.
2.

Among the responses collected, Post graduates are 50%, Undergraduates are 45%. So mostly
postgraduates and undergraduates are active in trading.
3.

HEDGING TOOL.

32

Among the responses collected, most of the people trading were salaried and business
professionals.
4.

Among the responses collected, 59% of the people are very active in hedging and 36% are
rarely active in hedging.
5.

Among the responses, 44% are active daily in hedging. Since most data is collected from
exports and imports firms, most of them are active in hedging daily. 28% hedge weekly and
21% hedge monthly.
6.
7.
8.
HEDGING TOOL.

33

6.
41% strictly prefer investing in banks than in brokerage firms. 40% of peoples decision
depends on situations. So they can be explained clearly and there is a chance of them
shifting to brokerage firms if satisfied.
7.

35% of people trade with banks to avoid mark to mark. 29% of people give importance to
security as they feel their money is secure with banks.

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34

8.
HEDGING TOOL.

35

Most of the people have ranked less brokerage as their first choice, which hints that firms
should work on their charges.
While ranking second in the services most of them ranked fewer margins as rank two in the
list showing that fewer margins is their second preference and firms should also look out for
that.
Coming to their third preference most people choose Good advisory as their third best option,
so again strategies and timely advices plays a crucial role.
HEDGING TOOL.

36

Next comes Quick responses, the fourth best option is quick response so firms should be able
to check on their customer relation services and quick reach with the clients, people working
there should be well aware of the market and timely advices are to be provided.
Safety has been ranked as the last priority by most of the people so people are ready to take
risks, so strategies should be designed in such a way that they yield more profits rather than
security to the investments.
9.

34% of people are flexible to shift to brokerage firms if explained the concept and costs
properly. 64% say that it depends on the situation to shift or not. So here also there is a
chance for people to shift with efficient explanation.

HEDGING TOOL.

37

7. CONCLUSION AND RECOMMENDATIONS:
1. There are many factors which affect the currency fluctuations and change in one currency
affects many other currencies.
2. If there is any recession or crisis, these factors have less impact and many other factors like
bankruptcy affect the currency fluctuations.
3. Hedging is a very useful tool for people who are not flexible towards risk. They can secure
their money through hedging.
4. Cost incurred in investing in banks is much more compared to that in brokerage firms.
5. There are many advantages in investing in brokerage firms compared to banks. This can be
clearly explained to people and attract them towards investing in FAIRWEALTH.
6. There are also some advantages of banks. So we can try and come up with new strategies so
as to show those points in a lighter way.

HEDGING TOOL.

38

REFERENCES
1.Rajneesh Jaswal and Somanath Ballari ,Introduction to Derivatives in India available at :
http://www.manupatra.co.in/newsline/articles/Upload/C943DB94-E220-41DD-8403-
9FBBC21260CF.pdf (accessed on 4th June,2014).
2.Shree Bhagwat(2012),An Analysis of Indian Financial Derivatives Market and its Position
in Global Financial Derivatives Market, Journal of Business Management & Social
Sciences Research (JBM&SSR) ISSN No: 2319-5614 Volume 1, No.2.
3.Yuliya Demyanyk(2008), Understanding the Subprime Mortgage Crisis, working paper,
Economist, Federal Reserve Bank of St. Louis, August.
4.Abhishek Sharma(2008),Understanding Sub-prime Crisis available at:
https://www.bcasonline.org/articles/artin.asp?755 (accessed on 6
th
June,2014).
5.David Hunt (May6, 2011), Why Interest Rates Matter For Forex Traders, available at
http://www.investopedia.com/articles/forex/08/interest-rates.asp (accessed 28th May,2014).
6. Jorge Canales-Kriljenko and Karl Habermeier (2004) , Structural Factors Affecting
Exchange Rate Volatility: A Cross-Section Study, working paper, Monetary and Financial
Systems Department, August.
7. http://onlinefx.westernunion.com/personal/learning-center/foreign-exchange-(fx
101)/understanding-why-currencies-fluctuate/ (accessed on 23
rd
may, 2014).
8. http://www.currencytrading.net/features/50-factors-that-affect-the-value-of-the-usdollar/
(accessed on 24
th
May,2014)
9. http://www.forextraders.com/forex-analysis/forex-fundamental-analysis.html (accessed on
25th may,2014)
10. Krishna Murari and Rajesh Sharma(2013), OLS Modeling for Indian Rupee
Fluctuations against US Dollar, research paper, Assistant Professor, FASC, MITS
University, Lakshmangarh, Sikar, Rajasthan, India , 3rd December
11. http://www.tradingeconomics.com/ (accessed very often, almost every day).
12. http://www.indiainfoline.com/Markets/News/sebi/5930398012 (accessed on 23rd June,
2014)

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June 10, 2014 A STUDY ON CURRENCY DERIVATIVES AN INVESTMENT OPTION OR A NEW

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