Currency Derivativessssssss

INTRODUCTION OF CURRENCY DERIVATIVES
CURRENCY DERIVATIVES
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INTRODUCTION OF 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. 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. 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 are 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. Thus, the currency units of a country involve an exchange of one currency for another. The price of one currency in terms of other
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RESEARCH METHODOLOGY
RESEARCH METHODOLOGY
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TYPE OF RESEARCH In this project Descriptive research methodologies were use. 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 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 practical considerations and ways of considering currency future price. To analyze different currency derivatives products. LIMITATION OF THE STUDY The limitations of the study were 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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INTRODUCTION TO THE TOPIC
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INTRODUCTION TO FINANCIAL DERIVATIVES
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. Alan Greenspan, Former Chairman. US Federal Reserve Bank 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. **DEFINITION OF FINANCIALDERIVATIVES** A word formed by derivation. It means, this word has been arisen by derivation. Something derived; it means that some things have to be derived or arisen out of the underlying variables. A financial derivative is an indeed derived from the financial market. Derivatives are financial contracts whose value/price is independent on the behavior of the price of one or more basic underlying assets. These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future. These assets can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil, soybeans, cotton, coffee and what you have. A very simple example of derivatives is curd, which is derivative of milk. The price of curd depends upon the price of milk which in turn depends upon the demand and supply of milk. CURRENCY DERIVATIVES Page 6
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 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 1. Forwards 2. Futures 3. Options 4. Warrants and Convertibles CURRENCY DERIVATIVES 1. Swaps
Complex
2.Exotics (Non STD)
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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 Commodity Futures Financial Futures Options (stock and index) Stock Index Future
Over The Counter Forward Contracts 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
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which act as a contractual intermediary and impose margin requirement. derivatives signify greater vulnerability DERIVATIVES INTRODUCTION IN INDIA
In contrast, OTC
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 BSE30 (Sensex) index. The trading in index options commenced in June 2001 and the trading in 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 CURRENCY DERIVATIVES Page 9
order to transact business, hedge against unfavorable changes in currency rates, or to speculate on rate fluctuations.Source: - (NCFM-Currency future Module)
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. Source :-( Recent Development in International Currency Derivative Market by Lucjan T. Orlowski) 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. 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. Thus, the currency units of a
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 CURRENCY DERIVATIVES Page 11
the assets or liability or cash flows of a firm which are 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 is the tick value. A tick is the minimum trading increment or price differential at which CURRENCY DERIVATIVES Page 12
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 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.50.2500. One tick move on this contract will translate to Rs.50.2475 or Rs.50.2525 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 .50.2500 +Rs. 00.0025 Rs .50.2525 Rs .50.2500 Rs. 00.0025 Rs.50. 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: 50.2600 50.2500 4 ticks * 5 contracts = 20 points 20 points * Rupees 2.5 per tick = Rupees 50
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BRIEF OVERVIEW OF FOREIGN EXCHANGE MARKET
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 CURRENCY DERIVATIVES Page 14
in March 1993. The unification of the exchange rate was instrumental in developing a marketdetermined 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. Source :-( Report of the RBI-SEBI standing technical committee on exchange traded currency futures) 2008.
CURRENCY DERIVATIVE PRODUCTS
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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. In a swap normally three basic steps are involve___
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(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. FOREIGN EXCHANGE SPOT (CASH) MARKET
The foreign exchange spot market trades in different currencies for both spot and forward delivery. Generally they do not have specific location, and mostly take place primarily by means of telecommunications both within and between countries.
It consists of a network of foreign dealers which are oftenly banks, financial institutions, large concerns, etc. The large banks usually make markets in different currencies.
In the spot exchange market, the business is transacted throughout the world on a continual basis. So it is possible to transaction in foreign exchange markets 24 hours a day. The standard settlement period in this market is 48 hours, i.e., 2 days after the execution of the transaction.
The spot foreign exchange market is similar to the OTC market for securities. CURRENCY DERIVATIVES
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centralized meeting place and no fixed opening and closing time. Since most of the business in this
market is done by banks, hence, transaction usually do not involve a physical transfer of currency, rather simply book keeping transfer entry among banks.
Exchange rates are generally determined by demand and supply force in this market. The purchase and sale of currencies stem partly from the need to finance trade in goods and services. Another important source of demand and supply arises from the participation of the central banks which would emanate from a desire to influence the direction, extent or speed of exchange rate movements. FOREIGN EXCHANGE QUOTATIONS
Foreign exchange quotations can be confusing because currencies are quoted in terms of other currencies. It means exchange rate is relative price. For example, If one US dollar is worth of Rs. 50 in Indian rupees then it implies that 45 Indian rupees will buy one dollar of USA, or that one rupee is worth of 0.022 US dollar which is simply reciprocal of the former dollar exchange rate.
EXCHANGE RATE
Direct The number of units of domestic Currency stated against one unit of foreign currency. CURRENCY DERIVATIVES
Indirect The number of unit of foreign currency per unit of domestic currency. Page 18
Re/$ = 50.7250 ( or ) $1 = Rs. 50.7250
Re 1 = $ 0.02187
There are two ways of quoting exchange rates: the direct and indirect. Most countries use the direct method. In global foreign exchange market, two rates are quoted by the dealer: one rate for buying (bid rate), and another for selling (ask or offered rate) for a currency. This is a unique feature of this market. It should be noted that where the bank sells dollars against rupees, one can say that rupees against dollar. In order to separate buying and selling rate, a small dash or oblique line is drawn after the dash.
For example, If US dollar is quoted in the market as Rs 50.3500/3550, it means that the forex dealer is ready to purchase the dollar at Rs 50.3500 and ready to sell at Rs 50.3550. The difference between the buying and selling rates is called spread.
It is important to note that selling rate is always higher than the buying rate. Traders, usually large banks, deal in two way prices, both buying and selling, are called market makers.
Base Currency/ Terms Currency: In foreign exchange markets, the base currency is the first currency in a currency pair. The second currency is called as the terms currency. Exchange rates are quoted in per unit of the base currency. That is the expression Dollar-Rupee, tells you that the Dollar is being quoted in terms of the Rupee. The Dollar is the base currency and the Rupee is the terms currency.
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Exchange rates are constantly changing, which means that the value of one currency in terms of the other is constantly in flux. Changes in rates are expressed as strengthening or weakening of one currency vis--vis the second currency. Changes are also expressed as appreciation or depreciation of one currency in terms of the second currency. Whenever the base currency buys more of the terms currency, the base currency has strengthened / appreciated and the terms currency has weakened / depreciated. For example, If Dollar Rupee moved from 43.00 to 43.25. The Dollar has appreciated and the Rupee has depreciated. And if it moved from 43.0000 to 42.7525 the Dollar has depreciated and Rupee has appreciated. 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 futures contract, mark to market obligations is settled on a daily basis. Since the profits or losses in the futures market are collected / paid on a daily basis, the scope for building up of mark to market losses in the books of various participants gets limited. The counterparty risk in a futures contract is further eliminated by the presence of a clearing corporation, which by assuming counterparty guarantee eliminates credit risk. 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 CURRENCY DERIVATIVES Page 20
their size. Other advantages of an Exchange traded market would be greater transparency, efficiency and accessibility. Source :-( Report of the RBI-SEBI standing technical committee on exchange traded currency futures) 2008. 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
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 non-residents 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 DERIVATIVES Page 21
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 inter-generational 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.
FUTURE TERMINOLOGY SPOT PRICE : The price at which an asset trades in the spot market. The transaction in which securities and foreign exchange get traded for immediate delivery. Since the exchange of securities and cash is virtually immediate, the term, cash market, has also been used to refer to spot dealing. In the case of USDINR, spot value is T + 2.
FUTURE PRICE : The price at which the future contract traded in the future market. CONTRACT CYCLE :
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The period over which a contract trades. The currency future contracts in Indian market have one month, two month, three month up to twelve month expiry cycles. In NSE/BSE will have 12 contracts outstanding at any given point in time. VALUE DATE / FINAL SETTELMENT DATE : The last business day of the month will be termed the value date /final settlement date of each contract. The last business day would be taken to the same as that for inter bank settlements in Mumbai. The rules for inter bank settlements, including those for known holidays and would be those as laid down by Foreign Exchange Dealers Association of India (FEDAI). EXPIRY DATE : It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. The last trading day will be two business days prior to the value date / final settlement date. CONTRACT SIZE : The amount of asset that has to be delivered under one contract. Also called as lot size. In case of USDINR it is USD 1000. BASIS : In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.
COST OF CARRY : The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance
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or carry the asset till delivery less the income earned on the asset. For equity derivatives carry cost is the rate of interest. INITIAL MARGIN : When the position is opened, the member has to deposit the margin with the clearing house as per the rate fixed by the exchange which may vary asset to asset. Or in another words, the amount that must be deposited in the margin account at the time a future contract is first entered into is known as initial margin.
MARKING TO MARKET : At the end of trading session, all the outstanding contracts are reprised at the settlement price of that session. It means that all the futures contracts are daily settled, and profit and loss is determined on each transaction. This procedure, called marking to market, requires that funds charge every day. The funds are added or subtracted from a mandatory margin (initial margin) that traders are required to maintain the balance in the account. Due to this adjustment, futures contract is also called as daily reconnected forwards. MAINTENANCE MARGIN : Members account are debited or credited on a daily basis. In turn customers account are also required to be maintained at a certain level, usually about 75 percent of the initial margin, is called the maintenance margin. This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.
USES OF CURRENCY FUTURES
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Hed ging: Presume Entity A is expecting a remittance for USD 1000 on 27 August 11. 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 11 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, 2011 is Rs.50.0000. The entity shall sell on August 27, 2011, USD 1000 in the spot market and get Rs. 50,000. The futures contract will settle at Rs.50.0000 (final settlement price = RBI reference rate). The return from the futures transaction would be Rs. 250, i.e. (Rs. 50,250 Rs. 50,000). As may be observed, the effective rate for the remittance received by the entity A is Rs.50. 2500 (Rs.50,000 + Rs.250)/1000, while spot rate on that date was Rs.50.0000. 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.48, 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.48.50. Assuming he buys USD 10000, it would require an investment of Rs.4,80,000. 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.50 and the three month futures trade at Rs.50.40. The minimum contract size is USD 1000. Therefore the speculator may buy CURRENCY DERIVATIVES Page 25
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. 50.50 against USD, (on the day of expiration of the contract), the futures price shall converge to the spot price (Rs. 50.50) and he 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. 50.20 (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.50. 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.
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 CURRENCY DERIVATIVES Page 26
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. 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 market:
TRADER ( BUYER )
TRADER ( SELLER )
Purchase order
Sales order
Transaction on the floor (Exchange)
MEMBER ( BROKER )
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 hardly it 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 Delivery date Method transaction Participants FORWARD FUTURES Structured as per requirement Standardized of the parties Tailored on individual needs Standardized
of Established by the bank or Open auction among buyers and seller on the broker through electronic floor of recognized exchange. brokers, multinational small companies, traders, media Banks, brokers, forex dealers, Banks, multinational institutional
companies, institutional
investors,
investors, speculators, arbitrageurs, etc. but Margin deposit required
Margins
arbitrageurs, traders, etc. None as such,
compensating bank balanced Maturity Settlement may be required Tailored to needs: from one Standardized week to 10 years Actual delivery or offset with Daily settlement to the market and variation cash settlement. No separate margin requirements
clearing house Market place Over the telephone worldwide At recognized exchange floor with worldwide Accessibility Delivery Secured and computer networks communications Limited to large customers Open to any one who is in need of hedging banks, institutions, etc. facilities or has risk capital to speculate More than 90 percent settled by Actual delivery has very less even below one actual delivery Risk is high being less secured percent Highly secured through margin deposit.
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ANALYSIS
INTEREST RATE PARITY PRINCIPLE
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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, 2012, 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 50.3500. Using the above equation the theoretical future price on January 10, 2012, expiring on June 12, 2012 is : the answer will be Rs.50.7908 per dollar. Then, this theoretical price is compared with the quoted futures price on January 10, 2012 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. 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.
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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 (Monday to Friday) Contract Size Tick Size Trading Period Contract Months Final Settlement Value date Last Trading Day Settlement Final Settlement Price date/ 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 Cash settled The reference Rate of exchange between one USD and INR 09:00 a.m. to 05:00 p.m.
rate
fixed by RBI two
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.50.19. 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 starts 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.50.19. 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 F I T
43.19
0 USD
D
L O S S
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.50.19. 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.
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
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P R O F I T
43.19
0 USD
D
L O S S
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: 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 - = CURRENCY DERIVATIVES Page 36
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. 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.
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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 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:
Price Watch CURRENCY DERIVATIVES Page 38
Order Book 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 Best 464 189 1 100 100 1 25 1 2 1 1 1 Best 49.8550 49.6925 49.8850 50.1000 49.9225 50.0000 49.0000 48.0875 48.1625 48.2375 48.3100 48.3825 Best 49.8575 49.7000 49.9250 50.2275 50.5000 51.0000 51.0000 50.5000 53.1900 Best 712 612 2 1 5 5 5 1 2 Buy Qty Buy Price Sell Price Sell Qty LTP Volume Open Interest 43785 111830 16809 6367 892 278 506 116 44 2215 79 2 -
49.8550 58506 49.7300 176453 49.9450 5598 50.1925 3771 49.9125 311 50.5000 47.1000 50.0000 49.1500 50.3000 6 51.2000 50.9900 50.9275 -
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 RBI reference rate USDINR 49.8500 Solution:
Rules, Byelaws & Regulations Membership Circulars List of Holidays
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) =111500.Rs. Choice of the number of contracts (hedging ratio)
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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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Exchange Traded Currency Options
Exchange Traded Currency Options SEBI and RBI permitted introduction of USDINR options on stock exchange from July 30 2010. SEBI approved it via SEBI Circular No. SEBI/CIR/DNPD/5/2010 dated July 30 2010 and RBI approved it via RBI Circular No RBI/2010-11/147 A.P. (DIR Series) Circular No. 5 dated July 30 2010. Persons resident in India are permitted to participate in the currency options market, subject to the directions contained in the Exchange Traded Currency Options (Reserve Bank) Directions, 2010, [Notification No.FED.01 / ED (HRK)-2010 dated July 30, 2010]. Eligible stock exchanges are expected to take approval from SEBI for introducing USDINR options. As of now, these options are available on National Stock Exchange (NSE) and United Stock Exchange (USE). In this chapter we will study about concepts, uses, risk management, pricing and contract design for currency option. CURRENCY DERIVATIVES Page 41
Options Definition, basic terms As the word suggests, option means a choice or an alternative. To explain the concept though an example, take a case where you want to a buy a house and you finalize the house to be bought. On September 1st 2010, you pay a token amount or a security deposit of Rs 1,00,000 to the house seller to book the house at a price of Rs 10,00,000 and agree to pay the full amount in three months i.e., on November 30th2010. After making full payment in three months, you get the ownership right of the house. During these three months, if you decide not to buy the house, because of any reasons, your initial token amount paid to the seller will be retained by him. In the above example, at the expiry of three months you have the option of buying or not buying the house and house seller is under obligation to sell it to you. In case during these three months the house prices drop, you may decide not to buy the house and lose the initial token amount. Similarly if the price of the house rises, you would certainly buy the house. Therefore by paying the initial token amount, you are getting a choice/ option to buy or not to buy the house after three months. The above arrangement between house buyer and house seller is called as option contract. We could define option contract as below: Option: It is a contract between two parties to buy or sell a given amount of asset at a pre- specified price on or before a given date. We will now use the above example, to define certain important terms relating to options. The right to buy the asset is called call option and the right to sell the asset is called put option. The pre-specified price is called as strike price and the date at which strike price is applicable is called expiration date. The difference between the date of entering into the contract and the expiration date is called time to maturity. The party which buys the rights but not obligation and pays premium for buying the right is called as option buyer and the party which sells the right and receives premium for assuming such obligation is called option seller/ writer. The price which option buyer pays to option seller to acquire the right is called as option price or option premium The asset which is bought or sold is also called as an underlying or underlying asset.
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Option pay offs Payoff means return from the derivative strategy with change in the spot price of the underlying. Option strategies result in non linear pay offs (that is not a straight line, but either curve or a line with a sharp bend) because of the optionality of options, which is` the right without obligation for the buyer. The buyer of option has limited downside and unlimited upside, while seller has limited upside and unlimited downside. This is unlike returns from a futures contract or returns from a position in cash market which are linear and are same for both buyer and seller. Given below is an illustrative payoff diagram of a long futures contract (Figure 1) and a long call option (Figure 2). Please note that in future contract, change in returns is similar for the same increase and decrease in price. In other words, the return would increase by say Rs 10 for every Rs 8 increase in spot price and would also decrease by Rs 10 for every Rs 8 decrease in spot price. However, in options, say a long call option, the change in return when spot price decreases is not same as when spot price increases. As shown in Figure 2, the returns are negative and remain constant irrespective of amount of decrease in spot price while returns keep increasing with increasing spot price.
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Similarly for a long put option, the returns are negative and remain constant irrespective of amount of increase in spot price while returns keep increasing with decreasing spot price. Please refer to figure 3 above for a pay off chart of long put and refer to figure 4 for payoff chart of short futures. Option strategies We will first explain the vanilla option strategies that could be used in FX market. Please note that all advanced strategies are built using these basic strategies and therefore it is important to learn these carefully.
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Vanilla options Vanilla options: These are four basic option positions, which are long call, long put, short call and short put option. Please note that in all the exchange traded currency option contracts, the final settlement of the contracts happen at RBI reference rate. Buying a call option or going long call option View: Option strategy: Considering this view, you bought a USD call option at strike price of 51 and pay premium of Rs 0.6 per USD. If on maturity, USDINR is above 51 you would exercise the option and buy USDINR at 51 when spot price is higher than 51. Therefore you realize an exercise profit which is equal to difference between spot price and 51. However, this profit is partly offset by the call option premium (Rs 0.6) that you have paid. You start making net positive cash flow for every price higher than 51.6 (also called as breakeven point). At the same time, you would not exercise the option if USDINR trades at or below 51 and in this case your loss is fixed at Rs 0.6 which is equal to the premium paid. Please refer to Figure below and notice the non linearity in the payoff: for option buyer, the losses are limited to premium paid (Rs 0.6) irrespective of extent of market movement and his profits are unlimited.
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Selling a call option or going short on call option View: Option strategy: You sell a USD call option at a strike price of 51 and receive a premium of Rs 0.6 per USD. If on maturity, USDINR is at or below 51 the other party (who has bought call option from you) would not exercise it and hence you gain the premium. However, if USDINR is higher than 51, the other party will exercise the option and you would be obliged to sell USDINR at 51. Under this scenario, the transaction gets into loss. The losses will keep increasing as INR keeps weakening. Please refer to Figure and notice the non linearity in the payoff: for option seller, the losses are unlimited while profits are limited to the premium received (Rs 0.6 per USDINR) irrespective of extent of market movement.
Buying a put option or going long put option Options strategy: Considering the view and objective, you bought a USD put option at strike price of 51 and paid a premium of Rs 0.5 per USD. If on maturity, USDINR is below 51 you would exercise the option and sell USDINR at 51 when spot price is lower than 51. Therefore you realize an exercise profit which is equal to difference between spot price and 51. However, this profit is partly offset by the put option premium (Rs 0.5) that you have paid. You start making net profit for every price lower than 50.5, which is the breakeven point (and equal to strike price minus put premium). At the same time, you would not exercise the option if USDINR trades at or above 51 and in this case your loss is fixed at Rs 0.5 which is equal to the premium paid. Please refer to Figure and notice the non linearity in the payoff: for option buyer, the losses are limited to premium paid (Rs 0.5) irrespective of extent of market movement and his profits are unlimited. Figure CURRENCY DERIVATIVES Page 46
Buying a put option or going long put option View: Assume current spot as 51.5 and you are of the view that in next one month there is high probability of USD weakening below 51 as against current spot of 51.5. Objective: You want to take full benefit of the view if it turns correct and at the same time want to limit your losses if view turns wrong. Options strategy: Considering the view and objective, you bought a USD put option at strike price of 51 and paid a premium of Rs 0.5 per USD. If on maturity, USDINR is below 51 you would exercise the option and sell USDINR at 44 when spot price is lower than 51. Therefore you realize an exercise profit which is equal to difference between spot price and 51. However, this profit is partly offset by the put option premium (Rs 0.5) that you have paid. You start making net profit for every price lower than 50.5, which is the breakeven point (and equal to strike price minus put premium). At the same time, you would not exercise the option if USDINR trades at or above 51 and in this case your loss is fixed at Rs 0.5 which is equal to the premium paid. Please refer to Figure and notice the non linearity in the payoff: for option buyer, the losses are limited to premium paid (Rs 0.5) irrespective of extent of market movement and his profits are unlimited.
Selling a put option or going short on put option CURRENCY DERIVATIVES Page 47
Option strategy: You sell a USD put option at a strike price of 51 and receive a premium of Rs 0.5 per USD. If on maturity, USDINR is at or above 51 the other party (who has bought put option from you) would not exercise it and hence you gain the premium. However, if USDINR is lower than 51, the other party will exercise the option ad you would be obliged to buy from him at 51. Under this scenario, the transaction would start getting into loss. The losses will keep increasing as INR keeps strengthening. Please refer to Figure 8 below and notice the non linearity in the payoff: for option seller, the losses are unlimited while profits are limited to the premium received (Rs 0.5 per USDINR) irrespective of extent of market movement. Did you notice that in illustrations given above, you could either buy one type of option or short another type of option to execute the same view? For example, when you are bullish on USD, you could either buy a call option or short a put option and vice versa. The choice is a function of your risk appetite to bear losses if your view turns wrong and your preference for either cash pay out to initiate a transaction or cash pay in to initiate it.
CALL OPTION CURRENCY DERIVATIVES
PUT OPTION Page 48
SPOT PRICE 49 49.25 49.5 49.75 50 50.25 50.5 50.75 51 51.25 51.5 51.75 52 52.25 52.5 52.75 53 53.25 53.5 PREMIUM 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6
STRIKE (50rs) 51 51 51 51 51 51 51 51 51 51 51 51 51 51 51 51 51 51 51
OPTIONS LONG -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.35 -0.1 0.15 0.4 0.65 0.9 1.15 1.4 1.65 1.9 SHORT 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.35 0.1 -0.15 -0.4 -0.65 -0.9 -1.15 -1.4 -1.65 -1.9 LONG 1.4 1.15 0.9 0.65 0.4 0.15 -0.1 -0.35 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 SHORT 0.6 0.6 0.6 0.6 0.4 0.15 -0.1 -0.35 -0.6 -0.85 -1.1 -1.35 -1.6 -1.85 -2.1 -2.35 -2.6 -2.85 -3.1
Combination strategies In the above section, we learnt about vanilla options and when they can be used. In the section below, we will learn about combination strategies which are more suitable when market view is moderately bullish/ bearish, range bound or uncertain and the transaction objective is to also reduce the overall payout of options premium. Combination strategies mean use of multiple options with same or different strikes and maturities. Numerous strategies can be worked out depending on the view on the market, risk appetite and objective. In this section, we will discuss some of the common combination strategies for following market views: Moderately bullish or bearish Range bound Break out on either side A. View: Moderately bullish or bearish CURRENCY DERIVATIVES Page 49
A.1 Bull call spread View: Assume current USDINR spot is 50 and you have a view that in three months it should trade around 51.5 i.e., you have a moderately bullish view on USD. Objective: You want to participate in the profits that would accrue if the view turns correct and are also keen to reduce the cost of executing this view. To reduce the cost, you are okay to let go of any profit that may accrue to you beyond 50.50. In other words, you do not mind if your potential profits are capped to reduce the cost. At the same time, you want to know how much the maximum loss could be if view turns wrong. Option strategy: You could buy an ATM or ITM call option for three months and pay premium for it. To reduce the cash payout resulting from option buying, you could also sell an OTM call option for same maturity and partly offset the cost of buying option by the premium received from selling a call option. The net cost would be related to the distance between the strike prices. Larger the spread between the two strike prices, the higher will be the net cost, and vice versa. In all cases, both profit and loss are limited. Example: You buy an ATM call at strike of 50 and pay a premium of 0.75 INR (leg A of transaction). To reduce the cost of buying ATM call, you also sell an OTM call with strike of 45 and receive a premium of 0.6 INR (leg B of transaction). This means that total cash outlay on account of premium is reduced from 0.75 to 0.15. In this combined strategy, leg A gets exercised and start resulting in profit when USD strengthens beyond 50 and leg B gets exercised and start resulting in losses beyond 50.50. Therefore the maximum net
Page 50
profit happens at 50.50 and is equal to 0.35. For any movement below 50, none of the legs get exercised and the losses are limited to the net premium paid which in this case is 0.15. Please note that exercise of leg B means that other party would buy USD from you at 45 when market is higher than 50.50 and you start making loss on leg B. However the premium received on leg B reduces the loss to the extent of premium received. For price move above, 50.50, both options are in-the-money and the profit is limited to 0.35. The following is summary of bullish call spread. Maximum loss: Net premium paid. Maximum loss occurs when the spot price is at or below lower strike price Maximum profit: (higher strike price - lower strike price) - net premium. Maximum profit occurs when spot price is at or above higher strike price Breakeven point: (lower strike price + net premium) above which there will be profit As a combined strategy, the price level at which the strategy starts resulting in profit (net of premiums) is called breakeven point. In the example given above, the breakeven point is 50. Please refer to illustration 1 below to study the detailed pay off table and pay off chart for this strategy. A.2 Bull put spread Another way to design the strategy is to use put option instead of call option. You could sell an ATM put to generate premium and reduce the risk by buying a farther OTM put (with lower strike price as compared to strike of long put). The view being that short put will not get exercised as USD is likely to be bullish and if it gets exercised (if view turns wrong) the risk can be reduced because of long put. This strategy is called as bull put spread. Example: You sell an ATM put at strike of 50 and receive a premium of 0.7 INR (leg A of transaction). To reduce the amount of losses that may incur if leg A gets exercised, you also buy an OTM put with strike of 49.50 and pay a premium of 0.5 INR (leg B of transaction). This means that total cash inflow on account of premium is reduced from 0.7 to 0.2. In this combined strategy, leg A gets exercised when USD weakens below 50 and leg B gets exercised below 49.50. For any movement above 50, none of the leg gets exercised and there is a fixed gain of net premium received which in this case would be 0.20. Please note that exercise of leg A means that other party would sell USD to you at 50 when market is lower than 50 and you start making loss on this leg. However the losses are reduced to the extent of premium received
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and the maximum possible loss is 0.3. The breakeven point comes at 49.80. The summary of bull put spread is as follows: Maximum loss: (higher strike price - lower strike price) - net premium. Maximum loss occurs when spot price is at or below lower strike price Maximum profit: net premium received. Maximum profit occurs when spot price is at or above higher strike price. Breakeven point: (higher strike price - net premium received) below which there will be loss Please refer to illustration 1 below to study the detailed pay off table and pay off chart for this strategy. Please note the choice of words in naming this strategy: Bull refers to the view being bullish on USDINR; spread word is generally used when same type of options/futures are used but which are contrasting and have different strike price or have different maturity. In case call option used, this strategy is called as bull call spread and if put is used it is called as bull put spread
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A.3 Bear put spread: This strategy has to be used when view is moderately bearish and transaction objective is same as above: reduce the option premium pay out by letting go off the profit beyond a price level when view turns correct and to fix the losses when view turns wrong Option design: The option design in moderately bearish view will be reverse of option design for moderately bullish view. You could buy an ATM or ITM put and reduce the payout of option premium by selling an OTM put for same maturity. This design is called Bear put spread. Example: You buy an ATM put at strike of 50 and pay a premium of 0.7 INR (leg A of transaction). To reduce the cost of buying ATM put, you also sell an OTM put with strike of 49.50 and receive a premium of 0.5 INR (leg B of transaction). This means that total cash outlay on account of premium is reduced from 0.7 to 0.20. In this combined strategy, leg A gets exercised and starts resulting in profit when USDINR weakens beyond 50 and leg B gets exercised and starts resulting in losses beyond 50. Therefore maximum profit happens at 49.50 and is equal to 0.3. For any movement above 50, none of the leg gets exercised and the losses are equal to the net premium paid which in this case is 0.25. Please note that exercise of leg B means that other party would sell USD to you at 49.50 when market is lower than 49.50 and you start making losses. However the losses are reduced to the extent of premium received and maximum possible loss is 0.25. The breakeven comes at 49.80. The summary of bear put spread if given below: Maximum loss: net premium. Maximum loss occurs when spot price is at or above higher strike price. Maximum profit: (Higher strike price - lower strike price) - net premium paid. Maximum profit occurs when spot price is at or below lower strike price. Breakeven point: (higher strike price - net premium paid) below which there will be profit A.4 Bear call spread You could also design the strategy by selling an ATM call to generate premium and reduce the risk by buying a farther OTM call. The view being that short call will not get exercised as USD is likely to be bearish against INR and if it gets exercised (if view turns wrong) the risk can be reduced because of long call. This design is called Bear call spread. Example: You sell an ATM call at strike of 50 and receive a premium of 0.75 INR (leg A of transaction). To reduce the losses that may occur if view turns wrong you also buy an OTM call at strike of 50.50 and pay a premium of 0.6 INR (leg B). This means that total cash inflow CURRENCY DERIVATIVES Page 53
on account of premium is reduced from 0.75 to 0.15. In this combined strategy, leg A gets exercised when USD strengthens above 50 and leg B gets exercised above 45. For any movement below 50, none of the leg gets exercised and the gains are equal to the net premium received which in this case is 0.15. Please note that exercise of leg A means that other party would buy USD from you at 50 when market is higher than 44.5 and you start making losses. However, the losses are reduced to the extent of premium received and the maximum loss is 0.35. The breakeven point comes at 50.15. The summary of bear call spread is given below: Maximum loss: (Higher strike price - lower strike price) - net premium received. Maximum loss occurs when the spot price is at or above higher strike price. Maximum profit: net premium received. Maximum profit occurs when spot price is at or below lower strike price Breakeven point: lower strike price + net premium received (above which there will be loss)
Given below is detailed payoff for example of these strategies and the related payoff chart. Please note the difference in each of the strategy with respect to maximum profit, profit zone and maximum loss.
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BULL CALL SPREAD SHORT SPOT PRICE LONG CALL ATM 50 PREMIUM 0.75 -0.75 -0.75 -0.75 -0.75 -0.75 -0.75 -0.75 -0.75 -0.75 -0.5 -0.25 0 0.25 0.5 0.75 1 1.25 1.5 CALL
BULL PUT SPREAD SHORT PUT ATM LONG PUT RETURN
OTM 50.50 RETURN 50 OTM 49.50 PREMIUM PREMIUM 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.35 0.1 -0.15 -0.4 -0.65 -0.9 -1.15 -0.15 -0.15 -0.15 -0.15 -0.15 -0.15 -0.15 -0.15 -0.15 0.1 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.7 -1.3 -1.05 -0.8 -0.55 -0.3 -0.05 0.2 0.45 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 PREMIUM 0.5 1 0.75 0.5 0.25 0 -0.25 -0.5 -0.5 -0.5 -0.5 -0.5 -0.5 -0.5 -0.5 -0.5 -0.5 -0.5 -0.5
48 48.25 48.5 48.75 49 49.25 49.5 49.75 50 50.25 50.5 50.75 51 51.25 51.5 51.75 52 52.25
-0.3 -0.3 -0.3 -0.3 -0.3 -0.3 -0.3 -0.05 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2
BULL CALL SPREAD
BULL PUT SPREAD
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SPOT PRICE
48 48.25 48.5 48.75 49 49.25 49.5 49.75 50 50.25 50.5 50.75 51 51.25 51.5
BEAR CALL SPREAD SHORT CALL ATM 50 PREMIUM 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.5 0.25 0 -0.25 -0.5 -0.75
LONG CALL OTM 50.50 PREMIUM 0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.35 -0.1 0.15 0.4
BEAR PUT SPREAD RETURN LONG PUT ATM 50 PREMIUM 0.7 0.15 1.3 0.15 1.05 0.15 0.8 0.15 0.55 0.15 0.3 0.15 0.05 0.15 -0.2 0.15 -0.45 0.15 -0.7 -0.1 -0.7 -0.35 -0.7 -0.35 -0.7 -0.35 -0.7 -0.35 -0.7 -0.35 -0.7 Page 56
SHORT PU PREMIUM -1 -0.75 -0.5 -0.25 0 0.25 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5
51.75 52 52.25
-1 -1.25 -1.5
0.65 0.9 1.15
-0.35 -0.35
-0.7 -0.7 -0.7
0.5 0.5 0.5
BEAR CALL SPREAD
BEAR PUT SPREAD
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B. View: Range bound view on USDINR or a break out view Range bound view means that USD /INR value is likely to hover in a range or move sideways and breakout view means that market could strongly break either of bullish side or a bearish side and will not remain range bound. We will first understand the strategies for a range bound view and later understand the reverse of same strategies for breakout view. Range bound view: Assume current USDINR spot is 50.5 and there is a strong view is that it is likely to be in range of 50 and 41 and not break this range. B.1 Short Strangle Objective: You want to earn a return from the expected range bound market movement and you are comfortable in taking losses if the view turns wrong and market does not remain in the range. Option composition: You sell one OTM call and one OTM put for same maturity i.e., one month. The premium received from selling the options is your return and the risk starts when market break beyond the strike price of any of the sold options. This design of using OTM options is called Strangle. The strike price of the call should be at the upper end of range and the strike of put should be at the lower end of range. Example: Since you believe that market is likely to be in a range, you sell OTM call at strike of 45 and earn premium of 0.6 and also sell OTM put at strike of 50 and earn premium of 0.5. The strategy results in maximum profit as long as both calls and puts are not exercised and the profit declines as either one or both the option are exercised. The maximum profit is 1.1 and happens in the range of 50 and 51 and it continues to decline beyond these levels. The return turns zero at 48.9 and 52.1 (also called as breakeven levels) and beyond these it turns into losses. Please note that in this strategy the profits are capped at 1.1 and losses can be infinite. The summary of short strangle is given below: CURRENCY DERIVATIVES Page 58
Maximum loss: Could be unlimited if price moves in either direction Maximum profit: Summation of two premiums received. Maximum profit occurs when spot price is within strike price Breakeven point: (A) (Higher strike price + premium received) above which there will be a loss and (B) (Lower strike price- premium received) below which there will be a loss
Also refer to illustration table and payoff chart given below. B.2 Short Straddle You could also achieve the same objective by designing a more risky strategy by selling ATM put and ATM call. This design of using ATM options is called Straddle Example: This strategy is relatively conservative than the previous one as the price range in which strategy will remain profitable is wider than the previous one. Here you sell one ATM call at strike of 50.50 and earn premium of 0.75 and also sell an ATM put at strike of 50.50 and earn premium of 0.7. The maximum return is 1.45 and happens at 50.50 and it continues to decline beyond these levels. The returns become zero at 49.05 and 51.95 (also called as breakeven levels) and it turns into negative beyond these levels. Please note that the difference in short strangle and short straddle. In short straddle, the ranges in which returns are positive is narrow as compared to short strangle and the maximum returns are also higher than short strangle. Therefore short straddle is more risky than short strangle. The summary of short straddle is given below: Maximum loss: unlimited if the price moves in either direction Maximum profit: limited to the premiums received. Maximum profit occurs when the spot price is at the strike price Breakeven point: (a) (strike price + premium received) above which there will be loss (b) (strike price - premium received) below which there will be loss
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SPOT PRICE
48 48.25 48.5 48.75 49 49.25 49.5 49.75 50 50.25 50.5 50.75 51 51.25 51.5 51.75 52
SHORT STRANGLE SHORT PUT OTM 50 PREMIUM 0.5 -1.5 -1.25 -1 -0.75 -0.5 -0.25 0 0.25 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5
SHORT CALL OTM 51 PREMIUM 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.35 0.1 -0.15 -0.4
SHORT STRADDLE RETURN SHORT PUT ATM 50.50 PREMIUM 0.7 -0.9 -1.8 -0.65 -1.55 -0.4 -1.3 -0.15 -1.05 0.1 -0.8 0.35 -0.55 0.6 -0.3 0.85 -0.05 1.1 0.2 1.1 0.45 1.1 0.7 1.1 0.7 1.1 0.7 0.85 0.7 0.6 0.7 0.35 0.7 0.1 0.7 Page 60
SHORT P PREMIUM 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.5 0.25 0 -0.25 -0.5 -0.75
52.25
0.5
-0.65
-1.15
0.7
-1
SHORT STRANGLE
SHORT STRADDLE
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C. View: Break out view of USDINR A break out view is opposite of range bound view. In this view, a bought option offers best reward and since direction of breakout is not clear it is suggested to buy both call and put. The design of these strategies is reverse of strategies used in range bound market view. In the examples given below, we have assumed a view that market is going to break the range of 50 51. Let us understand three popular strategies to be used in break out view. C.1 Long Strangle: You buy one OTM call and one OTM put for same maturity. The premium paid from buying these options is your cost and the return starts when market break beyond the strike price of any of the bought options. Example: You buy OTM put at strike of 50 and pay premium of 0.5 and also buy OTM call at strike of 51 and pay premium of 0.6. The maximum loss is if the market remains in the range of 50 to 51 and the losses are capped at summation of premium paid i.e., 1.1. For any movement, beyond 50 or 51, the losses continue to decline and the strategy turns profitable at 49 and 52.1 (also called as breakeven levels). C.2 Long Straddle: In this design instead of OTM strike, you chose ATM strike for buying both call and put options. Example: You buy ATM put at strike of 50.50 and pay premium of 0.7 and also buy ATM call at strike of 50.50 and pay premium of 0.75. The maximum loss occurs when the market remains at 50.50 and none of the option is exercised. The maximum losses are capped at summation of premium paid i.e., 1.45. For any movement, beyond 50.50, the losses continue to decline and the strategy turns profitable at 49.05 and 51.95 (also called as breakeven levels). SPOT PRICE LONG STRANGLE LONG PUT OTM 50 PREMIUM 0.5 LONG CALL OTM 51 PREMIUM 0.6 LONG STRADDLE RETURN LONG PUT ATM 50.50 PREMIUM 0.7 Page 62
48 48.25 48.5 48.75 49 49.25 49.5 49.75 50 50.25 50.5 50.75 51 51.25 51.5 51.75 52 52.25
1.5 1.25 1 0.75 0.5 0.25 0 -0.25 -0.5 -0.5 -0.5 -0.5 -0.5 -0.5 -0.5 -0.5 -0.5 -0.5
-0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.35 -0.1 0.15 0.4 0.65
0.9 0.65 0.4 0.15 -0.1 -0.35 -0.6 -0.85 -1.1 -1.1 -1.1 -1.1 -1.1 -0.85 -0.6 -0.35 -0.1 1.15
-1.8 -1.55 -1.3 -1.05 -0.8 -0.55 -0.3 -0.05 0.2 0.45 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7
LONG STRANGLE
LONG STRADDLE
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B.3 Long Butterfly You could also design a very conservative strategy to execute a range bound market view. Unlike Strangle/ Straddle, in long butterfly strategy the losses are limited and known in advance. Here you buy one ITM call, one OTM call and sell two ATM calls. Please note that strike price of all ITM call and OTM call have to be equidistant from the ATM strike. Example: You sell 2 ATM calls at strike of 50 and earn premium of 0.75 per call and you also buy one ITM call at strike of 49.50 and pay premium of 1.1 and buy another OTM call at strike of 50.50 and pay premium of 0.6. The profit zone in this strategy is 49.70 and 50.50 and returns turn negative beyond these levels. Please note that unlike strangle and straddle, the maximum losses in this strategy are capped at 0.2 and the maximum profit is also relatively lower at 0.2. The summary of long butterfly is given below: Maximum loss: limited to the net premium paid Maximum profit: limited to: (middle strike price - highest/lowest strike price) - net premium paid. Maximum profit occurs when the spot price is at middle strike price Breakeven point: (a) (highest strike price - net premium paid) above which there will be loss (b) (lowest strike price + net premium paid) below which there will be loss It must be noted that the butterfly strategy is a market-makers inventory management tool rather than a pure bet on the price. Besides the four commissions involved, profit occurs in a narrow range and to a lower amount, as shown in the table below. Retail investors may stay away from butterfly strategy in betting on price stability. CURRENCY DERIVATIVES Page 64
Now we will see a detailed payoff for these strategies and the related pay off chart. Please note the difference in each of the strategy with respect to maximum profit, profit zone and maximum loss. C.3 Short butterfly: You could also design a very conservative strategy to execute a breakout market view. Unlike Strangle/ Straddle, in this strategy the profits are limited and are known in advance. In this strategy, you sell one ITM call, one OTM call and buy two ATM calls. Please note that strike price of all ITM call and OTM call have to be equidistant from the ATM strike. Example: You sell ITM call at strike of 49.50 and receive premium of 1.1, you sell another OTM call at strike of 50.50 and receive premium of 0.6 and you buy two ATM calls at strike of 50 and pay premium of 0.75. The payoff of strategy is negative in the range of 49.70 and 50.30 and beyond this range it turns positive and remains flat irrespective of extent of market movement. Given below are detailed payoffs for examples discussed above and the related payoff charts. Please note the difference in each of the strategy with respect to maximum profit, profit zone and maximum los
SPOT PRICE
48 48.25 48.5 48.75 49 49.25 49.5 49.75 50 50.25 50.5 50.75 51 51.25 51.5 51.75 52 52.25
LONG BUTTERFLY SHORT 2 OTM CALL 50 PREMIUM 0.75 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1 0.5 0 -0.5 -1 -1.5 -2 -2.5 -3
LONG CALL ITM 49.50 PREMIUM 1.1 -1.1 -1.1 -1.1 -1.1 -1.1 -1.1 -1.1 -0.85 -0.6 -0.35 -0.1 0.15 0.4 0.65 0.9 1.15 1.4 1.65
LONG CALL OTM 50.50 PREMIUM 0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.6 -0.35 -0.1 0.15 0.4 0.65 0.9 1.15
SHO RETURN LON PRE -0.2 -1.5 -0.2 -1.5 -0.2 -1.5 -0.2 -1.5 -0.2 -1.5 -0.2 -1.5 -0.2 -1.5 0.05 -1.5 0.3 -1.5 0.05 -1 -0.2 -0.5 -0.2 0 -0.2 0.5 -0.2 1 -0.2 1.5 -0.2 2 -0.2 2.5 -0.2 3
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LONG BUTTERFLY
SHORT BUTTERFLY
D. Strategies complimenting existing position in futures market These strategies are used to protect the returns from existing position in currency futures, reduce losses on it or enhance the returns on it. CURRENCY DERIVATIVES Page 66
D.1 Covered call View / objective: Assume you already have a long position on USDINR futures and you are interested in reducing the potential losses on it if market weakens. While you seek to reduce losses, you are not keen for any cash payout to achieve the objective. Option design: You short OTM USDINR call option with same maturity as that of futures contract. This strategy of having an existing long position in currency and a complementing short call position is called covered call. In this strategy the long position provides cover to the short call i.e., in case the call gets exercised, you could use the long position to deliver the currency to settle the claim on short call. Hence the name covered call. Payoff: In case USDINR weakens, the futures position will result in losses and the short call position will not get exercised. The premium generated from short call can offset part of the losses from long futures position. On the other hand if USDINR strengthens, long currency futures position will turn profitable and short call position may get exercised and therefore offsetting part of the profits. Example: You already have a long futures position in USDINR at 50 and you are keen to reduce losses on this position if USDINR weakens beyond 50 i.e., goes below 50. As stated above, you are not keen to pay any upfront cash to buy protection and therefore you go short call at strike of 50.50 and also receive premium of 0.6. In USDINR weaken below 50, the futures position result in loss and the losses are partly offset by the premium received on short call. At the same time, when USDINR strengthens above 50 and stays below 50.50, there is profit in long futures position and you also earn premium on short call which is not exercised. Therefore the combined returns are higher than standalone long futures. And if USDINR strengthens above 50.50, the call gets exercised and partly offsets the profit on long futures position. Similarly, an exporter with USD receivables can reduce risk by writing a call option. D.2 Covered put Like covered call; you could also short a put on the back of an existing short currency futures position. This combination is called covered put. Example: You already have a short futures position in USDINR at 44.5 and you are keen to reduce losses on this position if USDINR strengthens beyond 44.5 i.e., goes above 44.5. As stated above, you are not keen to pay any upfront cash to buy protection and therefore you go short put at strike of 44 and also receive premium of 0.5. In USDINR strengthens above 44.5, the futures position result in loss and the losses are partly offset by the premium received on short put. At the same time, when USDINR weakens below 50 and stays below 49.50, there is profit in short futures position and you also earn premium on short put which is not exercised. Therefore the combined returns are higher than standalone short futures. And if USDINR CURRENCY DERIVATIVES Page 67
weakens below 49.50, the put gets exercised and partly offsets the profit on short futures position. Similarly, an importer with USD receivables can reduce risk by writing a put option.
SPOT PRICE
COVERED CALL FUTURE LONG 50 -2 -1.75 -1.5 -1.25 -1 -0.75 -0.5 -0.25 0 0.25 0.5 0.75 1 1.25 1.5 1.75 2 COVERED CALL
48 48.25 48.5 48.75 49 49.25 49.5 49.75 50 50.25 50.5 50.75 51 51.25 51.5 51.75 52
SHORT CALL 50.50 PREMIUM 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.35 0.1 -0.15 -0.4 -0.65 -0.9
COVERED PUT RETURN FUTURE SHORT 50 -1.4 -1.15 -0.9 -0.65 -0.4 -0.15 0.1 0.35 0.6 0.85 1.1 1.1 1.1 1.1 1.1 1.1 1.1 2 1.75 1.5 1.25 1 0.75 0.5 0.25 0 -0.25 -0.5 -0.75 -1 -1.25 -1.5 -1.75 -2
SHORT PUT 49 PREMIUM 0.5 -0.5 -0.25 0 0.25 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5
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COVERED PUT
D.3 Protective call View / objective: Assume you already have a short position on USDINR futures and you are interested in reducing the potential losses on it, if market strengthens. While you seek to reduce losses, you are okay to pay also to achieve the objective. Option design: You buy OTM USDINR call option with same maturity as that of futures contract. This strategy of having an existing short position in currency and a long call position is called protective call. Payoff: In case USDINR strengthens, the futures position will result in losses and the long call position will get exercised. The pay off from long call will partly offset the losses from short futures position. On the other hand if USDINR weakens, short currency futures position will turn profitable and long call position may not get exercised and therefore the premium loss on long call will offset the part of the profits. Example: You already have a short futures position in USDINR at 50 and you are keen to reduce losses on this position if USDINR strengthens beyond 50.50 i.e., goes above 50.50. As stated above, you are okay to pay upfront cash to buy protection. You go long call at strike of 50.50 and pay premium of 0.6. If USDINR strengthens above 50.50, the futures position result in loss and the losses are partly offset by gain in long call. At the same time, when USDINR weakens below 50 there is profit in short futures position but it is partly offset by the premium paid on long call. Therefore the losses in combined strategy are lower than standalone short futures. Please note that in price range of 50-50.50, the losses in combined strategy are higher than the standalone short futures. D.4 Protective put Like protective call, you could also have long put on the back of an existing long currency futures position. This combination is called protective put. Example: You already have a long futures position in USDINR at 50 and you are keen to reduce losses CURRENCY DERIVATIVES Page 69
on this position if USDINR weakens below 49.50. As stated above, you are okay to pay upfront cash to buy protection. You go long put at strike of 49.50 and pay premium of 0.5. If USDINR weakens below 49.50, the futures position result in loss and the losses are partly offset by gain in long put. At the same time, when USDINR strengthens above 49.50 there is profit in long futures position but it is partly offset by the premium paid on long put. Therefore the losses in combined strategy are lower than standalone short futures. Please note that in price range of 49.50 50, the losses in combined strategy are higher than the standalone long futures. Given below is detailed payoff for example of these strategies and the related pay of chart. Please note the difference in each of the strategy with respect to maximum profit, profit zone and maximum loss. PROTECTIVE CALL FUTURE SHORT 50 LONG CALL 50.50 PREMIUM 0.6 2 -0.6 1.75 -0.6 1.5 -0.6 1.25 -0.6 1 -0.6 0.75 -0.6 0.5 -0.6 0.25 -0.6 0 -0.6 -0.25 -0.6 -0.5 -0.6 -0.75 -0.35 -1 -0.1 -1.25 0.15 -1.5 0.4 -1.75 0.65 -2 0.9 PROTECTIVE PUT RETURN FUTURE LONG 50 LONG PUT 49.50 PREMIUM 0.5 1.4 -2 1 1.15 -1.75 0.75 0.9 -1.5 0.5 0.65 -1.25 0.25 0.4 -1 0 0.15 -0.75 -0.25 -0.1 -0.5 -0.5 -0.35 -0.25 -0.5 -0.6 0 -0.5 -0.85 0.25 -0.5 -1.1 0.5 -0.5 -1.1 0.75 -0.5 -1.1 1 -0.5 -1.1 1.25 -0.5 -1.1 1.5 -0.5 -1.1 1.75 -0.5 -1.1 2 -0.5
SPOT PRICE
48 48.25 48.5 48.75 49 49.25 49.5 49.75 50 50.25 50.5 50.75 51 51.25 51.5 51.75 52
0 0 0 0 1 1 1
PROTECTIVE CALL
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PROTECTIVE PUT
FINDINGS
Page 71
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. And its 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 because, 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.
SUGGESTIONS
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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.
CONCLUSIONS CURRENCY DERIVATIVES Page 73
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.
BIBLIOGRAPHY CURRENCY DERIVATIVES Page 74
Financial Derivatives (theory, concepts and problems) By: S.L. Gupta. NCFM: Currency future Module. BCFM: Currency Future Module. Center for social and economic research) Poland Recent Development in International Currency Derivative Market by: Lucjan T. Orlowski) Report of the RBI-SEBI standing technical committee on exchange traded currency futures) 2008 Report of the Internal Working Group on Currency Futures (Reserve Bank of India, April 2008)
Websites: www.sebi.gov.in www.rbi.org.in www.frost.com www.wikipedia.com www.economywatch.com www.bseindia.com www.nseindia.com
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INTRODUCTION OF CURRENCY DERIVATIVES

INTRODUCTION TO THE TOPIC

INTRODUCTION TO FINANCIAL DERIVATIVES

2.Exotics (Non STD)

Over The Counter Forward Contracts Swaps

Rs .50.2500 +Rs. 00.0025 Rs .50.2525 Rs .50.2500 Rs. 00.0025 Rs.50. 2475

BRIEF OVERVIEW OF FOREIGN EXCHANGE MARKET

CURRENCY DERIVATIVE PRODUCTS

Re/$ = 50.7250 ( or ) $1 = Rs. 50.7250

USES OF CURRENCY FUTURES

Transaction on the floor (Exchange)

Informs CLEARING HOUSE

investors, speculators, arbitrageurs, etc. but Margin deposit required

arbitrageurs, traders, etc. None as such,

INTEREST RATE PARITY PRINCIPLE

PRODUCT DEFINITIONS OF CURRENCY FUTURE ON NSE/BSE

fixed by RBI two

PRICING FUTURES COST OF CARRY MODEL

Price Watch CURRENCY DERIVATIVES Page 38

Rules, Byelaws & Regulations Membership Circulars List of Holidays

Exchange Traded Currency Options

CALL OPTION CURRENCY DERIVATIVES

PUT OPTION Page 48

BULL PUT SPREAD SHORT PUT ATM LONG PUT RETURN

BULL CALL SPREAD

BULL PUT SPREAD

0.65 0.9 1.15

-0.7 -0.7 -0.7

0.5 0.5 0.5

BEAR CALL SPREAD

BEAR PUT SPREAD

CONCLUSIONS CURRENCY DERIVATIVES Page 73

BIBLIOGRAPHY CURRENCY DERIVATIVES Page 74

Websites: www.sebi.gov.in www.rbi.org.in www.frost.com www.wikipedia.com www.economywatch.com www.bseindia.com www.nseindia.com

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