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Understanding Currency Derivatives

Understanding Currency Derivatives

Hedging using Currency Derivatives

More than often the term ‘derivatives’ immediately result in puzzled faces from those who do not have a financial background. And with the addition of the word ‘currency’ to ‘derivatives’, even for someone with some basic knowledge of finance, might result in a reaction of total bewilderment. To keep things simple, let us first understand what a derivative is. Derivative is a security whose value is ‘derived’ from the value of some underlying asset and they do not have an independent value.

Derivatives can broadly be divided in two categories, i.e. futures and options. Futures and options contracts are primarily used for hedging as a way to minimize risk or for speculation. They can be used to bet about the future prices of anything from the price of gold to the movements of the American stock market to currencies.

First started in August 2008 in India, currency derivatives are currently traded on three exchanges – National Stock Exchange (NSE), MCX-SX and Bombay Stock Exchange (BSE)

Use of currency derivatives

Currency derivatives can be used for hedging foreign currency exchange positions, speculation against movement of currencies or arbitraging.

HEDGING: The most important use of currency derivatives is to mitigate risk by offsetting currency fluctuations using hedging. Hedging can be used by individuals who have bought foreign currency for travelling abroad or who receive income from their family or friends earning abroad, producers shipping goods to different countries where they will be paid in that country’s currency, by exporters and importers shipping internationally and by banks involved in worldwide trade to minimise the risks owing to their exposure to foreign currencies.

For example, I am an individual travelling with my family to the US and I decide to take with me $10,000 which is equivalent to Rs 6,00,000 at the current rate of Rs 60 for 1 USD. Now considering the financial turbulence in the US region I am worried that when I return back and want to sell the unused dollars, I might lose money if the dollar falls. I believe that I would spend about $2,000 during my trip, so I decide to hedge the risk and sell 8 currency futures contracts of USD/INR on exchange, which is equivalent to $8,000 (1 contract denotes $1,000).

As I expected, by the time I returned after a month, the dollar was trading at Rs 57 due to sharp correction in USD and since I hedged my position I could save myself from a potential loss of Rs 24,000.

Hedging using Currency Derivatives

SPECULATION: Speculation is seeking to predict changes of market trends and then betting on currency value movements to make profits. For example, if you believe that an increase in exports from the Indian services and manufacturing sector combined with strong investment inflows from foreign investors will translate into a stronger rupee, you can sell the dollar-rupee pair.

ARBITRAGING: Market participants often get opportunities to exploit the price differential of currency pair between different markets and make profit from it. Price differential can potentially exist between over the counter (OTC), currency futures and non-deliverables forwards and can be leveraged for arbitrage. Arbitrage will ideally be used by more matured market participants who understand the technicalities involved and have access to higher capital.

DIVERSIFICATION: Currency derivatives can be used an additional asset class to diversify your portfolio. Since the currency derivative contracts in India are valid for up to twelve months, they are apt for investment purpose. However a good understanding of the currency market is needed to take investment exposure in any currency. A novice or a beginner should restrict the use of currency derivatives for hedging and only once they have a good understanding of the variables that affect the currency rates should they use it as an additional asset class for investment.

Understanding currency contracts

Currency contracts are always traded in pairs and are also called currency pairs. If you buy a contract for US dollars you are trading its value relative to another currency for example Indian Rupee. The currency is always traded alongside its pair like USD-INR or EUR-INR.

Each currency contract has its own specifications which include the date of the contract expiration (one month, 2-months, three months, one-year, etc), the minimum lot size of a contract and initial margin. Each options or futures contract represents multiple quantity of the underlying asset. For instance, one futures contract in dollar-rupee is $1000; so one contract equals $1,000, two contracts equal $2,000 and so forth. Buying a currency contract also requires paying an initial margin as dictated by the exchange, which varies from contract-contract and also changes depending on the volatility in the underlying currency pair.

The exchange traded currency derivatives contracts in India are settled in cash, which means the actual delivery of the currency does not take place – the profit or loss arising from the derivatives contract has to be settled in cash by the investor.

The final settlement day of all the contracts is the last working day (excluding Saturdays) of the expiry month. The last working day will be the same as that for Interbank Settlements in Mumbai. The contract specifications of all the traded currency pairs can be obtained from here.

How currency futures work?

Just like equity futures, in order to trade in currency futures contracts you need to keep a margin on the value of your contract in your trading account with your broker. This allows you to trade in currency by deploying a very small amount, so you can take an exposure of US$1000 (or Rs 60,000) by just paying a margin of Rs 2,778*.

In addition to the margin that you keep as a deposit with the broker, you have to pay a fee, brokerage, (which is often charged as a percentage of your total turnover) to the broker for using their trading services. The brokerage varies between 0.01% to 0.10% depending on the broker you choose, the level of service you require and also your volume.

Whether you enter either by buying (long) or selling (short) a futures contract, you can close your contract obligations by squaring-off your positions at any time during the life of that contract by taking opposite position in the same contract.

o If you long (buy) position you have to short (sell) the contract to square off your position or vice versa.
o If you don’t do anything your contract will automatically square off on the expiration date

How to use currency derivatives for hedging

What happens in November 2014?

Using Currency Derivatives for Hedging

Am I allowed to trade in currency derivatives?

Any resident Indian or company including banks and financial institutions can participate in the futures market. However, at present, foreign institutional investors (FIIs) and non-resident Indians (NRIs) are not permitted to participate in currency futures market.

To trade in currency derivatives you need to open a trading account with a currency broker. Arihant Capital offers currency derivatives trading services to its client.

Factors that affect a currency

Like any other financial instruments, movement in the prices of a currency depends on a lot of factors like market dynamics and economic environment. One of the most important factors to look out for when trading in a particular currency is the macroeconomic indicators like the political and economic events pertaining to that country as they can have a huge impact on exchange rates. Inflation expectations are also crucial. For example, if prices would rise in India, like what we are observing now, then the Reserve Bank of India is likely to have to raise interest rates in response. This makes the rupee more attractive relative to other currencies, driving up the exchange rate.

Also watch the balance of payments; this tells you whether a country is a global net provider, which means it has a surplus, or a consumer of goods and services. A large growing deficit is often complemented with a weakening currency. How much currency the country is printing also influences the money supply and in turn the exchange rate. Broadly speaking, the larger the supply of notes and coins, the lower their value will be against a less abundant currency.

Which currency can I trade in?

When the exchange currency derivatives started in 2008, only USD-Rupee (INR) Futures were available to trade, however since then the product basket of the currency pairs in futures have expanded to Euro-Rupee, British Pound-Rupee and Yen-Rupee. Currency option trading is also allowed on NSE but currently only in dollar-rupee.

Why exchange traded derivatives?

Currency derivatives is not a new concept in India as an OTC market already exists which already allows its primary users, banks and corporates, to take exposure in the currency. However, it is the first time that the retail investors have been allowed the access to take exposure in currency directly, helping them to add a new asset class in their portfolios. Moreover the exchange traded derivatives offer the added benefits of greater accessibility to participants, high price transparency, high liquidity, standardized contracts and counterparty risk management through Clearing Corporation, eliminating risk for the market participant.

In addition to these benefits, an affordable margin requirement and a considerably small lot or contract size make these instruments a reasonable prospect for all classes of market participants, whether big or small. Currency derivatives also offers the ease of trading through your broker, online trading and trading on your mobile. Arihant offers all three options of trading in currency derivatives to its clients.

As the market participants are realizing the benefits of exchange traded markets in currency, they are gradually moving to these markets as opposed to the OTC markets.

 Going Forward

While Indian financial newspapers and channels are all talks about equity, mutual funds and commodities, it is a known fact that globally foreign exchange is the biggest financial market with India having less than 1% share of the global markets. That shows the tremendous growth potential of currency trading in India.

Globally foreign exchange markets attract a lot of retail participation, which is almost negligible in India. Even many corporates are also having very low awareness of the availability of this product in Indian markets. Focus on investor education and increasing awareness about the product would help in increasing the depth of exchange traded currency derivatives market in the country. Moreover, currently the NRIs are not allowed to trade in India, but if this ban is lifted we could see some surge in volumes.

To trade in currency derivatives or for more details
SMS <Arihant> to 56677

*The initial margin requirement keeps varying and is fixed by the exchange.

View Comment (1)
  • What are the penalties if an NRI anyway trades in currency derivatives – using his trading account opened prior to emigration?

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