CERTIFICATE Certified that Mr. Jigar J Soni. Roll No. 05 Division A. MBA Semester 3rd Batch 2007-09 have worked on the project titled “Currency Derivatives” under my guidance. This is their original work and has not been submitted elsewhere for award of any degree/diploma so far. They have put their sincere efforts to complete the project. We wish them all the best. Date: 31/12/2008. Dr. R.K. Balyan (Director & Dean) [Project report on Currency Derivatives] IBMR-Ahmedabad Page 1
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CERTIFICATE
Certified that Mr. Jigar J Soni. Roll No. 05 Division A. MBA Semester 3rd Batch
2007-09 have worked on the project titled “Currency Derivatives” under my guidance. This
is their original work and has not been submitted elsewhere for award of any degree/diploma
so far. They have put their sincere efforts to complete the project.
We wish them all the best.
Date: 31/12/2008. Dr. R.K. Balyan
(Director & Dean)
[Project report on Currency Derivatives] IBMR-Ahmedabad Page 1
ACKNOWLEDGEMENT
On the occasion of completion and submission of project we would like to express our
deep sense of gratitude to IBMR-Ahmedabad for providing us Platform of management
studies. We thank to our Director Dr. R K. Balyan, and Faculty members for their moral
support during the project.
We are too glad to give our special thanks to our project guide Dr. Renu Choudhary
for providing us an opportunity to carryout project on currency derivatives and also for their
help and tips whenever needed. Without his co-operation it was impossible to reach up to
this stage.
At last, I sincere regards to my parents and friends who have directly or indirectly
helped me in the project.
[Project report on Currency Derivatives] IBMR-Ahmedabad Page 2
INTRODUCTION OF
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
lender’s currency. Thus, the currency units of a country involve an exchange of one
currency for another. The price of one currency in terms of other currency is known as
exchange rate.
The foreign exchange markets of a country provide the mechanism of exchanging different
currencies with one and another, and thus, facilitating transfer of purchasing power from
one country to another.
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
[Project report on Currency Derivatives] IBMR-Ahmedabad Page 4
[Project report on Currency Derivatives] IBMR-Ahmedabad Page 5
RESEARCH METHODOLOGY
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.
[Project report on Currency Derivatives] IBMR-Ahmedabad Page 6
The currency future is new concept and topic related book was not available in library
and market.
CONTENTSCHAPTER NO SUBJECTS COVERED PAGE NO
1 Introduction of currency derivatives 4
2 Research Methodology
Scope of Research Type of Research Source of Data collection Objective of the Study Data collection Limitations
7
3 Introduction to The topic
Introduction of Financial Derivatives Types of Financial Derivatives Derivatives Introduction in India History of currency derivatives Utility of currency derivatives Introduction to Currency Derivatives Introduction to Currency Future
8
4 Brief Overview of the foreign exchange market
Overview of foreign exchange market in India Currency Derivatives Products Foreign Exchange Spot Market Foreign Exchange Quotations Need for exchange traded currency futures Rationale for Introducing Currency Future Future Terminology Uses of currency futures Trading and settlement Process Regulatory Framework for Currency Futures Comparison of Forward & Future Currency
[Project report on Currency Derivatives] IBMR-Ahmedabad Page 40
dealers, multinational
companies, institutional
investors, arbitrageurs,
traders, etc.
institutional investors, small traders,
speculators, arbitrageurs, etc.
Margins None as such, but
compensating bank
balanced may be required
Margin deposit required
Maturity Tailored to needs: from one
week to 10 years
Standardized
Settlement Actual delivery or offset with
cash settlement. No
separate clearing house
Daily settlement to the market and
variation margin requirements
Market
place
Over the telephone
worldwide and computer
networks
At recognized exchange floor with
worldwide communications
Accessibility Limited to large customers
banks, institutions, etc.
Open to any one who is in need of
hedging facilities or has risk capital to
speculate
Delivery More than 90 percent
settled by actual delivery
Actual delivery has very less even below
one percent
Secured Risk is high being less
secured
Highly secured through margin deposit.
[Project report on Currency Derivatives] IBMR-Ahmedabad Page 41
ANALYSIS
INTEREST RATE PARITY PRINCIPLE
For currencies which are fully convertible, the rate of exchange for any date other than
spot is a function of spot and the relative interest rates in each currency. The assumption
is that, any funds held will be invested in a time deposit of that currency. Hence, the
forward rate is the rate which neutralizes the effect of differences in the interest rates in
both the currencies. The forward rate is a function of the spot rate and the interest rate
differential between the two currencies, adjusted for time. In the case of fully convertible
currencies, having no restrictions on borrowing or lending of either currency the forward
rate can be calculated as follows;
[Project report on Currency Derivatives] IBMR-Ahmedabad Page 42
Future Rate = (spot rate) {1 + interest rate on home currency * period} /
{1 + interest rate on foreign currency * period}
For example,
Assume that on January 10, 2002, six month annual interest rate was 7
percent p.a. on Indian rupee and US dollar six month rate was 6 percent p.a. and spot
( Re/$ ) exchange rate was 46.3500. Using the above equation the theoretical future
price on January 10, 2002, expiring on June 9, 2002 is : the answer will be Rs.46.7908
per dollar. Then, this theoretical price is compared with the quoted futures price on
January 10, 2002 and the relationship is observed.
[Project report on Currency Derivatives] IBMR-Ahmedabad Page 43
PRODUCT DEFINITIONS OF CURRENCY
FUTURE ON NSE/BSE
Underlying
Initially, currency futures contracts on US Dollar – Indian Rupee (US$-INR) would be
permitted.
Trading Hours
The trading on currency futures would be available from 9 a.m. to 5 p.m.
Size of the contrac t
The minimum contract size of the currency futures contract at the time of introduction
would be US$ 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.
[Project report on Currency Derivatives] IBMR-Ahmedabad Page 44
Settlement price
The settlement price would be the Reserve Bank Reference Rate on the date of
expiry. The methodology of computation and dissemination of the Reference Rate
may be publicly disclosed by RBI.
Final settlement day
The currency futures contract would expire on the last working day (excluding
Saturdays) of the month. The last working day would be taken to be the same as that
for Interbank Settlements in Mumbai. The rules for Interbank Settlements, including
those for ‘known holidays’ and ‘subsequently declared holiday’ would be those as
laid down by FEDAI.
The contract specification in a tabular form is as under:
Underlying Rate of exchange between one USD and
INR
Trading Hours
(Monday to Friday)
09:00 a.m. to 05:00 p.m.
Contract Size USD 1000
Tick Size 0.25 paisa or INR 0.0025
Trading Period Maximum expiration period of 12 months
Contract Months 12 near calendar months
Final Settlement date/
Value date
Last working day of the month (subject to
holiday calendars)
Last Trading Day Two working days prior to Final Settlement
DateSettlement Cash settled
Final Settlement Price The reference 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.43.19. The underlying
asset in this case is the currency, USD. When the value of dollar moves up, i.e.
when Rupee depreciates, the long futures position starts making profits, and when
the dollar depreciates, i.e. when rupee appreciates, it 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.43.19. If the price goes up, his futures position starts making profit. If the price falls, his futures position starts showing losses.
[Project report on Currency Derivatives] IBMR-Ahmedabad Page 46
Payoff for seller of futures: Short futures
The payoff for a person who sells a futures contract is similar to the payoff for a
person who shorts an asset. He has a potentially unlimited upside as well as a
potentially unlimited downside. Take the case of a speculator who sells a two month
currency futures contract when the USD stands at say Rs.43.19. The underlying
asset in this case is the currency, USD. When the value of dollar moves down, i.e.
when rupee appreciates, the short futures position starts 25 making profits, and
when the dollar appreciates, i.e. when rupee depreciates, it starts making losses.
The Figure below shows the payoff diagram for the seller of a futures contract.
[Project report on Currency Derivatives] IBMR-Ahmedabad Page 47
PROFIT
LOSS
USDD
0
43.19
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
[Project report on Currency Derivatives] IBMR-Ahmedabad Page 48
PROFIT
LOSS
USDD
0
43.19
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 - =
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.
[Project report on Currency Derivatives] IBMR-Ahmedabad Page 49
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 currency’s
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 firm’s profit will be affected by change in foreign exchange
rates. In all these situations, the firm can take long or short position in futures
currency market as per requirement.
The general rule for determining whether a long or short futures position will hedge a
potential foreign exchange loss is:
Loss from appreciating in Indian rupee= Short hedge
Loss form depreciating in Indian rupee= Long hedge
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
[Project report on Currency Derivatives] IBMR-Ahmedabad Page 50
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: