Currency Future

Currency Future

• A future contract is a legal contract or a commitment to buy or sell the underlying asset (currency or stock or commodity) at a fixed price and at a fixed date in future.
• In a stock or commodity futures contract the exchange takes place between currency (money) and stock or commodity. In a currency futures contract the exchange takes place between two currencies. A futures contract is always traded on any recognized exchange.
• Where a forward contract, essentially speaking, is the same as a futures contract except that it is traded on OTC (Over the counter) markets. Exchange traded futures contract as compared to forwards contracts 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. Expect on the maturity date, no money changes hands.
• In the case of an exchange traded futures contract, mark to obligations are setteled on a daily basis. Mark to market is the practice of revaluing securities and financial instruments using current market prices and is most seen in the mutual fund industry where the current net asset value (NAV) gives the MTM price. 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.
• As the currency futures are available for trading on any recognized exchanges, there is a guarantee of performance and hence there are no changes of any defaults whatsoever.
• Foreign exchange forwards contracts traded on OTC markets are suitable for banks, financial institutions and corporate customers due to large size of the contracts.  Foreign currency futures contracts traded on recognized exchanges are most suitable for small investors and business.

Exchange Traded Currency Futures

• Structural reforms in the Indian foreign exchange market stated from the early 90s. Exchange rate regime came to an end by March 1993 when it was fully floated .
• India took a revolutionary step in the direction of current account convertibility by permitting market-determined exchange rate of Rupee. Over the past few years , India has initiated some excellent measures in a phased wise manner to speed up the liberalization process.

Differences between Currency Futures and Currency Forwards

• An excessive fluctuation in the exchange rate was one of the major consequence of increased foreign exchange transactions. High volatility in the exchange rate created detrimental effects on the exporters, efficient price discovery and sustainability of current account balance. No doubt, the market participants as well as the policy makers were seriously concerned with taking these issues.
• After the introduction of currency futures trading in India, now there are two regulatory agencies RBI and SEBI (Securities and Exchange Board of India ). Foreign exchange is under the regulatory control of RBI under Foreign Exchange Management Act, 1999 (FEMA) and Currency futures is under the regulatory control of SEBI.
• In order to sort out of the issues arising out of overlapping of jurisdiction of currency futures , SEBI-RBI joint committee has been formed for overall coordination purposes. RBI and SEBI (securities and Exchange Board of India) finalized the guidelines for exchange-traded currency futures in April 2008. Based on the guidelines, RBI farmed the directives on currency futures trading on recognized stock exchanges and published it on 6th August , 2008.

RBI Guidelines for Exchange Traded Currency Futures

• RBI has initially granted permission for USD-INR currency futures. Other currency pairs may be allowed in future after the approval of RBI.
• At present only resident Indians are allowed to trade in currency futures to hedge their risks associated with exchange rate volatility or otherwise
• Specifications of standardized USD-INR contracts-lot size of $ 1000 , Maturity periods of up to 12 months, Quoted in INR , Settlement in cash in INR final settlement price as per RBI reference rate on the last trading day.
• No person other than resident person shall participate in the currency futures.
• Membership of currency futures market has been kept separate from equity markets.
• Trading and clearing membership shall be issued as per the guidelines of SEBI.

SEBI Guidelines for Exchange Traded Currency Futures

• Margins shall be composed of initial margin based on worst case scenario of maximum portfolio loss with 99% VaR (Value at risk) over one day horizon . Maintenance margin based on SPAN (standard portfolio Analysis of Risk) methodology with real time computation. Calendar spread margin at the rate of Rs. 250.
• Mark to market settlement with respect to daily settlement price shall be done on the base of T+1 day. Daily settlement price would be computed as the weighted average price of last half an hour`s trades.
• Maximum position limit has been capped at $25 million.
• An existing or new exchange by SEBI has to fulfil various criteria to be eligible for offering currency futures. Exchange has to be separate from the order market segments such as equity, equity derivatives and commodities.
• Entire clearing and settlement process has to be performed by a clearing corporation, which shall have to get its approval from SEBI. clearing corporation shall be separate from other market segments.
• Trading members shall have minimum networth requirement of Rs.1 crore and clearing members Rs. 10 crores.
• The exchange have to submit the proposals and get the approval from SEBI before the introduction of currency futures contracts or any other financial products.
• Initially fills and NRIs are not permitted to participate in the currency futures.
• SEBI and RBI joint committee would regularly meet to sort out the issues arising out of overlapping jurisdictions of currency futures.

Foreign Exchange Derivative Instruments

Foreign Exchange Forwards

• Authorised Dealers (Ads)  (Category-I) are permitted to issue forward contracts to persons resident in India with crystallised foreign currency/foreign interest rate exposure and based on past per for mance/actual import – expert turnover, as permitted by the Reserve Bank and to persons resident outside India with genuine currency exposure to the rupee, as permitted by the Reserve Bank .
• The residents in India generally hedge crystallised foreign interest rate exposure or transform exposure from one currency to another permitted currency. Residents outside India enter into such contracts to hedge or transform permitted foreign currency exposure to the rupee, as permitted by the Reserve Bank.

Foreign currency Rupee Swap              

• A person resident in India who has a long-term foreign currency or rupee liability is permitted to enter into such a swap transaction with Ads (Category-I) to hedge or transform exposure in foreign currency/foreign interest rate to rupee / rupee interest rate.

Foreign Currency Rupee Options

• Ads (Category-I) approved by the Reserve Bank and Ads (Category-I) who are not market makers are followed to sell foreign currency rupee options to their customers on a back-to-back basis, provided they have a capital to riskweighted assets ratio (CRAR) of 9 per cent or above. These options are used by customers who have genuine foreign currency exposures, as permitted by the Reserve Bank and by Ads (Category-I) for the purpose of hedging trading books and balance sheet exposures.

Cross-Currency Options

• Ads (Category-I) are permitted to issue cross-currency options to a person resident in India with crystallised foreign currency exposure, as permitted by the Reserve Bank.
• The clients use this instruments to hedge or transform foreign currency exposure arising out of current account transactions. Ads use this instrument to cover the risks arising out of market-making in foreign currency rupee options as well as cross currency options, as permitted by the Reserve Bank.

Cross currency swaps

Entities with borrowings in foreign currency under external commercial borrowing (ECB) are permitted to use cross cur rency swaps for transformation of and/or hedging foreign currency and interest rate risks. Use of this product in a structured product not conforming to the specific purpose is not permitted.

MAPIN

• MAPIN (Market Participant Identification Number) is the Market Participants and Investors Integrated Database. The SEBI (Central Database of Market Participants). Regulations,  2003 were notified on November 20,2003 under which, all the participants in the Indian Securities Market viz., SEBI registered intermediaries, listed companies and their associate and investors were required to
• Obtain a unique Identification Number ( UIN) in order to enable the identity of person(s).
•  In the light of SEBI`s  order of making PAN the sole identification number for all participants transecting in the securities market, irrespective of discontinue with the requirement of Unique Identification Number (UIN) under the SEBI (central Database of market Participants Regulations), 2005 MAPIN card as one of the documents for the purpose of proof of Identity (POI) has been withdrawn.

The players of Currency Trading

• So far, only OTC forex markets and inter-bank forex networks offered currency trading in India. Forex markets were beyond the reach of small investors, speculators and arbitragers. With the introduction of currency futures trading in India, apart from exporters, importers, companies and banks, many retail traders and investors would also get the opportunities for foreign exchange trading. Currency futures , like any other derivative market has three main participants.

Hedgers

• Hedging is an excellent tool to offset the risks associated with fluctuations in the price of the currency in foreign exchange markets. Hedging is the process of seeking a cover or insurance against price risks for protecting future cash flows and profitability. Hedger is the person who uses currency futures primarily for hedging the risks arising out of extreme volatility in foreign exchange rate.
• Hedger is an important player in the derivatives markets. Hedgers take position in currency futures markets only for protecting the position in cash market . Hedger hold large number of currency futures lost at a time and in such a way that the size is approximately equal to exposure in cash market. Hedger holds the position in currency futures market for a longer period until the cash position is ready for settlement.

Speculators

• Speculators are those participants who trade in the markets essentially for making profit from the anticipated up/down movement in the price of the currency. Speculators provide the necessary liquidity to the currency markets by offering ample demand and supply.
• Speculators are the participants who support continuous flow of transactions in the market. Speculators are risk takers (accept the risks). Speculators do not hold any offsetting (counter) position in the cash market.
• Speculator is an active buyer whenever it seems that the price of currency is lower than what it should be. Conversely, speculator would change his role from active buyer to active seller when the price of currency seems to be higher than anticipated price.
• Speculators tend to trade in smaller number of currency future contracts as compared to hedgers. Trading timeframe of speculators is very short-ranging from intraday to few weeks. Large participation from speculators is desirable in the currency futures markets in order to cater to the requirement of hedgers . Currency futures or any derivative market is a highly leveraged market where you trade with very small amount of margin. This is the most important factor for attracting speculators to the currency markets.

Arbitragers

• Arbitragers is the process of simultaneous buying and selling of same financial instrument in different markets in order to make immediate profits without any risk. Arbitragers make profit by spotting price discrepancy between the rates of same financial asset in different markets. Arbitragers know beforehand the minimum profit potential at the time of entering the markets.
• Arbitragers continuously watch the market screens to look out of the opportunities in price inconsistencies . Gross profits are very small and net profits after deducting the expenses and taxes become much smaller. Nevertheless, the profits are low-risk and hence arbitragers trade in large quantity.
• With globalization, arbitrage opportunities exist in plenty across different exchanges, markets, region, countries, and types of instruments and across combination of these conditions. Besides providing liquidity to the markets, arbitragers put a pressure on the market prices to move to rational or normal levels.