With the availability of abundant off-shore investment opportunities, investors may get tempted to diversify their investments. However, Financial Planners may help them in hedging the exchange risks through the effective use of Currency Futures.

1. CUrreNCY MANAGeMeNt
currency Futures –
a new Leap aheaD
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2. CUrreNCY MANAGeMeNt
with the availability of abundant off-shore investment opportunities, investors may get
tempted to diversify their investments. however, Financial planners may help them in
hedging the exchange risks through the effective use of currency Futures.
Amar Ranu
Senior Manager, Mutual Fund Research
Motilal Oswal Securities Limited
T Need for Exchange Traded Currency
he Indian market has been witnessing an increased
participation in other financial products, moving Futures
away from the obsession with equities. The interests Before introduction of Currency Futures pairs, the Indian
for other financial products provide an alternate avenue to foreign exchange market was dominated by OTC (Over
expand the basket of assets; it also provides hedging avenues the Counter) products which were predominantly for large
for the domestic investors. In 1990s, India got on to a series corporate houses. Although liberalization helped India’s forex
of structural reforms in the foreign exchange market. The market in various ways, there were excessive fluctuations of
exchange rate being pegged earlier was floated fully in March exchange rates in Indian forex market, leading to excessive
1993. The integration of the exchange rate was instrumental volatility. So, in context to upgrade Indian foreign exchange
in developing a market-determined exchange rate of the market to international standards, a well-developed foreign
rupee and an important step in the progress towards current exchange derivative market was required. The Reserve Bank
account convertibility, which was achieved in August 1994. of India (RBI), India’s Central Bank, set up an Internal
The RBI increased the ceiling for remittances for resident Working Group to explore the advantages of introducing
individuals under the Liberalized Remittance Scheme for currency futures. The group recommended the introduction
Resident Individuals to US $ 2,00,000 in a phased manner. of Currency Futures in April 2008.
Increased overseas investments have also been allowed for Exchange Traded Futures as compared to OTC forwards
corporate houses to facilitate overseas acquisitions and fund serve the same economic purpose, although it differs in
internal requirements. The prepayment limits have also been fundamental ways (Kindly see Table 1).
raised to liberalize the guidelines on External Commercial
Borrowings (ECBs). Hence, the globalization and
table 1: comparision of Forward and Futures contract
amalgamation of financial markets, coupled with increased
Desription Forward Contract Futures Contract
foreign exchange flows have led to the need of dynamic
currency risk management. The free trade flows with other Nature of Non-standardized/ Standardized contract
Contract Customized contract
countries, increased participation in international markets
Trading Over-the-counter Traded on Exchange
and strong economic environment have led to increased market; Private
inflows in the form of FDIs and FIIs’ investments. Moreover, contract between
the foreign exchange market has achieved a new feat in terms parties
of deeper participation, wide range of products, turnover and Risk Counter Party Risk; no Exchange provides the
guarantee is provided guarantee of settlement and
liquidity. The average daily turnover in the foreign exchange hence no counter party risk.
market increased from US $ 23.7 billion in March 2006 to Settlement Single - Precified Daily settlement, known as
US $ 33.0 billion in March 2007 in consonance with the Daily market settlement and
increase in foreign exchange transactions. Final settlement
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3. CUrreNCY MANAGeMeNt
In case of forward contract, the money exchange takes •
Settlement Mechanism: It is cash settled in Indian Rupees
place only on maturity date while in the case of exchange
at RBI Reference Rate on date of expiry.
traded future contract, mark to market obligations are settled
• Tenor of the contract: The maximum maturity is of 12
on a daily basis. Since the profits or losses in the futures market
months.
are collected / paid on daily basis, the scope for building up
• Tick Size: 0.25 paise or INR 0.0025.
of mark to market losses in the books of various participants
• Price Operating Range: +/- 3% of base price for tenure
gets reduced. The presence of a Clearing Corporation which
up to 6 months and +/- 5% of base price for tenure
provides Counterparty Guarantee reduces the counterparty
greater than 6 months.
risk in a future contract, thus, eliminates credit risk. Further,
• Settlement: Daily Settlement at T+1 and Final Settlement
at T+2.
Initially, forex markets were beyond the reach of
small investors, speculators and arbitragers but
the presence of a clearing corporation which with the introduction of currency futures trading in
provides counterparty Guarantee reduces India, apart from exporters, importers, companies
the counterparty risk in a future contract, and banks, many retail traders and investors can
also now take their positions in Foreign Exchange
thus, eliminates credit risk. trading. The following are the benefits for different
groups:
in an exchange driven product, the market lot size is much • Hedgers: Currency Futures provide a high-liquidity
smaller as compared to OTC market. It, thus, provides an platform for hedging against the effects of unfavorable
equal opportunity to all classes of investors whether large or fluctuations in the foreign exchange markets. Exporters,
small to participate in the futures market. Other advantages Importers, Corporate and Banks can hedge with
of an Exchange traded market would be greater transparency, Currency Futures at low entry and exit costs.
efficiency and accessibility. • Investors: All those who are interested in taking a view
on the direction of the market i.e. appreciation or
depreciation of exchange rate in the long and short term
Currency Futures Market – A Perspective can participate in Currency Futures. For example, if a
Initially the RBI and Securities and Exchange Board of person expects an appreciation in Indian Rupee against
India (SEBI) allowed trading in currency futures in India, USD, he can sell the USD-INR contract. However, if
based on the USD-INR exchange rate. This provided Indian one expects depreciation of the Indian Rupee against
corporate another tool for hedging their foreign exchange risk the US dollar, he can take long (buy) position in USD-
effectively and flexibly at transparent rates on an electronic INR contract.
trading platform. The contract specifications of the futures • Arbitrageurs: Arbitrageurs get opportunity to trade in
are as given below: interest rate differentials of respective countries implied
from currency futures.
• Underlying: Initially, currency futures contracts on US
Dollar – Indian Rupee (USD-INR) have been permitted; Currency Futures for Forex players and its
in April 2010. It has now been extended to Euro – Indian benefits
Rupee (EUR-INR), British Pound Sterling – Indian After the RBI increased the ceiling for remittances for
Rupee (GBP-INR) and Japanese Yen – Indian Rupee resident individuals under the Liberalized Remittance Scheme
(JPY-INR). for Resident Individual to US $ 2,00,000, the Currency Futures
• Size of the Contract: The minimum contract size of have attained a more important place due to increased forex
the currency futures market is 1,000 USD, 1,000 Euro, volatility. Moreover, Indian corporate houses, including small
1,000 Pound Sterling and 1,00,000 YEN for USD-INR, and medium scale, have seen increased participation in terms
EURO-INR, GBP-INR and JPY-INR respectively. of foreign currency borrowings as evident from the figures
• Quotation: The currency futures contracts are quoted in of External Commercial Borrowings (ECBs) and Foreign
Rupee terms, however, the outstanding positions are in Currency Convertible Bonds (FCCBs). So, the currency
respective currency terms. futures have occupied an important place in terms of reducing
• Trading Hours: The trading is available from 09:00 a.m. foreign exchange volatility. Also, High Networth Individuals
to 5 p.m. from Monday to Friday. (HNIs) have started dabbling in currency futures in search
• Available Contracts: All monthly maturities from 1 to 12 of alternate investment opportunity. There is no data on the
months are available. participation of retail investors in currency trade, but the
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4. CUrreNCY MANAGeMeNt
evidence suggests that the trend has started. The reasons are In Indian Rupee, the investment is worth Rs. 45,63,000,
many: one being the equity market is overvalued. Moreover, considering USD/INR is currently quoting at Rs. 45.63.
after the addition of the other currency pairs, there has been After six months, his call goes right and his investments
considerable interest in futures. The combined volume has grew by 10%; hence his investments would be worth US $
almost doubled. 1,10,000. Considering the current USD-INR rate at Rs. 41.20
and his investment of US $ 1,10,000, his portfolio would be
Let us understand how a currency future works in benefits worth of Rs. 45,32,000. This is a loss making proposition for
of different stakeholders including individuals: him, giving a loss of 0.68%, against actual returns of 10% on
his investments. During this period, the USD has depreciated
Consider an exporter XYZ exporting garments worth against the INR and therefore the returns are poor. Though
US $ 1,00,000 wants to protect himself from the possible he was successful in gauging the stock market movement in
appreciation in Indian Rupee in Nov 2010 i.e. when he US NASDAQ but he fails to capture and manage his currency
expects to receive the payment. He will lock-in the exchange exposure.
rate for the above transaction in the manner given below Let us now see how he can safeguard himself against his
(Kindly see Table 2): exposures in USD. If he perceives that USD will depreciate,
he can go short on currency futures i.e. he sells a USD/INR
table 2: cashflows of exporter XYZ contract. The table 3 explains the mechanics of hedging
One USD-INR Contract Size US $ 1,000 through Currency Futures.
Sell 100 USD-INR Nov 10 Contracts (May Rs. 44.75
15, 2010) table 3: mechanics of hedging through currency Futures
Buy 100 USD-INR Nov 10 Contracts in Rs. 44.40 particulars spot Market Futures Market
Nov 2010 Leg 1 The current exchange rate is INR USD-INR contract is at Rs. 45.95;
Strategy 45.63 per USD, therefore, the hence, the price per contract is
current investment of USD 1,00,000 INR 45,950. The approximate
Sell USD 1,00,000 in spot market @ Rs. is Rs. 45,63,000. number of contract he would
sell is 4563000/45950 = 99.30
44.40 in Nov 2010 ≈ 99. Sell 99 contracts for Rs.
45,49,050.
Assume that his predictions went right
and the rupee appreciated to Rs. 44.40 Leg 2 The spot rate is INR 41.20. Receive Buy back 99 contracts at the
USD 1,10,000 from his investments. prevailing rate of USD-INR 41.52.
per USD as predicted by the exporter by His revenue in INR: 1,10,000 × 41.2 Price per contract is 41,520.
end of Nov 2010 = INR 45,32,000 Hence, the value of 99 contract is
Rs. 41,10,480.
profit on Futures transaction is:
Profit/Loss from Futures (Nov 2010 = 100× 1000 × (44.75-44.40)
INR 45,49,050 Sale Price of Futures
Contracts)
= INR 35,000 (INR 41,10,480) (Buy Price of Futures)
INR 4,38,750 Profit on Futures
Analysis
The net receipt in INR for the hedged transaction would mitigating Forex Risk and calculating stock market Return
be: INR 45,32,000 Stock Proceedings
Rs. (1,00,000 × 44.40 + 35,000) = Rs. 44,75,000. Had he INR 4,38,750 Future Gains
not taken exposures in Currency Futures market, he would INR 49,70,750 Returns
have got only Rs. 44,40,000. Here, we have considered ‘nil’
margin for taking positions in Currency Futures. It is to be Observation: Had the exchange rate been dormant at
noted that the above examples do not include transaction fees Rs. 45.63 during the six-month period, the investment in
and any other fees, which are essential for calculating final Indian currency would have grown from Rs. 45,63,000 to
profit and loss. Rs. 50,19,300 fetching him an absolute return of 4,56,300.
Similarly, the opposite of the above mentioned strategy
can be taken if one anticipates depreciation in Indian Rupee. table 4: portfolio Return
Thus, we see that Currency Future is proved to be a boon for without hedging hedging with currency Futures
the market participants if it is used properly. Invest USD 1,00,000 (USD = Rs. Invests and sells 99 future contracts
45.63) at Rs. 45.95
How a retail investor can benefit from Investment grows to USD 1,10,000 After 6 months, square-off futures
Currency Futures? after 6 months position at Rs. 41.52.
Similarly, the currency futures can be used for Retail Sells his investment when the exchange rate is Rs. 41.2
Hedging particularly to remove forex risk while investing Return (In $) = 10% Return in Rs. Terms:
abroad. Let us say an investor invests USD 1,00,000 for a Loss (In Rs.) = 0.68% Loss on Investment (In Rs.)= Rs.
period of six months in the NASDAQ with a perspective 31,000
that the market will grow and he will earn a decent return. (1,10,000 × 41.2 - 1,00,000 × 45.63)/ On Futures = Rs. 4,38,750
(1,10,000 × 41.2) Net Return = 8.93%
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5. CUrreNCY MANAGeMeNt
However, during this period, the USD has depreciated by
It is the writer who might catch
9.71% and hence, this investment made a loss. The table 4 the imagination of young people,
gives a detailed presentation how he would benefit with and and plant a seed that will flower and
without currency hedging.
come to fruition
Thus, he could post a better return by hedging his
overseas portfolio using Currency Futures as compared to the - Issac asimov
one without hedging.
Indian Journey of Currency Futures
Indian Currency Futures market has surpassed all past
records in terms of volume in comparison to other assets
classes, including equity. The total monthly turnover in the
Currency Futures increased considerably, from Rs. 2.20 lakh
crore in Dec 2009 (NSE and MCX Data) to Rs. 7.19 lakh
crore in April 2009. Initially, when the USD-INR currency
pair was launched, the average daily volume of currency
wanted writers/
futures was Rs. 2,179.83 crore in Dec 2008 which increased Contributors for
Financial Planning Journal
to Rs. 18,929.05 crore in April 2010, a whooping increase
of 359.85 per cent CAGR or an absolute increase of 768
per cent. Even a report of SEBI has noted that the currency
futures market is slowly chipping away the market share from
the OTC market. This has resulted in reduction of bid-ask what we are looking for?
spreads (difference between the highest buying and lowest
selling price) in currency futures. The report also says that • Passion to take the Financial Planning
the participation of merchants (importers and exporters) in movement forward
the OTC market has declined from 62 per cent in November • Original and Thought Provoking Ideas
2008 to 20 per cent in August 2009. The main reason for
currency futures being tradable in large quantity is due to
• Ability to challenge the Paradigms
less initial money margin which ranges from Rs. 1,300 to Rs. • Research Orientation
3,500 per lot, depending upon the volatility and the liquidity
for the respective currency pair. Due to an affordable margin
requirement and a considerably small lot, these instruments what you get?
have become a favorite for traders as well as emerging • Recognition
companies including individuals that have a significant
• Continuous Education points for CFPCM
business exposure to the countries of the respective currency
certificants
in terms of revenue earnings.
• Feedback from the readers
Conclusion
The exchange traded currency pairs is an extension of
a deeply penetrated OTC market but with added benefits If you have it within you, then do contact
in terms of liquidity, price transparency, standardized Prashant Kapoor, assistant editor, Financial
Planning Journal at prashant@fpsbindia.org and
contracts, counterparty risk management through Clearing
be a part of the Financial Planning movement.
Corporation and no requirement of underlying exposure
in the currency. However, it would be too early to predict a
major shift in trading activity to exchange based Currency
Futures, compared to the OTC Market as OTC Market has
created a niche for itself and perhaps it would take some time
Financial Planning Journal, FPSB India,
for the currency futures market to create one for itself. 702, 7th Floor, Leela Business Park, Andheri Kurla Road
Andheri (East), Mumbai - 400059
Phone : 91 22 61712424 Fax: 91 22 61712444
Website: www.fpsbindia.org
amar.ranu@motilaloswal.com
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