Currency Futures

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Project report

Price risk management using currency futures


Greenback Forex Services Ltd.

In partial fulfillment of the requirements of
Masters of Management Studies
conducted by
University of Mumbai

Rizvi Institute of Management Studies and Research

under the guidance of

Prof. Vishal Singhi

Submitted by
Kaynat Chainwala
Batch: 2011 – 2013

This is to certify that Ms. Kaynat Chainwala, a student of Rizvi Management Institute, of MMS
III bearing Roll No. 32 and specializing in Finance has successfully completed the project titled
“Price risk management using currency futures”

under the guidance of Prof. Vishal Singhi in partial fulfillment of the requirement of Masters of
Management Studies by Rizvi Management Institutes for the academic year 2011 – 2013.

Prof. Vishal Singhi
Project Guide



Prof. Umar Farooq

Dr. Kalim Khan

Academic Coordinator


I would like to express my sincere gratitude towards thanking the following people:
Prof. Vishal Singhi, Internal Mentor, for supporting & guiding me through my summer
internship project.

I thank Dr. Kalim Khan, Director, Rizvi Institute of Management studies & Research, Mumbai,
for providing me the opportunity to have such a good experience of an internship project.

Finally, I am highly thankful to my parents, friends and my entire family, who have supported
me in this venture.

Kaynat Chainwala

Executive summary
The Indian rupee, that has weakened almost 25 per cent against the US dollar since the beginning
of the year 2012 is likely to remain volatile for some more time to come mainly due to
uncertainty in the domestic and global economic outlook. The partially convertible rupee got
battered in the month of June; 2012 and hit a record low of 56.80 against the dollar which was
almost 12 per cent down from the year's high of 50.57 recorded in March, 2012.
The rising oil import bill, increasing trade deficit, inflation, interest rates, capital outflows, slow
pace of Euro crisis which led to the recent depreciation of the Rupee especially post August 2011
have serious implications. The industry would be inhibited to go for capex due to cost escalations
as a result of import-led inflation, implied cost of borrowing in foreign currency. Exports will
become more competitive and demand should also benefit from a gradual, albeit very slow,
improvement in the global scenario. Simultaneously, the import bill of manufacturers will, or is
already rising. However, over time a realistic exchange rate should lend stability and
sustainability to economic performance.
The time has come for companies to use hedging as a well-planned ingredient and not continue
to use it as a short term strategic measure for risk management. Unlike the economic crisis of
2008 when oil prices crashed to aggravate the situation, the current volatility owed itself to
increasing demand for foreign exchange fuelled by domestic demand - for both internal like
import of gold and exports and the reluctance of the Reserve Bank of India to stem the runaway
depreciation of the rupee.
"Risk management has assumed underlined importance for the companies.‖Risk
management strategies for hedging foreign exchange, interest rate and commodity price risks
have assumed an imperative adjunct of corporate strategy, more so in a globalised economic



Current Status




Factors that affect currency rates


Currency risks


FOREX Risk Management- Process and Necessity


Hedging Strategies


Derivatives Instruments traded in India


Business Growth in Currency Derivatives in India






Market players


Major exchanges


Trading and volumes


Major contracts traded on the exchange


Futures terminology


Product specification


Pricing futures
Cost of carry model


Hedging with currency futures


Currency futures payoffs


 Using Purchasing Power Parity (PPP)


 Using Interest Rate Parity (IRP)


Quantitative analysis
Open interest and volumes of contracts traded


Correlation between OI and volumes traded


Returns for the past year


Historical volatility


Research work






Price risk management using currency futures

The main objective of this study is to study risks and hedging techniques used to manage them.
A significant number of firms hedge their risk exposures, with wide variations in which risks get
hedged and the tools used for hedging. A significant number of firms hedge against risks, some
risks seem to be hedged more often than others.
In this report, we will look at the most widely hedged risks – Exchange rate risk.
The most widely hedged risk is Exchange rate risk because it not only affects the multinational
companies but also the domestic companies since their revenue are dependent on inputs from
foreign markets.
Derivatives have been used to manage risk for a very long time, but they were available only to a
few firms and at high cost, since they had to be customized for each user. The development of
options and futures markets in the 1970s and 1980s allowed for the standardization of derivative
products, thus allowing access to even individuals who wanted to hedge against specific risk.
The range of risks that are covered by derivatives grows each year, and there are very few
market-wide risks that you cannot hedge today using options or futures.
The introduction of currency futures in India has passed a journey of almost four years and many
changes have been implemented in the trading system in this regard. Currency futures have
significantly gained importance all over the world since the first currency futures contract was
traded in the year 1972. The futures market holds a great importance in the economy and,
therefore, it becomes imperative that we analyse this important market and seek answers to a few
basic questions. The main theme of this paper is to assess the speed in which the growth of
currency futures in India has accelerated. It also aims at examining the volatility of the currency
futures. In order to study the growth of the currency futures, the number of contracts traded and
open interest at NSE has been inclusively compared.

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“If you don’t invest in risk management, it doesn’t matter what business you’re in, it’s a risky

When India remained largely unaffected by the US sub-prime crisis of 2007-08 that snowballed
into a global financial crisis, it was praised for not being exposed to complex debt instruments.
That was perhaps a good thing then.
But four years later, the scenario has changed. Now, India is more integrated with the global
economy. Besides, the interest rate outlook has turned more volatile.
The rupee crossed historic 56.40 levels recently against the dollar and depreciated against other
major currencies. The volatility in rupee movements is only set to increase on account of a host
of external and domestic forces.
The importance of currency risk management — adopting new hedging methods and moving
beyond forward contracts — has increased in this scenario. Bungling on currency risk
management can adversely affect profits, sales, cost, revenue and competitiveness of companies
involved in international business

Indian companies mainly use forward contract derivatives from their banks to hedge currency
exchange risk. Exchange-traded currency futures and options are yet to become popular, in spite
of the fact that these were introduced by RBI and SEBI to provide a transparent hedging system,
especially to small and medium scale units.
Indian companies went in for over-the-counter derivatives, duly encouraged by banks, only to
have their fingers burnt when the rupee rates moved against them.Such structures were
developed for speculation rather than for hedging, and now have been banned by RBI.

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Price risk management using currency futures
Another area where currency risk has been mismanaged is foreign currency loans. Companies
have taken huge cheap dollar loans, which have turned expensive with steep depreciation of the

Foreign currency exposures must be divided into monthly, quarterly, half-yearly and yearly
basis. Short-term exposures up to, say, one month may be fully covered with forward contract
derivatives, and after that the strategy of partial hedging may be used to deal with volatility in the
dollar-rupee rate.
The concept of stop loss, to follow market trends for hedging, should now be used seriously.
Option and futures exchange traded derivatives, which have transparency and offsetting
characteristics, may be used when rupee volatility against the dollar increases.
Such flexibilities are not available in the case of hedging by forward contracts. Futures can also
be used to correct the forward contract hedge at low cost and effort. Importers may remain
hedged using forward derivatives contract for short and medium-term committed exposures.
Hedging with forex derivatives may create situations for marked-to-market losses. Indian
corporates should give serious attention to operational hedging techniques, especially for very
long term exposures in foreign currencies.

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Price risk management using currency futures

Global and local macro economic factors, and risk avoidance by forex dealers, have created a
huge demand for the dollar. The global factors that have led to a strong dollar worldwide are: the
Euro debt crisis; financial uncertainty in France and Germany, the flagship Euro zone
economies; downgrading of Japan due to its high levels of debt; high oil and commodity prices;
and overall negative global sentiments. Added to these are local factors, such as a negative trade
deficit, high inflation, indifferent FII/FDI investments, growth slowdown, burgeoning fiscal
deficit, ratings downgrade, and paralysis in policymaking — all of which have led to rupee
depreciation against the dollar. But present trend of the declining rupee can be converted into big
opportunity, particularly by expanding exports in new international markets. Currency risk
management will play a crucial role in translating this potential into reality.
The rupee will not appreciate in any significant way, unless our current account achieves surplus
position. The rupee-dollar exchange rates are a critical factor in exports, imports, international
loans, foreign remittances, tourism and overseas education. The depreciating rupee poses major
challenges for importers and those servicing unhedged foreign currency loans. Future business
decisions will be influenced by the external value of the rupee against major currencies,
including the dollar.
Contrary to what is generally believed, even dollar depreciation can hurt exporters because
foreign buyers, especially in Europe and the US, exert pressure on Indian exporters to cut prices.
What's more, export-oriented large companies may have hedged their short, medium and longterm exposures at, say, 48-50 to a dollar, when the rupee was below 45.

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Price risk management using currency futures

Globalization and integration of financial markets, coupled with progressive increase of crossborder flow of capital, have transformed the dynamics of the Indian financial markets. This has
increased the need for dynamic currency risk management. The steady rise in India‘s foreign
trade, along with liberalization in foreign exchange regime, has led to large inflows of foreign
currency into the system in the form of FDI and FII investments. In order to provide a liquid,
transparent and vibrant market for foreign exchange rate risk management, Securities &
Exchange Board of India (SEBI) and Reserve Bank of India (RBI) have allowed trading in
currency futures on stock exchanges for the first time in India, initially based on the USDINR
exchange rate and subsequently on three other currency pairs – EURINR, GBPINR and JPYINR.
The USDINR futures contract is being traded on MCX-SX with more than US $3.05 billion
average daily turnover. This would give Indian businesses another tool for hedging their foreign
exchange risks effectively and efficiently at transparent rates on an electronic trading platform.
The primary purpose of exchange traded currency derivatives is to provide a mechanism for
price risk management and consequently provide price curve of expected future prices to enable
the industry to protect its foreign currency exposure. The need for such instruments increases
with increase of foreign exchange volatility.

Participants in Currency Markets:
The forex market is an OTC market without any centralized clearing house. It consists of two
• The interbank or wholesale market,
• Client or retail market
4 broad categories of participants operate within these two tiers i.e. the participants in the foreign
exchange market comprise;
(ii)Commercial banks

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Price risk management using currency futures
(iii)Exchange brokers
(iv)Central banks
Corporates: The business houses, international investors, and multinational corporations may
operate in the market to meet their genuine trade or investment requirements. They
may also buy or sell currencies with a view to speculate or trade in currencies to the extent
permitted by the exchange control regulations. They operate by placing orders with the
commercial banks. The deals between banks and their clients form the retail segment of foreign
exchange market.
Commercial Banks: are the major players in the market. They buy and sell currencies for their
clients. They may also operate on their own. When a bank enters a market to correct excess or
sale or purchase position in a foreign currency arising from its various deals with its customers, it
is said to do a cover operation. Such transactions constitute hardly 5% of the total transactions
done by a large bank. A major portion of the volume is accounted buy trading in currencies
indulged by the bank to gain from exchange movements. For transactions involving large
volumes, banks may deal directly among themselves. For smaller transactions, the intermediation
of foreign exchange brokers may be sought.
Exchange brokers: facilitate deal between banks. In the absence of exchange brokers, banks
have to contact each other for quotes. If there are 150 banks at a centre, for obtaining the best
quote for a single currency, a dealer may have to contact 149 banks. Exchange brokers ensure
that the most favorable quotation is obtained and at low cost in terms of time and money. The
bank may leave with the broker the limit up to which and the rate at which it wishes to buy or
sell the foreign currency concerned. From the intends from other banks, the broker will be able to
match the requirements of both. The names of the counter parties are revealed to the banks only
when the deal is acceptable to them. Till then anonymity is maintained. Exchange brokers tend to
specialize in certain exotic currencies, but they also handle all major currencies.
Central banks: most all central bank and treasuries participate in the forex market. Central banks
play very important role in foreign exchange market. However, these banks do not undertake
significant volume of trading. Each central bank has official/unofficial target of the forex rate
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for its home currency. If the actual price deviates from the target rate, the central banks intervene
in the market to set a tone. E.g. FeD, ECB, RBI...

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Price risk management using currency futures
Factors that affect currency rates:
Numerous factors determine exchange rates, and all are related to the trading relationship
between two countries.Exchange rates are relative, and are expressed as a comparison of
the currencies of two countries. The following are some of the principal determinants of the
exchange rate between two countries.
1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibit a rising currency
value, as its purchasing power increases relative to other currencies. During the last half of the
twentieth century, the countries with low inflation included Japan, Germany and Switzerland,
while the U.S. and Canada achieved low inflation only later. Those countries with higher
inflation typically see depreciation in their currency in relation to the currencies of their trading
partners. This is also usually accompanied by higher interest rates.
2. Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest
rates, central banks exert influence over both inflation and exchange rates, and changing interest
rates impact inflation and currency values. Higher interest rates offer lenders in an economy a
higher return relative to other countries. Therefore, higher interest rates attract foreign capital
and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if
inflation in the country is much higher than in others, or if additional factors serve to drive the
currency down. The opposite relationship exists for decreasing interest rates - that is, lower
interest rates tend to decrease exchange rates.
3. Current-Account Deficit
The current account is the balance of trade between a country and its trading partners, reflecting
all payments between countries for goods, services, interest and dividends. A deficit in the
current account shows the country is spending more on foreign trade than it is earning, and that it
is borrowing capital from foreign sources to make up the deficit. In other words, the country
requires more foreign currency than it receives through sales of exports, and it supplies more of
its own currency than foreigners demand for its products. The excess demand for foreign
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currency lowers the country's exchange rate until domestic goods and services are cheap enough
for foreigners, and foreign assets are too expensive to generate sales for domestic interests.
4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector projects and
governmental funding. While such activity stimulates the domestic economy, nations with large
public deficits and debts are less attractive to foreign investors. A large debt encourages
inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper
real dollars in the future. In the worst case scenario, a government may print money to pay part
of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a
government is not able to service its deficit through domestic means (selling domestic bonds,
increasing the money supply), then it must increase the supply of securities for sale to foreigners,
thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they
believe the country risks defaulting on its obligations. Foreigners will be less willing to own
securities denominated in that currency if the risk of default is great.
5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current accounts
and the balance of payments. If the price of a country's exports rises by a greater rate than that of
its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater
demand for the country's exports. This, in turn, results in rising revenues from exports, which
provides increased demand for the country's currency (and an increase in the currency's value). If
the price of exports rises by a smaller rate than that of its imports, the currency's value will
decrease in relation to its trading partners.
6. Political Stability and Economic Performance
Foreign investors inevitably seek out stable countries with strong economic performance in
which to invest their capital. A country with such positive attributes will draw investment funds
away from other countries perceived to have more political and economic risk. Political turmoil,
for example, can cause a loss of confidence in a currency and a movement of capital to the
currencies of more stable countries.
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Currency risks:
“The impact that unexpected exchange rates changes have on the value of the corporation.”
Currency risk is very important to a corporation as it can have a major impact on its cash flows,
assets and liabilities, net profit and ultimately its stock market value. Assuming the corporation
has accepted that currency risk needs to be managed specifically and separately, it has three
initial priorities:

1. Define what kinds of currency risk the corporation is exposed to
2. Define a corporate Treasury strategy to deal with these currency risks
3. Define what financial instruments it allows itself to use for this purpose

Currency risk is simple in concept, but complex in reality. At its most basic, it is the possible
gain or loss resulting from an exchange rate move. It can affect the value of a corporation
directly as a result of an unhedged exposure or more indirectly. Different types of currency risk
can also offset each other. For instance, take a US citizen who owns stock in a German auto
manufacturer and exporter to the US. If the Euro falls against the US dollar, the US dollar value
of the Euro-denominated stock falls individual sees the US dollar value of their holding decline.
However, the German auto exporter should in fact benefit from a weaker Euro as this makes the
company‘s exports to the US cheaper, allowing them the choice of either maintaining US prices
to maintain margin or cutting them further to boost market share. Sooner or later, the stock
market will realize this and mark up the stock price of the auto exporter. Thus, the stock owner
may lose on the currency translation, but gain on the higher stock price. This is of course a very
simple example and life unfortunately is rarely that simple. The first step in successfully
managing currency risk is to acknowledge that such risk actually exists and that it has to be
managed in the general interest of the corporation and the corporation‘s shareholders. Indeed, at
its best, prudent currency hedging can be defined as the elimination of speculation. The real
speculation is in fact not managing currency risk.
The next step, however, is slightly more complex and that is to identify the nature and extent of
the currency risk or exposure. It should be noted that the emphasis here is for the most part on
non-financial corporations, on manufacturers and service providers rather than on banks or other
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types of financial institutions. Non-financial corporation‘s generally having only a small amount
of their total assets in the form of receivables and other types of transaction. Most of their assets
are made up of inventory, buildings, equipment and other forms of tangible ―real‖ assets. In
order to measure the effect of exchange rate moves on a corporation, one first has to define the
type and then the amount of risk involved, or the ―value at risk‖ (VaR). There are three main
types of currency risk that a multinational corporation is exposed to and has to manage.

Kinds of Foreign Exchange Exposure

Types of Currency Risk
1. Transaction risk (receivables, dividends, etc.)
2. Translation risk (balance sheet)
3. Economic risk (present value of future operating cash flows)

Transaction Risk:

Transaction currency risk is essentially cash flow risk and relates to any transaction, such as
receivables, payables or dividends. The most common type of transaction risk relates to export
or import contracts. When there is an exchange rate move involving the currencies of such a
contract, this represents a direct transactional currency risk to the corporation. This is the most
basic type of currency risk that a corporation faces.

Translation Risk:

Translation risk is slightly more complex and is the result of the consolidation of parent company
and foreign subsidiary financial statements. This consolidation means that exchange rate impact
on the balance sheet of the foreign subsidiaries is transmitted or translated to the parent
company‘s balance.
Translation risk is thus balance sheet currency risk. While most large multinational corporations
actively manage their transaction currency risk, many are less aware of the potential dangers of
translation risk. The actual translation process in consolidating financial statements is done either
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at the average exchange rate of the period or at the exchange rate at the period end, depending on
the specific accounting regulations affecting the parent company. As a direct result, the
consolidated results will vary as either the average or the end-of-period exchange rate varies.
Thus, all foreign currency-denominated profit is exposed to translation currency risk as exchange
rates vary. In addition, the foreign currency value of foreign subsidiaries is also consolidated on
the parent company‘s balance sheet, and that value will vary accordingly. Translation risk for a
foreign subsidiary is usually measured by the net assets (assets less liabilities) that are exposed to
potential exchange rate moves.

Economic Risk:

The translation of foreign subsidiaries concerns the consolidated group balance sheet. However,
this does not affect the real ―economic‖ value or exposure of the subsidiary. Economic risk
focuses on how exchange rate moves change the real economic value of the corporation,
focusing on the present value of future operating cash flows and how this changes in line with
exchange rate changes. More specifically, the economic risk of a corporation reflects the effect
of exchange rate changes on items such as export and domestic sales, and the cost of domestic
and imported inputs. As with translation risk, calculating economic risk is complex, but clearly
necessary to be able to assess how exchange rate changes can affect the present value of foreign
subsidiaries. Economic risk is usually applied to the present value of future operating cash flows
of a corporation‘s foreign subsidiaries. However, it can also be applied to the parent company‘s
operations and how the present value of those change in line with exchange rate changes.
Summarizing this part, transaction risk deals with the effect of exchange rate moves on
transactional exposure such as accounts receivable/payable or dividends. Translation risk focuses
on how exchange rate moves can affect foreign subsidiary valuation and therefore the valuation
of the consolidated group balance sheet. Finally, economic risk deals with the effect of exchange
rate changes to the present value of future operating cash flows, focusing on the ―currency
of determination‖ of revenues and operating expenses.

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Foreign Exchange Risk Management: Process & Necessity
Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on account of
sudden/unanticipated changes in exchange rates, quantified in terms of exposures. Exposure is
defined as a contracted, projected or contingent cash flow whose magnitude is not certain at the
moment and depends on the value of the foreign exchange rates. The process of identifying risks
faced by the firm and implementing the process of protection from these risks by financial or
operational hedging is defined as foreign exchange risk management.

Necessity of managing foreign exchange risk
A key assumption in the concept of foreign exchange risk is that exchange rate changes are not
predictable and that this is determined by how efficient the markets for foreign exchange are.
Research in the area of efficiency of foreign exchange markets has thus far been able to establish
only a weak form of the efficient market hypothesis conclusively which implies that successive
changes in exchange rates cannot be predicted by analyzing the historical sequence of exchange
However, when the efficient markets theory is applied to the foreign exchange market under
floating exchange rates there is some evidence to suggest that the present prices properly reflect
all available information.This implies that exchange rates react to new information in an
immediate and unbiased fashion, so that no one party can make a profit by this information and
in any case, information on direction of the rates arrives randomly so exchange rates also
fluctuate randomly. It implies that foreign exchange risk management cannot be done away with
by employing resources to predict exchange rate changes.
Some firms feel hedging techniques are speculative or do not fall in their area of expertise and
hence do not venture into hedging practices. Other firms are unaware of being exposed to foreign
exchange risks. There are a set of firms who only hedge some of their risks, while others are
aware of the various risks they face, but are unaware of the methods to guard the firm against the
risk. There is yet another set of companies who believe shareholder value cannot be increased by
hedging the firm‘s foreign exchange risks as shareholders can themselves individually hedge
themselves against the same using instruments like forward contracts available in the market or
diversify such risks out by manipulating their portfolio.

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Hedging Strategies/ Instruments:
A derivative is a financial contract whose value is derived from the value of some other financial
asset, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an
index of prices. The main role of derivatives is that they reallocate risk among financial market
participants, help to make financial markets more complete. This section outlines the hedging
strategies using derivatives with foreign exchange being the only risk assumed.

Derivatives market in India:
Derivatives markets have been in existence in India in some form or other for a long time. In the
area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and,
by the early 1900s India had one of the world‘s largest futures industries. In 1952 the
government banned cash settlement and options trading and derivatives trading shifted to
informal forwards markets. In recent years, government policy has changed, allowing for an
increased role for market-based pricing and less suspicion of derivatives trading. The ban on
futures trading of many commodities was lifted starting in the early 2000s, and national
electronic commodity exchanges were created.
In the equity markets, a system of trading called ―badla‖ involving some elements of forwards
trading had been in existence for decades. However, the system led to a number of undesirable
practices and it was prohibited off and on till the Securities and Exchange Board of India (SEBI)
banned it for good in 2001. A series of reforms of the stock market between 1993 and 1996
paved the way for the development of exchange-traded equity derivatives markets in India. In
1993, the government created the NSE in collaboration with state-owned financial institutions.
NSE improved the efficiency and transparency of the stock markets by offering a fully
automated screen-based trading system and real-time price dissemination. In 1995, a prohibition
on trading options was lifted. In 1996, the NSE sent a proposal to SEBI for listing exchangetraded derivatives. The report of the L. C. Gupta Committee, set up by SEBI, recommended a
phased introduction of derivative products, and bi-level regulation (i.e., self-regulation by
exchanges with SEBI providing a supervisory and advisory role). Another report, by the J. R.
Varma Committee in 1998, worked out various operational details such as the margining
systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R) A, was amended
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so that derivatives could be declared ―securities.‖ This allowed the regulatory framework for
trading securities to be extended to derivatives. The Act considers derivatives to be legal and
valid, but only if they are traded on exchanges. Finally, a 30-year ban on forward trading was
also lifted in 1999.
The economic liberalization of the early nineties facilitated the introduction of derivatives based
on interest rates and foreign exchange. A system of market-determined exchange rates was
adopted by India in March 1993. In August 1994, the rupee was made fully convertible on
current account. These reforms allowed increased integration between domestic and international
markets, and created a need to manage currency risk. The easing of various restrictions on the
free movement of interest rates resulted in the need to manage interest rate risk.

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Derivatives Instruments Traded in India:
In the exchange-traded market, the biggest success story has been derivatives on equity products.
Index futures were introduced in June 2000, followed by index options in June 2001, and options
and futures on individual securities in July 2001 and November 2001, respectively.
Derivatives on stock indexes and individual stocks have grown rapidly since inception. In
particular, single stock futures have become equally popular to the index futures. In fact, NSE
has the highest volume (i.e. number of contracts traded) in the single stock futures globally,
enabling it to highest rank holder among world exchanges at point of time. While single stock
options were less popular than stock futures, they have witnessed a high growth rate since
starting of 2011 after they were changed to European style. On the other hand, index options are
hugely popular than index futures. Now a days, index options turnover share the 2/3rd of the
total F&O turnover. NSE launched interest rate futures in 2009 on 10 Year Notional Couponbearing Govt. of India Security & the recently introduced (2011) 91-day Govt. of India T-Bill;
but in contrast to equity derivatives, there has been little trading in them. This particular segment
is still in its nascent stage.
Regulators permitted the exchanges to launch currency derivatives contracts to start with
USDINR currency pair in 2nd half of 2008. Later on three more currency pairs EURINR,
GBPINR & JPYINR is allowed in Feb. 2010. Currency options contracts were launched on Oct.
29th 2010 on USDINR only & so far now this is the only option contract available in the
segment. Since its launch forex derivatives have seen continuous activity & rising trading
volumes than interest rate derivatives and any other segments.
Exchange-traded commodity derivatives have been allowed for trading only since April 2003.
The number of commodities eligible for futures trading is 109 by 2011 on 21 recognized
exchanges. Of all the commodities, bullion contracts shares 40.75%, most of the total turnover.
Among all exchanges, MCX enjoys the biggest share of turnover of more than 82% of the total
traded value.

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A Derivative is a financial product that is derived out of the value of an underlying asset.
Derivatives are very popular and are widely used financial instruments.
Derivative products can be classified into the following main types:
1. Forwards
2. Futures
4. Swaps
Out of these Futures & Options are actively traded on organized stock exchanges whereas
Forwards are traded in OTC Exchanges.
Forwards Contract:
A forward contract is the simplest of the Derivative products. It is a mutual agreement between
two parties, in which the buyer agrees to buy a quantity of an asset at a specific price from the
seller at a future date. The Price of the contract does not change before delivery. These types of
contracts are binding, which means both the buyer and seller must stay committed to the
contract. This means they are bound to deliver or take delivery of the product on which the
forward contract was agreed upon. Forwards contracts are very useful in hedging.

Important Characteristics of Forwards Contracts:
1.They are Over the counter (OTC) contracts
2. Both the buyer and seller are bound by the contractual terms
3. The Price remains fixed
Limitations of Forwards contracts:
1. Lack of centralized trading. Any two individuals can enter into a forwards contract
2. Lack of Liquidity
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3. Counterparty risk - The case wherein either the buyer or seller does not honor his end of the
Futures Contract:
A futures contract is an agreement to buy or sell an asset at a certain time in the future at a
specific price. The Contractual terms of the futures contracts are very clear. The Futures market
was designed to solve the shortcomings in the forwards contracts. Unlike forwards, futures are
traded in organized exchanges. They also use a clearing house that provides the necessary
protection to both the buyer and the seller. The price of the futures contract can change prior to
delivery. Hence, both participants must settle daily price changes as per the contract values.

An Example of a futures contract would be an agreement to 100 tonnes of Steel at Rs. 10000/per tonne at some date say in December 2008. If no interim payments are made and if the price
of Steel moves violently, a considerable credit risk could build up. To avoid this margin system
is used by the exchanges. As per the margin system, both parties must deposit a small sum with
the exchange. This amount will be a small percentage of the total contract. This amount is called
the initial margin. As the steel value changes, the contract value also changes. If the contract
value changes, the margin must be topped up by an amount corresponding to the change in price
of steel. The margin money is the property of the person who deposits it and would be returned
to them if the contract gets cancelled/completed.
Characteristics of Futures contract:
1. They are traded in organized exchanges
2. Credit risk is eliminated with the margin system. Both parties deposit a portion of the contract
with the clearing house.
3. Both the buyer and seller are bound by the contract terms and are expected to honor their end
of the contract.

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Price risk management using currency futures
Options Contract:
An options contract is nothing but the right to buy or sell something at a specified price within a
period of time. The feature of the options contract for a buyer is that, the buyer has the right to
buy, but he may choose to buy or may even choose to cancel the contract. Hence the buyer‘s
maximum loss is only the initial amount that was paid to gain the rights. Unlike buyers, the
options contracts for sellers are an obligation. If a seller enters into an agreement, he has to
deliver the asset on the specified date and the price agreed upon.Thus the loss for a seller could
The right to buy is called a "CALL" option while the right to sell is called a "PUT" option.
Please note that an option is only a right to do something. It is not an obligation to carry out the
action. For a buyer it is only a right and not an obligation, but for a seller it is an obligation.
For Example, you want to buy Gold. You form an options contract with a Gold merchant to buy
1000 grams of Gold at the rate of say Rs. 1000/- per gram of gold on December 1st 2008. The
total value of the contract would sum up to 10, 00, 000/- (10 lacs). As part of getting into the
contract you make an initial payment of say 2% of the contract value to the merchant. You make
a payment of Rs. 20 thousand (Rs. 20,000/-) and the contract gets formed. Now you are the
buyer and the merchant is the seller.
A Swap is an agreement between two parties to exchange future cash flows according to a
predefined formula. These streams of cash flow are called the "Legs" of the swap. Usually, when
the swap contract is formed at least one of these series of cash flows is determined by a random
or uncertain value like interest rate or equity price etc.Most swap contracts are traded OTC
which are tailor made for the counterparties. Some are also traded in organized exchanges. The
four generic types of swaps are:
1.Interest rate swaps
2. Currency swaps
3. Equity swaps
4. Commodity swaps
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Price risk management using currency futures

Business Growth in Currency Derivatives Segment:

Currency Futures

Currency Options





of Turnover









( cr.)

of Notional


of Turnov




( cr.)


( cr.)

6,84,576.48 4,19,22,048 2,28,021.21 16,75,20,

e Daily
( cr.)





33,78,488.9 27,19,72,15 12,96,500.9 97,33,44,









32,79,002.1 3,74,20,147 1,70,785.59 74,96,02,











17,82,608.0 -















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Price risk management using currency futures

Currency Futures
A Powerful tool to manage currency risk:
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
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 and delivery date. Both parties of the futures contract must
fulfill their obligations on the settlement date.
Internationally, 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 the ―tick‖ value is.
A tick is the minimum trading increment or price differential at which 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 paisa or 0.0025
Rupee. 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.52.2500.One tick move on this contract will
translate to Rs.52.2475 or Rs.52.2525 depending on the direction of market movement.
Purchase price:
Price increases by 1 tick:
New price:


Purchase price:

.0025 Price decreases by 1tick:

New price:


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Price risk management using currency futures
The value of one tick on each contract is Rupees 2.50 (1000X 0.0025). So if a trader buys
5contracts and the price moves up by 4 ticks, he makes Rupees 50.00.
Step 1:

52.2600 – 52.2500

Step 2:

4 ticks * 5 contracts = 20 points

Step 3:

20 points * Rupees 2.5 per tick = Rupees 50.00

Introduction of currency futures in India:
Important dates of Currency Futures Market:

1972:- First trading of Currency Futures in Chicago Mercantile Exchange.
June 7, 2007:- First trading of Rupee Futures in Dubai gold and commodities exchange.
Nov, 2007:- Internal working group of RBI submitted its recommendation for currency
Futures trading in Exchanges.
April, 2008:- Raghuram Rajan committee report on Financial sector reforms has also
suggested to start currency Futures trading.
May 29, 2008:-Standing committee of RBI and SEBI submitted its report on currency
Futures trading in Exchanges.
August 06, 2008:- Circular Issued for currency Futures trading in stock exchanges.
August 07, 2008:- Joint panel of RBI and SEBI have decided to introduce currency
Futures trading in stock exchanges.
August 14, 2008:- Application invited from traders for membership
August 27, 2008:- Mock trading conducted under the guidance of FEDAI and NSE at
04.30-05.30 PM
August 29, 2008:- Actual trading kicked off at NSE
October 1, 2008:- Trading kicked off at BSE
October 7,2008:- Trading started at MCX

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Price risk management using currency futures

Rationale for introducing Currency Futures:
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 nonresidents 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 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.
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Price risk management using currency futures
However, financial planning horizon is much smaller than the long-run, which is typically intergenerational 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.

Due to internationalization of Indian economy, exchange rate changes of rupee against USD are
exposing our corporate sector to a formidable business risk. Rupee touching the historic low
level of Rs 57.09 against USD caused adverse damage to companies having imports and foreign
currency loans. Unpredictable cycles of depreciation and appreciation resulted in additional risk
factors to already very risky international business.

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Price risk management using currency futures
Due to global economic uncertainties, rupee touched 52 level in 2009 but recovered to 44 per
USD. Now bearish sentiments are more powerful and chances of such recovery in short term are
not bright. To meet challenges of rupee‘s sudden and steep depreciation, innovative currency risk
hedging strategies have to be developed in consonance to the hedging policies of the company.
More dynamism has to be shown to meet the challenges of unpredictable exchange rate
fluctuations. Indian companies now have to track USD/ INR rates seriously because more than
85% of our exports and imports are invoiced in USD, further, majority of foreign currency
borrowing were also raised in USD.


Indian corporates raised huge dollar denominated funds under ECB / FCCB schemes of RBI due
to rupee appreciation and availability of loans at cheap LIBOR rates for USD in 2011. During
such period, Indian companies mobilized huge USD funds to meet their requirements for capital
intensive imports, investment in infrastructure, refinancing high cost existing foreign currency
loans, overseas acquisition etc. via automatic and approval route as per RBI guidelines.

Foreign borrowing constitutes high percentage (40% to 90%) of loan portfolio of big companies.
Domestic loans became expensive due to RBI monetary policy. Companies raised funds costing
interest of 5%p.a to 7%p.a and converted to rupee equivalent when market rate of USD were at
the 44 – 45 per dollar. At that level, nobody forecasted that the exchange rates would fall to
56.09 in such a short span of time. Majority of borrowers either did not hedge or partially
hedged. Such situation has created huge burden of repayment of principal and interest on
borrowing which are due for payment in the upcoming months. In majority of cases foreign
currency loans will prove to be bad choice for Indian companies resulting in poor results next yr.

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Price risk management using currency futures

Market players:
Presume Entity A is expecting a remittance for USD 1000 on 27 August 08. 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 08‘ 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, 2008 is Rs.44.0000. The entity shall sell on
August 27, 2008, USD 1000 in the spot market and get Rs. 44,000. The futures contract will
settle at Rs.44.0000 (final settlement price = RBI reference rate).
The return from the futures transaction would be Rs. 250, i.e. (Rs. 44,250 – Rs. 44,000). As
may be observed, the effective rate for the remittance received by the entity A is Rs.44. 2500
(Rs.44,000 + Rs.250)/1000, while spot rate on that date was Rs.44.0000. The entity was able to
hedge its exposure.

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.42, 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, hecan profi t
if say the Rupee depreciates to Rs.42.50. Assuming he buys USD 10000, it would require an
investment of Rs.4,20,000. 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.

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Price risk management using currency futures
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.42 and the three month futures
trade at Rs.42.40. The minimum contract size is USD 1000. Therefore the speculator may
buy 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. 42.50
against USD, (on the day of expiration of the contract), the futures price shall converge to the
spot price (Rs.42.50) 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.

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. 42.20 (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.42.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.

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Price risk management using currency futures

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
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

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Price risk management using currency futures

Major exchanges:
In India the Forex future currency trade can be carried out through recognized stock markets –
Bombay Stock Exchange, National Stock Exchange and Multi Commodity Exchange. National
Stock Exchange has started Forex future currency trading from August 29, 2008. NSE is the first
exchange in India to have obtained an in principle approval from Security and Exchange Board
of India to set up currency derivatives segment. BSE is the third exchange in India to have
obtained an in principle approval from Security and Exchange Board of India after NSE and
In brief the history of Trading in Currency Future contracts in India can be traced back to the
year 2008 when various stock exchanges started trading in currency futures on the following
National Stock Exchange started its operation on August 29, 2008
Multi Commodity Exchange started its operation on October 7, 2008
United Stock Exchange launched its operations on September 20, 2010.

(MCX got the approval from SEBI before BSE but it could start trading in Currency future after
BSE) This shows that trading in currency futures in India is not very old rather it is at the stage
of infancy.

NSE: All the trades done at NSE are cleared and settled by National Security Clearing
Corporation. NSCCL is a separate and independent entity. The following data shows the
increasing trade of currency futures at NSE

MCX: MCX-SX started live operations on October 7, 2008 by launching monthly
contracts in the USDINR currency pair under the regulatory framework of Securities and
Exchange Board of India (SEBI), and Reserve Bank of India (RBI). Consequently, the
stock exchange expanded its currency derivatives offerings to Euro-Indian Rupee
(EURINR), Pound Sterling-Indian Rupee (GBPINR) and Japanese Yen-Indian Rupee
(JPYINR). The currency futures trading will be through MCX Stock Exchange, the new
company that MCX has recently floated. Presently all future contracts on MCX-SX are
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Price risk management using currency futures
cash settled. There will be no physical contracts. All trade on MCX-SX takes place on its
nationwide electronic trading platform that can be accessed from dedicated terminals at
locations of the members of the exchange. All participants on the MCXSX trading
platform have to participate only through trading members of the Exchange. Participants
have to open a trading account and deposit stipulated cash/collaterals with the trading
member. MCX-SX stands in as the counterparty for each transaction; so participants need
not worry about default. In the event of a default, MCX-SX will step in and fulfills the
obligations of the defaulting party, and then proceed to recover dues and penalties from

Those who entered either by buying (long) or selling (short) a futures contract can close their
contract obligations through squaring-off their positions at any time during the life of that
contract by taking opposite position in the same contract. A long (buy) position holder has to
short (sell) the contract to square off his/her position or vice versa. The participants will be
relieved of their contract obligations to the extent they square off their positions. All contracts
that remain open at expiry are settled in Indian rupees in cash at the reference rate specified by

USE: The United Stock Exchange of India (USE) is the fourth pan India exchange to be
launched for trading financial instruments specifically currency futures and currency
options. USE has Bombay Stock Exchange as a strategic partner. USE represents the
commitment of ALL 21 Indian public sector banks, private banks and corporate houses to
build an institution of standing. USE launched its operations on 20 Sept 2010. USE began
operations in the future contracts in each of the following currency pairs:
-Indian Rupee (USD-INR)
-Indian Rupee (EUR-INR)
-Indian Rupee (GBP-INR)
-Indian Rupee (JPY-INR)
There would be 12 contracts i.e. one for each of the next 12 months in each of the above
currency pair. Outright contracts as well as calendar spread contracts are available in each pair
for trading.
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Price risk management using currency futures

Trading and volumes:
Exchange-trading of the rupee, in India, started in 2010. At a point in time, turnover in exchangetraded currency futures did seem to have overtaken the OTC forward market. The USD-INR
futures contract on MCX-SX, NSE, and USE with a contract size of USD 1000 occupied the
first three ranks for volume in the world in 2010 and 2011. The USD-INR options contract on the
NSE ranked fourth while the EUR-INR futures on the NSE also featured in the top 20 forex
futures contracts in the world.
Volumes have also seen a rising trend here in India which shows the increased participation in
this new emerging asset class. Combined volumes in currency futures have increased at a CAGR
of 132% from 2009 to 2011 in NSECDS and MCX-SX exchanges after it opened up for trading
on Indian bourses in 2008. Depth has increased in all currency futures pairs as well

MCX-SX, whose application for a full-fledged stock exchange was recently approved by SEBI,
currently offers trading in only currency futures.
It has witnessed a steady and significant growth in currency futures turnover and open interest
and continued to maintain its leadership in currency futures with a market share of 43.57 per cent
in the last fiscal (FY11-12).
The average daily turnover has increased from Rs 324.78 crore during its first month of
operations to Rs 13,530.47 crore at the end of July 2012.

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Price risk management using currency futures

Major Contracts traded on the exchange:

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Price risk management using currency futures

Futures terminology:
Some of the common terms used in the context of currency futures market are given below:
 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 is traded in the future market.
 CONTRACT CYCLE :The period over which a contract trades. The currency future
contracts in Indian market have one month, two month, and 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 SETTLEMENT 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 100
 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.

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Price risk management using currency futures
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 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.

MARGIN:Member‘s 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.

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Price risk management using currency futures

Product Specifications:


Instrument Type


Unit of trading

1 (1 unit denotes 1000 USD)




Rs. per USD

Tick size

0.25 paise or INR 0.0025

Trading hours

Monday to Friday 9:00 a.m. to 5:00 p.m.

Contract trading cycle 12 month trading cycle.
Two working days prior to the last business day of the expiry month at

Last trading day

Last working day (excluding Saturdays) of the expiry month.

Final settlement day

The last working day will be the same as that for Interbank Settlements
in Mumbai.
Theoretical price on the 1st day of the contract. On all other days, DSP

Base price

of the contract.

Price operating range

Tenure up to 6 months

Tenure greater than 6 months

+/-3 % of base price

+/- 5% of base price


total open interest total open interest or total open interest or
or USD 10 million



Higher of 6% of Higher of 15% of the Higher of 15% of the

Position limits


Trading Members


USD 50 million

USD 100 million

1.75% on first day & 1% thereafter.

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Price risk management using currency futures
Extreme loss margin

1% of MTM value of gross open position.
Rs. 400/- for a spread of 1 month, Rs. 500/- for a spread of 2 months,

Calendar spreads

Rs. 800/- for a spread of 3 months &Rs. 1000/- for a spread of 4 months
or more
Daily settlement : T + 1


Final settlement : T + 2

Mode of settlement
Daily settlement price

Cash settled in Indian Rupees
DSP shall be calculated on the basis of the last half an hour weighted
average price of such contract or such other price as may be decided by
the relevant authority from time to time.


RBI reference rate

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Price risk management using currency futures

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
r=Cost of financing (using continuously compounded interest rate)
rf= one year interest rate in foreign
T=Time till expiration in years
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. 56.0775.
From the equation above the one year forward exchange rate should be
F = 56.0775 * e^(0.10-0.07 )*1=57.78
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.

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Price risk management using currency 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 futures. Probably he has only one option rupee with dollar. This is called cross hedge.

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Price risk management using currency futures

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 september 2012. And he will have to pay 100000 USD on
1st December2012. 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 58.0000.
What he will do to protect against depreciating Indian rupee? Spot value of 1 USD is 55.66.

Solution:He should buy ten contract of USDINR 28102012 at the rate of 56.0775. Value of the
contract is (56.0775*1000*100) =5607750. (Value of currency future per USD*contract size*No
of contract).
For that he has to pay 5% margin on 5607750 i.e.he will have to pay Rs.280387.5 at present.
And suppose on settlement day the spot price of USD is 58.0000. On settlement date payoff of
importer will be (58.0000-56.0775) =1.9225 per USD. And (1.9225*100000) =192250.Rs.

Choice of the number of contracts (hedging ratio)
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 56.0775
And spot value is 55.66
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Price risk management using currency futures

Hedging against Indian Rupee appreciation
Let‘s assume an Indian IT exporter receives an export order worth EUR100,000 from a European
telecom major with the delivery date being in three months. At the time of placing the contract,
the Euro is worth 64.05 Indian Rupees in the Spot market, while a Futures contract for an expiry
date that matches the order payment date is trading at INR64. This puts the value of the order,
when placed, at INR6,405,000. However, if the domestic exchange rate appreciates significantly
(to INR63.20) by the time the order is paid for (which is one month after the delivery date), the
firm will receive only INR6,320,000 rather than INR6,405,000.
To insure against such losses, the firm can, at the time it receives the order, enter into 100 Euro
Futures contracts of EUR1,000 each to sell at INR64 per Euro, which involves contracting to sell
a foreign Currency on expiry date at the agreed exchange rate. If on the payment date the
exchange rate is INR63.20, the exporter will receive only INR6,320,000 on selling the Euro in
the Spot market, but gains INR80,000 (ie 64 - 63.20 * 100 * 1,000) in the Futures market.
Overall, the firm receives INR6,400,000 and protects itself against the sharp appreciation of the
domestic Currency against the Euro.
In the short term, firms can make gains or losses from hedging. The basic purpose of hedging is
to protect against excessive losses. Firms also tend to benefit from knowing exactly how much
they will receive from the export deals and can avoid the uncertainty associated with future
exchange rate movements.

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Price risk management using currency futures

Hedging against Indian Rupee depreciation
An organic chemicals dealer in India places an import order worth EUR100,000 with a German
manufacturer. Let‘s assume the current Spot rate of the Euro is INR64.05 and at this rate the
value of the order is INR 6,405,000. The importer is worried about the sharp depreciation of the
Indian Rupee against the Euro during the months until the payment is due. So, the importer buys
100 Euro Futures contracts (EUR1, 000 each) at INR64 per Euro. At expiry, the Rupee has
depreciated to INR65 and the importer has to pay INR6,500,000, gaining INR100,000 (ie
INR65-64 * 100 * 1,000) from the Futures market and the resulting outflow would be only
In the short term, firms can make gains or losses from hedging. The basic purpose of hedging is
to protect against excessive losses. Firms also tend to benefit from knowing exactly how much
they will pay for the import order and avoid the uncertainty associated with future exchange rate

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Price risk management using currency futures

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
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.53.19. 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.






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.56.07. 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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Price risk management using currency futures
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.56.07. 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 56.07. 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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Price risk management using currency futures

Managing currency risk through currency Futures:
Understanding currency risk
Case: (When firm has foreign currency payable in future)
ABC, an Indian company, imports machinery from US firm for $ 5 million. Due date for
payment is January 22, 2011. Present exchange rate is Rs. 47/$ (as on January 22, 2010)
Inflation in India = 6%
Inflation in US= 1%
Interest rate in India = 8%
Interest rate in US= .5%

Situation: - ABC company needs to pay $ 5 million on January 22, 2011. Since the payment will
be made in future and exchange rate does not remain constant, there is uncertainty with the
actual cash outflow. USD may appreciate or depreciate in future. If USD appreciates cash
outflow in terms of rupee will me more which leads to risk.
Risk: Volatility of exchange rate (especially when USD appreciates)
Problem 1: How to eliminate the risk.
Problem 2: How to forecast the forward rate

Solution 1: In this situation, ABC needs to go long hedge by buying currency futures for $ 5
million for 1 year. Since contract size for USD future is $1000, number of contract will be
5000000/1000=5000 to get perfect hedge.

Solution 2: There two basic methods to calculate spot and future exchange rate.
(a) Purchasing power parity (PPP)
(b) Interest rate parity (IRP)

Determination of Exchange rate as per Purchasing Power Parity:PPP theory follows law of one price, which states that the price of identical goods should be
same all over the world. Exchange rate of currency is being adjusted if the inflation rate is
different in two countries.

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Price risk management using currency futures
Absolute form of PPP

Case 2: Suppose 1 kg apple costs $5 in USA and Rs 220 in India, then as per this theory the
exchange rate will be 220/5 = Rs 44/$

Relative form of PPP

According to this theory, exchange rate is determined by the inflation of one country over
inflation of another country. It states that the percentage change in the exchange rate should
equal the percentage in the ratio of the price indices of the two countries.
Spot exchange rate at time t = value of country A‘ currency in terms of country B at the
beginning of the period * (Inflation rate of country A/ Inflation rate of country B)^t

Determination of Exchange rate as per Interest Rate Parity

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;
As per this IRP, interest rate difference between two countries is equal to the percentage
difference between the forward exchange rate and the spot exchange rate.
Forward exchange rate for settlement at period N= Current spot exchange rate*(1+domestic
country interest rate)/ (1+foreign country interest rate)
Here the Spot rate is $1 = Rs. 47
Interest rate in India = 8%
Interest rate in US= .5%
One year forward rate for $ will be 47*(1.08/1.005) ^1=50.51
Therefore, the country with a higher interest rate would have a lower forward exchange rate.
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Price risk management using currency futures

Quantitative Analysis:
i)Open Interest and Volume of Contracts Traded
Open interest is the total number of outstanding contracts that are held by the market
partricipants at the end of the day. It is also considered as the number of futures contracts that
have not yet been exercised, expired or fulfiled by delivery. It is often used to confirm the trends
and trends reversals for futures markets. It measures the flow of money into the futures market.
A sellor and a buyer forms one contract and hence in order to determine the total open interest in
the market we need to know either the total of buyers or the sellors and not the sum of both.the
open interest position that is reported each day represents the increase or decrease in the number
of contracts for that day. An increasing open interest means that the new money is flowing in the
marketplace and the present trend will continue. If the open interest is declining it implies that
the market is liquidating and the prevailing price trend is coming to an end. The leveling off of
open interest following a sustained price advance is often an early warning of the end to an
uptrending or bull market.
The interpretations which can made on the basis of the open interest may be shown with the help
of the following table:

Open Interest




Market is Strong



Market is weakening



Market is Weak



Market is Strengthening

The number of contracts traded on a stock exchange shows the total volume of contracts traded.
An increase in the number of contracts traded on an stock exchange expresses the growth of
trade in that particular stock exchange for a particular currency future.

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Price risk management using currency futures

Correlation between open interest and no. of contracts traded at NSE and

Open Interest


total vol


Null hypothesis:

no significant correlation between open interest and contracts traded

Alternate hypothesis: significant correlation between open interest and contracts traded
Inference: A linear correlation is found
Alternate hypothesis is accepted with extreme significance
No. of points: 230
Contract considered: 29 august 2012
Correlation coefficient: 0.8984
In order to understand Growth trajectory of the currency futures, open interest and no. of
contracts traded at NSE and MCX-SX have been compared, explained and statistically
supported. A correlation between the two was calculated and result depicted that they have a
significant relationship with correlation coefficient of 0.8984 which concludes growth in both the
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Price risk management using currency futures

ii) Returns for past 1 year on major exchanges
Returns for 2011-12

returns on mcx sx
returns on nse


Returns on $-rupee contracts haven‘t been that great in the last 1 year, more or less the same on
both the leading currency futures exchanges.
Returns on MCX SX


Returns on NSE


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Price risk management using currency futures

(iii) Historical volatility

Annualized Volatility 2011-12














closing price
90 day Hvol
20 day Hvol

Sep '11
Oct '11
Nov '11
Nov '11
Dec '11
Jan '12
Jan '12
Feb '12
Feb '12
Mar '12
April '12
April '12
May '12
May '12
June '12
July '12
July '12


closing price



Annualized historical volatility in 2003- 3.4
Annualized historical volatility in 2008- 6.5
Annualized historical volatility in 2012- 9.2( as shown in the graph)
Over the years, there has been a trend increase in Dollar-Rupee volatility, measured by the
percentage movement in a month. The Rupee used to fluctuate an average of 1% (or 45 paise)
earlier, but the monthly fluctuation is now averaging 5% (about 225-250 paise). Moreover, the
volatility is likely to remain above 3% (135-150 paise) in the future.
The main reason behind the structural increase in volatility is the growth of India's Current
Account, including exports and imports of both goods and services, and India's Capital Account,
which is witness to a high degree of volatility in portfolio investment flows. This has led to a
huge increase in the daily turnover in the Dollar-Rupee market, to such an extent that it is now
increasingly difficult for the RBI to contain the volatility on a daily basis. As the economy
continues to grow and open up, it is unlikely that forex volatility is going to decrease.
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Price risk management using currency futures

Research work:
I have taken the case of an exporter who is expecting payment of $100000 every month starting
from January 2011.In this piece of work I have taken 30 paise as the threshold i.e. if the currency
movement breaches 30 paise mark in a day I will cover that contract that day itself. Here I have
taken 2 case scenarios to see the difference in returns due to proportion covered under hedging.
1. if 50 % of the contract is covered undered futures and 50% is managed actively.
2. If 25% of the contract is covered undered futures and 75% is managed actively.
Here I have taken different time frames to see the impact of currency fluctuations on the
exporters income. If the exporter starts receiving payment from January 2011 or march 2011 or
june 2011 then the probable returns he may receive are given in the following table:
When 25 % is hedged

When 50 % is hedged

Jan 2011



March 2011



June 2011



This table shows that Hedging is a very crucial strategy for both importers and exporters but it is
very important on the part of trader as well that he is actively involved to make gains which are
offset by losses due to hedging, thereby getting higher returns. It even throws light on the fact
that putting a portion aside for active management gives higher returns than fully hedged but
then the investor has to monitor the market on a daily basis.
Having said that hedging is important for preventing losses rather than making gains, which is its
very definition. So for a trader who is involoved active foreign trade, hedging comes to be of
great help.

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Price risk management using currency futures

The Indian currency futures market has experienced an impressive growth since its introduction.
The upward trend of the volumes and open interest for currency futures in NSE explains the
whole story in detail. The growth of USD-INR currency futures since August 2008 led to the
introduction of three other currency futures in January 2010. The GBP-INR, JPY-INR and the
USD-INR currency futures have recorded a growth and thus confirmed that the introduction of
currency futures have been a good step taken by the Government.
The correlation between the open interest and the contracts traded has been the maximum in this
case. It is +0.87 thus signifying the growth of the USD-INR currency futures.
Although currency futures has reduced volatility asymmetric and have led to enhancement in the
quality of transactions and information , the fact that the currency market just plus 4 years old
does to some extent cloud the conclusion as volatility has increased substantially in 2011-12 to
June 2012 period due to global crises and rising CAD(Current Account Deficit) in India.
The growth of currency futures in India and the volatility pattern in the Indian exchange market
has proved the influence of currency futures as a hedging instrument in India. Although currency
futures has reduced volatility and has led to enhancement in the quality and speed of market
transactions, the fact that the currency futures market just 4 plus years old does to some extent
cloud the conclusion as volatility has increased substantially in 2011-12 to June 2012 period due
to various global issues (Eurozone crisis) and domestic issues such as rising Current Account
Deficit (CAD).

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Price risk management using currency futures


The introduction of currency derivatives on exchanges has provided investors new asset class to
dabble with – Nirmal Bang
Currency futures – taxes, levy and liquidity –Mint
NCFM – Currency Future Module
Currency futures traded on the NSE- Dharen Kumar Pandey


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