Currency Futures

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NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

Module – 23 Transaction Exposure Management –Part-2

Developed by: Dr. A.K.Misra Assistant Professor, Finance Vinod Gupta School of Management Indian Institute of Technology Kharagpur, India Email: [email protected]

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NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

Transaction Exposure Management-Part-2 Learning Objectives:
In this session, various financial products like futures markets and currency option are discussed with examples for management of transaction exposure.

Highlights & Motivation:
In this session, the following details about management of transaction exposure are discussed. • Foreign Exchange Futures Market • Features of Futures Contracts • Futures Trading Mechanism • Understanding Futures Market Quotes • Currency Futures Contract Specifications of Indian Currency Futures Market • Concept of “Tick” in Futures Contracts • Currency Futures as an Instrument of Hedging • Currency Options The session would help readers to understand the currency forward, futures and options markets and their applications for hedging currency risk.

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NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

Introduction
Foreign Exchange Future Market for Transaction Exposure Management A Currency Futures Contract is an agreement to buy or sell at “future exchange” a standard quantity of foreign currency at a future date at the price agreed to between two parties to the contract. Although the contract are traded between two parties, however, for clearing purposes “clearing House” of future exchanges is the counterparty to each contract. This system, thus, eliminates “credit risk’ on the counterparty to a large extent.

Features of Futures Contracts
Exchange Traded Unlike forward contracts, which are OTC product, futures are traded on organized future exchanges. Continuous trading provides liquidity to future contracts holders and also significantly helps in price discovery process. Standardization with respect to Price Quality Contract Size Delivery date Mark to Market Daily MTM to avoid credit risk Initial Margin It is essential to avoid default in daily MTM Both buyer and seller keep initial margin Novation Exchange becomes the counter-party all transactions It avoid the credit risk
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NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

Clearing House The clearing House is the principal institution in a future market. All settlements take place through the clearing house and buyers and sellers they do not know each other. Delivery is Rare In futures market, actual delivery is rare or hardly one percent of all contracts traded. This indicates, futures market is used for hedging device against price risk and may be for speculative purpose. Anonymous Trading Buyer does not know the seller and vice-a-versa Only exchange knows about the buyers and sellers for Margin and MTM and any other legal purposes. Easy Exit Investors can exit from the future contract anytime by going to exchange traded market and selling it to the exchange and cancel the transaction.

Futures Trading Mechanism
Futures contracts are traded in an open system of electronic trading system by traders who are members of the exchange. Traders who traded for themselves are called floor traders those who traded for their customers are called floor brokers. Buyers of futures contracts take a Long Position and sellers of futures contracts a Short-position. While taking a position, both short or long, pay an initial margin. Since futures are MTM, as price changes, gain will be credit to initial margin and loss will be debited from initial margin. When loss crosses beyond certain level, the trader receive a Margin call for putting money in the account so as to maintain the initial margin amount. All these things take place through the Exchange.

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NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

Understanding Futures Market Quotes
Settlement Price On Settlement price Price Change Fall in settlement Price Rise in Settlement Price Open Interest Notional Principal Total Volume Size of Future Market Liquidity or Traded Value : Average of last few minutes Trading prices : MTM Works : Change in Settlement Prices : MTM Lose for Long position : MTM lose for Short position : Aggregate of all Long/short positions : Settlement price* Multiplier : Traded Quantity : Open Interest *Settlement Price*Multiplier : Total Volume*Settlement Price* Multiplier

Currency Futures Contract Specifications: Indian Currency Futures Market Underlying: USD-INR, EURO-INR,GBP-INR & JPY-INR contracts are allowed to be traded. Size of each contract: minimum contract size of USD 1000. Trading hours: 9 a.m. to 5 p.m. Quotation: In Indian Rupees. However, the outstanding positions will be dollar terms. Tenor: Maximum maturity of 12 months. Minimum Price Fluctuation (Tick Size): INR 0.0025 or 0.25 Paise Available Contracts: All monthly maturities from 1 to 12 months would be available. Settlement: in Indian Rupees. The settlement price shall be the Reserve Bank’s reference rate on the last trading day. Last trading day is 2 days prior to the last working day in the spot market. Daily Settlement: T + 1 Final Settlement: T + 2 • Final Settlement Day: Last working day of the expiry month. The last working day will be the same as that for Interbank Settlements in Mumbai.
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NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

S. No. 1. 2. 3. 4. 5. 6.

Currency Australian dollar Canadian dollar Euro Japanese yen Pound sterling Swiss franc

Contract Size Aus$100000 Can$100000 125000 ¥12500000 £62500 SFr1.25000

Minimum Variation (tick) US $0.0001/Aus$ (=U$$10) US $0.0001/Can$ (=US$ 10) US$0.0001/ (US$12.50) US$0.000001 N(=US$12.50) US $0.0002/£ (=US$ 12.5 0) US$0.0001/SFr (= US$12.50)

Standar d sizes of Curren

cy Futures on Chicago Mercantile Exchange

Concept of “Tick” in Futures Contracts
Standardization of futures contracts relates to minimum variation, called "tick". Variations in dollar prices of future contracts cannot be random. It should be multiple of a certain minimum value. For example, the minimum variation for pound sterling is US$0.0002/£. In other words, the value of a pound -sterling futures can vary only in terms of $12.50 (0.0002 x 62500). So the value of one tick is $12.50, Suppose, at any time, a poundsterling futures is quoting at US$1,7940/£. This price can change to US$ I.7942/E or US$1.7938/£ or US$1.7944/£ etc., but not to US$1.7941 or $1.7939. The variation has to be necessarily in multiples ofUS$0.0002/£.

Thus, if a sterling futures passes from US$1,8070 to US$1.7868, the variation in the value of futures contract can be worked out as follows:
Price variation = US$(1.8070 - 1.7868) = US$0.0202 Number of ticks = US$0.0202 = 101 US$0.0002 Value of one tick = £62500 x $0.0002/£ = $12.50

Hence, the variation in the price of the sterling contract = Number of ticks x Value of one tick =$101 x $12.50=$1262.50

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NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

Currency Futures: An Instrument of Hedging
If an organization has a receivable in a currency, say US$, which it would like to hedge, it should opt for a futures position in such a way that the futures generate a positive cash flows whenever the value of the receivable declines. In other words, a receivable indicates that the organization has a long position in the underlying assets, and hence it should sell futures contracts or have a short position in the futures market. In case of underlying is a liability or payable, it should go long in futures market.

Example:
An Indian Tea exporter will be receiving US$20,000 in June 30. Since the delivery of US$ will be after three month, the exporter is facing transaction exposure for US$ against Indian Rupee. He wanted to book futures contracts for US$ against Indian Rupee. The Spot exchange rate, as on 1st March, is Rs.48.6700/- per US$ and May future, which will be delivered May 30, is trading at Rs.48.6750. How many contracts the exporter would buy/sell so as to immune the position and also what is the pay off, if the May Futures are traded at Rs.48.6675 and May 30, spot exchange rate is Rs.48.6650 per US$. The rupee futures have a contract size of $1000.

Answer
Spot exchange rate as on March 1, 2010 Spot exchange rate as on May 30, 2010 Receivable Amount If not Hedge, Transaction Exposure Rs.48.6700 Rs.48.6650 US$20,000 Rs.100

{US$20,000(48.6650-486700)}
Size of Contracts Delivery Date Number of Futures Contracts need to Sell Futures US$1000 US$20,000 1-Jun-10 20

Exposure Amount

(Exposure Amount/Contract Size)

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NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

As on March 1, Price of May 30, Futures contract As on May 30, Price of May 30, Futures contract Loss in Receivable

Rs.48.6750 Rs.48.6675 Rs.100

{US$20,000(48.6650-486700)}
Gain Rs.150 on Futures Contracts

{US$20,000(48.6750-48.6675)} Pay off (Net Gain) Rs.50 (Receivable Loss – Futures Contract Gain):

Currency Options
A currency option gives its holder a right and not an obligation to buy or sell a currency at a predetermined rate on or before a specified maturity date. Options are traded on the Over-the-Counter (OTC) market as well as on organised exchanges. To acquire the right, the buyer pays a premium to the seller, also called “option writer”. If the buyer chooses to exercise his right to buy or sell the asset the seller has the obligation to deliver or take delivery of the underlying asset. The potential loss to an option seller is unlimited and to the buyer it is limited to the premium paid.

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NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

Option Terminology
Call Option: The right to buy specified amount of one currency against another currency is known as call option. Put option: The right to sell specified amount of one currency against another currency is known as put option. Premium: The amount paid by the buyer of an option to the seller is called premium. Strike Price: The price at which option can be exercised is called an exercise price or a strike price. Underlying Assets: The asset on which the put or call option is created is referred to as the underlying asset. European option When an option is allowed to be exercised only on the maturity date, it is called a European option. American option When the option can be exercised any time before its maturity, it is called an American option Expiration Date: The last date up to which the option can be exercised. In-the-money A put or a call option is said to in-the-money when it is advantageous for the investor to exercise it. Out-of-the-money A put or a call option is out-of-the-money if it is not advantageous for the investor to exercise it. At-the-money When the holder of a put or a call option does not lose or gain whether or not he exercises his option.

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NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

Call Option Buy a call option You should exercise call option when: Market Price at expiration > Exercise price. Do not exercise call option when: Market Price at expiration < Exercise price. The value of the call option at expiration is : Maximum [Market Price – Exercise price, 0]. Put Option Buy a put option Exercise the put option when: Exercise price > Market price at expiration. Do not exercise the put option when: Exercise price < Market price at expiration. The value of the put option at expiration is: Maximum [Exercise price – Market price at expiration, 0].

Premium or Price of an Option:
The premium or price of an option depends on a number of factors: 1) Time to maturity: Longer is the time to maturity, higher is the price of an option (whether call or put). If the maturity is farther in time, it means there is greater uncertainty and possibility of currency rates fluctuating in wider range is more. So the writer would demand higher premium. 2) Volatility of the exchange rate of underlying currency: Greater volatility increases the probability of the spot rate going above exercise price for call or going below exercise price for put. 3) Type of option: Typically an American type option will have greater price since it gives greater flexibility of exercise than European type. 4) Forward premium or discount: When a currency is likely to harden (greater forward premium), call option on it will have higher price. Likewise, when a currency is likely to decline (greater forward discount), higher will be price of a put option on it.
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NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

5) Interest rates on currencies: Higher interest rate of domestic currency means lower present value of exercise price. So lower exercise price of a call makes it dearer as the probability of its exercise increases. On the other hand, lower exercise price lowers the probability of a put being exercised. Thus higher domestic interest rate has the effect of increasing the price of call and lowering the price of put. Similarly, higher foreign interest rate will reduce the call premium and increase put premium. 6) Exercise Price: The call price will decrease with higher exercise price since its probability of use will be less. On the contrary, put premium will decrease with higher exercise price since the probability of its use will increase.

Dealing in Currency options
Different ways of using options to make gain are known as option strategies. Different strategies may be adopted depending on the anticipation of the market with regard to the evolution of exchange rate in future. Options are used either in simple form or in a complex combination. Simple profit strategy means that a single call or put is used. On the other hand, a complex profit strategy involves buying and selling of several options with different features simultaneously. Simple option strategies are discussed here.

Anticipation of appreciation of underlying currency:
If a market operator anticipates that the underlying currency is likely to appreciate, then he can buy a call option. Exercise of call option on the maturity date may result in a profit. Gain or profit resulting from a call option can be written as in equation.

Profit = Value - Premium Profit = (ST-X)-c = -c where for ST>X for ST<X

ST = Spot rate at the time of exercise of the option X = Exercise or strike exchange rate c = Premium paid to acquire call option

The buyer of call option will have a maximum loss limited to the premium paid but he will have unlimited profit as long as ST moves in his favour. The graphical representation of profit profile for the holder of call option is shown in following figure.

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NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

Profit

O -c

X (X+c) ST

Reverse is the profit profile of the writer (seller) of a call option. This simply means that the profit of the writer of a call option is limited to the amount of premium he received while his losses are unlimited.

Anticipation of Depreciation of Underlying Currency
If a market operator anticipates that underlying currency would depreciate, then he can buy a put option. Exercise of put option on or before the maturity date may result in a profit for the operator. The gain resulting from a put option can be as in equation (2).

Profit = (X - ST) - p =-p

for ST< X for ST> X

where ST = spot rate at the time of exercise of the option X = Exercise or strike exchange rate P = Premium paid to acquire the put option

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NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

The buyer of put option will have a maximum loss limited to the premium paid but he will have unlimited profit so long as ST moves in his favour. These profits are limited by the possibility of ST becoming zero. The profit profile of the holder a put option is shown in the first left Figure. Reverse is the profit profile of the writer (seller) of a put option. In other words, the profit of the writer of a put option is limited to the amount of premium he received while his loss is unlimited. Hedging with Currency Options Currency options provide the corporate another tool for hedging foreign exchange risks arising out of the firm’s operations. Options provide the hedger to gain from favourable exchange rate movements while being protected against unfavourable movements.

Example:
An Indian importer needs to make a payment of US$1million to an American supplier in October. The current spot rate is Rs.48.5500 per US$. In Indian Currency Option market, the October Call option for US$ has a strike price of Rs.49.0500 and the premium is Rs.0.75 per US$. The contract size is US$1000 and the brokerage fee per contract is US$2. What would be the strategy of the Indian importer and what would be the pay off if October Spot price is Rs.49.75 per US$.

Answer
The importer can purchase call option to immune its open position for October. Contract Size: US$1000, Exposure Amount: US$1million Number of Contracts need to Sell: (Exposure Amount/Contract Size): US$100000/US$1000= 1000 Contracts October Call Option Strike Price : Rs.49.0500 Premium for Call Option : Rs.00.7500 Brokerage per Contract : Rs.90.0000 Brokerage Per $ : Rs.00.0900 October Call option: cost per US$ :Rs.49.8900
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NPTEL International Finance Vinod Gupta School of Management, IIT. Kharagpur.

In October US$ Spot rate: Rs.49.7500. Since US$ is cheaper in Spot market, the call option holder would not exercise the option. The loss would be the brokerage fee and the Call Option Premium which is amounting to Rs.84000 {(Rs.0.75+0.09)*1million}

References
• • • • Sachs, J.D, Warner, A, Aslund, A & Fischer, S, “Economic Reform and the Process of Global Integration” Brookings Papers on Economic Activity, Vo.1995, No.1, 25th Anniversary Issue. 1995, pp.1-118. Foreign Trade of India 1947-2007: Trends, Policies and Prospects, Vibha Mathur, New Century Publication, 2006. http://en.wikipedia.org/wiki/World_Trade_Organization http://www.blackwellpublishing.com/content/BPL_Images/Content_store/Sample_chapt er/9780631229513/001.pdf

Model Questions
1. Write in brief various products for management of Transaction exposure. 2. Explain various features of Futures Market and bring out its distinctive advantages of over the Forward Market.

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