Concept Paper on Currency Derivatives

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CONCEPT PAPER
ON

CURRENCY DERIVATIVES
PREPARED BY KRUTARTH MANKAD

SUBMITTED TO: IBS HYDERABAD

Introduction: Globalization and amalgamation of financial markets along with continuous boost of cross border flow of capital have transformed the dynamics of Indian financial markets. This has increased the need for dynamic currency risk management. In today’s globalised and integrated business environment, many entities irrespective of its business are impacted by currency risk either directly or indirectly. The stable rise in India’s foreign trade along with liberalization in foreign exchange regime has led to large inflow of foreign currency into the system. This has been in the form of FDI and FIIs investments. Utility of Curre ncy Derivatives: Currency-based derivatives are used by exporters invoicing receivables in foreign currency, willing to protect their earnings from the foreign currency depreciation by locking the currency conversion rate at a high level. Their use by importers hedging foreign currency payables is effective when the payment currency is expected to appreciate and the importers would like to guarantee a lower conversion rate. Investors in foreign currency denominated securities would like to secure strong foreign earnings by obtaining the right to sell foreign currency at a high conversion rate, thus defending their revenue from the foreign currency depreciation. Multinational companies use currency derivatives because of being engaged in direct investment overseas. They want to guarantee the rate of purchasing foreign currency for various payments related to the installation of a foreign branch or subsidiary, or to a joint venture with a foreign partner. Currency Derivatives are primarily of 2 types: Currency Futures and Currency Options.

Currency Futures:
Currency Future is “A transferable futures contract that specifies the price at which a specified currency can be bought or sold at a future date." We can explain currency futures as, "Currency future contracts allow investors to hedge against foreign exchange risk. Since these contracts are marked-to-market daily, investors can--by closing out their position--exit from their obligation to buy or sell the currency prior to the contract's delivery date." Characteristic of Futures: It is a type of standardized derivative contract It is traded on recognized exchanges Price and date of delivery are predetermined There is transparency in pricing Settlement is done through clearing house

For providing a liquid, crystal - clear and pulsating market for foreign exchange rate risk management, Securities & Exchange Board of India (SEBI) and Reserve Bank of India (RBI) have permitted trading in currency futures in India based on the USD-INR exchange rate. This

gave Indian corporate another tool for hedging their exchange risk effectively. The primary purpose of exchange traded currency future 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. In spite of it being in the nascent stage, currency future is a better option for investment than other futures and options.

History of Curre ncy Futures: Chicago Mercantile Exchange (CME) was the first exchange that came out with currency futures in 1972 The CME established the International Monetary Market and launched trading in 7 currency futures Today IMM is a division of CME

Curre ncy Futures in India: Currency Futures was started trading in Mumbai from August 29, 2008 On the first day itself there were nearly 70000 contracts being traded The first trader on NSE was made by East India Securities Ltd. Banks contributed around 40% of total gross volume of the contract with HDFC bank being the first to carry out a trade The largest trade was made by Standard Chartered Bank constituting 15000 contracts

Characteristic / Features of Currency Futures: It...
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