Investment Vehicles

Currency Derivative

Introduction

Money! Money! Money!

Is the famous dialogue in a Tamil film that created sensation among Tamil audience.

Money has become everything for many people in this world. It has taken many forms in human history and finally settled as paper money. Lets us start this chapter with interesting information on transformation of money.

Everyone or all countries in this world cannot have everything they want. They have to exchange the goods with them with another or exchange the service they offer with another one's service. To fulfill this need, humans have adopted various forms of medium of exchange like goods for goods which is known as barter system, and then moved to exchange of metals for goods and services and then finally paper with value assigned to it was exchanged for goods and services. This various medium of exchange is called “money”. And finally, paper money was universally accepted and proved to be the best medium of exchange. The money in which ever form it is is called “Currency”. In trade between countries, the need to exchange one currency to the other country's currency arises and this exchange of two currencies is called foreign exchange or forex in short.

For smooth functioning of international trade it was necessary to determine the relative value of all currencies. Earlier countries used to value their currency against other country's currency by using their gold reserves as benchmark. This method was called gold standard method. Later, developed countries moved to market determined exchange rate system and developing countries moved to either pegged system or managed rate system. Under pegged system value of currency is pegged to another currency or basket of currencies. In managed rate system, countries have control over the value of their currency by intervention of its central bank. Currently, “Managed Exchange Rate System” is adopted by India.

Under managed rate system, though the value of currency is controlled by the central bank to some extent, the economic factors such as inflation, interest rates, countries external debts etc influences the value of the currency. The relative value of any two currencies so determined is expressed as “exchange rate”. In other words, it is the value of one currency expressed against the value of another currency. For example, when we say the value of USDINR is 68.8922 (as on 18th July, 2019 morning), it means 1 USD = 68.8922 INR. Now let us delve further into this to understand the pairing of currencies.

Currency Pairs

Currency pair is the method of quoting the value of one currency against the other currency. Trading in currency cannot be done independently, meaning one currency cannot be bought and sold independently like how we trade in single equity share, commodity or debt instrument. Currency is always traded in pairs. If you trade in a currency pair, you will be buying one currency and selling the other currency. Suppose you want to trade in US dollar, you will have to trade in it against any other currency, say Indian rupee (INR) or Japanese Yen or Euro. In this case, US dollar will have different values against different currencies, because each country's currency is valued as per that country's economic parameters. For example as on 18th July, 2019 afternoon, the value of one US dollar was 68.8922 against INR and it was 0.89 against Euro and 107.75 against Japanese Yen. In this example the value of currency pairs are expressed as follows:

 

 

 

The currency that is mentioned at first place is called “Base Currency” and the following one is called “Quote or Quoting Currency”. In the above example USD is the base currency and INR, EUR and JPY are quote currencies. It means that 68.89 rupees is needed to buy one US dollar, Euro wise you need 0.89 Euro to buy one US dollar and you need 107.75 Japanese Yen to buy 1 US dollar. Alternatively, you can say that the price of one US dollar is 68.8922 rupees or 0.89 euro or 107.75 Japanese Yen. If you want to know the value of one rupee in terms of US dollar, then you should specify the currency pair as INRUSD.

Following are the major currencies of the world:

 

 

 

 

 

Among these the most actively traded currency pairs are:

EURUSD
USDJPY
GBPUSD
AUDUSD
USDCAD
USDCHF

The currencies that are traded against US dollar are called “Majors”. The currencies that are not traded against US dollar are called “Minors” or “Exotics”.

Currency Derivative Market In India

In previous chapter we have discussed what is derivatives. The same is applicable to currency derivatives also. Prices of currency derivative is derived from the spot price of the currencies. Like any other derivatives, currency derivatives are used to hedge against the risk in its underlying currency movement. In India, both National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) have currency derivatives segments. The currency pairs that are currently allowed to trade in Indian currency derivatives market are:

USDINR
EURINR
GBPINR
JPYINR

Cross currencies that are traded in Indian currency derivatives market are:

EURUSD
GBPUSD
USDJPY

Options trading are allowed on USDINR, EURINR, GBPINR and JPYINR

Brief on currencies that are allowed to trade in Indian derivative segment

US Dollar (USD)

US dollar is the universally accepted base currency. It assumes the role of “investment” currency in many capital markets, role of “reserve” currency with many central banks, role of “transaction” currency in many international commodity market, role of “invoice” currency in many contracts, role of “vehicle” currency in foreign exchange transactions and role of “intervention” currency for monetary authorities in market operations to influence their own exchange rates. US dollar is widely used as vehicle currency to convert one currency to another currency. For example to convert Indian rupee to United Arab's Dirham, traders convert Indian rupee to US dollars first and then convert US dollars to UAE's Dirham.

Euro (EUR)

Euro is the second most traded currency in the world next to US dollar. It is widely traded against US dollar which is denoted by EURUSD. Euro is also used as vehicle currency.

Japanese Yen (JPY)

Japanese Yen is the third most traded currency in the world.

British Pound (GBP)

British Pound (GBP) is most actively traded against Euro and US dollar.

Margins

Traders in currency derivatives in India are required to pay two types of margins. One is the initial margin which is based on SPAN and the other is Extreme Loss Margin (ELM) applicable on mark to market (MTM) value.

The margins on USDINR is the lowest among all four currency pairs. It is 1% SPAN and 1% extreme loss margin (ELM). For GBPINR it is 2% SPAN and 0.5% ELM. For EURINR it is 2% SPAN and 0.3% ELM and for JPYINR it is 2.3% SPAN and 0.7% ELM. Below is the margins presented in tabular form.

Margins on Calendar Spread Trades

Calendar spread is a type of trade entered into by traders in options where they will initiate a long trade and a short trade in same underlying at same strike price but in contracts with different expiry. In other words, in this type of trade, the initial trade is hedged by taking an opposite position in the same underlying and strike price in another month contract. For example when a trader wishes to initiate a calendar spread trade in USDINR the trade set up will be as follows:

The margins on calendar spread trades will be as follows:

Contracts, expiry and settlement

There are 12 contracts in currency derivatives one being in each month. On expiry of one contract, subsequent month contract will be introduced and 12 contracts will be outstanding at any given point of time.

Contract size will be the futures price multiplied by the lot size fixed by the exchange for currency pairs. The lot size for currency pairs are as follows:

Settlement happens at two levels. One is on daily basis for mark to marking (MTM) of the trades and the other is at the final settlement date.

Final settlement date will be the last business day of the month for inter bank currency trades done between banks. It is cash settled on T+2 basis. Final settlement date is different from expiry date. Expiry date of the contract will be two days prior to the final settlement date. It is the last trading day of the contract.

Daily Settlement Price for mark to market settlement of futures contracts

For mark to market (MTM) purpose, daily settlement is carried out on T+1 basis. The settlement price for daily settlement of the futures is the closing price of such contracts on the trading day. The closing price for a futures contract 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. For the unexpired futures contracts that are not traded during the last half an hour on any day, theoretical price is calculated as per a formula.

Final settlement

Final settlement price for a futures contract for the various currencies shall be as mentioned below, or as may be specified by the relevant authority from time to time.

Other specifications of the contract

Price operating range

Price operating ranges for the contracts is fixed as +/‐3% of the base price for contracts with tenure up to 6 months and +/‐5% for contracts with tenure greater than 6 months. This price range is adopted to avoid erroneous order entries.

Quantity freeze

NSE has set 10001 and above as freeze quantity to avoid any order above specified limits. This is made to curb drastic price movements on either side.

Participants and Intermediaries

Hedgers, speculators and arbitrageurs are the participants in currency futures. Hedgers are mainly business people who have exposure to foreign exchange risk. They could be exporter or importer of goods and services. Regular traveler to foreign countries would also hedge their exposure to foreign exchange risk as they will be spending in foreign currency. Further, investment in international commodity that is denominated in US dollar especially risk in investment made in gold could also be hedged by taking an opposite position in currency futures.

Speculators are the market makers in any financial market. They play an important role in currency futures too. They trade in currency futures to derive profit out of the currency futures movement. And arbitrageurs are the ones who take advantage of the difference in currency rate between spot and futures price.

Intermediaries that operate in currency futures market are the same as in equity futures market. Stock brokers, clearing members and clearing corporations are the intermediaries in currency futures market.

Regulators

Indian currency derivatives market is governed and regulated jointly by Reserve Bank of India (RBI) and Securities Exchange Board of India (SEBI) and the following entities and Acts.

• RBI‐SEBI Standing Technical Committee on Exchange Traded Currency and Interest Rate Derivatives.
• Foreign Exchange Management Act 1999
• Securities Contracts (Regulation) Act, 1956

In the year 2017, RBI permitted NRIs to trade in Indian currency futures market to hedge currency risk arising out of their investment in India.

How to trade in currency futures?

You can trade in currency futures just like equity shares. You need to open a trading account with a stock broker and activate currency segment to trade in currency futures. You can punch in the orders from your mobile or PC through the trading platform or app provided by your stock broker. Alternatively, you can also place the order with your stock broker over phone.

But, to decide upon the currency pair and the direction of the trade, you need to know the facts that impacts the currency prices and understand the strength or weakness of the currency you intend to trade.

Factors that impacts currency prices

There are various factors that impacts the value of a currency. Basically, the demand and supply affects the currency value. More importantly, economic factors such as interest rate, inflation, trade deficit, current account deficit etc influences the value of the currency. Let us see some of the economic factors that affects currency value.

Balance of payments

Balance of payments means the current account balance of a country. Current account includes balance of export earnings and spending on imports. It also includes the country's borrowings in foreign currency. If the outgo is more than the inflow it leads to the balance in current account to depreciate and weakens the value of local currency against other currencies.

US Dollar movement

The movement of US dollar will have an impact on all other currencies, as US dollar is used as base currency for many transactions internationally. So, when US dollar strengthens, it weakens the other currencies against US dollar.

Inflation and interest rates

Inflation and interest rates has an impact on currency values. High interest rates in the economy will attract more foreign investment thereby strengthening local currency. However, consistent high rate of inflation is also not good for currency valuation.

Since, all economic factors are inter-related, currency valuation will be impacted by more than one factor, with any one factor being the major contributor at a given point of time. Hence, a thorough analysis of the factors that influence currencies is necessary.

How to identify whether the currency is appreciating or depreciating?

We hear analysts and experts saying USDINR or GBPINR is appreciating or depreciating. On what basis they say it is appreciating or depreciating? How can I identify whether it is appreciating or depreciating?

At the beginning of this chapter we saw that in a currency pair, the currency that is quoted first is base currency and the next one is quoted currency. And we also saw that when we say USDINR is 68, then it means we need 68 rupees to buy 1 USD. Suppose USDINR increases to 69, then it means we need more INR to buy 1 USD. So, USD is becoming costly, meaning USD is strengthening or appreciating. And it means the quote currency INR is weakening or depreciating.

Interest Rate Futures

Introduction

Two decades ago, when I started my career and was trying to get a home loan, my boss advised me to opt for floating rate on home loan instead of fixed interest rate. I was not able to comprehend the rationale behind this. But blindly, I heeded to his advice. He was in the idea that interest rates will fall going forward. So, he advised me to go for floating interest rate option. However, it is sad during that period borrowers and investors had no other option to hedge interest rate risk.

But now, we have a derivative product to hedge against interest rate risk and that is called “Interest Rate Futures” (IRF). Interest rate futures is a futures contract with debt instrument that pays interest as underlying asset. Hence, it is also called “Bond Futures”. Government bonds and Treasury Bills (T-Bills) are the underlying debt instrument.

Prevailing interest rate in an economy keeps changing according to the economic condition of the country. This exposes the investors in debt instruments and borrowers to interest rate risk.   And investors in longer term debt instruments are exposed to interest rate fluctuations.  Borrowers can hedge their exposure by taking an opposite position in interest rate futures.

Regulators

Regulator of debt market is the regulator of interest rate futures market. Since the interest rate is the function of a debt market, Reserve Bank of India (RBI) regulates the interest rate market. However, when it comes to secondary market, the derivative instrument “interest rate futures” is regulated by Securities and Exchange Board of India (SEBI).

Exchanges that offer interest rate futures trading

Both NSE and BSE offers trading facility in interest rate futures.

Below are the underlying on which interest rate futures contracts are traded in NSE and BSE:

1. Standardized contracts based on 6 year, 10 year and 13 year Government of India Security (NBF II)
2. Standardized contracts based on 91-day Government of India Treasury Bill (91DTB).
3. FBIL (Board of Financial Benchmarks India Pvt Ltd) Overnight Mumbai Interbank Outright Rate (MIBOR)

MIBOR is the new benchmark rate for unsecured loans of one day duration fixed by the Board of Financial Benchmarks India Pvt Ltd (FBIL) based on the actual transactions in the inter-bank call money market.

Click here to view the contract specification

Margins

The initial margin based on SPAN is applicable for cash settled interest rate future contract. SPAN margin and exposure margin is collected as initial margin. Minimum is 1.5% of the value of the contract subject to minimum of 2.8% on the first day of trading and for 91-Day T-Bill futures contracts minimum of 0.10% of the notional value of the futures contract on the first day of trading and 0.05% of the notional value of the futures contract thereafter (The notional value of the contract shall be Rs 200000) will be scaled up by look ahead period as may be specified by the Clearing Corporation from time to time.

Tradeplus provides margin calculator for interest rate futures, wherein you can check the margin requirement before initiating a trade. The snapshot is provided below.

 

Settlement of trades

Interest rate futures are cash settled at daily settlement price arrived by considering the weighted average price of the underlying bond based on the process during the last two hours of the trading on NDS-OM subject to minimum of 5 trades.

In case of insufficient trades executed in the underlying bond during the last two hours of trading, then FBIL price shall be used as final settlement price. Board of Financial Benchmarks India Pvt Ltd (FBIL) is an entity appointed by RBI for valuation of portfolios of government securities.

How to trade in interest rate futures

Interest rate futures price is derived from its underlying bond prices, mainly government bonds. Before proceeding further, let us understand the basic of Bonds. Bonds are issued at its face value to investors. Generally, the face value will be Rs.100. And it carries an interest generally ranging between 6% to 8%. Let us see with an example how the change in interest rate in the economy affects the demand for the bonds.

Example - 1

Suppose you want to invest in a bond and you are tracking the bond that has face value of Rs.100 and 7% interest rate or coupon rate as it is usually called. Now you have to decide whether to buy that bond or not. What you will do under different scenarios.

From the above example it is clear that interest rate and bond prices are inversely related. Hence, when interest rate falls, bond prices moves up and when interest rate increases, bond prices will fall.

Right! Having understood the relationship between interest rates and bond prices, now how to trade in interest rate futures. Simple, below picture depicts the trade to be initiated under different interest rate scenarios.

When RBI increases the interest rate, bond price will fall. So sell interest rate futures (bond futures) and make profit.

When RBI reduces interest rate, bond price will increase. So buy interest rate futures (bond futures) and make profit.

Example - 2

In this example, we will see how a borrower can hedge against the interest rate risk that exists on his loan.

At the beginning of this chapter I said that I was advised to opt for floating rate loan when I had to take a home loan.

Now let us see how I will hedge against the interest rate risk as a borrower. I have depicted my trading strategy in a picture under both the case of fixed interest rate and floating interest rate.

You can find that either way (whether fixed or floating interest rate) I will lose under different interest rate scenarios. So I am using interest rate futures to hedge against interest rate risk on my home loan.

Benefits of Interest rate futures

From the above examples you would have understood the benefits of interest rate futures. It is a risk management tool to hedge against interest rate risk.

Trading in interest rate futures does not attract securities transaction tax (STT) and hence, transaction cost is less. Moreover, NSE provides the facility to trade in interest rate futures with single collateral that can be used for currency trading as well as interest rate futures.

Key points to remember

• Currency pairs is the method of quoting the value of one currency against the other currency.
• Currency mentioned at first place is called base currency and the following is called quote currency. When we say USDINR is 68, it means 68 INR is needed to buy one USD.
• Calendar spread trade means buying one contract and selling another contract of same underlying with same strike price.
• There are 12 monthly contracts at any given point of time in currency
• Currency trades are cash settled on T+2 basis.
• Final settlement date will be the last business day of the month for interbank currency trades.
• Expiry date will be 2 days prior to final settlement date
• RBI reference rate will be the final settlement price.
• Interest rate futures are called bond futures as bonds are the underlying
• Interest rate futures is a risk management tool to hedge against interest rate risk
• SPAN and exposure margin is collected as initial margin for interest rate futures
• Interest rate futures are cash settled at daily settlement price
• Trading in interest rate futures does not attract securities transaction tax (STT) and hence, transaction cost is less
• Interest rate and bond prices are inversely related. Hence, when interest rate falls, bond prices moves up and when interest rate increases, bond prices will fall.

Round Up

Currency derivative trading is very useful for the business people and corporates who are engaged in import and export of goods and services. They use currency derivatives to hedge their exposure to foreign currency risk. Currency valuation is influenced by economic factors such as inflation, interest rate, inflow and outflow of foreign investment etc. As with any other financial instruments trading, speculators take advantage of the fluctuations in currency derivatives to make short term gains.

Interest rate futures is an useful tool to hedge against the interest rate risk. Investors in debt instrument and borrowers can use interest rate futures to hedge their exposure to interest bearing instruments.