Currency Derivatives

Objectives

How to the read the quotes

Evolution of Foreign Exchange Market

Factors affecting the Currency Market

Current scenario

Currency Futures – Opportunities & Advantages

Currency options

Currency Futures specifications

Foreign Exchange

Price of one currency viewed in relation to another currency is called a exchange rate…

What you see above are quotes to buy/sell three currency pairs.

Currencies are pairs, in the above example, Euro against US Dollar or GBP against US Dollar

Interpret the quotes

There are two ways to quote currency pairs in the FX market: direct quote and indirect quote

Direct quote in US Dollars: Number of US Dollar required to buy 1 unit of foreign currency. eg.

GBP/USD or EUR/USD1.2437 USD required to buy 1 USD.

Indirect quote in US Dollars: Number of units of foreign currency that can be bought with 1 US Dollar

eg. USD/JPY or 1 USD can buy 78.00 JPY

Direct Quote & Indirect Quote

This is a direct quote in US Dollars

The currency that comes on left,

here Euro, becomes the base

currency. Hence, in EUR/USD, the

question is how many Dollars for 1

Euro

One would require 1.2435 US

Dollars to buy 1 unit of Euro

This is an indirect quote in US Dollars

USD is on the left, hence it is 1 unit of

USD.

One US Dollar can buy 55.5450 Indian

Rupees

Direct Quote & Indirect Quote

If a client sells EUR/USD, he sells at

the bid rate, i.e., 1.2434.

Once a client sells EUR/USD, he

becomes long on the US Dollar and

short on Euro. Remember, the quote

means 1.2434 US Dollar is required

to buy 1 Euro.

If a client sell EUR/USD @ 1.2434

and after an hour EUR/USD @

1.2420, then the client makes 14

pips

If a client buys USD/JPY, he buys at the

offer rate, i.e., 78.03

Once a client buys USD/JPY, we

becomes long on USD and short on JPY

If a client buys USD/JPY @ 78.03 and

after an hour USD/JPY @ 78.33, then

the client makes 30 pips

How much money do I make….

Evolution of FX market

Foreign Exchange Market is mainly a decentralized global market where

trading of currencies takes place. Also known as fx/forex or currency market.

Came into being in 1970s when countries shifted from fixed exchange rate

system to floating exchange rate system

Trades mainly in OTC market, where participants negotiate directly amongst

themselves (96% - OTC; 4% - Exchanges).

Main participants include – banks, large corporate, hedge funds, central banks

and financial institutions

Retail participation (HNIs) is primarily through dedicated currency funds, as

ticket size is usually quite large in OTC markets

Evolution contd….

Trading in currencies started as a mechanism

To facilitate international trade and investment, and

To hedge foreign exchange risk

But soon emerged as the largest “alternative investment” asset class in the

world, because of its unique features:

Continuous trading opportunity : i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday

Standardization of underlying contract (trading on relative value between two currencies)

Huge trading volume leading to high liquidity

Variety of factors that affect exchange rates (sheer sensitivity to different news make it known as

“adults” market in trading circle)

Geographical dispersion (it is said – currency market never sleeps)

Higher leverage and hence opportunity to make higher profit /loss

How big is the pond

Today, trading volume in currency market far exceeds any other asset class.

Main trading centre are – Tokyo, Singapore, London and New York

Most active pairs are – EUR/USD, USD/JPY, GBP/USD, known as G3

currencies , followed by G10 currencies (AUD/USD, USD/CAD etc)

Of late, EM currencies are gaining momentum because of liberalized policies

and higher growth potential

Asset Class Approx. ADV (in USD billion)

Currencies 4700

Fixed Income 2300

Commodities 1200-1300

Equities 300-350 ADV = Average Daily Volume

India – Forex Market

INR trades in a managed floating exchange rate regime

INR is fully convertible on India’s current account but not on capital account

Forex transaction mainly confined to banks and network of dealers/brokers,

known as OTC market.

Entities having underlying exposure can only access OTC market

Suitable for large entities having bigger exposure and greater access to banks

Total volume – approx USD 32-34 billion all combined (spot + forwards +

swaps)

What is Currency Futures (CF)?

Launched in August 2008 in consultation with SEBI and RBI.

Futures are standardized version of forward contracts with fixed expiry and

size

Unlike OTC market where forward points are quoted separately, forward

points are in-built in futures price

Trades on regulated exchanges

Aims to provide higher access to SMEs, HNIs and retail investors.

Futures are cash settled contracts – No delivery possible

Why Currency Futures (CF)?

Average daily volume of more than 25,000 cr.

One of the fastest growing futures market presently in India

Activity in exchange traded options is buzzing.

Average daily volume of more than 4,000 cr.

Why Currency Options?

Why Currency Futures (CF)?

Daily average volatility of 0.6-1.00%, hence better control over portfolio

Lower Exchange margin requirement

Minimum Initial Margin requirement: 3-4%

Kotak Securities Total Margin Charged – 5% to 6%

Hence, higher leverage of 18-20 times

Better risk-reward ratio

No STT (Securities Transaction Tax)

Only cost involved – Brokerage + Stamp Duty + SEBI fee + exchange trans. charges

Brokerage: 0.02% or 10 per lot, whichever is higher (can be negotiated on volume)

Stamp duty: 0.002%

SEBI fee: 0.0002%

Opportunity to churn in profit at minimum of 5 ticks (tick size – 0.0025 paise)

What affects the currency movement?

Long Term

Interest rate differential (Change in interest rate - monetary policy)

GDP growth – Higher GDP growth potential entails stronger currency

Medium Term

Change in macro-economic indicators (Worsening of trade balance, current account deficit and

fiscal deficit adversely affects the currency)

Short Term

Capital flows (FIIs, FDI or corporate flow) – Higher inflow leads to stronger currency

Performance of equity markets (Nifty & Rupee has inverse relationship)

Movement in currencies of peer countries like Korea, Taiwan (EMs in Asia), or movement in

crosses like EURUSD, USDJPY etc (overall risk sentiment in the market)

Central bank intervention – RBI intervenes sometimes to stem volatility and maintain fair value

Key economic data announcements like inflation, IIPs etc.

Equity market & Rupee

Nifty Index and USD/INR has inverse relationship (co-relation of plus 60%)

On few days, this relationship may not work because of currency market positioning

India’s macros: CAD and Rupee

A widening Current Account Deficit is negative for Indian Rupee

Oil & Gold command a lion share of imports… Petro, jewelry & engg. goods

command a lion share of exports

India’s macros: FII inflows

Monthly FII inflows (debt/equity combined) (Rs crore)

Inflows dried in 2011, except for an LTRO lead push during Q1 2012

India’s macros: Capital Account

and Rupee

Stress in BOP made Rupee one of the weak FX in the world…

Since July of 2011, INR depreciated @ 25%...

Rupee & the world markets

Stress in the Eurozone causing spike in Spanish yields (%) and decline in

equities

Supporting factors for Rupee

Monthly QaINTBWREER

91.273

104.21

Line, QaINTBWREER, Cvalue(Last), (S1, S2)

30/04/2012, 93.4

Value

92

96

100

104

1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

1990 2000 2010

INR 36 currency REER

Weekly QINR=, QLCOc1

Price

USD

.1234

44

45

46

47

48

49

50

51

52

53

54

5555.1700

Value

USD

Bbl

.123

-40

-20

0

20

40

60

80

-13.001

Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

2009 2010 2011 2012 [Delayed]

Annual change in Brent crude (%-

red) & USD/INR (black)

Supporting factors for Rupee

Indian gold imports- USD Bn IIP (yellow) & Non-oil, non-gold

imports (blue)

India imported 655 tons in FY12 v/s

969 tons in FY11

Currency Futures - Opportunities

Directional Views

Taking directional call on different currency pairs against INR

Price view on cross currency pairs like EUR/USD, USD/JPY GBP/USD

through combination of futures contracts

Hedging current exposure

Importers and exporters can hedge their short term exposure

Borrowers can hedge FCY loans for interest or principal payments

Hedge for offshore investment by Resident Indians

Trade & Capital Flows

Remittances for trade or services or capital transactions

Arbitrage

Arbitrage opportunity between exchange, OTC and off-shore market, if any