Futures & Options [F&O] – Currency Futures
INTRODUCTION
Currency markets provide various choices to market participants through the spot market or derivatives market. Before explaining the meaning of currency futures, let us present different choices of a market participant. The market participant may enter into a spot transaction and exchange the currency at current time. The market participant wants to exchange the currency at a future date. Here the market participant may either:
- Enter into a futures/forward contract, whereby he agrees to exchange the currency in the future at a price decided now, or,
- Buy a currency option contract, wherein he commits for a future exchange of currency, with an agreement that the contract will be valid only if the price is favorable to the participant.
Derivatives are financial contracts whose value is determined from one or more underlying variables, which can be a stock, a bond, an index, an interest rate, an exchange rate etc. Currency derivatives can be described as contracts between the sellers and buyers whose values are derived from the underlying which in this case is the Exchange Rate. Currency derivatives are mostly designed for hedging purposes, although they are also used as instruments for speculation.
Base Currency / Terms Currency
In foreign exchange markets, the base currency is the first currency in a currency pair. The second currency is called as the terms currency. Exchange rates are quoted in per unit of the base currency. For example, the expression US Dollar–Rupee, tells you that the US Dollar is being quoted in terms of the Rupee. The US Dollar is the base currency and the Rupee is the terms currency. If US Dollar–Rupee moved from 73.00 to 73.25, the US Dollar has appreciated and the Rupee has depreciated.
The contract specifications of the Currency Futures are as given below:
- Underlying: Initially, currency futures contracts on US dollar – Indian Rupee (USD-INR) have been permitted: in April 2010. It has been now extended to Euro – Indian Rupee (EUR-INR), British pound sterling - Indian rupee (GBP-INR) and Japanese yen – Indian rupee (JPY-INR).
- Size of the contract: The minimum contract size of the currency futures market is 1,000 USD, 1,000 Euro, 1,000 Pound sterling and 1,00,000 YEN for USD-INR, Euro-INR, GBP – INR and JPY-INR respectively.
- Quotation: the currency futures contracts are quoted in rupee terms, however, the outstanding positions are in respective currency terms. Trading Hours: The trading is available from 09.00 a.m. to 5 p.m. from Monday to Friday.
- Available Contracts: All monthly maturities from 1 to 12 months are available.
- Settlement Mechanism: It is cash settled in Indian Rupees at RBI Reference Rate on date of expiry
- Tenor of the contract: The maximum maturity is of 12 months. Tick Size: 0.25 paise or INR 0.0025.
- Price Operating Range: +/- 3% of base price for tenure up to 6 months and +/- 5% of base price for tenure greater than 6 months.
- Settlement: Daily settlement at T+1 and Final settlement at T+2
CURRENCY FUTURES MARKET – A PERSPECTIVE
Initially the RBI and Securities and Exchange Board of India (SEBI) allowed trading in currency futures in India based on the USD-INR exchange rate. This provided Indian corporate another tool for hedging their foreign exchange risk effectively and flexibly at transparent rates on an electronic trading platform. Forex markets were beyond the reach of small investors, speculators and arbitragers but with the introduction of currency futures trading in India, apart from exporters, importers, companies and banks, many retail traders and investors can also now take their positions in foreign exchange trading.
Different types of traders in the Currency Futures Market:
- Hedgers: currency futures provide a high –liquidity platform for hedging against the effects of unfavorable fluctuations in the foreign exchange markets. Exporters, Importers, corporate and Banks can hedge with currency futures at low entry and exit costs.
- Investors: all those who are interested in taking a view on the direction of the market. i.e., appreciation or depreciation of exchange rate in the long and short term can participate in currency futures. For example, if a person expects an appreciation in Indian Rupee against USD, he can sell the USD-INR contract. However, if one expects depreciation of the Indian Rupee against the US dollar, he can take long (Buy) positions in USD-INR contract.
- Arbitrageurs: Arbitrageurs get opportunity to trade in interest rate differentials of respective countries implied from currency futures.
FACTORS INFLUENCING THE INDIAN CURRENCY MARKET:
There are several factors that influence the currency market. Some of the important ones among them, which have impacted the market recently, are discussed below:
Change of Interest Rate
The value of the currency of any country depends on the interest rate of that country. In case of upward movement of interest rate in the United States, the US Dollar (USD) appreciates against other currencies as well as against the Indian Rupee (INR). Any change of interest rate by the Federal Reserve Bank of New York (FED) through the Federal Open Market Committee (FOMC) has a great impact on the currency market.
Even an expectation of change of interest rate has a great impact on currency market. Whenever there is any such expectation, the market reacts sharply. The possibility of changes in interest rate is a speculative move, and the market reacts only for a short period of time. The market generally discounts some portion of such expectations well in advance, before they actually happen.
USD INR Price volume analysis
Inflow of Foreign Funds
The exchange rate depends on demand and supply of currency. Strong economic fundamentals and good ratings by international rating agencies have boosted foreign investors’ confidence in the Indian market. During the last one to oneand- a-half years, the Indian rupee has shown a tendency to appreciate due to a huge inflow of foreign funds in the Indian market by FIIs or through FDIs in the form of External Commercial Borrowings (ECB) and Foreign Currency Convertible Bonds (FCCBs). A direct relationship may be drawn between the USD–INR exchange rate and the BSE index. Considering all other factors to be constant, whenever overseas FIIs buy shares from the Indian market, there is an upward movement of the BSE index.
At the same time, due to inflow of foreign funds (foreign investors have USD to sell—they will buy INR to invest in Indian market against USD) in the Indian market, the supply of USD increases in the market and it depreciates against INR, or INR appreciates against USD. On the other hand, if there is any negative flow of funds by FIIs, there would be a downward movement of the BSE index, and consequently USD would appreciate against INR. Price of Oil
A large portion of India’s import payment is mainly for payment of oil. Internationally, crude prices are named as BRENT, NYMEX, and Dubai Crude. Whenever there is any hike in the oil price per barrel, the Indian Rupee depreciates against the US Dollar. As such, the Indian Government buys more USD against INR to honour the import liability, resulting in heavy demand for USD. Consequently, the Indian rupee depreciates against USD. The Indian currency market largely depends on the price of Dubai Crude. Whenever FIIs book profits by selling their shares, the BSE index falls, and at the same time INR depreciates against the USD.
Comments from Political Leaders
Comments from political leaders and top bureaucrats do influence the market, but this is very short-term. It is quite common in India, particularly when it comes to comments from political leaders or the Governor of the Reserve Bank of India (RBI). We know that the Japanese economy is export-oriented, and that Japanese exporters welcome any move that depreciates the Japanese Yen. It has been observed that Whenever the Yen strengthens against the USD; Japanese politicians tend to pass comments on economy that allows the Yen to slip back to its original level. Political unrests can also strongly influence the currency market, but again only for a short period of time. Extended periods of political uncertainty can, however, cause the rest of the world to lose confidence in that country, and could finally result in a steep fall in the value of that country’s currency.
Release of Economic Data
The economic data or surveys released by various national and international agencies, including FED, RBI, Moody’s, etc. can influence market sentiments and lead to movement in exchange rates. Some data from the US, such as Non-Farm Payroll, Jobless Claim, US trade deficit and GDP growth rate are known to influence the currency market. Annual economic review, RBI credit policy, monetary policy, etc. also strongly influence the currency market. Understanding, interpretation and correlation of different data are important to gain a thorough understanding of the exchange rate movement by any corporate. Any mistake in the interpretation of data released could cause heavy loss to an organization.
RBI Intervention
The RBI, which regulates the Indian currency market, does intervene whenever it feels it is required to stabilize the market, or to keep market volatility under control. It is the responsibility of the RBI to keep the exchange rate unaffected at a time of volatility in the foreign currency market. It has been observed that RBI intervenes in the currency market whenever there is any abnormal movement in the exchange rate, either upward or downward. The RBI buys foreign currency (USD) to depreciate the domestic currency, and sells foreign currency when the domestic currency depreciates abnormally. Sometimes the RBI does not intervene at all. In April and May 2006, the Indian Rupee depreciated heavily in the wake of the fall of the BSE Index, but the RBI did not intervene, much as previously the Indian Rupee had appreciated (in January and February 2006) to such a level that it needed to be depreciated solely by market forces.
Natural Calamities
Natural calamities may also affect the currency market for a short period of time. In August 2005, Hurricane Katrina affected the entire region around the Gulf of Mexico. This region contributes around one-third of US oil production and accounts for around half of the nation’s refining capacity. Besides, a large part of US oil imports reaches ports in this area. The hurricane caused a huge loss in production of crude oil and natural gas. It affected the prices of crude oil and prices shot up. Automatically, the oil price increased globally and at the same time affected the exchange rate.