Hedging Through Currency Futures

“Hedging through Currency Futures”

Ambesh Kumar Srivastava Post Graduate Diploma in Management Institute of Integrated Learning in Management (Graduate School of Management) Class of 2008 - 09

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“Hedging through Currency Futures”

Under the guidance of: Mr. Aloke Nandi Head Currency Futures Department Unicon Investment Solutions

Disclaimer: This research report is intended as general information only. The contents of this work reflect the views of the author who is responsible for the facts and accuracy of the data presented. No reproduction of any part of the report may be sold or distributed for commercial gain, nor shall it be modified or incorporated in any other work, publication or site. Responsibility for the application of the material to specific cases, however, lies with the user of the report and no responsibility in such cases will be attributed to the author. This report may contain references from research papers, development reports or articles which have been published earlier.

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Acknowledgment

This project is the outcome and result of the extensive work in the area of “Currency Futures”. I would like to thank my project guide Mr. Aloke Nandi for his continuous support and guidance. He had guided me about different aspects of practical working methodology in the financial markets and helped me to develop profound understanding about the market. I would like to give my heartiest thanks to my project mentor Mr.Japinder Singh for taking me under his guidance and giving me his precious time for the successful completion of the project. I also express my gratitude to the HR of unicon Miss. Isha Sood for her incomparable support and addressing all our concerns to ensure that our experience at Unicon was free of any hassles. I would like to thank my faculty guide Prof. Ferojuddin M. A. Khan for giving me the proper guidance and providing me with new and innovative aspects to work on. A well combination of theory and practice helped me in compiling this report on “Hedging through Currency Futures”. I express my deep sense of gratitude and thanks to exporters, importers, retailers, offshore inventors and commodity players for their co-operation regarding this project and I am also grateful to all those people who directly or indirectly helped me in accomplishing this project.

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Executive Summary

Derivatives markets are one of the most important classes of financial instruments that are central to today’s financial and trade markets. They offer various types of risk protection and allow innovative investment strategies. In India the derivatives market was small and domestic just a few years back. Since then it has grown impressively and had reached to a sizable position, for example on an average providing 3,500 crores of volume in on the national stock exchange in daily currency derivative trade. No other class of financial instruments has experienced as much innovation. Product and technology innovation together with competition have fuelled the impressive growth that has created many new jobs both at exchanges and intermediaries as well as at related service providers. Given the derivatives market’s global nature, users can trade around the clock and make use of currency derivatives that offer exposure to the investor in almost any “Underlying Currency” across all markets. The Currency derivatives market is growing at a fast pace and providing all different investing horizons to the investors like Hedging, Speculation, Arbitrage, Investment. There are two competing segments in the currency market: the off-exchange or over-the-counter (OTC) segment and the on-exchange segment. From a customer perspective, OTC trading is approximately less expensive than on-exchange trading. By and large, the currency derivatives market is safe and efficient. Risks are particularly well controlled in the exchange segment, where central counterparties (CCPs) operate very efficiently and mitigate the risks for all market participants. In this respect, derivatives have to be distinguished from e.g. structured creditlinked security such as collateralized debt obligations that triggered the financial crisis in 2007. The currency derivatives market has successfully developed under an effective regulatory regime in India. All three prerequisites for a well-functioning market – safety, efficiency and innovation – are fulfilled. While there is no need for structural changes in the framework under which OTC players and exchanges operate today, improvements are possible. Particularly in the OTC segment, increasing operating efficiency, market transparency and enhancing counterparty risk mitigation would help the global derivatives market to function even more effectively. At the end of the day, currency derivatives market opens up new window for the investors in India to go beyond the stereotype equity and commodity market and enjoy the Currency market.

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TABLE OF CONTENTS Introduction to the FOREX Market

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Exchange Rates

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Factors Affecting Currency Trading

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Derivatives

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Currency futures

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Rupee future

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Currency derivatives trading system

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Working with Reuters

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Uses of currency futures

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Hedging using currency futures

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Fundamental Analysis of Rupee

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Putting Theory to Practice at Unicon

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Conclusion

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Bibliography

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Glossary

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List of Abbreviations

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Introduction to the FOREX Market

The foreign exchange (currency or forex or FX) market exists wherever one currency is traded for another. It is the largest and most liquid financial market in the world. Exchanging currencies can take two basic forms: an outright or a swap. When two parties exchange one currency for another the transaction is called an outright. When two parties agree to exchange and reexchange (in future) one currency for another, it is called a swap. There are many interesting things that can be pointed out about the foreign exchange market, however there are a few major things that really separate this market from the equities and futures markets. 24 Hour Liquidity:– Probably the biggest advantages that traders of the forex market will cite is that the market is by far the largest market in the world, and that main currencies can be traded actively 24 hours a day. The huge amount of volume traded in the world’s main currencies each day, dwarfs the volume traded in the equities and the futures markets many times over. This combined with the 24 hour trading day gives traders the ability to determine their own trading hours instead of having to trade within set hours as they would have to when trading stocks and/or futures. More importantly than this however is that as the market is more liquid than the futures and equities markets, price slippage (the difference between where you click to enter or exit a trade and where you actually get in or out) in the forex market is normally much smaller than in the stock and futures market. Leverage:There is more leverage provided to traders by most forex trading firms than any other market in the world. Many firms offer you up to 1 to 200 leverage which if fully used would essentially take a .5% move in the market and turn it into a 100% gain or loss on the value of the account. As the most highly traded currencies rarely move more than a couple of percent in a day, this allows traders to tailor the forex market to their needs, making it a conservative instrument when traded without leverage or the crack cocaine of financial instruments when making full use of the leverage available. Only Macro Events Affect the Forex Market:Unlike stocks where individual company events have a huge affect on price movements the most highly traded currencies are only affected by macro events like the capital flows between countries, and changes in government or central bank policies. This is often pointed to as an advantage by Forex Traders who feel that this brings less uncertainty to their trades than stock

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trades which can be thrown way off track if a surprise happens such as a CEO quitting or something similar in the micro picture. No Upward Bias:Over the long term the US stock market has always gone up giving stocks in the US an upward bias when trading. As currencies are traded in pairs when the value of one currency is falling this automatically means that the value of another currency is rising. This is an advantage from the standpoint of there is equal opportunity for profit from both long and short trades. This is a disadvantage from the standpoint of not having that upward bias working for you when you are in a long trade.

Exchange Traded and Over the Counter Markets:Exchange Traded Markets:When trading stocks or futures you normally do so via a centralized exchange such as the New York Stock Exchange, Bombay stock exchange, or the Chicago Mercantile Exchange. In addition to providing a centralized place where all trades are conducted, exchanges such as these also play the key role of acting as the counterparty to all trades. What this means is that while you may be buying for example 100 shares of Infosys stock at the same time someone else is selling those shares, you do not buy those shares directly from the seller but instead from the exchange. The fact that the exchange stands on the other side of all trades in exchange traded markets is one of their key advantages as this removes counterparty risk, or the chance that the person who you are trading with will default on their obligations relating to the trade.

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A second key advantage of exchange traded markets is that as all trades flow through one central place, the price that is quoted for a particular instrument is always the same regardless of the size or sophistication of the person or entity making the trade. This in theory should create a more level playing field which can be an advantage to the smaller and less sophisticated trader. Lastly, because all firms that offer exchange traded products must be members and register with the exchange, there is greater regulatory oversight which can make exchange traded markets a much safer place for individuals to trade. Over the counter market:Unlike the stock market and the futures market which trade on centralized exchanges, the spot forex market and many debt markets trade in what’s known as the over the counter market. What this means is that there is no centralized place where trades are made, instead the market is made up of all the participants in the market trading among themselves. The biggest advantage to over the counter markets is that because there is no centralized exchange and little regulation, you have heavy competition between different providers to attract the most traders and trading volume to their firm. This being the case transaction costs are normally lower in over the counter markets when compared to similar products that trade on an exchange. As there is no centralized exchange the firms that make prices in the instrument that is trading over the counter can make whatever price they want, and the quality of execution varies from firm to firm for the same instrument. While this is less of a problem in liquid markets such as FX where there are multiple price reference sources, it can be a problem in less highly traded instruments. 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. Eg. 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. Exchange rates are constantly changing, which means that the value of one currency in terms of the other is constantly in flux. Changes in rates are expressed as strengthening or weakening of one currency vis-à-vis the other currency. Changes are also expressed as appreciation or depreciation of one currency in terms of the other currency. Whenever the base currency buys more of the terms currency, the base currency has strengthened / appreciated and the terms currency has weakened / depreciated. Eg. If US Dollar–Rupee moved from 43.00 to 43.25, the US Dollar has appreciated and the Rupee has depreciated.

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Who Really Controls the Forex Market? The market is something known as the Interbank market. While technically any bank is part of the Interbank market, when an FX Trader speaks of the interbank market he or she is really talking about the 10 or so largest banks that make markets in FX. These institutions make up over 75% of the over $3 Trillion dollars in FX Traded on any given day. There are two primary factors which separate institutions with direct interbank access from everyone else which are as below:1. Access to the tightest prices. 1 Million in currency traded those who have direct access to the Interbank market save approximately $100 per trade or more over the next level of participants. 2. Access to the best liquidity. As the forex market is over the counter, liquidity is spread out among different providers, with the banks comprising the interbank market having access to the greatest amount of liquidity and then declining levels of liquidity available at different levels moving away from the Interbank market. The next level of participants are the hedge funds, brokerage firms, and smaller banks who are not quite large enough to have direct access to the Interbank market. As we just discussed the difference here is that the transaction costs for the trade are a bit higher and the liquidity available is a bit lower than at the Interbank level. The next level of participants has traditionally been corporations and smaller financial institutions who do make foreign exchange trades, but not enough to warrant the better pricing.

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How Central Banks Move the Market While the 10 largest banks which make up the forex Interbank market account for over 75% of the over $3 Trillion in daily trading volume, there is actually a level of participants with even more clout in the market. While generally nowhere near as active as the banks just mentioned, the Central Banks of countries also participate in the forex market, and as they have such deep pockets, have huge clout when they decide to enter the market. The two main reasons why central bank would participate in the forex market are: 1. To fix the value of its currency to a particular level: A central bank normally try to fix its currency value by buying their own currency when the value gets too weak creating more demand for the currency and therefore driving the value up, and selling their own currency when it gets to strong creating a greater supply of that currency and therefore lowering its value back to the desired level. 2. To protect the value of a floating currency from extreme movements: Unlike China and many other developing economies in the world, the US, The Euro Zone, Japan and the other major economies of the world have what is known as a floating exchange rate. Very simply what this means is that instead of having the value of the currency pegged to something else which therefore determines its value, the value of the currency is determined by market forces.

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Players in the Forex Market

Diverse a commodity market, where all participants have access to the same price levels, the forex market is separated into levels of access. At the peak is the interbank industry, which is made up of the most prominent investment funds banking firms. Inside the interbank marketplace, gaps, which are the deviation between the bidding and ask cost, are razor sharp and normally unavailable, and not known to participants outside the inner circle. As you go down the degrees of access, the difference between the bidding and ask costs extends. This is due to mass. If a swing trader can guarantee immense amounts of dealings for huge amounts, they can require a more minor difference between the bidding and ask price, which is named to as a better spreading. The toptier interbank industry accounts for 53% of all transactions. When that there are usually more minor investment banks, followed by heavy multinational corporations (which want to hedge risk and pay employees in diverse countries), big hedge funds, and potentially a few of the retail forex market makers. Major Pension funds, insurance policy companies, mutual funds, and other institutional investors have wagered an increasingly significant role in financial markets in general, and in FX markets in particular, since the early 2000s. Central Banks National primal banks play a please note role in the foreign exchange marketplaces. They seek to check the revenue supply, inflation, and/or interest rates and often have prescribed or unofficial target values for their currencies. They can use their oftentimes substantial foreign exchange reserves to stabilize the marketplace. The strength of primal banking institute stabilising hypothesis is in question because primal banking firms don't go bankrupt if they make huge losses, like more traders would, and there are no convincing grounds to believe that they do make a profits dealing. Key banking institutes do not universally accomplish their objectives, however. The merged resources of the industry can easily sweep over whatever central banking concern. Some scenarios of this nature were seen in the 1992/93 ERM collapse, George soros bet on bank of England, and in more recent times in Southeast Asia. Banking Institutions The interbank market caters for each the majority of commercial turnover and large numbers of speculative dealing each day. A prominent bank may swap billions of dollars every day. Some of this swapping is undertaken on behalf of customers, but great deal is conducted by proprietary desks, swapping for the banking firms own account. Until lately, foreign exchange agents did heavy amounts of business, helping interbank dealing and coupling anonymous counterparts for small scale fees. Today, however, great deal of this

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business has moved on to more efficient electronic systems, such as Bloomberg, EBS, Reuters Dealing 3000, the Chicago Mercantile Exchange and TradeBook(R). The professional squawk box lets dealers hear in on ongoing interbank dealing and is heard in almost all dealing rooms, however turnover is perceptibly littler than just two or three years ago. Investment Funds Management Firms Investing management firms (who occasionally manage vast accounts on behalf of clients such as pension funds and endowments) utilise the foreign exchange industry to facilitate dealings in foreign securities. For instance, an investment funds manager with an worldwide equity portfolio will require to choose and deal foreign currencies in the area market in order to compensate for purchases of alien stocks. Because the forex trading transactions are secondary to the de facto investing decision, they are not seen as speculative or calculated at profit maximization. Some investing management houses also have more speculative specialist currency overlay operations, which manage client’s currency exposures with the aim of generating profits as well as limiting risk. Whilst the figure of this type of specialist firms is quite microscopic, many have a big value of assets under management (AUM), and hence can generate immense trades. Commercial Corporations An important side of this marketplace comes from the financial activities of corporations seeking extraneous exchange to pay for goods or services. Commercial corporations much business deal fairly pocket size amounts likened to those of banks or speculators, and their trades frequently have little short term impact on market merits. However, business deal flows can be an please note ingredient in the semipermanent direction of a currency’s exchange rate. A few transnational corporations can have an unpredictable impact when very enormous positions could be reported due to exposures that want to be not widely known by more marketplace players. Hedge Funds Hedge funds, such as George Soross Quantum fund have profited a reputation for pushy currency hypothesis since 1990. They moderate trillions of dollars of equity and may borrow millions more, and thus might overpower interference by central banking firms to support just about any currency, if the economic basics can be in the hedge funds favour. Retail Forex Brokers Retail foreign currency exchange agents or industry makers address a minute divide of the sum volume of the alien exchange marketplace. Based on data from CNN, one retail professional estimates retail volume at $2550 billion every day, which is around 2% of the whole industry

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Exchange Rates Exchange Rates - What are they and how are they calculated? Like most other rates in economics, the exchange rate is essentially a price and can be analyzed in the same way we would a price. Take a typical supermarket price, say lemons are selling at the price of 3 for a dollar or 33 paisa each. Then we can think of the rupee-to-lemon exchange rate as being 3 lemons because if we give up one rupee, we can get three lemons in return. Similarly, the lemon-to-rupee exchange rate is 1/3 of a rupee or 33 paisa, because if you sell a lemon, you will get 33 paisa in return. So when we speak of an X-to-Y exchange rate of Z, this means that if we give up 1 unit of X, we get Z units of Y in return. If we want to know the Y-to-X exchange rate, we calculate it using the simple exchange rate formula: Y-to-X exchange rate = 1 / X-to-Y exchange rate Of course, the exchange rates we read in the paper or hear on radio or TV are not prices for X and Y or for oranges and lemons. Instead they're relative prices for different currencies, but they work in the same fashion. On June 30, 2009 the U.S.-to-Japan exchange rate was 97 yen, so this means that you can purchase 97 Japanese yen in exchange for 1 U.S. dollar. To figure out how many U.S. dollars you can get for 1 Japanese yen, we can just use the formula: Japan-to-U.S. exchange rate = 1 / U.S.-to-Japan exchange rate Japan-to-U.S. exchange rate = 1 / 97 = .0103 So this tells us that one Japanese yen is worth .0103 U.S. dollars, which is less than a penny. Similarly if the Canadian dollar is worth .67 U.S. dollars, we have a Canada-to-U.S exchange rate of .67. If we want to know how many Canadian dollars we can buy with 1 U.S. dollar, we use the formula: U.S.-to-Canada exchange rate = 1/Canada-to-U.S. Exchange rate U.S.-to-Canada exchange rate = 1/0.67 = 1.4925 So one U.S. dollar can get us $1.49 in Canadian funds. Exchange Rates - Arbitrage Suppose the Euro-to-USD exchange rate is 2. We would expect then that the USD-to-Euro exchange rate would be 1/2 or 0.5. But suppose for a second that it wasn't. Instead assume that the current market USD-to-Euro exchange rate is 0.6. Then an investor could take five Euro and exchange them for 10 USD. She could then take her 10 USD and exchange them back for Euro. At the USD-to-Euro exchange rate, she'd give up 10 USD and get back 6 Euro. Now she has one more Euro than she did before. This type of exchange is known as arbitrage. Since our investor

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gained a Euro, and since we're not creating or destroying any currency, the rest of the market must have lost a USD. This of course is bad for the rest of the market. We would expect that the other agents in the currency exchange market will change the exchange rates that they offer so these opportunities to get exploited are taken away. Still there is a class of investors known as arbitrageurs who try to exploit these differences. Arbitrage generally takes on more complex forms than this, involving several currencies. Suppose that the Algerian dinars-to-Bulgarian leva exchange rate is 2 and the Bulgarian leva-toChilean peso is 3. To figure out what the Algerian-to-Chilean exchange rate needs to be, we just multiply the two exchange rates together: A-to-C = (A-to-B)*(B-to-C) This property of exchange rates is known as transitivity. To avoid arbitrage we would need the Algerian-to-Chilean exchange rate to be 6 and the Chilean-to-Algerian exchange rate needs to be 1/6. Suppose it was only 1/5. Then our investor could again take five Algerian dinars and exchange them for 10 Bulgarian leva. She could then take her 10 leva and get 30 Chilean pesos at the Bulgarian-to-Chilean exchange rate of 3. If she then exchanged her 30 Chilean pesos at the Chilean-to-Algerian rate of 1/5, she'd get 6 Algerian dinars in return. Once again our investor has gained a dinar and the rest of the market has lost one. For any three currencies A, B, and C, trading A for B, B for C and C for A is known as a currency cycle. The A-to-C exchange rate not only places restrictions on the C-to-A exchange rate, but it also places restriction on the A-to-B and B-to-C pair of exchange rates. Exchange Rates - Supply Basic economic theory teaches us that if the supply of a good increases, and nothing else changes, the price of that good will decrease. If the supply of a country's currency increases, we should see that it takes more of that currency to purchase a different currency than it did before. Suppose there was a big jump in the supply of the Canadian dollar. We would expect to see the Canadian dollar become less valuable relative to other currencies. So the Canadian-to-U.S. Exchange rate should decrease, from 67 cents down to, say, 50 cents. Each Canadian dollar would give us less American dollars than it did before. Similarly, the U.S.-to-Canadian exchange rate would increase from $1.49 to $2.00, so each U.S. dollar would give us more Canadian dollars than it did before, as a Canadian dollar is less valuable than it used to be. Why would the supply of a currency increase? Currencies are traded on the foreign exchange market, and the supply of a currency on that market will change over time. There are a few different organizations whose actions will cause a rise in the supply of the foreign exchange market:

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1. Export Companies Suppose a South African farm sells the cashews it produces to a large Japanese firm. It is likely that the contract will be negotiated in Japanese yen, so the farm will receive its revenue in a currency with limited use outside of Japan. Since the company needs to pay it's employees in the local currency, namely the South African rand, the company would sell its yen on a foreign exchange market and buy rands. The supply of Japanese yen on the foreign exchange market will increase, and the supply of South African rands will decrease. This will cause the rand to appreciate in value (become more valuable) relative to other currencies and the yen to depreciate. 2. Foreign Investors A German automobile manufacturer wants to build a new plant in Windsor, ON, Canada. To purchase the land, hire construction workers, etc., the firm will need Canadian dollars. However most of their cash reserves are held in euros. The company will be forced to go to the foreign exchange market, sell some of its euros, and buy Canadian dollars. The supply of euros on the foreign exchange market goes up, and the supply of Canadian dollars goes down. This will cause Canadian dollars to appreciate and euros to depreciate. 3. Speculators Like the stock market, there are investors who try to make a fortune (or at least a living) by buying and selling currencies. Suppose a currency investor thinks that the Mexican peso will depreciate in the future, so it will be less valuable than other currencies than it is now. In that case, she is likely to sell her pesos on the foreign exchange market and buy a different currency instead, such as the South Korean won. The supply of pesos goes up and the supply of won goes down. This causes pesos to depreciate, and won to appreciate. 4. Central Bankers One of the responsibilities of the central banks is to control the supply, or the amount, of currency in a country. The most obvious way to increase the supply of money is to simply print more currency, though there are much more sophisticated ways of changing the money supply. If the central bank prints more 10 and 20 dollar bills, the money supply will increase. When the government increases the money supply, it is likely some of this new money will make its way to the foreign exchange market, so the supply of U.S. dollars will increase there as well. If the Fed decides that the U.S. dollar has appreciated in value too much relative to the Japanese yen, it will sell some of the U.S. dollars it has in reserve and buy Japanese yen. This will increase the supply of dollars on the foreign exchange market, and decrease the supply of yen, causing a depreciation in the value of the dollar relative to the yen. These are the organizations who will increase the supply of currency on the exchange market.

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Exchange Rates - Demand Why would the demand for a currency increase? Not surprisingly pretty much the same organizations who caused supply changes will cause demand changes. They are as follows: 1. Import Companies A British retailer specializing in Chinese merchandise will often have to pay for that merchandise in Chinese yuan. So if the popularity of Chinese goods goes up in other countries the demand for Chinese yuan will go up as retailers purchase yuan to make purchases from Chinese wholesalers and manufacturers. 2. Foreign Investors As before a German automobile manufacturer wants to build a new plant in Windsor, ON, Canada. To purchase the land, hire construction workers, etc., the firm will need Canadian dollars. So the demand for Canadian dollars will rise. 3. Speculators If an investor feels that the price of Mexican pesos will rise in the future, she will demand more pesos today. This increased demand leads to an increased price for pesos. 4. Central Bankers A central bank might decide that its holdings of a particular currency are too low, so they decide to buy that currency on the open market. They might also want to have the exchange rate for their currency decline relative to another currency. So they put their currency on the open market and use it to buy another currency. So Central Banks can play a role in the demand for currency.

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Factors Affecting Currency Trading

Even if exchange rates are affected by numbers of factors, in the end, currency costs are a result of supply and require forces. The worlds currency markets can be considered as a massive melting pot: in a big and changing mix of current events, supply and demand ingredients are constantly switching, and the cost of one currency in relation to a second shifts accordingly. No additional marketplace comprehends as much of what is proceeding in the community at any given time as foreign currency exchange. Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic ingredients, political conditions and marketplace psychology. Market psychology Perhaps the most difficult to define (there are no balance sheets or income statements), market psychology influences the foreign exchange industry in a variety of ways: Buy the rumor, sell the fact: This industry truism can apply to numerous currency situations. It is the tendency for the cost of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a marketplace being oversold or overbought. Flights to quality: Unsettling international events can lead to a flight to quality with investors seeking a safe haven. There will be a greater demand, thus a higher cost, for currencies perceived as stronger over their relatively weaker counterparts. Long term trends: Very often, currency marketplaces move in long, pronounced trends. While currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer term cost trends that may arise form economic or political trends. Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman like effect the number itself becomes important to industry psychology and may have an immediate impact on short term market moves. What to watch can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight. Economic factors These include economic policy, disseminated by government agencies and central banks, and economic conditions, generally revealed through economic reports.

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Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government’s central bank influences the supply and cost of money, which is reflected by the level of interest rates). Economic conditions include: Inflation levels and trends: Typically, a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency. Economic growth and health: Reports such as gross domestic product (GDP), employment levels, retail sales, capacity utilization and others, detail the levels of a country’s economic growth and health. Generally, the more healthy and robust a country’s economy, the better its currency will perform, and the more demand for it there will be. Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country’s currency. Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country’s currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nations economy. For example, trade deficits may have a negative impact on a nations currency. Political conditions Internal, regional, and international political conditions and cases can have a profound effect on currency marketplaces. For instance, political upheaval and instability can have a negative impact on a nation’s economy. The rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, cases in one country in a region may spur positive or negative interest in a neighboring country and, in the process, affect its currency.

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A Breakdown of the Forex Trading Day Unlike the futures and equities markets, the forex market trades actively 24 hours a day with active trading hours following the sun around the globe to each of the major money centers. As the foreign exchange market is an over the counter market where two counterparties can trade with each other whenever they want, technically the market never closes. Most electronic trading platforms however open for trading at around 5 PM Eastern Time on Sunday, which corresponds to the start of Monday’s business hours in Australia and New Zealand. While there are certainly banks in these countries which actively make markets in foreign exchange, there is very little trading done in these countries when compared to other major money centers of the world. The first major money center to open and therefore the start of the first major session in the forex market is the Asian Trading session which corresponds with the start of business hours in Tokyo at 7pm Eastern Time on Sunday. Next in line is the European trading session which begins with the start of London business hours at 2 AM Eastern Standard Time. While New York is considered by most to be the largest financial center in the world, London is still king of the forex market with over 32% of all forex transactions taking place in the city. As London is the most active session in the forex market it is also the session with the most volatility for all the currency pairs which we will be studying in this span of our interns. Last but not least is the US session which begins with the start of New York business hours at 8 AM Eastern Standard Time. New York is a distant second to London in terms of forex trading volumes with approximately 19% of all forex transactions flowing through New York Dealing Rooms. The most active part of the US Trading session, and the most active time for the forex market in general, is from about 8am to 12pm when both London and New York trading desks are open for business. You can see very large volatility during this time as in addition to both New York and London trading desks being open, most of the major US economic announcements are released during these hours as well. The trading day winds down after 12pm New York time with most electronic platforms closing for business at around 4 PM Eastern Standard Time on Friday.

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DERIVATIVES Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, foreign exchange, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the "underlying". In the Indian context the Securities Contracts (Regulation) Act, 1956 [SC(R)A] defines "derivative" to include1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2. A contract which derives its value from the prices, or index of prices, of underlying securities. Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A. The term derivative has also been defined in section 45U(a) of the RBI act as follows: An instrument, to be settled at a future date, whose value is derived from change in interest rate, foreign exchange rate, credit rating or credit index, price of securities (also called “underlying”), or a combination of more than one of them and includes interest rate swaps, forward rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign currency options, foreign currency-rupee options or such other instruments as may be specified by the Bank from time to time. DERIVATIVE PRODUCTS Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. We take a brief look at various derivatives contracts that have come to be used. Forwards: A forward contract is a customized contract between two parties, where settlement takes place on a specific date in the future at today's pre-agreed price. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that they are standardized and are generally traded on an exchange. Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given

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future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Swaps: Swaps are agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: • Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. • Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

HISTORY OF DERIVATIVES MARKETS Early forward contracts in the US addressed merchants' concerns about ensuring that there were buyers and sellers for commodities. However 'credit risk" remained a serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first 'exchange traded" derivatives contract in the US, these contracts were called 'futures contracts". In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME were, until recently the two largest organized futures exchanges, which have merged to become the “CME Group”. The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc.

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GROWTH DRIVERS OF DERIVATIVES Over the last three decades, the derivatives market has seen a phenomenal growth. A large variety of derivative contracts have been launched at exchanges across the world. Some of the factors driving the growth of financial derivatives are: 1. Increased volatility in asset prices in financial markets, 2. Increased integration of national financial markets with the international financial markets, 3. Marked improvement in communication facilities and sharp decline in their costs, 4. Development of more sophisticated risk management tools, providing a wider choice of risk management strategies, 5. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets, leading to higher returns, reduced risk and lower transactions costs as compared to individual financial assets. KEY ECONOMIC FUNCTION OF DERIVATIVES 1. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future prices. 2. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for risks. 3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. 4. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these types of mixed markets. 5. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefits of which are immense. In a nut shell, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.

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CURRENCY FUTURES A futures contract is a standardized contract, traded on an exchange, to buy or sell a certain underlying asset or an instrument at a certain date in the future, at a specified price. When the underlying asset is a commodity, e.g. Oil or Wheat, the contract is termed a “commodity futures contract”. When the underlying is an exchange rate, the contract is termed a “currency futures contract”. In other words, it is a contract to exchange one currency for another currency at a specified date and a specified rate in the future. Therefore, the buyer and the seller lock themselves into an exchange rate for a specific value and delivery date. Both parties of the futures contract must fulfill their obligations on the settlement date. Internationally, currency futures can be cash settled or settled by delivering the respective obligation of the seller and buyer. All settlements, however, unlike in the case of OTC markets, go through the exchange. Currency futures are a linear product, and calculating profits or losses on Currency Futures will be similar to calculating profits or losses on Index futures. In determining profits and losses in futures trading, it is essential to know both the contract size (the number of currency units being traded) and also what the “tick” value is. A tick is the minimum trading increment or price differential at which traders are able to enter bids and offers. Tick values differ for different currency pairs and different underlying. For e.g. in the case of the USD-INR currency futures contract the tick size shall be 0.25 paisa or 0.0025 Rupee. To demonstrate how a move of one tick affects the price, imagine a trader buys a contract (USD 1000 being the value of each contract) at Rs. 42.2500. One tick move on this contract will translate to Rs.42.2475 or Rs.42.2525 depending on the direction of market movement. Purchase price:

Rs.42.2500

Price increases by one tick: New price:

+Rs.00.0025 Rs.42.2525

Purchase price: Price decreases by one tick: New price:

Rs.42.2500 –Rs.00.0025 Rs.42.2475

The value of one tick on each contract is Rupees 2.50 (1000X 0.0025). So if a trader buys 5 contracts and the price moves up by 4 ticks, he makes Rupees 50.00 Step 1:

42.2600 – 42.2500

Step 2:

4 ticks * 5 contracts = 20 points

Step 3:

20 points * Rupees 2.5 per tick = Rupees 50.00

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FUTURES TERMINOLOGY • Spot price: The price at which an asset trades in the spot market. In the case of USD/INR, spot value is T + 2. • Futures price: The price at which the futures contract trades in the futures market. • Contract cycle: The period over which a contract trades. The currency futures contracts on the SEBI recognized exchanges have one-month, two-month, and three-month up to twelve-month expiry cycles. Hence, these exchanges will have 12 contracts outstanding at any given point in time. • Value Date/Final Settlement Date: The last business day of the month will be termed the Value date / Final Settlement date of each contract. The last business day would be taken to the same as that for Inter-bank Settlements in Mumbai. The rules for Inter-bank Settlements, including those for ‘known holidays’ and ‘subsequently declared holiday’ would be those as laid down by Foreign Exchange Dealers’ Association of India (FEDAI). • Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. The last trading day will be two business days prior to the Value date / Final Settlement Date. • Contract size: The amount of asset that has to be delivered under one contract. Also called as lot size. In the case of USD/INR it is USD 1000. • Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices. • Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures (in commodity markets) the storage cost plus the interest that is paid to finance or ‘carry’ the asset till delivery less the income earned on the asset. For equity derivatives carry cost is the rate of interest. • Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. • Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called marking-to-market. · Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

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RUPEE FUTURE RATIONALE BEHIND CURRENCY FUTURES Futures markets were designed to address certain problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. A futures contract is standardized contract with standard underlying instrument, a standard quantity of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. The standardized items in a futures contract are:    

Quantity of the underlying The date and the month of delivery The units of price quotation and minimum price change Location of settlement

The rationale for introducing currency futures in the Indian context has been outlined in the Report of the Internal Working Group on Currency Futures (Reserve Bank of India, April 2008) as follows; “The rationale for establishing the currency futures market is manifold. Both residents and nonresidents purchase domestic currency assets. If the exchange rate remains unchanged from the time of purchase of the asset to its sale, no gains and losses are made out of currency exposures. But if domestic currency depreciates (appreciates) against the foreign currency, the exposure would result in gain (loss) for residents purchasing foreign assets and loss (gain) for non residents purchasing domestic assets. In this backdrop, unpredicted movements in exchange rates expose investors to currency risks. Currency futures enable them to hedge these risks. Nominal exchange rates are often random walks with or without drift, while real exchange rates over long run are mean reverting. As such, it is possible that over a long – run, the incentive to hedge currency risk may not be large. However, financial planning horizon is much smaller than the long-run, which is typically inter-generational in the context of exchange rates. Per se, there is a strong need to hedge currency risk and this need has grown manifold with fast growth in crossborder trade and investments flows. The argument for hedging currency risks appear to be natural in case of assets, and applies equally to trade in goods and services, which results in income flows with leads and lags and get converted into different currencies at the market rates. Empirically, changes in exchange rate are found to have very low correlations with foreign equity and bond returns. This in theory should lower portfolio risk. Therefore, sometimes argument is advanced against the need for hedging currency risks. But there is strong empirical

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evidence to suggest that hedging reduces the volatility of returns and indeed considering the episodic nature of currency returns, there are strong arguments to use instruments to hedge currency risks. Currency risks could be hedged mainly through forwards, futures, swaps and options. Each of these instruments has its role in managing the currency risk. The main advantage of currency futures over its closest substitute product, viz. forwards which are traded over the counter lies in price transparency, elimination of counterparty credit risk and greater reach in terms of easy accessibility to all. Currency futures are expected to bring about better price discovery and also possibly lower transaction costs. Apart from pure hedgers, currency futures also invite arbitrageurs, speculators and those traders who may take a bet on exchange rate movements without an underlying or an economic exposure as a motivation for trading. From an economy-wide perspective, currency futures contribute to hedging of risks and help traders and investors in undertaking their economic activity. There is a large body of empirical evidence which suggests that exchange rate volatility has an adverse impact on foreign trade. Since there are first order gains from trade which contribute to output growth and consumer welfare, currency futures can potentially have an important impact on real economy. Gains from international risk sharing through trade in assets could be of relatively smaller magnitude than gains from trade. However, in a dynamic setting these investments could still significantly impact capital formation in an economy and as such currency futures could be seen as a facilitator in promoting investment and aggregate demand in the economy, thus promoting growth”. REGULATIONS SET BY RBI FOR CURRENCY TRADING  The membership of the currency futures market will be separate from that of the equity derivatives segment, RBI said  Only US dollar-rupee contracts with a size of $1,000 (Rs42,000) each will be allowed for trading. The contracts will be quoted and settled in the local currency with a maturity of not more than 12 months.  The membership of the currency futures market of an exchange will be separate from the membership of the equity derivatives segment or the cash segment, RBI said. Such an exchange will be subject to the guidelines of the capital market regulator.  The Bombay Stock Exchange, the National Stock Exchange and Multi-Commodity Exchange are in the race to set up the platform for such an exchange.  Currently, rupee currency futures are traded only on the Dubai Gold and Commodities Exchange.  Only a resident of India can participate in the trading and no other agency, including banks, can participate in the futures market without getting the approval of its concerned regulator.

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 A bank can become a trading or a clearing member of such an exchange provided it has capital and reserves worth Rs500 crore, 10% capital adequacy ratio, 3% or less net nonperforming assets and has a three-year profit record.  Sebi said the limit on the gross open positions of a trader in such contracts should not exceed $25 million or 15% of the total open interest, or total number of open contracts. For banks, however, the gross open position limit is $100 million, or 15% of the total open interest. NSE’S CURRENCY DERIVATIVES SEGMENT The phenomenal growth of financial derivatives across the world is attributed to the fulfillment of needs of hedgers, speculators and arbitrageurs by these products. In this part of report we look at contract specifications, participants, the payoff of these contracts, and finally at how these contracts can be used by various entities in the economy. PRODUCT DEFINITION RBI has currently permitted futures only on the USD-INR rates. The contract specification of the futures shall be as under: Underlying Initially, currency futures contracts on US Dollar – Indian Rupee (USD-INR) would be permitted. Trading Hours The trading on currency futures would be available from 9 a.m. to 5 p.m. From Monday to Friday. Size of the contract The minimum contract size of the currency futures contract at the time of introduction would be USD 1000. Quotation The currency futures contract would be quoted in Rupee terms. However, the outstanding positions would be in dollar terms. Tenor of the contract The currency futures contract shall have a maximum maturity of 12 months.

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Available contracts All monthly maturities from 1 to 12 months would be made available. Settlement mechanism The currency futures contract shall be settled in cash in Indian Rupee. Settlement price The settlement price would be the Reserve Bank of India Reference Rate on the last trading day. Final settlement day Would be the last working day (subject to holiday calendars) of the month. The last working day would be taken to be the same as that for Inter-bank Settlements in Mumbai. The rules for Interbank Settlements, including those for ‘known holidays’ and ‘subsequently declared holiday’ would be those as laid down by FEDAI (Foreign Exchange Dealers Association of India). In keeping with the modalities of the OTC markets, the value date / final settlement date for the each contract will be the last working day of each month and the reference rate fixed by RBI two days prior to the final settlement date will be used for final settlement. The last trading day of the contract will therefore be 2 days prior to the final settlement date. On the last trading day, since the settlement price gets fixed around 12:00 noon, the near month contract shall cease trading at that time (exceptions: sun outage days, etc.) and the new far month contract shall be introduced. The contract specification in a tabular form is as under:

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Difference between Currency Forward and Currency Future

Definition

Contract Size

Expiry Date

Currency Forward

Currency Future

A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time at an agreed price. Depending on the transaction and the requirements of the contracting parties. Mostly the minimum deal size is $250,000. Depending on the client’s needs

A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. Standardized i.e. $1,000/contract for dollar rupee.

Expiry date is 2 days before last working day of the month. Transaction Theses are OTC. Negotiated directly by Quoted and traded on the Exchange. method the buyer and seller. One of the parties is bank. Counter party Risk Bank will issue credit line/forward limit Party must deposit an initial margin. The only on suitable security offered by the value of the operation is marked to party. Profits and losses are cash market rates with daily settlement of settled at expiry. profits and losses. Method of pre- Forward contracts can be cancelled at Opposite contract on the exchange. termination: any point on the basis of the ongoing interbank prices. Profit or loss will be to client’s account. Institutional Party must have forward/credit limit Clearing House. Guarantee with the bank. Settlement Settled by physical delivery i.e. No physical delivery. Contracts are currencies are actually exchanged. usually closed prior to expiry by taking a compensating position. At expiry contracts can be cash settled. Market regulation Regulated under RBI/FEDAI guidelines. Government regulated market

CURRENCY DERIVATIVES TRADING SYSTEM The Currency Derivatives trading system of NSE, called NEAT-CDS (National Exchange for Automated Trading – Currency Derivatives Segment) trading system, provides a fully automated screen-based trading for currency futures on a nationwide basis as well as an online monitoring and surveillance mechanism. It supports an order driven market and provides complete transparency of trading operations. The online trading system is similar to that of trading of equity derivatives in the Futures & Options (F&O) segment of NSE.

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The software for the Currency Derivatives segment has been developed to facilitate efficient and transparent trading in Currency Derivatives instruments. Keeping in view the familiarity of trading members with the current F&O trading system, modifications have been performed in the existing F&O trading system so as to make it suitable for trading currency futures. During our training in UNICON we learnt to use another software also called as NOW (NEAT on Web.

Entities in the trading system There are four entities in the trading system. Trading members, clearing members, professional clearing members and participants. 1.

Trading members (TM): Trading members are members of NSE. They can trade either on their own account or on behalf of their clients including participants. The exchange

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assigns a trading member ID to each trading member. Each trading member can have more than one user. The number of users allowed for each trading member is notified by the exchange from time to time. Each user of a trading member must be registered with the exchange and is assigned an unique user ID. The unique trading member ID functions as a reference for all orders/trades of different users. This ID is common for all users of a particular trading member. It is the responsibility of the trading member to maintain adequate control over persons having access to the firm’s User IDs. 2. Clearing members (CM): Clearing members are members of NSCCL. They carry out risk management activities and confirmation/inquiry of participant trades through the trading system. 3. Professional clearing members (PCM): A professional clearing members is a clearing member who is not a trading member. Typically, banks and custodians become professional clearing members and clear and settle for their trading members and participants. 4. Participants: A participant is a client of trading members like financial institutions. These clients may trade through multiple trading members but settle through a single clearing member. Client Broker Relationship in Derivatives Segment A client of a trading member is required to enter into an agreement with the trading member before commencing trading. A client is eligible to get all the details of his or her orders and trades from the trading member. A trading member must ensure compliance particularly with relation to the following while dealing with clients: i. ii. iii. iv. v. vi. vii. viii. ix. x. xi. xii. xiii.

Filling of 'Know Your Client' form Execution of Client Broker agreement Bring risk factors to the knowledge of client by getting acknowledgement of client on risk disclosure document Timely execution of orders as per the instruction of clients in respective client codes. Collection of adequate margins from the client Maintaining separate client bank account for the segregation of client money. Timely issue of contract notes as per the prescribed format to the client Ensuring timely pay-in and pay-out of funds to and from the clients Resolving complaint of clients if any at the earliest. Avoiding receipt and payment of cash and deal only through account payee cheques Sending the periodical statement of accounts to clients Not charging excess brokerage Maintaining unique client code as per the regulations.

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Working with Reuters

During our summers along with now we were also provided with another software called as “Reuters”. This portal help us to monitor many things that we are not able to get on NEAT or NOW like forex news update and interbank spot rate of other global currencies. There are lots of things that we get on Reuters some are as below: Gives current Bid/Ask rate of different currencies  Graphs and technical analysis of different factors like NDF, Crude, exchanges, currencies, etc.  Latest news update from different areas like Forex, political, social, economics, etc  Give bid/ask quote for currency contracts  Give prices of different metals, and agricultural commodities  Give information of different currency indexes  Provide information of NDF, LIBOR,etc

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USES OF CURRENCY FUTURES Hedging: Presume Entity A is expecting a remittance for USD 1000 on 27 August 08. Wants to lock in the foreign exchange rate today so that the value of inflow in Indian rupee terms is safeguarded. The entity can do so by selling one contract of USDINR futures since one contract is for USD 1000. Presume that the current spot rate is Rs.43 and ‘USDINR 27 Aug 08’ contract is trading at Rs.44.2500. Entity A shall do the following: Sell one August contract today. The value of the contract is Rs.44,250. Let us assume the RBI reference rate on August 27, 2008 is Rs.44.0000. The entity shall sell on August 27, 2008, USD 1000 in the spot market and get Rs. 44,000. The futures contract will settle at Rs.44.0000 (final settlement price = RBI reference rate). The return from the futures transaction would be Rs. 250, i.e. (Rs. 44,250 – Rs. 44,000). As may be observed, the effective rate for the remittance received by the entity A is Rs.44.2500 (Rs.44,000 + Rs.250)/1000, while spot rate on that date was Rs.44.0000. The entity was able to hedge its exposure. Speculation: Bullish, buy futures Take the case of a speculator who has a view on the direction of the market. He would like to trade based on this view. He expects that the USD-INR rate presently at Rs.42, is to go up in the next two-three months. How can he trade based on this belief? In case he can buy dollars and hold it, by investing the necessary capital, he can profit if say the Rupee depreciates to Rs.42.50. Assuming he buys USD 10000, it would require an investment of Rs.4,20,000. If the exchange rate moves as he expected in the next three months, then he shall make a profit of around Rs.5000. This works out to an annual return of around 4.76%. It may please be noted that the cost of funds invested is not considered in computing this return. A speculator can take exactly the same position on the exchange rate by using futures contracts. Let us see how this works. If the INR- USD is Rs.42 and the three month futures trade at Rs.42.40. The minimum contract size is USD 1000. Therefore the speculator may buy 10 contracts. The exposure shall be the same as above USD 10000. Presumably, the margin may be around Rs.21,000. Three months later if the Rupee depreciates to Rs. 42.50 against USD, (on the day of expiration of the contract), the futures price shall converge to the spot price (Rs. 42.50) and he makes a profit of Rs.1000 on an investment of Rs.21,000. This works out to an annual return of 19 percent. Because of the leverage they provide, futures form an attractive option for speculators.

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Bearish, sell futures Futures can be used by a speculator who believes that an underlying is over-valued and is likely to see a fall in price. How can he trade based on his opinion? In the absence of a deferral product, there wasn't much he could do to profit from his opinion. Today all he needs to do is sell the futures. Let us understand how this works. Typically futures move correspondingly with the underlying, as long as there is sufficient liquidity in the market. If the underlying price rises, so will the futures price. If the underlying price falls, so will the futures price. Now take the case of the trader who expects to see a fall in the price of USD-INR. He sells one two-month contract of futures on USD say at Rs. 42.20 (each contact for USD 1000). He pays a small margin on the same. Two months later, when the futures contract expires, USD-INR rate let us say is Rs.42. On the day of expiration, the spot and the futures price converges. He has made a clean profit of 20 paise per dollar. For the one contract that he sold, this works out to be Rs.200. Arbitrage: Arbitrage is the strategy of taking advantage of difference in price of the same or similar product between two or more markets. That is, arbitrage is striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. If the same or similar product is traded in say two different markets, any entity which has access to both the markets will be able to identify price differentials, if any. If in one of the markets the product is trading at higher price, then the entity shall buy the product in the cheaper market and sell in the costlier market and thus benefit from the price differential without any additional risk. One of the methods of arbitrage with regard to USD-INR could be a trading strategy between forwards and futures market. As we discussed earlier, the futures price and forward prices are arrived at using the principle of cost of carry. Such of those entities who can trade both forwards and futures shall be able to identify any mis-pricing between forwards and futures. If one of them is priced higher, the same shall be sold while simultaneously buying the other which is priced lower. If the tenor of both the contracts is same, since both forwards and futures shall be settled at the same RBI reference rate, the transaction shall result in a risk less profit. Example – Let’s say the spot rate for USD/INR is quoted @ Rs. 44.325 and one month forward is quoted at 3 paisa premium to spot @ 44.3550 while at the same time one month currency futures is trading @ Rs. 44.4625. An active arbitrager realizes that there is an arbitrage opportunity as the one month futures price is more than the one month forward price. He implements the arbitrage trade where he; o Sells in futures @ 44.4625 levels (1 month) o Buys in forward @ 44.3250 + 3 paisa premium = 44.3550 (1 month) with the same term period o On the date of future expiry he buys in forward and delivers the same on exchange platform

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o In a process, he makes a Net Gain of 44.4625-44.3550 = 0.1075 o i.e. Approx 11 Paisa arbitrage o Profit per contract = 107.50 (0.1075x1000) The discrepancies in the prices between the two markets have given an opportunity to implement a lower risk arbitrage. As more and more market players will realize this opportunity, they may also implement the arbitrage strategy and in the process will enable market to come to a level of equilibrium. TRADING SPREADS USING CURRENCY FUTURES Spread refers to difference in prices of two futures contracts. A good understanding of spread relation in terms of pair spread is essential to earn profit. Considerable knowledge of a particular currency pair is also necessary to enable the trader to use spread trading strategy. Spread movement is based on following factors: o Interest Rate Differentials o Liquidity in Banking System o Monetary Policy Decisions (Repo, Reverse Repo and CRR) o Inflation Intra-Currency Pair Spread: An intra-currency pair spread consists of one long futures and one short futures contract. Both have the same underlying but different maturities. Inter-Currency Pair Spread: An inter–currency pair spread is a long-short position in futures on different underlying currency pairs. Both typically have the same maturity. Example: A person is an active trader in the currency futures market. In September 2008, he gets an opportunity for spread trading in currency futures. He is of the view that in the current environment of high inflation and high interest rate the premium will move higher and hence USD will appreciate far more than the indication in the current quotes, i.e. spread will widen. On the basis of his views, he decides to buy December currency futures at 47.00 and at the same time sell October futures contract at 46.80; the spread between the two contracts is 0.20. Let’s say after 30 days the spread widens as per his expectation and now the October futures contract is trading at 46.90 and December futures contract is trading at 47.25, the spread now stands at 0.35. He decides to square off his position making a gain of Rs. 150 (0.35 – 0.20 = 0.15 x $1000) per contract.

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HEDGING USING CURRENCY FUTURES Hedging: Hedging means taking a position in the future market that is opposite to a position in the physical market with a view to reduce or limit risk associated with unpredictable changes in exchange rate. A hedger has an Overall Portfolio (OP) composed of (at least) 2 positions: 1. Underlying position 2. Hedging position with negative correlation with underlying position Value of OP = Underlying position + Hedging position; and in case of a Perfect hedge, the Value of the OP is insensitive to exchange rate (FX) changes. Types of FX Hedgers using Futures Long hedge: • Underlying position: short in the foreign currency • Hedging position: long in currency futures Short hedge: • Underlying position: long in the foreign currency • Hedging position: short in currency futures

The proper size of the Hedging position • Basic Approach: Equal hedge • Modern Approach: Optimal hedge Equal hedge: In an Equal Hedge, the total value of the futures contracts involved is the same as the value of the spot market position. As an example, a US importer who has an exposure of £ 1 million will go long on 16 contracts assuming a face value of £62,500 per contract. Therefore in an equal hedge: Size of Underlying position = Size of Hedging position. Optimal Hedge: An optimal hedge is one where the changes in the spot prices are negatively correlated with the changes in the futures prices and perfectly offset each other. This can generally be described as an equal hedge, except when the spot-future basis relationship changes. An Optimal Hedge is a hedging strategy which yields the highest level of utility to the hedger.

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Hedging by Importers and Exporters: Before the introduction of currency futures, a corporate hedger had only Over-the-Counter (OTC) market as a platform to hedge his currency exposure; however now he has an additional platform where he can compare between the two platforms and accordingly decide whether he will hedge his exposure in the OTC market or on an exchange or he will like to hedge his exposures partially on both the platforms. Example 1: Long Futures Hedge Exposed to the Risk of Strengthening USD Unhedged Exposure: Let’s say on January 1, 2008, an Indian importer enters into a contract to import 1,000 barrels of oil with payment to be made in US Dollar (USD) on July 1, 2008. The price of each barrel of oil has been fixed at USD 110/barrel at the prevailing exchange rate of 1 USD = INR 39.41; the cost of one barrel of oil in INR works out to be Rs. 4335.10 (110 x 39.41). The importer has a risk that the USD may strengthen over the next six months causing the oil to cost more in INR; however, he decides not to hedge his position. On July 1, 2008, the INR actually depreciates and now the exchange rate stands at 1 USD = INR 43.23. In dollar terms he has fixed his price, that is USD 110/barrel, however, to make payment in USD he has to convert the INR into USD on the given date and now the exchange rate stands at 1USD = INR43.23. Therefore, to make payment for one dollar, he has to shell out Rs. 43.23. Hence the same barrel of oil which was costing Rs. 4335.10 on January 1, 2008 will now cost him Rs. 4755.30, which means 1 barrel of oil ended up costing Rs. 4755.30 - Rs. 4335.10 = Rs. 420.20 more and hence the 1000 barrels of oil has become dearer by INR 4,20,200.

Hedged: Let’s presume the same Indian Importer pre-empted that there is good probability that INR will weaken against the USD given the current macroeconomic fundamentals of increasing

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Current Account deficit and FII outflows and decides to hedge his exposure on an exchange platform using currency futures. Since he is concerned that the value of USD will rise he decides go long on currency futures, it means he purchases a USD/INR futures contract. This protects the importer because strengthening of USD would lead to profit in the long futures position, which would effectively ensure that his loss in the physical market would be mitigated. The following figure and Exhibit explain the mechanics of hedging using currency futures.

 Is short on USD 110000 in the spot market  Is long (buys) 110 USD/INR futures contracts

OIL IMPORTER  Buys back (sells) USD/INR futures contracts to square off transaction  Buys USD to meet import requirement in the spot market

Date

Spot Market

1-Jan-08

1-July-08

Futures Market

The current exchange rate is INR 39.41 per July USD contract is at INR 39.90. Price per USD, therefore the current cost of 1000 contract is INR 39,900 (39.90*1000). The appropriate number of contract is 110000/1000= barrel of oil in INR is Rs. 43,35,100 110. Buy 110 contract for 43,89,000. The spot rate is 43.23. Buy the 110000USD Sell 110 contracts at the prevailing rate of to import the oil. Cost in Rupees USDINR 43.72. Price per contract is INR 110000(43.23)=INR 47,55,300 43,720(43.72*1000), hence the value of 110 contract is INR 48,09,200

Analysis:The oil ended up costing INR 4755300-INR 4335100=INR 420200 more The profit on the future transaction is: INR 48,09,200 (Sale price of the Future) (INR 43,89,000) (less – Buy price of Future) INR 4,20,200 Profit on Future Return to Hedge:47,55,300 (Cash Purchase) 4,20,200 (Future gain)

43,35,100 (Return to hedge)

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Example 2: Short Futures Hedge Exposed to the Risk of Weakening USD Unhedged Exposure: Let’s say on March 1, 2008, an Indian refiner enters into a contract to export 1000 barrels of oil with payment to be received in US Dollar (USD) on June 1, 2008. The price of each barrel of oil has been fixed at USD 80/barrel at the prevailing exchange rate of 1 USD = INR 44.05; the price of one barrel of oil in INR works out to be is Rs. 3524 (80 x 44.05). The refiner has a risk that the INR may strengthen over the next three months causing the oil to cost less in INR; however he decides not to hedge his position. On June 1, 2008, the INR actually appreciates against the USD and now the exchange rate stands at 1 USD = INR 40.30. In dollar terms he has fixed his price, that is USD 80/barrel; however, the dollar that he receives has to be converted in INR on the given date and the exchange rate stands at 1USD = INR40.30. Therefore, every dollar that he receives is worth Rs. 40.30 as against Rs. 44.05. Hence the same barrel of oil that initially would have garnered him Rs. 3524 (80 x 44.05) will now realize Rs. 3224, which means 1 barrel of oil ended up selling Rs. 3524 – Rs. 3224 = Rs. 300 less and hence the 1000 barrels of oil has become cheaper by INR 3,00,000.

Hedged: Let’s presume the same Indian refiner pre-empted that there is good probability that INR will strengthen against the USD given the current macroeconomic fundamentals of reducing fiscal deficit, stable current account deficit and strong FII inflows and decides to hedge his exposure on an exchange platform using currency futures. Since he is concerned that the value of USD will fall he decides go short on currency futures, it means he sells a USD/INR future contract. This protects the importer because weakening of USD would lead to profit in the short futures position, which would effectively ensure that his loss in the physical market would be mitigated. The following figure and exhibit explain the mechanics of hedging using currency futures.

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 Is long on USD 80000 in the Spot market  Is short (sells) 80 USD/INR futures contracts

OIL REFINER  Buys back USD/INR futures contracts to square off transaction  Buys USD to meet import requirement in the spot market

Date

Spot Market

1-Mar-07

1-June-07

Futures Market

The current exchange rate is INR 44.05 per June USD contract is at INR 44.20. Price per USD, therefore the current cost of 1000 contract is INR 44,200 (44.20*1000). The appropriate number of contract he should sell is barrel of oil in INR is Rs. 35,24,000 80000/1000=80. Buy 80 contract for 35,36,000. The spot rate is 40.30. Receive80000USD Buy 80 contracts at the prevailing rate of for export of oil. Revenues in Rupees USDINR 40.45. Price per contract is INR 80000(40.30)=INR 32,24,000 40,450(40.45*1000), hence the value of 80 contract is INR 32,36,000

Analysis:The oil ended up gaining INR 35,24,000-INR 42,24,000=INR 3,00,000 less The profit on the future transaction is: INR 35,36,000 (Sale price of the Future) (INR 32,36,000) (less – Buy price of Future) INR 3,00,000 Profit on Future Return to Hedge:32,24,000 (Cash Sales) 3,00,000 (Future gain)

35,24,000 (Return to hedge) Example 3: Retail Hedging – Long Futures Hedge Exposed to the Risk of a stronger USD On 1st March 2008, a student decides to enroll for CMT-USA October 2008 exam for which he needs to make a payment of USD 1,000 on 15th September, 2008. On 1st March, 2008 USD/INR rate of 40.26, the price of enrolment in INR works out to be Rs. 40,260. The student has the risk that the USD may strengthen over the next six months causing the enrolment to cost more in INR hence decides to hedge his exposure on an exchange platform using currency futures.

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Since he is concerned that the value of USD will rise, he decides go long on currency futures; it means he purchases a USD/INR futures contract. This protects the student because strengthening of USD would lead to profit in the long futures position, which would effectively ensure that his loss in the physical market would be mitigated. The following figure and Exhibit explain the mechanics of hedging using currency futures.

Date

Spot Market

1-Mar-08

15-Sep-08

Futures Market

The current exchange rate is INR 40.26 per September USD contract is at INR 40.50. Price USD, therefore the current cost of 1000 USD per contract is INR 40,500 (40.50*1000). The appropriate number of contract is 1. Buy 1 in INR is Rs. 40,260 contract for 40,500. The spot rate is 46.00. Buy the 1000 USD to Sell 1 contracts at the prevailing rate of USDINR enroll for the program. Cost in Rupees 46.24, hence the value of contract is INR 46,240 1000(46.00)=INR 46,000 (46.24*1000)

Analysis:The enrolment ended up costing INR 46,000-INR 40,260=INR 5,740 more The profit on the future transaction is: INR 46,240 (Sale price of the Future) (INR 40,500) (less – Buy price of Future) INR 5,740 Profit on Future Return to Hedge:46,000 (Cash purchase) 5,740 (Future gain) 40,260 (Return to hedge) Example 4: Retail Hedging – Remove Forex Risk while Investing Abroad Let’s say when USD/INR at 44.20, an active stock market investor decides to invest USD 200,000 for a period of six months in the S&P 500 Index with a perspective that the market will grow and his investment will fetch him a decent return. In Indian terms, the investment is about Rs. 8,840,000. Let’s say that after six months, as per his anticipation, the market wherein he has invested has appreciated by 10% and now his investment of USD 200,000 stands at USD 220,000. Having earned a decent return the investor decides to square off all his positions and bring back his proceeds to India. The current USD/INR exchange rate stands at 40.75 and his investment of USD 220,000 in Indian term stands at Rs. 8,965,000. Thus fetching him a meager return of 1.41% as compared to return of 10% in USD, this is because during the same period USD has depreciated by 7.81% against the INR and therefore the poor return. Consequently, even after gauging the overseas stock market movement correctly he is not able to earn the desired overseas return because he was not able to capture and manage his currency exposure. Let’s presume the same Indian investor pre-empted that there is good probability that the USD will weaken given the then

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market fundamentals and has decided to hedge his exposure on an exchange platform using currency futures. Since he was concerned that the value of USD will fall he decides go short on currency futures, it means he sells a USD/INR futures contract. This protects the investor because weakening of USD would lead to profit in the short futures position, which would effectively ensure that his loss in the investment abroad would be mitigated. The following figure and Exhibit explain the mechanics of hedging using currency futures.

 Is long on USD 200000 in the Spot market  Is short (sells) 199 USD/INR futures contracts

STOCK INVESTER  Buys back USD/INR futures contracts to square off transaction  sells USD the spot market

Leg Leg 1

Leg 2

Spot Market

Futures Market

The current exchange rate is INR 44.20 per USDINR contract is at INR 44.50. Price per contract USD, therefore the current investment of is INR 44,500 (44.50*1000). The appropriate number USD 200000 in INR is Rs. 88,40,000 of contract he should sell is 88,40,000/44,500=199. Buy 199 contract for 88,55,500. The spot rate is 40.75. Receive 220000 USD Buy back 199 contracts at the prevailing rate of for his investment. Revenues in Rupees USDINR 41.05. Price per contract in INR 41,050 220000(40.75)=INR 89,65,000 (41.05*1000), hence the value of 199 contract is INR 81,68,950

Analysis:The enrolment ended up gaining INR 97,24,000-INR 89,65,000=INR 7,59,000 less The profit on the future transaction is: INR 88,55,500 (Sale price of the Future) (INR 81,68,950) (less – Buy price of Future) INR 6,86,550 Profit on Future Mitigating foreign risk – Fetching comparable stock market return 89,65,000 (Stock proceedings) 6,86,550 (Future gain) 96,51,550 (Return to hedge)

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Example 5: Retail Hedging – Remove Forex Risk while Trading in Commodity Market Gold prices on Exchanges in India have a very high correlation with the COMEX gold prices. That is, Indian gold prices decrease with the decrease in COMEX prices and increase with the increase in COMEX prices. But it doesn’t mean the increase and decrease will be same in Indian exchanges in percentage terms as that in COMEX. This is because in both the markets the quotation is in different currency, for COMEX gold is quoted in USD and in India gold is quoted in INR. Hence any fluctuation in USD/INR exchange rate will have an impact on profit margins of corporates/clients having positions in Indian Gold Futures. By hedging USD/INR through currency futures, one can offset the deviation caused in COMEX and Indian prices. The following example explains the same. Let’s say with gold trading on COMEX at USD 900/Troy Ounce (Oz) with USD/INR at 40.00, an active commodity investor, realizing the underlying fundamentals, decides that it’s a good time to sell gold futures. On the basis of this perspective, he decides to sell 1 Indian Gold Future contract @ Rs. 11,580/10 gm Let’s say after 20 days, as per his expectation, gold prices did decline drastically on COMEX platform and gold was now trading at USD 800/oz, a fall of 11.11%. However, in India gold future was trading @ Rs. 11,317/10 gm, which is a profit of 2.27%. This is because during the same period the INR has depreciated against the USD by 10% and the prevalent exchange rate was 44.00. Had the USD/INR exchange rate remained constant at 40.00, the price after 20 days on the Indian exchange platform would have been Rs. 10,290 and thus profit realization would have been the same 11%. Let’s presume the same Indian investor pre-empted that there is good probability that the INR will weaken given the then market fundamentals and has decided to hedge his exposure on an exchange platform using currency futures. Since he was concerned that the value of USD will rise, he decides go long on currency futures, it means he buys a USD/INR futures contract. This protects the investor because strengthening of USD would lead to profit in the long futures position, which would effectively ensure that his loss in the commodity trading would be mitigated.

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Fundamental Analysis of Rupee Till now we had discussed about what is FOREX market, what we understand by Derivative market, and many other uses and ways of investment. As we proceed further I want to see some other dimensions of rupee. As we trade in the global environment so we cannot ignore the facts that there are many different factors that affect our value of rupee and show a behavioral trend with rupee. Positives for rupee in longer duration 1. Stable government in India 2. Falling dollar index 3. Rising equity and commodity markets 4. China’s diversification into gold, other commodities 5. Heavy foreign flow into India Negatives for rupee in short term 1. Rising crude oil prices 2. Fiscal deficit in India 3. RBI likely intervention around 46.8-47 to protect exporters. 4. SMO (Special market Operation) window shutdown 5. Overbought equity and commodity market, any significant fall means potential dollar outflow 6. Crucial technical multiple support around 47 Some of the factors that should be taken in account which directly or indirectly affect the movement of rupee are as below: Dollar  EURO  Crude oil  Equity These are some major factors in the global market that affect the value of rupee. We will discuss them one by one.

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INR and CRUDE:Crude plays a major role on the value of rupee it is one of the crucial element in the global market and use to effect all the currencies trading in the global market. As crude oil work as the main factor which drives all the industries and other major sectors of any country that’s why it becomes the major factor. Rising crude oil prices Rising crude oil prices increases the import bills & since India imports 70% of the energy requirement – any increase in crude oil prices will certainly raise demand for dollar. As every industry and sector need crude they have to import crude at higher prices so they will demand more dollar and thus because of the demand supply relationship the prices of dollar will increase and rupee will become weaker in respect of dollar. For e.g. At $50 a barrel – import bill amounts to $ 26.25 bln & at $ 70 a barrel it will swell to $ 36.8 bln. Given the rising trend in crude oil prices, which is expected to be at $ 70 a barrel – India import bill is likely to jump by $ 5.3 bln. Thus, rising crude oil price can be a deterrent. However, SMO facility by RBI extended to oil companies have helped in facilitating dollar demand without exerting pressure on INR. The graph below shows the prices of crude and rupee from 26th June, 2008 to 26th June 29, 2009. The red line shows the spot price of rupee and the black line shows the price of crude for the same period.

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There are two school of thought on the effect of crude oil prices on the value of the USD and Euro and hence subsequently on the INR. One school of thought espouses that since crude is denominated in dollars, when oil prices rise, the demand of USD increases and hence Euro/INR will depreciate. This is seen from the above graph. We can easily see the relationship between rupee and crude they are negatively correlated. If the price of crude is increasing we can see fall in the exchange rate of rupee and rupee will get worse in comparison to US dollar. Increasing price of crude in India will lead to more demand of dollar and increasing supply of rupee this demand supply effect will enhance the price of dollar in the market and will lead to decline in the worth of rupee. Increase in the prices of crude has a immediate effect on the spot rates of INR and the prices of dollar they are directly related to each another and effect each other’s value in the market. The second school of thought states that the demand for crude oil increases when the economy is doing well. At times like these investors will remove money from low yielding currencies (like the USD) and invest them in higher yielding currencies (like the INR). The final relation between crude oil prices and INR is an interplay of the above two schools of thoughts. Hence it is very difficult explicitly state a clear selection that holds true under all circumstances.

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INR and Stock Market:-

Rupee and stock market are directly correlated with each another if the sensitive index is moving up we will see upward moment in rupee as because of improvement in the companies value and goodwill in the market. More and more people start investing in the companies stocks and there will also be a huge amount of capital inflow from the global investors which will rise the demand of rupee in the county’s local exchange market. In the graph below we can see the trend of sensitivity index of BSE (Bombay Stock Exchange) which is called SENSEX and the fluctuations in the spot value of INR or rupee. This graph includes the trend of the sensitivity index and rupee from 26th June, 2008 to 26th June 29, 2009. The continues upward moment of Sensex has resulted to an upward moment in the price of the Rupee (INR) and made it much stronger in the comparison of US Dollar which we can clearly figure out. Both show a proportionate relationship moment of any of these two elements will result the same directional moment in the other factor.

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INR and US Dollar:Indian rupee is quoted in dollar terms this relation of rupee and dollar makes it more dependent on each other. There is a relationship seen in dollar and major currencies of world, if dollar is falling against Euro or against Euro or Yen then it will fall against another major currencies. On the basis of dollars value with other currencies there is a dollar index which is prepared. And this predicts the dollar value worldwide that how it is performing and also how it is fluctuating. This index is calculated by factoring in the exchange rates of six major world currencies: The euro, Japanese yen, Canadian dollar, British pound, Swedish kroner and Swiss franc. In the graph below we can see the trend of dollar index and rupee value from 26th June, 2008 to 26th June 29, 2009. This graph shows the dollar trend among the other currencies in the world which is being denoted by the black line and the red line shows the ups and downs seen by the rupee. We can directly figure out the relationship between dollar index and rupee over here when the dollar index get stronger the rupee is getting weak and when the rupee get stronger the dollar index is falling so the relation is dollar and rupee is inversely proportionate to each another. In other words, when the dollar index goes up rupee falls and when the rupees value in terms of dollar appreciates the dollar index comes down. By this relationship it is clear that because the rupee is quoted in the dollar terms they become inversely correlated to each other.

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INR and EURO:Euro is one of the major currencies in the global Forex market and it is quoted in the terms of dollar. On the other hand rupee is not directly related to euro but is somehow because of being quoted against common currency euro moment effect rupee also. If dollar is getting weak in relation to euro most of the times it will also fall in relation with rupee and this type of indirect relation make rupee dollar pair predictable by the move in the euro dollar currency pair. In the graph below we can see the trend of Euro and rupee value from 26th June, 2008 to 26th June 29, 2009. From this graph we can easily figure out that how the both currency pairs are related. When we see euro at stronger position we can also see that rupee is showing recovery sign against its base currency which is dollar. Dollar being the common in both currency pair makes them interrelated to each another. There is also one more factor which makes these pairs so closely related to each other. Euro and rupee both are high yielding currency so if there is a flow in market towards high yielding currency from low yielding currency like dollar the demand of that currency increase and we see and the similar kind of moment in both currency pairs.

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Putting Theory to Practice at Unicon During our summer at unicon we come to know about different aspects of the currency derivative market. Starting of our internship had provided us with a sound understanding of how the derivative and forex market work. We were told about what all are the different participates in the market also with the exposure to the different factors effecting the interbank and global foreign exchange market. From introduction to the practical experience we were told about each and every aspect that how the things function and how they all affect each another. All our needs were properly catered and from hard skills to soft skills we had got a good exposure of all the important aspects about how to sustain and perform in any organization. At the end of the day I will like to mention our major learning at unicon: Provided by sound knowledge of financial markets and how they function.  Different factors and participates in the forex and derivative markets.  What all are the things that directly or indirectly affect these markets.  How to interpret and predict the flow of markets with the help of different factors.  Understanding different uses of the currency futures and practical demonstration.  Meeting with Importers, Exporters, Commodity players, offshore investors, Speculators, Investors, etc.  Understanding the needs of different class of investor and catering them with right investment pattern.  We had also provided the opportunity to use the NOW (NEAT on Web) currency portal under the guidance of members of currency trading team.  We were told that how different positions are taken in relation with different factors and how these factor affect their decision.  We were also told about what all are the contract specifications of the market and how different service providers regulate this market.  How proper mix of theory and practical is being done in the global financial market and how investors and brokerage houses use them. At the end of the day, I want to conclude that the experience and exposure we got in unicon was outstanding. Getting such kind of guidance had helped us to develop profound knowledge of the market. With the blend of hard and soft skills that I had experienced in unicon it will be very helpful to us in coming future and will work like a light house in any organization.

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Conclusion

Derivatives play a two-fold role in the economy. They provide a useful role in hedging and risk management so as to facilitate capital flows to developing economies. At the same time, however, they create the conditions for the possibility for raising risk in relation to capital through leveraging and by dodging prudential regulatory safeguards. They can also make fixed exchange rate systems less stable, and then later quicken the pace and deepen the impact of devaluation once it occurs. This functions to increase the systemic risk in financial markets and raises the possibility of spreading contagion amongst economies. In the wake of the crisis they can make the process of post-crisis recovery policy making even more difficult. After studying about the different aspects of the forex and currency futures market I had get known the different trade opportunities which this market is providing to the Indian investors. In future currency futures is going to be one of the most important investment in major investor’s portfolios. There lie a huge chunk of market to be explored in this segment and most of the benefiters are not aware about the basis of this market there is a need of proper steps to be taken by the SEBI and NSE enhance the understanding of this instrument in the mind of investors, exporters and importers. Derivatives markets, both exchange traded and over-the-counter, must become more transparent by reporting requirements for transactions (price, volume and contract type), open interest (especially large open positions) and collateral and margin standards. Overall, the implication for regulatory policy is that derivatives regulations must contain provisions that shape the structure of the incentives for derivatives trading so that they will be used in proper ways to facilitate capital flows without their being used in destructive ways to increase risk-tocapital and out-maneuvering government safeguards.

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Bibliography Websites: www.informedtrades.com  www.wikipedia.com  www.bloomberg.com  www.marketwatch.com  www.nism.ac.in  www.way2wealth.com  www.useindia.com  www.netdania.com  www.dailyfx.com Reference Books: Options, Futures and other derivatives Author -- Jhon C. Hull  Derivatives Simplified - An Introduction To Risk Management Author -- P Vijaya Bhaskar and B Mahapatra  Day trading the currency market Author--- Kathy lien  Currency futures Author -- Glenlake and Fitzroy Dearnborn  Currency Trading for Dummies Author—Mark Galant and Brian Dolan

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Glossary:Agent bank A bank, either a local bank or a foreign bank branch, that acts on behalf of a foreign investor’s $custodian (entity that performs custody services). Asset-backed security A security whose payments are linked to a portfolio of assets such as receivables. Bid-ask spread The difference between the best bid price and the best ask price for a security at a given time. Broker A broker acts as an intermediary between buyers and sellers of derivatives or securities, effectively channeling orders to the market for execution and charges a commission for this service. Broker-dealer A broker also acting as buyer or seller to transactions and thus becoming a principal party to a deal (often in the form of market making). In the OTC derivatives segment, broker-dealers usually act as counterparty to end customers. As the broker-dealer – usually a large universal or investment bank – also assumes principal risk, commissions are higher than for pure brokerage. Cash settlement The final settlement of a contract by the payment or receipt of a cash amount. Central counterparty (CCP) Legal entity that acts as an intermediary between the parties to a securities or derivatives trade and is the seller to every buyer and the buyer to every seller, minimizing the default risk and facilitating netting, without revealing the buyer’s or seller’s identity. Clearing In the case of derivatives, the management of open derivatives positions including their netting. Termination of derivatives contracts is also part of derivatives clearing involving the establishment of final positions for settlement. Mitigating the counterparty risks on open derivatives positions is the most important aspect of derivatives clearing. As derivatives contracts can have very long lives, clearing plays a crucial role in the derivatives value chain and is considerably more complex than e.g. the clearing of cash equities. Clearing margin Margin posted by a member of a clearing house.

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Collateral Financial or other tangible assets pledged by a borrower to secure an obligation. If the borrower defaults, the collateral is used to fulfill the obligation. Collateralization The use of collateral to secure a transaction. Collateralization plays an important role to cover counterparty risk, e.g. in the on-exchange segment, collateral is pledged to CCPs. Collateralized debt obligation (CDO) A security whose payments are linked to a portfolio of debt. Usually several classes (or tranches) of securities with different returns are created from a debt portfolio. Repayment for these classes differs in the case of borrowers in the portfolio defaulting on their debt. As securities, CDOs have to be differentiated from derivatives (contracts). Collateralized loan obligation (CLO) A CDO whose payments are linked to a portfolio of loans. As securities, CLOs have to be differentiated from derivatives (contracts). Corporate An industrial company or non-financial services firm. Counterparty The opposite party to a financial transaction. Normally the counterparty of the buyer of a contract is the seller of that contract. In the case of CCP-cleared derivatives, the clearing house acts as the central counterparty to each party to a transaction, thereby removing counterparty risk from the members. Counterparty risk The risk that a counterparty to a (derivatives) contract defaults and cannot (completely) fulfill its contractual obligations. Credit default swap (CDS) A derivatives contract to transfer the credit risk of underlying debt instruments (mostly bonds or loans). A CDS buyer receives credit protection. In the case of default, he or she will be compensated by the CDS seller (the seller either has to buy the debt instrument at its face value or has to pay the difference between value in the case of default and face value). In return for the credit protection, the seller receives periodic payments from the CDS buyer. Exercise Calling for the fulfillment of an obligation arising from an options contract. If the option buyer exercises a call (put) option the seller must sell (buy) the underlying at the price specified in the options contract. So-

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called American options can be exercised during the whole life of the contract. European options can only be exercised at maturity. Exotic derivative A nonstandard derivative with e.g. an unusual pay-off structure. Exotic underlying A nonstandard underlying to a derivatives contract such as weather indicators, freight rates or economic indicators (e.g. the unemployment rate). Expiration End of maturity of warrants and options. Also known as the expiry, or expiry date. Forward (contract) A derivatives contract for the delivery or receipt of a specifi c amount of an underlying, at a set price, on a certain date in the future. Future (or futures contract) A standardized derivatives contract for the delivery or receipt of a specific amount of an underlying, at a set price, on a certain date in the future. Futures are traded in the derivatives market. Gross market value The aggregate market value of several derivatives contracts calculated by summing up the positive market value one side of each contract has. Hedging The use of derivatives to reduce or protect against risk. Interdealer-broker An intermediary facilitating transactions between different ( broker-)dealers in the OTC segment. In the derivatives market, the interdealer-broker segment has gained significantly in importance in recent years and is now – in terms of revenues – almost as large as the exchange segment. International central securities depository (ICSD) A CSD that settles trades in international securities and various domestic securities, usually through direct or indirect (through local agents) links to local CSDs. In the derivatives arena ICSDs only provide their services in the rare case of physical settlement. Legal risk The risk that claims resulting from a derivatives contract are legally disputed and cannot be enforced.

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Limit order Buy or sell orders, which are to be executed at their specified limit or better. Liquidity risk The risk that a derivatives contract cannot be unwound at its fair value due to a lack of sufficient supply/demand in the market. Margin deposit Cash or securities deposited with a clearing house by trading parties of exchange traded derivatives contracts. Margin deposits serve to protect the clearing house in case of the default of trading parties. The amount of margin required is calculated in relation to the market risk exposure of each trading party and covers the risk of adverse price changes that devalue the trading position. Market maker A financial intermediary that offers to buy and sell securities or derivatives by providing quotes on a continuous basis. Thereby it is assured that parties wanting to trade find a counterparty and liquidity is ensured. Large universal and investment banks often act as market makers ( broker-dealer). Market risk The risk that the price of a derivative changes because the price of the underlying changes. Participants in the derivatives market want market risk exposure. Maturity (maturity date) The date on which the final obligations defined in a derivatives contract are due. Mortgage-backed security (MBS) A security whose payments are linked to a portfolio of debt. As securities, MBSs have to be differentiated from derivatives (contracts). Notional amount Value or nominal amount of the underlying of a derivatives contract. Open interest Open derivatives positions either measured in terms of contracts or in terms of value. Operational risk The risk that deficiencies in information systems or internal controls, human error, or management failure result in unexpected losses.

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Option (or options contract) A derivatives contract giving the buyer the right to buy (call) or sell (put) a specific quantity of a specific underlying, at a fixed price, on, or up to, a specified date. The seller is obliged to deliver or accept the asset, when the option is exercised ( exercise). Order A contractually binding request to other market participants to buy or sell a specific quantity of a financial instrument at a defined price. Order book Contains all current orders for a certain product at a derivatives exchange or an OTC trading platform. Over the counter (OTC) Bilateral transactions between (two) trading parties that are not conducted on a regulated exchange. In the derivatives market, the over-the-counter segment is by far the largest part of the market. Payment and delivery In the case of derivatives, the sole payment of cash to fulfill the obligation arising from a derivatives contract ( cash settlement) or the payment of cash for an underlying and the delivery of the underlying in return ( physical delivery). Physical delivery The settlement of a transaction through delivery of the underlying against payment. Pre-trading The gathering of orders from trading parties and the channeling of these orders to the market. In both the OTC and the exchange segment this function is mostly fulfilled by brokers and broker-dealers. Quote The simultaneous entry of a limit buy and limit sell order for a derivatives product at an exchange or another electronic marketplace. Market makers provide quotes effectively establishing a market in a product. Regulatory capital The capital that banks must maintain according to certain statutory rules (often based on the BIS’ capital standards). The amount of regulatory capital required depends on the riskiness of the bank’s assets. A bank active in the derivatives market must maintain certain regulatory capital to cover part of the exposure (mostly in the form of counterparty risk) from its open positions.

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Security An investment instrument, which offers evidence of debt or equity usually issued by a corporation, government or other organization. Settlement ---- payment and delivery. Straight-through processing (STP) In the case of derivatives, the fully automated, electronic handling of derivatives orders, contracts and open positions across all functions and providers along the derivatives value chain. Swap (contract) A derivatives contract under which the two counterparties agree to exchange cash flows at future dates as stipulated in the contract. Systemic risk The risk that the failure of one market participant has adverse effects on other participants, destabilizing the market as a whole. Underlying The financial instrument, physical asset or variable upon which a derivatives contract is based. Warrant A securitized form of a standardized option. Warrants are almost exclusively traded by retail investors on specialized exchanges such as Scoachor Euwax.

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List of Abbreviations

AG

Aggregate Gap

CAD

Canadian Dollar

CBOT

Chicago Board of Trade

CM

Clearing Member

CME

Chicago Mercantile Exchange

CRAR

Capital Risk Adjusted Ratio

CRR

Cash Reserve Ratio

DP

Depository Participant

ETCF

Exchange Traded Currency Futures

FEDAI

Foreign Exchange Dealers Association of India

FEMA

Foreign Exchange Management Act

FIFO

First-in First-out

FII

Foreign Institutional Investor

FX

Foreign exchange

GBP

Great Britain Pound

GDP

Gross Domestic Product

ICAI

Institute of Chartered Accountants of India

INR

Indian Rupee

IOC

Immediate or Cancel

KYC

Know Your Customer

LTP

Last Traded Price

MTM

Mark-to-Market

NOP

Net Open Position

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NPA

Non Performing Assets

NRI

Non-resident Indian

OTC

Over-the-Counter

PAN

Permanent Account Number

PCM

Professional Clearing Member

Pro/Cli

Proprietary order / Client order

RBI

Reserve Bank of India

SC(R)A

Securities Contracts (Regulation) Act, 1956

SDR

Special Drawing Rights

SEBI

Securities and Exchange Board of India

SPAN

Standard Portfolio Analysis of Risk

STT

Securities Transaction Tax

TCM

Trading-cum-Clearing Member

TM

Trading Member

TWS

Trader Workstation

UCC

Unique Client Code

USD

Us Dollar

USD/INR

US Dollar – Indian Rupee Forex Transaction

VaR

Value-at-Risk

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