CURRENCY

FUTURES
Spot : Immediate delivery but standard convention is T+2 days
(an exception is USDCAD which has T+1)
Types of Spot
Value Cash : Trade day / Same day
Value Tom : Trade date + 1 (tomorrow)
Spot : Trade date + 2

Forward / Outright Forward = anytime greater than Spot
Any rate other than Spot rate is based/referenced on Spot Rate

Base Currency / Term Currency
USD INR
Base/Denominator Term / Numerator

Quotation is for BASE CURRENCY always
How much Term Currency is required to buy 1 Base Currency
How much Term Currency can you buy with 1 Base currency

Introduction to Currency Markets
Introduction to Currency Markets..
Strengthening Weakening
Appreciation Depreciation
Costlier Cheaper
For 2 parts of a currency pair they go opposite

45.0000 USD INR
47.0000 Strong/appreciate Weak/depreciate
42.0000 Weak/depreciate Strong/appreciate

Swaps:
Simultaneous purchase / sale of currency
Facilitate funding in currency other than the one you have
Each party gets to use a foreign currency for a specific time
Liquidity in one currency is converted into another for a period of time
US Dollar Index Designed to show movement against major currencies Euro, GBP and Yen
Currency rates can impact:
Consumer prices
Investment decision
Interest rates
Economic growth
Location of industry
US Dollar is the most traded currency
It is used as :
Investment currency : capital markets
Reserve currency : Central Banks
Transaction Currency : International commodity markets
Invoice currency : contracts
Intervention currency : Monetary authority intervention
Vehicle currency : to trade two illiquid currencies (Euro has emerged)

Want to convert INR to Pesos
Sell INR for USD & the Buy Pesos for the USD
Two transactions, but better control and liquid
Less number of currencies to maintain and research
Reduces number of exchange rates to be maintained
Eg: 10 currencies 9 pairs / 45 pairs
Reason for USD role as Vehicle currency Bretton Woods par value system

Second major currency : Euro
Third major currency : Yen
British pound GBP : Only until WWII, also known as Cable
Swiss Franc : Does not belong to EMU / G7 countries
Learn to read the currency table

Factors affecting exchange rate : interest rates, inflation & GDP
Indicators of strong economy result in appreciation of currency against others
Foreign Exchange Derivatives
Every derivative product has to have a Bases / Underlying
Price of any derivative is driven by the Spot price of the underlying
SCRA 1956 defines derivative
Derivatives are securities under SCRA and hence governed by SCRA i.e. SEBI
Derivatives also defined in Sec 45U(a) of RBI Act
Under RBI Act derivatives include instruments on Foreign Exchange

Derivative products emerged as hedge against commodity prices
Commodity linked derivatives were most prominent for almost 300 yrs
Financial derivatives in spot light post 1970
Financial derivatives became prominent (2/3 of all transactions ) by 1990
Types of Derivative Products:
Forwards: Customized contract
Futures : forward contract that is standardized and traded on an exchange
Options :
Warrants : long dated option contracts traded in OTC
LEAPS : Long dated options traded on exchange


Market players:
Hedgers-to lower or eliminate risk
Speculators-bet on future movement with leverage
Arbitrageurs-mispricing/discrepancy in prices
Key economic functions:
Prices of derivative converge with prices of underlying at expiration
Derivatives help in discovery of future prices
Derivatives help in transferring RISK
Derivatives help in increasing volumes in underlying market

Forward contracts brought buyer and seller to the market
Forwards still carried Credit Risk
Hence Futures contracts were introduced on Exchanges
CME & CBOT the largest exchanges. Now merged to form CME group.

Derivatives traded on Exchange are called Exchange Traded Derivatives
Privately negotiated derivatives are called OTC Derivatives (Over The Counter)
Out of the two, Exchange Traded Derivatives have rigid structure
OTC markets have the following feature:
Management of counter party / credit risk is not centralised
No formal limits, positions, leveraging , margining etc
No formal rules for risk sharing
No rules for market stability and integrity
No formal regulators generally

Problems in OTC:
Dynamic exposure
Information asymetry
High concentration of activity with small number of institution

Rapid asset price change / counterparty credit failures pose systemic risk


Exchange Traded Currency Futures
Currency Futures:
Standardised contract
Traded on exchange
Contract to buy/sell certain qty of underlying
Underlying is an exchange rate between 2 currencies
At a certain future date
At a certain decided price
Locking a certain exchange rate in case of currency futures
Settlement can be cash or delivery
Always routed thru the Exchange
Linear product

Tick Size : MINIMUM trading increment allowed
Tick size movement : 47.0025 47.0050 47.0075
Value of tick size = tick size * contract size
Rs 2.5 = Rs 0.0025 * 1000
Bought 5 contracts and price moved 4 ticks = Profit /loss is 5 * 4 * 2.5 = Rs 50
Future Terminology:
Spot price : spot market price / the price for T+2 day settlement
Future price : price of futures contract
Contract cycle : 12 monthly contracts
Value date/ Final settlement date : date of final settlement ( last business day of month)
Expiry date : last trading day (two business days prior to value date)
Contract Size : 1000 USD in case of USD INR
Basis : Futures price Spot price. Normally positive. i.e. Futures price is generally HIGHER than spot
Cost of carry : spot price + storage cost + interest cost earning from asset.
Initial Margin :
Marking to Market (MTM) : Adjustment to margin a/c at day end based on daily settlement price

Why Currency Futures:
To overcome problems in Forward Market
Contracts are standardized for underlying, quantity, timing of settlement, location of settlement, units of price
Improves liquidity

Advantage: price transparancy, no counterparty risk, easy reach, better price discovery, lower transaction cost
CME created first ever FX futures in 1972
FX derivatives could emerge due to the abondonment of Bretton Woods agreement

Interest Rate Parity:
Price of future is dependent on spot rate & difference in interest rate in both currencies

If interest rate in US is 1%
Interest rate in India is 6%
USD INR rate today is 50.0000
What will be USD INR rate one year future price

Calculation based on bringing USD on loan in India and investing. Price of one year future should not leave
any arbitrage opportunity

Always use Continuous componding formula F = S * e ^( (r-p) *t)
50 * e ^ (.06-.01) * 1
50 * 1.05 = 52.5634
by heart e = 2.7182
first find out the value of what ever is raised to the power of e separately
type 2.7182
click x^y
type the value derived above
the result should be multiplied by spot price
Strategies using Currency Futures
Hedgers look to manage / transfer risk
Speculators look to take risk
Both are required for a healthy liquid market
Speculation is not similar to manipulation
Manipulator pushes prices in reverse of market equilibrium
Long Future Position :
Buying while expecting price to rise
Buying without underlying position is speculative long

Short Future Position:
Selling while expecting price to fall
Selling without underlying position is speculative short

Hedging:
Taking opposite positions in spot & futures market to reduce risk OR lock prices
Hedger has an Overall Portfolio (OP) of atleast 2 positions
1 underlying position
2 Hedging position with counter effect of 1 position

Trading
Underlying : rate of USD / INR
Contract size: 1000 USD
Tick size : Rs 0.0025
Price Bands : not applicable
12 monthly contracts max 1 year
Expiry / last trading day : 2 days before last day of month
Settlement days : daily MTM T+1 final settlement T+2
Settlement price : daily MTM closing price of future contract; final settlement at RBI ref rate on last trading day
Settlement method : cash settled
Market time : 9 to 5 pm

Base price : on first day its theoretical future price
: on other days its the daily settlement price
Closing Price : Last half hour weighted average price for the contract AND If not traded at all or not
traded in half hour then THEORETICAL price

OHLL : Open, High, Low & LTP is continuously disseminated


Entities:
Trading Member (TM)
Members of recognized stock exchange
Trade on own behalf (proprietary) or for Client including Participant
Exchange assigns TM ID to each member
Can have more than one user, each user has unique ID
Members responsible for control over all user ids
Clearing Member (CM)
Member of the clearing corporation
Manage risk and confirm Participant trades
Trading Cum Clearing Member (TCM)
Can trade as well as clear self and other members trades
Professional Clearing Member (PCM)
No right to trade only clearing function
Participants
Type of client like a financial institution
Trade through multiple TM but clear through single CM



Clearing, Settlement & Risk Management
Clearing Corporation (CC) undertakes clearing & settlement
Acts as legal counter party to all trades
This is called NOVATION
Guarantees financial settlement

Clearing & Settlement includes:
1. Clearing
2. Settlement
3. Risk Management

Clearing Entities:
Clearing Members = TCM and PCM clear trades. For each additional TM under them they have to bring additional
deposit
Clearing Banks = Used for Funds settlement
Each member required to open an account with Clearing Bank


Clearing Mechanism
Means working out open positions and obligations of PCM / TCM
The calculated position is used for exposure and daily margin calculation
Position of CM
Sum of open position of all TM under him
Sum of open position of all Participants under him

Position of TM
Net proprietary position PLUS sum of each client position

Position of Clients
Sum of net position in each contract (either long / Short)

Margin Requirement
Initial security deposit used for trading exposure
For additional exposure additional deposit required
Surplus with exchange is not returned (returned only on written request in 3 days)

Initial Margin
Based on worst case basis to cover 99% VAR over one day

Portfolio Based Margin
SPAN based
Computed at 5 times during day - begin day, 11, 12:30, 2 and end of day

Calendar Spread Margin
Rs 250 PLUS 1/3 of far month value
Calendar spread margin benefit only till expiry of near month
Eg JULY-AUGUST spread


Safeguard Clients Money
CC segregates the margin deposited by CMs for own a/c and client a/c
Clients money held in trust for use of client only

UCC (Unique Client Code)
Each member required to provide a UCC to each client that is unique