CURRENCY FUTURES - A BOON TO MARKET PARTICIPANTS

It was a proud moment in the history of the Indian financial market when the finance minister P Chidambaram inaugurated trading in currency futures on National Stock Exchange on 29^th August, 2008. Previously banks and corporates were allowed to operate in Over The Counter (OTC) market to enter into forward contracts in foreign currencies. Now, by allowing trading in Currency Futures, ordinary investors, traders, corporates and speculators are provided with a wonderful derivative product both for managing currency risks and also for making profit. It is the appropriate time that the authorities and regulators introduced this derivative instrument especially at a time when the value of rupee has registered wild fluctuations over the past one year or so. Besides NSE, BSE and MCX were also allowed to trade Currency Futures. The Reserve Bank of India and Securities and Exchange Board of India are the joint regulators for trading in Currency Futures.

A Currency Future is a derivative contract to buy or sell a specified amount of currency against another currency on a specified future date at a price specified on the date of contract. Currency Future or forex derivative contract enables a person, a bank or an institution to buy or sell a particular currency against the other on a specified future date, and at a price specified in the contract. It is similar to other derivative contracts like Options and Futures in Shares or Commodities. It should be remembered that trading in Rupee Dollar Futures contract was commenced in the Dubai Gold and Commodities Exchange in June 2007. There was a compelling need to allow trading in Currency Futures in India though only partial float of the rupee has been permitted in India. The RBI has not yet allowed capital convertibility in foreign exchange in India. Our regulatory system is strong enough to monitor and exercise effective surveillance over any exigencies in the operation of Currency Futures. Similarly markets in India like NSE, BSE, MCX and NCDEX have well equipped systems to handle trading, settlement and monitoring manipulations by participants. The existing network of dealers and participants and large size of the client base of these participants are added advantage for introducing this innovative product in the Indian Financial Market.

Need for Currency Futures

Before introducing Currency Futures, Exporters and Importers were allowed to hedge their positions through Deliverable Rupee Forwards in the OTC market. In the OTC market the companies were allowed to deal with Banks where they enter into forward contracts to trade Dollar at a future date at a specified rate. Now with introduction of Currency Futures, they get and an alternative opportunity to manage their currency risk exposures. It does not mean that the Currency Futures absolutely replaces the OTC market. Both OTC and Currency Futures (Exchange Traded System) coexist side by side. Currency Future is a standardized contract which is non deliverable and exchange traded. Hence there is speedy settlement and no counter party risk. Compared to forward contracts in Rupee Dollar trade Currency Futures is more flexible, standardized, transparent and liquid. It also facilitates quick and efficient exchange rate discovery. It acts as an important hedging tool to exporters and importers. It would protect exporters and importers from high volatility in exchange rate on their foreign exchange exposures by hedging their positions.

The Rupee Dollar exchange rate has seen wide fluctuations in the recent past. The boom in the stock market attracted a lot of FII investments in the stock market. The huge inflow of Dollar resulted in the appreciation of Rupee and the exchange rate touched a low of Rs. 39 a Dollar last year. The impact of global liquidity crisis witnessed large sell offs by FIIs in the Indian markets and the outflow of Dollar. Together with this the ever increasing crude oil prices in the international market resulted in heavy demand for Dollar. Suddenly the value of Rupee has depreciated heavily to record the all time high rate of Rs. 50 a Dollar. It is the marginal exporters and importers who face the brunt of the problem on account of currency exchange rate fluctuations.

Features of Currency Futures

1. It is a derivative product and the underlying is the US$/Indian Rupee (USD/INR).

2. Only Currency Futures of Indian Rupee and US Dollar is available for trading for the time being.

3. The size of the contract is fixed at $1000.

4. Only resident Indians are allowed to trade in Currency Futures.

5. All contracts shall be quoted and settled in Indian Rupees.

6. The maturity period shall not exceed 12 months.

7. The RBI’s Reference Rate on the last trading day shall be used for settling contracts.

8. The clearing corporations of the exchanges would specify the margin requirements of dealers. Since mark to market loss is settled on a daily basis dealers would be required to bring in additional margin if necessary.

9. The maximum exposure limit to various classes of participants shall be subject to the guide lines issued by SEBI.

Operation of Currency Futures

• The existing infrastructure of NSE, BSE and MCX can be applied to Currency Futures trading. This includes a nationwide network of members, online trading, Internet trading, surveillance systems, facilities of Clearing Corporation etc. Under the online trading system quotes will be readily available to market participants on real time basis making transactions speedier, easier and more transparent. The real time buying and selling rates (bid ask rates) of the underlying is available to a market participant during trading hours. Accordingly one can place orders with his broker for buying or selling a specified lot of the contract. The price of a Currency Futures contract is similar to the forward rate for a given currency. But the Futures contract price varies from the spot rate when the interest rates on the two currencies differ. However, a substantial difference in spot and futures rate gives potential opportunities for arbitrage by speculators.

• Each Stock/ Commodity Exchange has a Clearing House. The Clearing House arranges for delivery of asset and payment of money. Clearing House becomes the counter party to both the contracting parties.

• The Exchange prescribes margin requirements on participants to cover fluctuations in the value of the contracts. Any loss arising from the contracts would be adjusted through margin and, therefore, there is no credit risk. An importer like crude oil refiner purchases Currency Futures to hedge his foreign currency payables and outstanding. Similarly an exporter like a software company sells Currency Futures to hedge his receivables. The operators may close their positions before the settlement dates by entering into a reverse contract and take profit or book a loss. Speculators often enter into Currency Futures contract on the expectation of fluctuations in the exchange rates. Exporters and importers who hedge their positions close their contracts by exchanging the currency/cash on the settlement dates.

Advantages of Currency Futures

Currency Futures acts an important hedging tool to exporters and importers. They get greater flexibility in managing their forex risk exposure by hedging their outstanding positions. It also brings in more liquidity into the market since the number and volume of contracts would be much higher than under forward contracts. Compared to Forward contracts Currency Futures contract is exchange traded, transparent and exchange rate discovery system is efficient.

By keeping the contract size very reasonable, that is $1000, small and marginal exporters and importers that do not have sufficient financial power to participate on the OTC market can participate in Currency Futures.

By allowing both the Stock Exchanges and Commodity Exchanges, there is the advantage of both reach and volume. The existing client base of these exchanges offers good potential for trading in Currency Futures since most of them have been trading in derivative segments.

The transaction cost is very low and brokers are charging only nominal rates of commission on contracts.

There is absolutely no counter party risk as in exchange traded contracts the participant can look forward to the Clearing Corporation for settlement.

Currency Futures provides good opportunities to individual investors and speculators in a volatile forex market to make a profit. Forex market is inherently volatile due to the interplay of a host of factors and this makes scope for speculation by dealers.

Guidelines for Currency Futures

The Reserve Bank of India (RBI) and the capital market regulator Securities Exchange Board of India (SEBI) have notified guidelines for exchange traded Currency Futures. Currency Futures are standardized foreign exchange derivative contracts traded on a stock exchange to buy or sell one currency against another on a specified future date, at a price specified on the date of contract. Initially, trading contracts denominated in the US Dollar and the Indian Rupee will only be permitted. According to the RBI guidelines, only US Dollar-Rupee contracts with a size of $1,000 each for a single contract will be allowed for trading. The tick size (minimum price fluctuation) will be 0.25 paise. The contracts will be quoted and settled in the local currency with a maturity of not more than 12 months. The contracts will be quoted and settled only in Indian Rupees. However, the outstanding positions will be stated in US Dollars. A maximum of 200 contracts are allowed per person and the market timings will be from 9 am to 5 pm. The final settlement will be at 12 noon on the last business day of the month. The membership of the Currency Futures market of an exchange will also be separate from the membership of the equity derivatives segment or the cash segment. Such an exchange will be subject to the guidelines of the capital market regulator.

Under the current guidelines non-resident investors have been restrained from entering into currency derivative contracts in India. Foreign Institutional Investors (FIIs), hedge funds and Non Resident Indians (NRIs) are presently excluded from the market. A bank can become a trading or a clearing member of such an exchange provided it has capital and reserves worth Rs.500 crores. Further it requires a capital adequacy ratio of 10 percent, Net Non-Performing Assets below 3 percent and has a track record of past three years according to the norms set out by RBI. The approval of their Board of Directors of the banks will also be needed to become a trading member. The RBI has further clarified that banks which do not meet these requirements (including urban co-operative banks) can participate only as clients and that too after securing necessary approval. The limit on the gross open positions of individuals is $5 million while the trading limit for trading members in such contracts will not exceed $25 million or 15 percent of the total open interest, or total number of open contracts. For banks, however, the gross open position limit is $100 million, or 15 percent of the total open interest.

Conclusion

The authorities and regulators have taken a bold step by allowing trading in currency futures in India. The introduction of Currency Futures also will enable the Indian market to progress towards Currency Options market and ultimately give way to full convertibility of the rupee on the capital account. Though India's Currency Futures market is presently small compared to the forward contracts market, it will grow by at least 15-20 percent per year and achieve good trading volumes within a year. Definitely trading in currency futures is going to be a boon to all market participants. But one should always remember the comment made by Warren Buffet as “all derivative products are instruments of mass destruction”.

Copyrights©Dr.A.M.Viswambharan

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