currency derivatives at religare
TRANSCRIPT
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CHAPTER
No.
CONTENTS P No.1 INTRODUCTION
Introduction to currency derivatives
Objectives
Scope
Research Methodology
Source of Data
Limitation
Hypothesis
2
2 Review of Literature 14
3 Company Profile 18
4 Theoretical Framework 27
5 Brief Overview of Foreign Exchange Market 39
6 Analysis 54
7 Finding, Suggestions and conclusions 75
8 Bibliography 79
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Chapter 1
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INTRODUCTION OF CURRENCY DERIVATIVES
The current currency rate mechanism has evolved over thousands of years of the
world community trying with various mechanism of facilitating the trade of goods and
services. Initially, the trading of goods and services was by barter system where in goods
were exchanged for each other. For example, a farmer would exchange wheat grown on his
farmland with cotton with another farmer. Such system had its difficulties primarily because
of non-divisibility of certain goods, cost in transporting such goods for trading and difficulty
in valuing of services. For example, how does a dairy farmer exchange his cattle for few liters
of edible oil or one kilogram of salt? The farmer has no way to divide the cattle! Similarly,
suppose wheat is grown in one part of a country and sugar isgrown in another part of the
country, the farmer has to travel long distances every time he has to exchange wheat for
sugar. Therefore the need to have a common medium of exchange resulted in the innovationof money
With time, countries started trading across borders as they realized that everything
cannot be produced in each country or cost of production of certain goods is cheaper in
certain countries than others. The growth in international trade resulted in evolution of
foreign exchange (FX) i.e., value of one currency of one country versus value of currency of
other country. Each country has its own brand alongside its flag. When money is branded it
is called currency. Whenever there is a cross-border trade, there is need to exchange one
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brand of money for another, and this exchange of two currencies is called foreign exchange
or simply forex (FX).
The introduction of currency derivatives in India is a landmark decision which is
likely to be a boon for importers, exporters and companies with foreign exchange exposure.
These derivative products have a wide range with their special features suiting to the needs
and requirements of the individuals. As currency derivative is new to India, it is time to have
a broad understanding of them which are mostly couched in jargons and technical terms.
Thus the very subject raises a kind of aversion for the common people. The currency
derivatives are contracts just like any other derivatives viz., Stock, Index etc. Unlike the
stock, the underlying in this case is currencies. The value of the currencies determine the
values of the currency derivatives.
As it is universally accepted that market risks are ones which can not eliminated in
absolute terms. But their management is perfectly possible. The currency derivatives are
efficient tools for management of risks in money and forex markets. The need to protect the
exposure against unforeseen and unpredictable movement in currency and interest rates has
led to the emergence of these kinds of derivatives. Thus external borrowings or receivables or
payments in foreign currencies come within the purview of management under it .As we all
know the exporters and importers incur huge obligations in terms of foreign currencies and
they can guard their interest by buying appropriate product
With the multiple growths of international trade and finance all over the
world, trading in foreign currencies has grown tremendously over the past several decades.
Since the exchange rates are continuously changing, so the firms are exposed to the risk of
exchange rate movements. As a result the assets or liability or cash flows of a firm which are
denominated in foreign currencies undergo a change in value over a period of time due to
variation in exchangerates.
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OBJECTIVES OF THE STUDY:-
The basic idea behind undertaking Currency Derivatives project to
gain knowledge about currency future market.
To study the basic concept of Currency future
To study the exchange traded currency future
To understand the practical considerations and ways of considering
currency future price.
To analyze different currency derivatives products.
SCOPE OF THE STUDY:-
Globalization of the financial market has led to a manifold increase in investment.
New markets have been opened; new instruments have been developed; and new services
have been launched. Besides, a number of opportunities and challenges have also been
thrown open.
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Online currency trading is new as compared to equity market in India. Mainly three
exchanges are involved in online commodities trading MCX, NSE and ise-india. Hence, the
scope of Currency market is very wide in the market.
RESEARCH METHODOLOGY-
In this project Descriptive research methodologies were use.
The research methodology adopted for carrying out the study was at the
first stage theoretical study is attempted and at the second stage observed online trading on
NSE/BSE.
SOURCE OF DATA COLLECTION:-
Secondary data were used such as various books, report submitted by
RBI/SEBI committee and NCFM/BCFM modules.
LIMITATION OF THE STUDY:-
The analysis was purely based on the secondary data. So, any error in the
secondary data might also affect the study undertaken.
The currency future is new concept and topic related book was not available in
library and market.
HYPOTHESIS:-
It has been said in the past that derivatives are k indof a side show, where the
main event takes place in the money and capital markets. One could attend the side show
without taking part in the main event and vice- versa. With respect to derivative and
money/capital markets, that is simply not true todey. Derivatives are so widely used that even
if one has no intension of using them, it is important to understand how they are used by
others and what effects, positive and negative; they could have on money and capital
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markets.
..Peter L. Bernstien
The futures market holds a great importance in the economy and, therefore, it becomes
imperative that we analyse this important market and seek answers to a few basic questions.
The main theme of the study is to assess the progress of the currency futures in India with a
compact view over the volatility of the currency futures. In order to study the growth of the
currency futures, the number of contracts traded and open interest at NSE and MCX have
been inclusively compared. A correlation between the two was calculated and the result
depicted that they have a significant relationship with a correlation cofficient of 0.83 in case
of NSE. A plot of that correlation is shown in Figure 1.
Attempt has also been made to check whether the daily returns of the NSE and MCX
on currency futures are normally distributed and the data have been used for the
Kolmogorov- Smirnov Test to test the hypothesis that the returns are normally distributed.
Kolmogorov- Smirnov Test is a non-parametric test and it is used to determine whether the
distribution is homogeneous. With the measure of skewness and kurtosis it has been found
that the returns are normally distributed and, thus, the null hypothesis is accepted.
The hypothesis tested in the study is as follows:
H0: The returns of the currency futures are normally distributed.
H1: The returns of the currency futures are not normally distributed
FIGURE 1: PLOTTED GRAPH OF CORRELATION BETWEEN OPEN INTEREST
AND CONTRACTS TRADED AT NSE:-
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III.QUANTITATIVE ANALYSIS :-
The growth of the currency futures in India has been assessed by measuring the growth in
two variables which are open interestand contracts traded. A correlation between the two
was calculated and the result depicted that they have a significant relationship with a
correlation cofficient of 0.83 in case of NSE
TABLE 2: CORRELATION BETWEEN OPEN INTEREST AND CONTRACTS
TRADED IN NSE:-
Linear Correlation
Number of points = 320
Correlation coefficient (r) = 0.8324
95% confidence interval: 0.7953 to 0.863
Coefficient of determination (r squared) = 0.6928
Test: Is r significantly different than zero?
The two-tailed P value is < 0.0001, considered extremely significant.
The growth of the open interest and contracts traded are explained below
Open interestis the total number of outstanding contracts that are held by the market
Participants at the end of the day. It is also considered as the number of futures contracts that
have not yet been exercised, expired or fulfilled by delivery. It is often used to confirm the
trends and trends reversals for futures markets. It measures the flow of money into the futures
market. A seller and a buyer forms one contract and hence in order to determine the total
open interest in the market we need to know either the total of buyers or the sellers and not
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the sum of both. the open interest position that is reported each day represents the increase or
decrease in the number of contracts for that day. An increasing open interest means that the
new money is flowing in the market .Marketplace and the present trend will continue. If the
open interest is declining it implies that the market is liquidating and the prevailing price
trend is coming to an end. The leveling off of open interest following a sustained price
advance is often an early warning of the end to an up trending or bull market. The
interpretations which can made on the basis of the open interest may be shown with the help
of the following table
Price Open Interest Interpretation
Rising Rising Market is Strong
Rising Falling Market is weakening
Falling Rising Market is Weak
Falling Falling Market is Strengthening
I. Figure 2 shows the daily movement in the open interest of currency futures in both NSE
and MCX. It depicts that the open interest in both NSE and MCX have been increasing with a
steady speed since the currency futures are been traded. The open interest in the NSE was
406200 on 31st Dec. 2009 as compared to 16332 on 28th Aug. 2008 and that on MCX it was
425451 on 31stDec. 2009 as compared to 17331 on 7th Oct. 2008. It can be seen that in terms
of the open interest, the growth of the MCX is more as compared to the NSE .
FIGURE 2
The trend as depicted by figure 1 it is found that the growth of open interest in both
NSE and MCX was down during March 2009 to August 2009 which is the indicator that it
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was affected by the global recession experienced by the Indian economy. Figure 3, which
shows the open interest at the end of each month, also depicts that there was a fall in the open
Interest during the period of January-July 2009. Hence, it can be said that this slackening in
trade was due to the global recession. However, the market has recovered itself and a good
growth is being experienced
FIGURE 3
II. CONTRACTS TRADED:-
The number of contracts traded on a stock exchange shows the total volume of contracts
traded. An increase in the number of contracts traded on an stock exchange expresses the
growth of trade in that particular stock exchange for a particular currency future. The number
contracts traded in the NSE increased to 1444150 contracts on 31st Dec. 2009 from 65798
contracts on 28th Aug. 2008, and from 59952 contracts on 7th Oct. 2008 to 1556411
contracts on 31st Dec. 2009 in the MCX. Figure 4 clearly depicts the growing trend in the
daily volumes traded in both NSE and MCX. It can also be noticed over here that the number
of contracts traded in MCX have been more than that traded in the NSE.
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FIGURE 4
III. MONTHLY TURNOVER
The monthly turnover of both the stock exchanges (NSE and MCX) have also
experienced an upward trend in the year 2009 with a total of Rs. 48395 crore in Jan. 2009 and
Rs. 319195 crore in Nov. 2009. Figure 5 depicts the clear picture of the currently moving
trend in both the stock exchanges. This too says that the currency futures trading at MCX is
growing faster than that at NSE.
NORMALITY IN THE DAILY CHANGES IN VALUE OF RUPEE
The distribution of the changes in the value of Rupee is not symmetric as the skewness is not
mzero in any case. Presence of positive skewness in Dec. 2008, Feb. 2009, Mar. 2009, Apr.
2009, June 2009, July 2009, Aug. 2009, Sept. 2009, Nov. 2009 and Dec. 2009 means that the
distribution has a right tail and the negative skewness in rest of the months means that the
distribution has a left tail. In case of kurtosis, it can be concluded that the distribution was
normal only during May 2009 and during the rest of the period it was not normally
distributed. A detailed statistic is given in the Table 1.
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TABLE 1: DESCRIPTIVE STATISTICS OF DAILY CHANGES IN THE VALUE OF
RUPEE (MONTH-WISE)
Period No. of Obs. Mean S.D. Min Max Skewness Kurtosis
Sept. 08 20 0.1575 0.3774 -0.92 0.69 -1.28 2.32Oct. 08 15 0.1433 0.4404 -0.58 0.73 -0.2846 -1.18
Nov. 08 17 0.0518 0.6189 -1.44 1.22 -0.3942 1.04
Dec. 08 20 -0.082 0.5413 -1.1 1.1 0.4118 0.24
Jan. 09 19 0.0153 0.2841 -0.52 0.43 -0.2313 -1.15
Feb. 09 16 0.105 0.2712 -0.21 0.69 1.0553 0.14
Mar. 09 18 -0.0444 0.3574 -0.63 0.54 0.008 -0.17
Apr. 09 15 -0.0053 0.3327 -0.62 0.53 0.0068 -0.67
May. 09 19 -0.1258 0.4296 -1.38 0.49 -1.2914 3.04
Jun. 09 21 0.042 0.2734 -0.38 0.53 0.0373 -0.82
Jul. 09 22 0.0032 0.2793 -0.56 0.71 0.464 0.91
Aug. 09 19 0.0532 0.2055 -0.33 0.41 0.0656 -0.37
Sept. 09 18 -0.0383 0.185 -0.39 0.33 0.2875 -0.38
Oct. 09 17 -0.0394 0.3477 -0.56 0.4 -0.1591 -1.71
Nov. 09 19 -0.0295 0.2227 -0.41 0.54 0.4711 1.15
Dec. 09 20 0.0115 0.1108 -0.2 0.23 0.0388 -0.06
Contrary to the statistical results based on skewness and kurtosis, the Kolmogorov-Smirnov
test says that the distribution is normal in every case. The detailed results are given in the
Table 2
Dec
. 09
Nov.
09
Oct.
09
Sep
t.
09
Aug.
09
Jul.
09
Jun.
09
M
ay
09
Ap
r.0
9
Mar
. 09
Feb
. 09
Ja
n.
09
De
c.
08
No
v.
08
Oc
t.
08
Sep
t.
08
N 20 19 17 18 19 22 21 19 15 18 16 19 20 17 15 20
Normal
mean
Parameters
a,,b
.011
5
-
.0295
-.0394 -
.038
3
.0532 .003
2
.041
9
-
.12
58
-
.00
53
-
.044
4
.105
0
.01
53
-
.08
20
.051
8
.14
33
.157
5
Std.Deviation
.11080
.22270
.34773 .18497
.20548
.27929
.27336
.42964
.33273
.35741
.27124
.28408
.54129
.61891
.44042
.37741
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Most
Extreme
Differences
Absolute
.111 .133 .184 .186 .108 .112 .133 .17
6
.11
2
.106 .213 .13
3
.17
6
.132
.14
2
.163
Positive .111 .133 .159 .186 .108 .112 .133 .08
7
.11
2
.106 .213 .13
3
.17
6
.122
.10
4
.093
Negative -.089 -.130
.184
-.121 -.076 -
.071
-
.130
-
.17
6
-
.09
4
-
.088
-
.123
-
.12
1
-
.07
2
-
.132
-
.14
2
-
.163
Kolmogoro
v-Smirnov
Z
.494 .578 .758 .790 .472 .527 .608 .76
8
.43
6
.451 .853 .58
2
.78
9
.544
.55
2
.730
a. Test distribution is Normal.
b. Calculated from data
CONCLUSIONS AND SUGGESTIONS
The Indian currency futures market has experienced an impressive growth since its
introduction. The upward trend of the volumes and open interest for currency futures in both
NSE and MCX explains the whole story in detail. The growth was only the reason for the
introduction of three other currency futures in January this year. In the coming future it is
expected that the market participants will find some more currency futures introduced into
the market. Currently on 26 th March, 2010 the SEBI allowed the United Stock Exchange of
India to launch currency futures. It became the fourth currency future exchange after NSE,
BSE a nd MCX. The two exchanges (NSE and MCX) are currently clocking an average dailyturnover of over Rs 20,000 crore in currency products while it was just Rs 2,400 crore in
January last year. It can be thus concluded that the currency futures market will get more
success in the coming future and the economy and the risk hedgers will definitely be
benefited from this trade. The correlation test also explained that the relationship between the
open interest and traded volumes is very much significant and that the change in the value of
currency is normally distributed thus illustrating that the risk is minimum in the currency
futures contracts. The risk involved is comparatively low in this case and currency futures has
proved to be a good tool for hedging the risk involved in the currency of a country (currency
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risk). It is hoped that the currency futures market will develop faster and it will be a good
choice for all the market participants in the near future and it will find its way in the Indian
economy.
Chapter 2
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Literature Review:-
The introduction of currency futures markets enable the traders to transact in
large volumes at much lower transaction costs relative to the cash market. This results in an
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increase in order flow to futures markets, reasons of which are unresolved on both theoretical
and on empirical front. A future market has two contrasting effects:
If the speculators observe a noisy but informative signal, the hedgers react to the noise in
the speculative trades, producing an increase in volatility.
The futures market improves risk sharing and therefore reduces price volatility. Opponents
of speculative trading activity have generally argued that increased trading in futures leads to
unnecessary price volatility in the underlying cash markets. Some researchers suggest that the
participation of speculative traders in the systems that allow high degrees of leverage lowers
the quality of the information in the market, e.g. Figlewski (1981) and Stein (1987). Cox
(1976), among others, notes that uninformed traders could play a stabilizing role in the cash
markets. Others question the role of future markets as representative of an institutional
alternative for accurate price forecasting,e.g. Martin and Garcia (1981). In contrast, models
developed by Danthine (1978 )argue that the futures markets improve market depth and
reduce volatility because the cost to informed traders of responding to mispricing is reduced.
Froot and Perold (1991) extend Kyles (1985) model to show that market depth is increased
by more rapid dissemination of market-wide information and the presence of market makers
in the futures market in addition to the cash market. Ross (1989) assumes that there exists an
economy that is devoid of arbitrage and proceeds to provide a condition under which the
noarbitrage situation will be sustained. It implies that the variance of the price change will be
equal to the rate of information flow. The implication of this is that the volatility of the asset
price will increase as the rate of information flow increases.
Thus, if futures increase the flow of information, then in the absence of
arbitrage opportunity, the volatility of the spot price must change. It has also been suggested
that the futures markets have become an important medium of price discovery in cash
markets, e.g. Schwarz and Laatsch (1991). Questions pertaining to the impact of derivative
trading activity on cash market volatility have been empirically addressed in two ways.First,
researchers have attempted to establish the impact of derivatives trading on cash markets by
comparing cash market volatilities during the pre and post-futures trading eras. The majority
of studies on this area suggests that speculative (derivatives) markets either add to the
stability, or do not impact the volatility of cash markets e.g. Simpson and Ireland (1985),
Edward (1988), Skinner (1989). Second, researchers have examined the relationship between
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speculative (derivative) trading activity and cash markets by directly evaluating the impact
of futures trading activity on the behavior of cash market e.g. Samanta (2007).
Edward (1988) and Bessembinder and Seguin (1992) provide evidence that
futures trading activity improves the stability in equity indices. In case of currency futures the
study of the relationship between futures trading and the variability of the underlying cash
market is complicated by the nature of exchange rate movements. The exchange rates move
like random walk but the changes do not, e.g. Meese and Rogoff (1983) and Manasanton
(1986). Under these conditions, the applicability of traditional volatility measures, such as the
absolute change in prices, provides inconsistence estimates in the study of the trading-activity
versus exchange rate-volatility relationship. A financial time series like this can not be
modeled in the normal way. To model such time series, time varying volatility models is
required. Engel (1982) first time proposed to incorporate time varying nature of volatility
using ARCH process. The work of Engle (1982) was made better by Bollerslev (1986), who
incorporated GARCH models to overcome some of the lacunas of ARCH models like
overfitting and breach of non-negativity constraints. Many researchers have found GARCH
family of models outperforming other models.
Different researchers used different markets and different methods to
communicate the same thing of applicability of GARCH family of models for modeling
conditional volatility.On US-based data the studies are Akgiray (1989), Pagan and Schwert
(1980), Brails Ford and Faff (1996) and Brooks (1998). On Europe based data the study is
Corhay and Rad (1994). On Asian Countries based data the study is Andersen and
Bollserslev (1998). All the researchers have found that GARCH family of models provide
more accurate forecast of volatility of returns of the financial assets. Out of three special
features of financial time series data (leptokurtic distribution, volatility clustering and
leverage effect) the leptokurtic and volatility clustering nature of the financial return data has
been captured by GARCH models but asymmetric behavior has not been captured. To solve
the issue Nelson (1991), Zakoian (1994) and GJR (1993) proposed EGARCH, TARCH and
GJR models respectively which can capture these tendencies of asymmetric nature of
financial data (Engle and Victor 1993) too.
Chapter 3 :-
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2. COMPANY PROFILE
Religare is an emerging markets financial services group with a presence
across Asia, Africa, Middle East, Europe, and the Americas. In India, Religares largestmarket, the group offers a wide array of products and services including broking, insurance,
asset management, lending solutions, investment banking and wealth management. With
10,000-plus employees across multiple geographies, Religare serves over a million clients,
including corporate and institutions, high net worth families and individuals, and retail
investors.
RELIGARE Securities Ltd. (RSL) is a wholly owned subsidiary of
RELIGARE Financial Services Ltd. (RFSL), a Company promoted by the late Dr. Parvinder
Singh, Ex-CMD of Ranbaxy Laboratories Ltd.
The primary focus of Religare Securities Ltd. is to cater to services in Capital
Market Operations to Institutional Investors. The Company is a member of the National
Stock Exchange (NSE) and OTCEI. The growing list of financial institutions with whom
RSL is empanelled as approved Broker is a reflection of the high levels of services
maintained by the Company.
As on date the Company is empanelled with UTI, IDBI, IFCI, SBI, BOI-MF,
Punjab National Bank, PNB-MF, Oriental Insurance, GIC, UTI-Offshore, ICICI Can bank
MF, Punjab & Sind Bank, Pioneer ITI, SUN F&C, IDBI Principal, Prudential ICICI, ING
Baring and J M Mutual Fund.
RELIGARE was founded with the vision of providing integrated financial care
driven by the relationship of trust. The bouquet of services offered by RELIGARE includes
Broking (Stocks and Commodities), Depository Participant Service, Advisory on Mutual
Fund Investments and Portfolio Management Services.
RELIGARE is a pioneer in the concept of partnership to reach multiple
locations in order to effectively service its large base of individual clients. Besides the reach
of Industry :Finance - General
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BSE Code :532915
Book Closure :11/08/2010
Group :Religare
NSE Code : RELIGARE
Market Cap :Rs. 6,897.44 Cr.
ISIN No :INE621H01010
Market Lot :1
Face Value :Rs. 10.00
RELIGARE, the clients of the company greatly benefit by its strong research
capability, which encompasses fundamentals as well as technical knowledge.
GROUP :
RELIGARE in recent years has expanded its reach in health care and financial
services wherein it has multiple specialty hospital and labs which provide health care services
and multiple financial services such as secondary market equity services, portfolio
management services, depository services etc.
RELIGARE financial services group comprises of Religare Securities
Limited, RELIGARE Comdex Limited and RELIGARE Finvest Limited which provide
services in Equity, Commodity and Financial Services business & Religare Insurance
Advisory Ltd.
RELIGARE SECURITIES LIMITED:-
1. Member of National Stock Exchange of India and Bombay Stock
Exchange of India.
2. Depository Participant with National Securities Depository
Limited (NSDL) and Central Depository Services Limited(CDSL).
3. A SEBI approved Portfolio Manager.
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RSL provides platform to all segments of the investor to leverage the immense
opportunity offered by equity investing in India either on their own or through managed
funds in Portfolio Management.
The ARN No. of the Religare Securities Ltd. is 33764. The ARN No. is required by to
be available with the broker who deals on behalf of investors or sell the mutual funds of the
different companies present in the market.
Currency Broking:
Religare Securities Limited (RSL), the broking arm of REL, offers a comprehensive
range of services which include equity broking and currency futures and options broking.
Exchange-driven currency trading has shown remarkable growth over the past few years. It is
the basis for cross-border diversification and business deals. It is our strong belief that a
valuable broking franchise is one that has a very high level of client retention and can provide
differentiated services based on client needs.
At Religare, we enable our clients to seize investment opportunities in the currency market by
facilitating futures and options trades in four currency pairs:
US$-Indian Rupee
Euro-Indian Rupee
Pound Sterling-Indian Rupee
Japanese Yen-Indian Rupee
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Religare Enterprises Limited
Religare Securities Limited
Equity Broking
Online Investment Portal
Portfolio Management Services
Depository Services
Religare Commodities Limited
Commodity Broking
Religare Capital Markets Limited
Investment Banking
Proposed Institutional Broking
Religare Realty Limited
In house Real Estate Management Company
Religare Hichens Harrison**
Corporate Broking
Institutional Broking
Religare Finvest Limited
Lending and Distribution business
Proposed Custodial business
Religare Insurance Broking Limited
Life Insurance
General Insurance
Reinsurance
Religare Arts Initiative Limited
Business of Art
Gallery launched - arts-i
Religare Venture Capital Limited
Private Equity and Investment Manager
Religare Asset Management*
Derivatives Sales
Corporate finance
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MISSION:-
To be India's first Multinational providing complete financial services solution
across the globe
VISION:-
Providing integrated financial care driven by the relationship of trust and
confidence.
PRODUCTS:
Products Subscription
fees
Enrolment
Deposit
R-ALLY NIL NIL
R-ALLY Lite (Browser Based) NIL Rs. 5,000
R-ALLY Pro (Application Based) Rs. 1,800 NIL
Trading in Equities with Religare truly empowers you for your
investment needs. We ensure you have a superlative trading experience through -
A highly process driven, diligent approach
Powerful Research & Analytics and
One of the "best-in-class" dealing roomsFurther, Religare also has one of the largest
retail networks. Now, you can walk into any of our branches and connect to our
highly skilled and dedicated relationship managers to get the best services.
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The Religare Edge :-
Pan India footprint
Powerful research and analytics supported by a pool of highly skilled research
analysts
Ethical business practices
Offline/Online delivery models
Single window for all investment needs through your unique CRN.
BROKERAGE :-
INTRADAY:- 3 paisa (.3%) (NEGOTIABLE)
DELIVERY :- 30 paisa (.03%) (NEGOTIABLE)
SERVICES:-
Arts
Initiative
Investment
Wealth
Personal
Insurance
Mutual
Fund
Commodity
Equity
REL
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Organization Structure of Religare Securities:
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Competitions of Religare :-
There are several financial security companies playing their roles in Indian equity market.
But Religare faces competitions from these few companies.
ICICI Direct.com
Share Khan (SSKI)
Kotak Securities.com
India Bulls
HDFC Securities
5paisa.com
Motital Oswal
IL&FS
Karvy
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Chapter 4
Theoritical framework of
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About Financial Derivatives:-
DEFINITION OF FINANCIAL DERIVATIVES:-
A word formed by derivation. It means, this word has been arisen by derivation.
Something derived; it means that some things have to be derived or arisen out of the
underlying variables. A financial derivative is an indeed derived from the financial
market.
Derivatives are financial contracts whose value/price is independent on the behavior
of the price of one or more basic underlying assets. These contracts are legally
binding agreements, made on the trading screen of stock exchanges, to buy or sell an
asset in future. These assets can be a share, index, interest rate, bond, rupee dollar
exchange rate, sugar, crude oil, soybeans, cotton, coffee and what you have.
A very simple example of derivatives is curd, which is derivative of milk. The price
of curd depends upon the price of milk which in turn depends upon the demand and
supply of milk.
The Underlying Securities for Derivatives are :
Commodities: Castor seed, Grain, Pepper, Potatoes, etc.
Precious Metal : Gold, Silver
Short Term Debt Securities : Treasury Bills
Interest Rates Common shares/stock
Stock Index Value : NSE Nifty
Currency : Exchange Rate.
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TYPES OF FINANCIAL DERIVATIVES:
Financial derivatives are those assets whose values are determined by the value of
some other assets, called as the underlying. Presently there are Complex varieties of
derivatives already in existence and the markets are innovating newer and newer ones
continuously. For example, various types of financial derivatives based on their different
properties like, plain, simple or straightforward, composite, joint or hybrid, synthetic,
leveraged, mildly leveraged, OTC traded, standardized or organized exchange traded, etc. are
available in the market. Due to complexity in nature, it is very difficult to classify the
financial derivatives, so in the present context, the basic financial derivatives which are
popularly in the market have been described. In the simple form, the derivatives can be
classified into different categories which are shown below :
DERIVATIVES
Financials Commodities
Basics Complex
1. Forwards 1. Swaps
2. Futures 2.Exotics (Non STD)
3. Options
4. Warrants and Convertibles
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One form of classification of derivative instruments is between commodity derivatives and
financial derivatives. The basic difference between these is the nature of the underlying
instrument or assets. In commodity derivatives, the underlying instrument is commodity
which may be wheat, cotton, pepper, sugar, jute, turmeric, corn, crude oil, natural gas,
gold, silver and so on. In financial derivative, the underlying instrument may be treasury
bills, stocks, bonds, foreign exchange, stock index, cost of living index etc. It is to be
noted that financial derivative is fairly standard and there are no quality issues whereas in
commodity derivative, the quality may be the underlying matters. Another way of
classifying the financial derivatives is into basic and complex. In this, forward contracts,
futures contracts and option contracts have been included in the basic derivatives whereas
swaps and other complex derivatives are taken into complex category because they are
built up from either forwards/futures or options contracts, or both. In fact, such derivatives
are effectively derivatives of derivatives.
Derivatives are traded at organized exchanges and in the Over The Counter ( OTC
) market :
Derivatives Trading Forum
Organized Exchanges Over The Counter
Commodity Futures Forward Contracts
Financial Futures Swaps
Options (stock and index)
Stock Index Future
Derivatives traded at exchanges are standardized contracts having standard delivery
dates and trading units. OTC derivatives are customized contracts that enable the parties
to select the trading units and delivery dates to suit their requirements.
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A major difference between the two is that of counterpar ty r iskthe risk of default
by either party. With the exchange traded derivatives, the risk is controlled by
exchanges through clearing house which act as a contractual intermediary and impose
margin requirement. In contrast, OTC derivatives signify greater vulnerability.
DERIVATIVES INTRODUCTION IN INDIA:-
The first step towards introduction of derivatives trading in India was the
promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the
prohibition on options in securities. SEBI set up a 24 member committee under the
chairmanship of Dr. L.C. Gupta on November 18, 1996 to develop appropriate regulatory
framework for derivatives trading in India, submitted its report on March 17, 1998. The
committee recommended that the derivatives should be declared as securities so that
regulatory framework applicable to trading of securities could also govern trading of
derivatives.
To begin with, SEBI approved trading in index futures contracts based on S&P
CNX Nifty and BSE-30 (Sensex) index. The trading in index options commenced in June
2001 and the trading in options on individual securities commenced in July 2001. Futures
contracts on individual stocks were launched in November 2001.
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HISTORY OF CURRENCY DERIVATIVES:-
Currency futures were first created at the Chicago Mercantile Exchange (CME) in
1972.The contracts were created under the guidance and leadership of Leo Melamed, CME
Chairman Emeritus. The FX contract capitalized on the U.S. abandonment of the Bretton
Woods agreement, which had fixed world exchange rates to a gold standard after World War
II. The abandonment of the Bretton Woods agreement resulted in currency values being
allowed to float, increasing the risk of doing business. By creating another type of market in
which futures could be traded, CME currency futures extended the reach of risk management
beyond commodities, which were the main derivative contracts traded at CME until then. The
concept of currency futures at CME was revolutionary, and gained credibility through
endorsement of Nobel-prize-winning economist Milton Friedman.
Today, CME offers 41 individual FX futures and 31 options contracts on 19
currencies, all of which trade electronically on the exchanges CME Globex platform. It is the
largest regulated marketplace for FX trading. Traders of CME
FX futures are a diverse group that includes multinational corporations, hedge funds,
commercial banks, investment banks, financial managers, commodity trading advisors
(CTAs), proprietary trading firms; currency overlay managers and individual investors. They
trade in order to transact business, hedge against unfavorable changes in currency rates, or to
speculate on rate fluctuations.
Source: - (NCFM-Currency future Module)
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UTILITY OF CURRENCY DERIVATIVES:-
Currency-based derivatives are used by exporters invoicing receivables in foreign
currency, willing to protect their earnings from the foreign currency depreciation by locking
the currency conversion rate at a high level. Their use by importers hedging foreign currency
payables is effective when the payment currency is expected to appreciate and the importers
would like to guarantee a lower conversion rate. Investors in foreign currency denominated
securities would like to secure strong foreign earnings by obtaining the right to sell foreign
currency at a high conversion rate, thus defending their revenue from the foreign currency
depreciation. Multinational companies use currency derivatives being engaged in direct
investment overseas. They want to guarantee the rate of purchasing foreign currency for
various payments related to the installation of a foreign branch or subsidiary, or to a joint
venture with a foreign partner.
A high degree of volatility of exchange rates creates a fertile ground for foreign
exchange speculators. Their objective is to guarantee a high selling rate of a foreign currency
by obtaining a derivative contract while hoping to buy the currency at a low rate in the future.
Alternatively, they may wish to obtain a foreign currency forward buying contract, expecting
to sell the appreciating currency at a high future rate. In either case, they are exposed to the
risk of currency fluctuations in the future betting on the pattern of the spot exchange rate
adjustment consistent with their initial expectations.
The most commonly used instrument among the currency derivatives are currency
forward contracts. These are large notional value selling or buying contracts obtained by
exporters, importers, investors and speculators from banks with denomination normally
exceeding 2 million USD. The contracts guarantee the future conversion rate between two
currencies and can be obtained for any customized amount and any date in the future. They
normally do not require a security deposit since their purchasers are mostly large business
firms and investment institutions, although the banks may require compensating deposit
balances or lines of credit. Their transaction costs are set by spread between bank's buy and
sell prices.
Exporters invoicing receivables in foreign currency are the most frequent users of
these contracts. They are willing to protect themselves from the currency depreciation by
locking in the future currency conversion rate at a high level. A similar foreign currency
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forward selling contract is obtained by investors in foreign currency denominated bonds (or
other securities) who want to take advantage of higher foreign that domestic interest rates on
government or corporate bonds and the foreign currency forward premium. They hedge
against the foreign currency depreciation below the forward selling rate which would ruin
their return from foreign financial investment. Investment in foreign securities induced by
higher foreign interest rates and accompanied by the forward selling of the foreign currency
income is called a covered interest arbitrage.
Source :-( Recent Development in I nternational Curr ency Deri vative Market by Lucjan T.
Orlowski)
Exchanges Trading in Currency Derivatives
MCX Stock Exchange Ltd. (MCXSX):-
MCX Stock Exchange Ltd. (MCXSX) commenced operations in the currency derivatives
segment on 7th October, 2008, within the regulatory framework of Securities & Exchange
Board of India (SEBI) and Reserve Bank of India (RBI). The all-India electronictrading
platform of MCX-SX offers participants the benefits of high liquidity, trade transparency,
easy online accessibility and counterparty guarantee through MCXSX Clearing
Corporation Ltd. (MCX-SX CCL), established on the lines of global clearing corporations.
MCX-SX has emerged as the first exchange in India to provide currency futures rates on a
real-time basis through mobile across all service providers, to publish a primer on currency
futures trade for guidance of interested participants and to launch websites in various
regional languages. MCXSX has also signed MOUs with varioustrade associations across
India. For more information please visitwww.mcx-sx.com.
National Stock Exchange (NSE)
National Stock Exchange (NSE) commenced operations in 1994 and provides a nationwide
electronic trading platform for various types of securities for investors under one roof. These
instruments are available for trading under different segments: Wholesale Debt Market
Segment; Capital Market Segment, Futures and Options Segment and Currency Derivatives
http://www.mcx-sx.com/http://www.mcx-sx.com/http://www.mcx-sx.com/http://www.mcx-sx.com/ -
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Segment. Derivatives trading at NSE commenced in the year 2000, and the product
base includes trading in futures and options on S&P CNX Nifty Index, CNX IT Index, Bank
Nifty Index, CNX Nifty Junior Index, CNX 100 Index, Nifty Midcap 50 Index, S&P CNX
Index; futures and options on around 200 single stocks; and currency futures on the USDINR
contracts presently. NSEs trading presence is now in over 1,500 cities across India. NSE
ranks 3rd in the world, in terms of number of transactions executed on a stock exchange; 2nd
in the world, in terms of the number of contracts traded in Single Stock Futures; 3rd in the
world, in terms of number of contracts traded, in Stock Index Futures; and 2nd in Asia, in
terms of number of contracts traded, in equity derivatives instrument. For more information
please visit www.nseindia.com.
United Stock Exchange (USE)
United Stock Exchange (USE), Indias newest stock exchange, represents the
commitment of all 21 Indian public sector banks, respected private banks and corporate
houses to build an institution that is on its way to becoming an enduring symbol of Indias
modern financial markets. USE also boasts of Bombay Stock Exchange, as a strategic
partner. As Asias oldest stock exchange, BSE lends decades of unparalleled expertise in
exchange technology, clearing & settlement, regulatory structure and governance.
Leveraging the collective experience of its founding partners, USE has developed a
trustworthy and state of the art exchange platform that provides a truly world class trading
experience. For more information please visit www.useindia.com
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INTRODUCTION TO CURRENCY DERIVATIVES:-
Each country has its own currency through which both national and
international transactions are performed. All the international business transactions
involve an exchange of one currency for another.
For example,
If any Indian firm borrows funds from international financial market in US
dollars for short or long term then at maturity the same would be refunded in particular
agreed currency along with accrued interest on borrowed money. It means that the
borrowed foreign currency brought in the country will be converted into Indian currency,
and when borrowed fund are paid to the lender then the home currency will be converted
into foreign lenders currency. Thus, the currency units of a country involve an exchange
of one currency for another.
The price of one currency in terms of other currency is known as
exchange rate.
The foreign exchange markets of a country provide the mechanism of exchanging
different currencies with one and another, and thus, facilitating transfer of purchasingpower from one country to another.
With the multiple growths of international trade and finance all over the world,
trading in foreign currencies has grown tremendously over the past several decades. Since
the exchange rates are continuously changing, so the firms are exposed to the risk of
exchange rate movements. As a result the assets or liability or cash flows of a firm which
are denominated in foreign currencies undergo a change in value over a period of time due
to variation in exchange rates.
This variability in the value of assets or liabilities or cash flows is referred to
exchange rate risk. Since the fixed exchange rate system has been fallen in the early 1970s,
specifically in developed countries, the currency risk has become substantial for many
business firms. As a result, these firms are increasingly turning to various risk hedging
products like foreign currency futures, foreign currency forwards, foreign currency options,
and foreign currency swaps.
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INTRODUCTION TO CURRENCY FUTURE
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 futurescontract.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 or delivery date. Both parties of the futures contract must fulfill their
obligations on the settlement date
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 (thenumber of currency units being traded) and also what is the tick value.
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 paise or 0.0025 Rupees. 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: +Rs. 00.0025
New price: Rs .42.2525
Purchase price: Rs .42.2500
Price decreases by one tick: Rs. 00.0025
New price: Rs.42. 2475
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The value of one tick on each contract is Rupees 2.50. So if a trader buys 5
contracts and the price moves up by 4 tick, she makes Rupees 50.
Step 1: 42.260042.2500
Step 2: 4 ticks * 5 contracts = 20 points
Step 3: 20 points * Rupees 2.5 per tick = Rupees 50
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Chapter 5
BRIEF OVERVIEW OF FOREIGN
EXCHANGE MARKET
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OVERVIEW OF THE FOREIGN EXCHANGE MARKET IN INDIA:-
During the early 1990s, India embarked on a series of structural reforms in the
foreign exchange market. The exchange rate regime, that was earlier pegged, was partially
floated in March 1992 and fully floated in March 1993. The unification of the exchange rate
was instrumental in developing a market-determined exchange rate of the rupee and was
an important step in the progress towards total current account convertibility, which was
achieved in August 1994.
Although liberalization helped the Indian foreign market in various ways, it led to
extensive fluctuations of exchange rate. This issue has attracted a great deal of concern from
policy-makers and investors. While some flexibility in foreign exchange markets and
exchange rate determination is desirable, excessive volatility can have an adverse impact on
price discovery, export performance, sustainability of current account balance, and balance
sheets. In the context of upgrading Indian foreign exchange market to international standards,
a well- developed foreign exchange derivative market (both OTC as well as Exchange-
traded) is imperative.
With a view to enable entities to manage volatility in the currency market, RBI on
April 20, 2007 issued comprehensive guidelines on the usage of foreign currency forwards,
swaps and options in the OTC market. At the same time, RBI also set up an Internal Working
Group to explore the advantages of introducing currency futures. The Report of the Internal
Working Group of RBI submitted in April 2008, recommended the introduction of Exchange
Traded Currency Futures.
Subsequently, RBI and SEBI jointly constituted a Standing Technical Committee to
analyze the Currency Forward and Future market around the world and lay down the
guidelines to introduce Exchange Traded Currency Futures in the Indian market. The
Committee submitted itsreport on May 29, 2008. FurtherRBI andSEBI also issued circulars
in this regard on August 06, 2008.
Currently, India is a USD 34 billion OTC market, where all the major currencies like
USD, EURO, YEN, Pound, Swiss Franc etc. are traded. With the help of electronic trading
and efficient risk management systems, Exchange Traded Currency Futures will bring in
more
http://www.bseindia.com/deri/Downloads/CDX/rbirep_290508.pdfhttp://www.bseindia.com/deri/Downloads/CDX/rbi_circular060808.pdfhttp://www.bseindia.com/deri/Downloads/CDX/sebi_060808.pdfhttp://www.bseindia.com/deri/Downloads/CDX/sebi_060808.pdfhttp://www.bseindia.com/deri/Downloads/CDX/rbi_circular060808.pdfhttp://www.bseindia.com/deri/Downloads/CDX/rbirep_290508.pdf -
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transparency and efficiency in price discovery, eliminate counterparty credit risk, provide
access to all types of market participants, offer standardized products and provide transparent
trading platform. Banks are also allowed to become members of this segment on the
Exchange, thereby providing them with a new opportunity.
Source :-( Report of the RBI -SEBI standing techn ical committee on exchange traded
currency futures) 2008.
CURRENCY 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.
FORWARD :
The basic objective of a forward market in any underlying asset is to fix a price for a
contract to be carried through on the future agreed date and is intended to free both the
purchaser and the seller from any risk of loss which might incur due to fluctuations in the
price of underlying asset.
A forward contract is customized contract between two entities, where settlement
takes place on a specific date in the future at todays pre-agreed price. The exchange rate is
fixed at the time the contract is entered into. This is known as forward exchange rate or
simply forward rate.
FUTURE :
A currency futures contract provides a simultaneous right and obligation to
buy and sell a particular currency at a specified future date, a specified price and a standard
quantity. In another word, a future contract is an agreement between two parties to buy or
sell an asset at a certain time in the future at a certain price. Future contracts are special types
of forward contracts in the sense that they are standardized exchange-traded contracts.
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SWAP: Swap is private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolio of forward
contracts.
The currency swap entails 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. There are a various types of currency swaps like as fixed-to-fixed
currency swap, floating to floating swap, fixed to floating currency swap.
In a swap normally three basic steps are involve:-
(1) Initial exchange of principal amount
(2) Ongoing exchange of interest
(3) Re - exchange of principal amount on maturity.
OPTIONS :
Currency option is a financial instrument that give the option holder a right
and not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per
unit for a specified time period ( until the expiration date ). In other words, a foreign
currency option is a contract for future delivery of a specified currency in exchange for
another in which buyer of the option has to right to buy (call) or sell (put) a particular
currency at an agreed price for or within specified period. The seller of the option gets the
premium from the buyer of the option for the obligation undertaken in the contract. Options
generally have lives of up to one year, the majority of options traded on options exchanges
having a maximum maturity of nine months. Longer dated options are called warrantsand
are generally traded OTC.
FOREIGN EXCHANGE SPOT (CASH) MARKET:-
The foreign exchange spot market trades in different currencies for both spot and
forward delivery. Generally they do not have specific location, and mostly take place
primarily by means of telecommunications both within and between countries. It consists of
a network of foreign dealers which are oftenly banks, financial institutions, large concerns,
etc. The large banks usually make markets in different currencies.
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In the spot exchange market, the business is transacted throughout the world on a
continual basis. So it is possible to transaction in foreign exchange markets 24 hours a day.
The standard settlement period in this market is 48 hours, i.e., 2 days after the execution of
the transaction.
The spot foreign exchange market is similar to the OTC market for securities. There is
no centralized meeting place and no fixed opening and closing time. Since most of the
business in this market is done by banks, hence, transaction usually do not involve a physical
transfer of currency, rather simply book keeping transfer entry among banks.Exchange rates
are generally determined by demand and supply force in this market. The purchase and sale
of currencies stem partly from the need to finance trade in goods and services. Another
important source of demand and supply arises from the participation of the central banks
which would emanate from a desire to influence the direction, extent or speed of exchange
rate movements.
FOREIGN EXCHANGE QUOTATIONS
Foreign exchange quotations can be confusing because currencies are quoted in terms of
other currencies. It means exchange rate is relative price.
For example,
If one US dollar is worth of Rs. 45 in Indian rupees then it implies that 45
Indian rupees will buy one dollar of USA, or that one rupee is worth of 0.022 US dollar
which is simply reciprocal of the former dollar exchange rate.
EXCHANGE RATE
Direct Indirect
The number of units of domestic The number of unit of foreign
Currency stated against one unit currency per unit of domestic
of foreign currency. currency.
Re/$ = 45.7250 ( or ) Re 1 = $ 0.02187
$1 = Rs. 45.7250
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There are two ways of quoting exchange rates: the direct and indirect.
Most countries use the direct method. In global foreign exchange market, two rates are
quoted by the dealer: one rate for buying (bid rate), and another for selling (ask or
offered rate) for a currency. This is a unique feature of this market. It should be noted
that where the bank sells dollars against rupees, one can say that rupees against dollar. In
order to separate buying and selling rate, a small dash or oblique line is drawn after the
dash.
For example-
If US dollar is quoted in the market as Rs 46.3500/3550, it means that the
forex dealer is ready to purchase the dollar at Rs 46.3500 and ready to sell at Rs 46.3550.The difference between the buying and selling rates is called spread It is important to note
that selling rate is always higher than the buying rate. Traders, usually large banks, deal in
two way prices, both buying and selling, are called market makers.
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 thebase currency. That is the expression Dollar-Rupee, tells you that the Dollar is being quoted
in terms of the Rupee. The 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--vis the second currency. Changes are also expressed as
appreciati on or depreciationof one currency in terms of the second currency. Whenever the
base currency buys more of the terms currency, the base currency has strengthened /
appreciated and the terms currency has weakened / depreciated.
For example,
If DollarRupee moved from 43.00 to 43.25. The Dollar has appreciated and
the Rupee has depreciated. And if it moved from 43.0000 to 42.7525 the Dollar has
depreciated and Rupee has appreciated.
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NEED FOR EXCHANGE TRADED CURRENCY FUTURES:-
With a view to enable entities to manage volatility in the currency market, RBI on
April 20, 2007 issued comprehensive guidelines on the usage of foreign currency forwards,
swaps and options in the OTC market. At the same time, RBI also set up an Internal Working
Group to explore the advantages of introducing currency futures. The Report of the Internal
Working Group of RBI submitted in April 2008, recommended the introduction of exchange
traded currency futures. Exchange traded futures as compared to OTC forwards serve the
same economicpurpose, yet differ in fundamental ways. An individual entering into a
forwardcontract agrees to transact at a forward price on a future date. On the maturitydate,
the obligation of the individual equals the forward price at which thecontract was executed.
Except on the maturity date, no money changes hands. On the other hand, in the case of an
exchange traded futures contract, mark to marketobligations is settled on a daily basis. Since
the profits or losses in the futuresmarket are collected / paid on a daily basis, the scope for
building up of mark to market losses in the books of various participants gets limited.The
counterparty risk in a futures contract is further eliminated by the presence of a clearing
corporation, which by assuming counterparty guarantee eliminates credit risk.
Further, in an Exchange traded scenario where the market lot is fixed at a much lesser size
than the OTC market, equitable opportunity is provided to all classes of investors whether
large or small to participate in the futures market. The transactions on an Exchange are
executed on a price time priority ensuring that the best price is available to all categories of
market participants irrespective of their size. Other advantages of an Exchange traded
market would be greater transparency, efficiency and accessibility.
Source :-(Report of the RBI -SEBI standing techn ical commi ttee on exchange traded
currency futu res) 2008.
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RATIONALE FOR INTRODUCING CURRENCY FUTURE:-
Futures markets were designed to solve the 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 and quality 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
Quality 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 non-residents purchase domestic currency assets. If the exchange rate remains unchangedfrom 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.
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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. As such, there is a strong need to
hedge currency risk and this need has grown manifold with fast growth in cross-border 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 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.
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FUTURE TERMINOLOGY:-
SPOT PRICE :
The price at which an asset trades in the spot market. The transaction in
which securities and foreign exchange get traded for immediate delivery. Since the
exchange of securities and cash is virtually immediate, the term, cash market, has also
been used to refer to spot dealing. In the case of USDINR, spot value is T + 2.
FUTURE PRICE :
The price at which the future contract traded in the future market.
CONTRACT CYCLE :
The period over which a contract trades. The currency future
contracts in Indian market have one month, two month, and three month up to twelve
month expiry cycles. In NSE/BSE will have 12 contracts outstanding at any given
point in time.
VALUE DATE / FINAL SETTELMENT 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 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 case of USDINR it is USD 1000.
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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 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 :
When the position is opened, the member has to deposit the margin with
the clearing house as per the rate fixed by the exchange which may vary asset to asset.
Or in another words, the amount that must be deposited in the margin account at the
time a future contract is first entered into is known as initial margin.
MARKING TO MARKET :
At the end of trading session, all the outstanding contracts are reprised at
the settlement price of that session. It means that all the futures contracts are daily
settled, and profit and loss is determined on each transaction. This procedure, called
marking to market, requires that funds charge every day. The funds are added or
subtracted from a mandatory margin (initial margin) that traders are required to
maintain the balance in the account. Due to this adjustment, futures contract is also
called as daily reconnected forwards.
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MAINTENANCE MARGIN :
Members account are debited or credited on a daily basis. In turn
customers account are also required to be maintained at a certain level, usually about
75 percent of the initial margin, is called the 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.
TRADING PROCESS AND SETTLEMENT PROCESS :-
Like other future trading, the future currencies are also traded at organized exchanges.
The following diagram shows how operation take place on currency future market:
It has been observed that in most futures markets, actual physical delivery of the underlying
assets is very rare and hardly has it ranged from 1 percent to 5 percent. Most often buyers and
TRADER
(BUYER)
TRADER
(SELLER)
MEMBER
(BROKER)
MEMBER
(BROKER)
CLEARING
HOUSE
Purchase order Sales order
Transaction on the floor (Exchange)
Informs
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sellers offset their original position prior to delivery date by taking an opposite positions.
This is because most of futures contracts in different products are predominantly speculative
instruments. For example, X purchases American Dollar futures and Y sells it. It leads to two
contracts, first, X party and clearing house and second Y party and clearing house. Assume
next day X sells same contract to Z, then X is out of the picture and the clearing house is
seller to Z and buyer from Y, and hence, this process is goes on.
REGULATORY FRAMEWORK FOR CURRENCY FUTURES:-
With a view to enable entities to manage volatility in the currency market, RBI on April 20,
2007 issued comprehensive guidelines on the usage of foreign currency forwards, swaps and
options in the OTC market. At the same time, RBI also set up an Internal Working Group toexplore the advantages of introducing currency futures. The Report of the Internal Working
Group of RBI submitted in April 2008, recommended the introduction of exchange traded
currency futures. With the expected benefits of exchange traded currency futures, it was
decided in a joint meeting of RBI and SEBI on February 28, 2008, that an RBI-SEBI
Standing Technical Committee on Exchange Traded Currency and Interest Rate Derivatives
would be constituted. To begin with, the Committee would evolve norms and oversee the
implementation of Exchange traded currency futures. The Terms of Reference to the
Committee was as under:
1. To coordinate the regulatory roles of RBI and SEBI in regard to trading of Currency
and Interest Rate Futures on the Exchanges.
2. To suggest the eligibility norms for existing and new Exchanges for Currency and
Interest Rate Futures trading.
3. To suggest eligibility criteria for the members of such exchanges.
4. To review product design, margin requirements and other risk mitigation measures on
an ongoing basis.
5. To suggest surveillance mechanism and dissemination of market information.
6. To consider microstructure issues, in the overall interest of financial stability.
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COMPARISION OF FORWARD AND FUTURES CURRENCY CONTRACT:-
BASIS FORWARD FUTURES
Size Structured as per requirement of
the parties
Standardized
Delivery date Tailored on individual needs Standardized
Method of transaction Established by the bank or
broker through electronic media
Open auction among buyers and seller on the floor of
recognized exchange.
Participants Banks, brokers, forex dealers,
multinational companies,
institutional investors,
arbitrageurs, traders, etc.
Banks, brokers, multinational companies, institutional
investors, small traders, speculators, arbitrageurs, etc.
Margins None as such, but
compensating bank balanced
may be required
Margin deposit required
Maturity Tailored to needs: from one
week to 10 years
Standardized
Settlement Actual delivery or offset with
cash settlement. No separate
clearing house
Daily settlement to the market and variation margin
requirements
Market place Over the telephone worldwide
and computer networks
At recognized exchange floor with worldwide
communications
Accessibility Limited to large customers
banks, institutions, etc.
Open to any one who is in need of hedging facilities or
has risk capital to speculate
Delivery More than 90 percent settled by
actual delivery
Actual delivery has very less even below one percent
Secured Risk is high being less secured Highly secured through margin deposit.
A currency future, also known as FX future, is a futures contract to exchange one currency
for another at a specified date in the future at a price (exchange rate) that is fixed on the
purchase date. On NSE the price of a future contract is in terms of INR per unit of other
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currency e.g. US Dollars. Currency future contracts allow investors to hedge against foreign
exchange risk. Currency Derivatives are available on four currency pairs viz. US Dollars
(USD), Euro (EUR), Great Britain Pound (GBP) and Japanese Yen (JPY). Currency options
are currently available on US Dollars.
Clearing & Settlement - Currency Derivatives National Securities Clearing
Corporation Limited (NSCCL) is the clearing and settlement agency for all deals executed on
the Currency Derivatives segment. NSCCL acts as legal counter-party to all deals on NSE's
Currency Derivatives segment and guarantees settlement. A Clearing Member (CM) of
NSCCL has the responsibility of clearing and settlement of all deals executed by Trading
Members (TM) on NSE, who clear and settle such deals through them.
Futures vs. Forwards:-
Currency Futures Forwards
Type of Contracts Standardized Customized
Price transparencyHigh, Real time rate Low, Over the phone
Accessibility Online / Offline modes Offline/ OTC
Underlying exposure Not Required Required
Margin
Requirement
3.00% Non standardized may vary from 8-12
%
MTM Settlement Daily Settled NA
Settlement Net settled in INR
(Cash)
Physical Settlement
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Chapter :
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Concept of interest rate parity:-
Let us assume that risk free interest rate for one year deposit in India is 7% andin USA it is 3%. You as smart trader/ investor will raise money from USA and deploy it in
India and try to capture the arbitrage of 4%. You could continue to do so and make this
transaction as a non ending money making machine. Life is not that simple! And such
arbitrages do not exist for very long.
We will carry out the above transaction through an example to explain the concept of
interest rate parity and derivation of future prices which ensure that arbitrage does not exist
Assumptions:
1. Spot exchange rate of USDINR is 50 (S)
2. One year future rate for USDINR is F
3. Risk free interest rate for one year in USA is 3% (RUSD)
4. Risk free interest rate for one year in India is 7% (R INR)
5. Money can be transferred easily from one country into another without anyrestriction of
amount, without any taxes etc
You decide to borrow one USD from USA for one year, bring it to India, convert it in
INR and deposit for one year in India. After one year, you return the money back to USA.On
start of this transaction, you borrow 1 USD in US at the rate of 3% and agree to return 1.03
USD after one year (including interest of 3 cents). This 1 USD is converted into INR at the
prevailing spot rate of 50. You deposit the resulting INR 50 for one year at interest rate of
7%. At the end of one year, you receive INR 3.5 (7% of 50) as interest on your deposit and
also get back your principal of INR 50 i.e., you receive a total of INR 53.5. You need to use
these proceeds to repay the loan taken in USA.
Two important things to think before we proceed:
The loan taken in USA was in USD and currently you have INR. Therefore you
need to convert INR into USD
What exchange rate do you use to convert INR into USD?
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At the beginning of the transaction, you would lock the conversion rate of INR into
US Dusing one year future price of USDINR. To ensure that the transaction does not result
into any risk free profit, the money which you receive in India after one year should be equal
to the loan amount that you have to pay in USA. We will convert the above argument into a
formula:
S(1+R INR)= F(1+R USD)
Or, F/S = (1+R INR)/(1+RUSD)
Another way to illustrate the concept is to think that the INR 53.5 received after one year in
India should be equal to USD 1.03 when converted using one year future exchange rate.
Therefore,
F/ 50 = (1+.07) / (1+.03)
F= 51.9417
Approximately, F is equal to the interest rate difference between two currencies i.e.,
F = S + (R INR- R USD)*S
This concept of difference between future exchange rate and spot exchange rate being
approximately equal to the difference in domestic and foreign interest rate is called theInterest rate parity. Alternative way to explain, interest rate parity says that the spotprice
and futures price of a currency pair incorporates any interest rate differentials between the
two currencies assuming there are no transaction costs or taxes. A more accurate formula for
calculating, the arbitrage-free forward price is as follows.
F = S(1 + RQCPeriod) / (1 + RBCPeriod)
Where
F = forward price
S = spot price
R BC = interest rate on base currency
R QC = interest rate on quoting currency
Period = forward period in years
For a quick estimate of forward premium, following formula mentioned above for USDINR
currency pair could be used. The formula is generalized for other currency pairand is given
below:
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F = S + (S(RQCRBC)Period)
In above example, if USD interest rate were to go up and INR interest rate were to remain at
7%, the one year future price of USDINR would decline as the interest rate difference
between the two currencies has narrowed and vice versa. Traders use expectation on change
in interest rate to initiate long/ short positions in currency futures. Everything else remaining
the same, if USD interest rate is expected to go up (say from 2.5% to 3.0%) and INR interest
rate are expected to remain constant say at 7%; a trader would initiate a short position in
USDINR futures market.
Illustration:
Suppose 6 month interest rate in India is 5% (or 10% per annum) and in USA are 1% (2%
per annum). The current USDINR spot rate is 50. What is the likely 6 month USDINR
futures price? As explained above, as per interest rate parity, future rate is equal to the
interest rate differential between two currency pairs. Therefore approximately 6 month future
rate would be:
Spot + 6 month interest difference = 50 + 4% of 50
= 50 + 2 = 52
The exact rate could be calculated using the formula mentioned above and the answer comes
to 51.98.
51.98 = 50 x (1+0.1/12 x 6) / (1+0.02/12 x 6)
Concept of premium and discount
Therefore one year future price of USDINR pair is 51.94 when spot price is 50. It means that
INR is at discount to USD and USD is at premium to INR. Intuitively to understand why INRis called at discount to USD, think that to buy same 1 USD you had to pay INR 50 and you
have to pay 51.94 after one year i.e., you have to pay more INR to buy same 1 USD. And
therefore future value of INR is at discount to USD. Therefore in any currency pair, future
value of a currency with high interest rate is at a discount (in relation to spot price) to the
currency with low interest rate.
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PRODUCT DEFINITIONS OF CURRENCY FUTURE ON NSE/BSE:
Underlying
Initially, currency futures contracts on US Dollar Indian Rupee (US$-INR) would be
permitted.
Trading Hours
The trading on currency futures would be available from 9 a.m. to 5 p.m.
Size of the contract
The minimum contract size of the currency futures contract at the time of introduction would
be US$ 1000. The contract size would be periodically aligned to ensure that the size of the
contract remains close to the minimum size.
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.
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 Reference Rate on the date of expiry. The
methodology of computation and dissemination of the Reference Rate may be publicly
disclosed by RBI.
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Final settlement day
The currency futures contract would expire on the last working day (excluding Saturdays) of
the month. The last working day would be taken to be the same as that for Interbank
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.
The contract specification in a tabular form is as under:
Underlying Rate of exchange between one USD and
Trading Hours 09:00 a.m. to