foreign currency final

8/8/2019 Foreign Currency Final

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Bonanza Portfolio Ltd, Ahmedabad.

Kalol Institute of Management, Kalol (2009-11) Page 1

Bonanza Portfolio Ltd., Ahmedabad

A Project Report

On

Scope and Limitation of Currency Derivative in India

For the partial fulfilment of the requirement of MBA programme

Submitted To:-Kalol Institute of Management

Kalol

Submitted By:-

Chitrang Patel

Enrolment No: - 097250592005

Kalol Institute of Management, Kalol


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Project Title: Scope and Limitation of Currency Derivative in India

Company Name: Bonanza Portfolio Limited

Address: 403-406 Shital Varsha Arcade,

Nr. Girish Cold Drink Cross Roads,

C.G. Road, Ahmedabad

Phone No.: 79-30014300

Website: www.bonanzaonline.com

Department: Derivatives Division

Project Guide: Mr. Ashish Mishra,

Manager Currency

Mobile: 9898884357

E- mail: [email protected]


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ACKNOWLEDGEMENT

I hereby take the opportunity to express my wholehearted thankfulness to Bonanza Portfolio

Limited, Ahmedabad. Summer Internship Programme at Bonanza Portfolio Limited,

Ahmedabad has been very fruitful and I have heartily enjoyed work allotted to me.

Successful completion of the project is indebted to the support of all the members of

derivative department of Bonanza Portfolio Limited, involved directly or indirectly with the

project. This association has provided me with a comprehensive insight into the currency

derivative market.

I would like to express my gratitude to my project guide Mr. Ashish Mishra, Manager

Currency, Bonanza Portfolio Limited, who gave me an opportunity to pursue project with the

organization.

I would like to place on record my indebtedness to Lecturer Bhumi Parekh,Faculty Guide,

Kalol Institute Of Management, Kalol, for encouraging me and showing confidence in me to

take up as guide for my project, and other faculty members (Especially in the area of finance)

at the institute, who trained me not only to understand the business environment but also to

adapt to the demanding needs of the business community.

Chitrang Patel

Roll No:-157-A

Enrollment No:- 097250592005


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DECLARAT ON

I, the undersigned, Mr.Chitrang Patel student of M.B.A. hereby declare that project work

presented here is my own work and has been carried out under supervision ofMr. aashish

Mishra(Manager-Currency) and Miss Bhumi Parekh (Lecturer of Kalol Institute of

Management) and has not been submitted to any other university for any examination.

Signature of Student

Chitrang Patel

Kalol Institute of Management

M.B.A.

Gujarat Technological University


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Executive Summary

The projectis a comprehensivestur

y ofscope andlimitation ofcurrency derivative in India.

Bonanza Portfolio Limited is a leading Financial Services & Brokerage company working

since 1994. Ithasspreaditstrustworthytentacles alloverthe country with more than 1025

outletss pread across 340 cities. Especially itsservices in derivatives are best among

competitors.

As Indian derivative market developed with time, the numbers of users of derivatives has

grown u p rapidly. The variety of derivatives instruments available for trading is also

expanding. Still there isscope for development. This project is a study of the customers or

users of their derivatives andfind outsuitable products according to customers need. For

this purpose a survey is prepared andsent to respondents and then an analysis of the

response is done.

There are many legal bindingfor derivatives in India as well. Reserve Bank of India has

made many regulations regarding derivative contracts. Further regulatory reform willhelp

the markets grow faster. For example, Indian commodity derivatives have great growth

potentialbutgovernmentpolicies have resultedin the underlyingspot/physicalmarketbeing

fragmented (e.g. due to lack offree movementofcommodities and differentialtaxation within

India).

As Indian derivatives markets grow more sophisticated, greater investor awareness will

become essential. Thefirms providingthese services are boundto understandthe customer

needs devote resourcesto develop the business processes andfulfilthem.

The projectreportalso coversthe people use currency derivatives, product, trading process,

advantage, limitations, andsuggestion in currency derivatives.


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TABLE OF CONTENT

Sr.

No.

Particular Page

No.1. Industry Profile 7

2. Company Profile 14

3. Brief Overview Of the Foreign Exchange Market In India 173.1- Purpose 183.2- Foreign Exchange Spot (Cash) Market ... 193.3- Foreign Exchange Quotations . 20

4 Introduction about Currency Derivatives 224.1- Definition and Uses of Derivatives . 224.2- Rise of Derivatives market .. 22

4.3- Exchange-Traded and Over-the-Counter Derivative Instruments.............. 234.4- Concept of Currency Derivative . 244.5- Types of Currency Derivative Instrument . 244.6- Development of Derivative Markets in India . 274.7- Derivatives Users in India .. 284.8- Why Use of Currency Derivatives .. 30

6 Accounting of Currency Derivatives 33

7. Regulatory Framework 357.1- Evolution of a legal framework for derivatives trading in India . 357.2- International regulation of derivatives markets ... 38

7.3- RBI Regulations .. 398. Foreign Exchange Risk Management 43

8.1- Necessity of managing foreign exchange risk . 438.2- Foreign Exchange Risk Management Framework .. 448.3- Factors affecting the decision to hedge foreign currency risk . 46

9. Report On Project Work 479.1- Title of the Project: .. 479.2- Objectives of the Project: 479.3- Research Methodology and Data Collection ... 479.4- Primary Data Analysis . 49

10. Findings & suggestions 5711. Conclusion 58

12. Annexure 6011.1-Questionnaire 60


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INDUSTRY PROFILE

The Indian broking industry is one of the oldest trading industries that have been aroundeven before the establishment of the BSE in 1275. Despite passing through a number ofchanges in the post liberalization period, the industry has found its way towards sustainablegrowth. With the purpose of gaining a deeper understanding about the role of the Indianstock broking industry in the countrys economy, we present in this section some of theindustry insights gleaned from analysis of data received through primary research.

For the broking industry, we started with an initial database of over 1,800 broking firms thatwere contacted, from which 464 responses were received. The list was further short listed

based on the number of terminals and the top 210 were selected for profiling. 394 responses,that provided more than 85% of the information sought have been included for this analysis

presented here as insights. All the data for the study was collected through responsesreceived directly from the broking firms. The insights have been arrived at through ananalysis on various parameters, pertinent to the equity broking industry, such as region,terminal, market, branches, sub brokers, products and growth areas.

Some key characteristics of the sample 394 firms are:

y On the basis of geographical concentration, the West region has the maximumrepresentation of 52%. Around 24% firms are located in the North, 13% in the South

and 10% in the Easty 3% firms started broking operations before 1950, 65% between 1950-1995 and 32%

post1995

y On the basis of terminals, 40% are located at Mumbai, 12% in Delhi, 8% inAhmedabad, 7% in Kolkata, 4% in Chennai and 29% are from other cities

y From this study, we find that almost 36% firms trade in cash and derivatives and 27%are into cash markets alone. Around 20% trade in cash, derivatives and commodities

y In the cash market, around 34% firms trade at NSE, 14% at BSE and 52% trade atboth exchanges. In the derivative segment, 48% trade at NSE, 7% at BSE and 45% at

both, whereas in the debt market, 31% trade at NSE, 26% at BSE and 43% at bothexchanges

y Majority of branches are located in the North, i.e. around 40%. West has 31%, 24%are located in South and 5% in East

y In terms of sub-brokers, around 55% are located in the South, 29% in West, 11% inNorth and 4% in East

y Trading, IPOs and Mutual Funds are the top three products offered with 90% firmsoffering trading, 67% IPOs and 53% firms offering mutual fund transactions

y In terms of various areas of growth, 84% firms have expressed interest in expandingtheir institutional clients, 66% firms intend to increase FII clients and 43% areinterested in setting up JV in India and abroad

y In terms of IT penetration, 62% firms have provided their website and around 94%firms have email facility.


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Terminals

Almost 52% of the terminals in the sample are based in the Western region of India,followed by 25% in the North, 13% in the South and 10% in the East. Mumbai has got the

maximum representation from the West, Chennai from the South, New Delhi from the Northand Kolkata from the East.

Mumbai also has got the maximum representation in having the highest number ofterminals. 40% terminals are located in Mumbai while 12% are from Delhi, 8% fromAhmedabad, 7% from Kolkata, 4% from Chennai and 29% are from other cities in India.

Branches & Sub-Brokers

The maximum concentration of branches is in the North, with as many as 40% of allbranches located there, followed by the Western region, with 31% branches. Around 24%branches are located in the South and East constitutes for 5% of the total branches of the

total sample.

In case of sub-brokers, almost 55% of them are based in the South. West and North follow,with 30% and 11% sub-brokers respectively, whereas East has around 4% of total sub-

brokers.


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Financial Markets

The financial markets have been classified as cash market, derivatives market, debt market

and commodities market. Cash market, also known as spot market, is the most sought afteramongst investors. Majority of the sample broking firms are dealing in the cash market,

followed by derivative and commodities. 27% firms are dealing only in the cash market,whereas 35% are into cash and derivatives. Almost 20% firms trade in cash, derivatives and

commodities market. Firms that are into cash, derivatives and debt are 7%. On the otherhand, firms into cash and commodities are 3%, cash & debt market and commodities aloneare 2%. 4% firms trade in all the markets.

In the cash market, around 34% firms trade at NSE, 14% at BSE and 52% trade at both

exchanges. In the equity derivative market, 48% of the sampled broking houses are members

of NSE and 7% trade at BSE, while 45% of the sample operate in both stock exchanges.

Around 4% of total sub-broker.


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Financial Markets

The financial markets have been classified as cash market, derivatives market, debt market

and commodities market. Cash market, also known as spot market, is the most sought afteramongst investors. Majority of the sample broking firms are dealing in the cash market,

followed by derivative and commodities. 27% firms are dealing only in the cash market,whereas 35% are into cash and derivatives. Almost 20% firms trade in cash, derivatives and

commodities market. Firms that are into cash, derivatives and debt are 7%. On the otherhand, firms into cash and commodities are 3%, cash & debt market and commodities alone

are 2%. 4% firms trade in all the markets.

In the cash market, around 34% firms trade at NSE, 14% at BSE and 52% trade at both

exchanges. In the equity derivative market, 48% of the sampled broking houses are members

of NSE and 7% trade at BSE, while 45% of the sample operate in both stock exchanges.

Around 43% of the broking houses operating in the debt market, trade at both exchangeswith 31% and 26% firms uniquely at NSE and BSE respectively.


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Details ofBig Broker Houses

Company name Total teminals Sub brokers No.ofemployees No. of

branches

City

Angel broking ltd 5081 2408 1800 66 Mumbai

Bonanza portfolio ltd 2177 536 1200 380 Delhi

Geojit portfolio ltd 2410 109 2100 383 Kochi

ICICI securities ltd 1051 587 1833 270 Mumbai

Indiabulls securities

ltd

2700 NA 8922 475 New delhi

Motilal oswal

securities ltd

4179 638 2000 60 Mumbai

SMC global securities

ltd

3132 800 1000 800 New delhi

Company name Total

terminals

Sub

brokers

No.of

employees

No. of

branches

City

Angel broking ltd 5081 2408 1800 66 Mumbai

Bonanza portfolioltd

2177 536 1200 380 Delhi

Geojit portfolio ltd 2410 109 2100 383 Kochi

ICICI securities ltd 1051 587 1833 270 Mumbai

Indiabullssecurities ltd

2700 NA 8922 475 New delhi

Motilal oswalsecurities ltd

4179 638 2000 60 Mumbai

SMC globalsecurities ltd

3132 800 1000 800 New delhi


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Market Structure

Indian securities market is fairly large as compared to several other emerging markets. Thereare 22 stock exchanges in the country, though the entire liquidity is shared between thecountrys two national level exchanges namely, the National Stock Exchange of India andthe Bombay Stock Exchange Ltd. The regional stock exchanges are in pursuit of business

models that make them viable and vibrant. Meanwhile, these exchanges have becomemembers of the national level exchanges through formation of subsidiaries whose businessis showing continuous growth and progress.

The number of brokers in various stock exchanges rose from 6,711 in 1994-95 to 9,335 inFY06. The number of brokers in all the exchanges together peaked to 10,213 in the yearFY01 but gradually declined thereafter when the regional stock exchanges began to lose

business in the light of wide ranging market structure reforms introduced since then. InFY01, when the markets were in upswing, several regional stock exchanges were generating

business owing to the availability of deferral products, such Badla and different settlementcalendars prevailing at that time in these exchanges. For instance in FY01, the Delhi Stock

Exchange registered cash market turnover of Rs 838.71 bn; Uttar Pradesh Stock Exchange,Rs 247.47 bn, Ludhiana Stock Exchange Rs 97.32 bn, Pune Stock Exchange Rs 61.71 bn asagainst Rs 13,395.11 bn of the turnover at the National Stock Exchange and Rs 10,000.32 bnturnover at the Bombay Stock Exchange. With the abolition of the deferral products andintroduction of uniform T+2 settlement cycle, the liquidity in these exchanges flowed to thenational level system consisting of NSE and BSE.


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Indian Stock Markets: Growth of Market Structure (In Number)

Source: Securities and Exchange Board of India

Sub-brokers are an important constituent of Indian stock markets. Sub-brokers work under brokers with specified limits for trading and risk management. Sub -brokers are term asuseful part in the value chain since they provide active interface with a large number ofinvestors across the country and also extend the reach and access of the services of the

brokerage firms. With the rapid growth of securities trading and deepening of the stockmarkets, the number of sub-brokers nearly doubled in the last ten years from 9,957 in FY01

to 23,479 in FY06.

Exchange-wise Brokers and Sub-Brokers in Indian StockExchanges 2005-06

Source: Securities and Exchange Board of India


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COMPANY PROFILE

Bonanza a leading Financial Services & Brokerage House working diligently since 1994 can

be described in a single word as a "Financial Powerhouse". With acknowledged industryleadership in execution and clearing services on Exchange Traded Derivatives and cash

market products. Bonanza has spread its trustworthy tentacles all over the country with more

than 1025 outlets spread across 340 cities.

It provides an extensive smorgasbord of services in equity, commodities, currency

derivatives, wealth management, distribution of third party products etc.

1.1. Products and Services:- Primary Brokerage Services

y Equityy Equity Derivativesy Commodityy Depository Services

Fixed Incomey Mutual Fundy

IPOy Insurance

Investment Management Professional Fund Management Other Services

y Dedicated portfolio manager contacty Expert initial and on-going advicey Continual fund monitoring

In depth reporting on portfolio performance, including graphs & charts.


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Mission & Vision:-

We believe in making money, not mistake.

We owe that to you, for trusting us

Bonanza - it's a windfall:-

One core Mission is clients' wealth generation through professional advice backed by

thorough research and in-depth analysis. We offer a single point access to the vast world of

Financial services. Our strengths included diverse product name, state-of-the-art technology

& vast network across India.

Proven and accredited leaders in the Financial services business, Bonanza provides you the

unique opportunity to trade offline and online while cutting across all geographic barriers.

y Strategic tie-up that provide latest technology for access and processingy Trading over425 locations across 160 cities in India.y 24 hour access to Account Information via the net or Electronic File transfer (FTP)

facilities.

y Corporate Agents for life & Non-life Insurance|(both foreign/private state ownedinsurance companies)

y One of the largest distributors of leading Mutual Funds in India

Achievements ofBonanza Portfolio Ltd:-

(1)Top Equity Broking House in Terms of Branch Expansion 2007.(2) 3rd in Term of Number of Trading Account For 2008*.(3)

6

th

in term trading Terminals in for Two Consecutive years 2007& 2008*.

(4)9th in term of Sub Brokers for 2007*( as per the Studies Carried out by DUN &BRADSTREET for top Equity Broking Firm)

(5)Awards by BSE Major Volume Drivers 2006-2007 & 2004-2005.(6) Nominated among the top 3for the Best Financial Advisor Awards 2008 in the

Category of National Distributors-retail instituted by CNBC-TV18.


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(7)Awarded by CNBC channel.(8)Bonanza has 6th position in terms of terminal in India through Economic Times.(9)Provide 24 hours back office.(10)More than 100 franchises in Gujarat in short time.

Membership:-

(1)National Stock Exchange of India(NSEIL)(2)The Bombay Stock Exchange(BSE)(3)Multi Commodity Exchange(MCX)(4)National Commodity & Derivatives Exchange Ltd(NCDEX)(5)National multi commodity exchange(NMCE)(6)Depository Participant for Equity(NSDL/CDSL)(7)Depository participant for commodity(8)Dubai Gold & Commodity Exchange(DGCX)(9)SEBI Authorized PMS(10)Registered Distributor with AMFI

Core Value ofBonanza Portfolio Ltd.:-

Customer satisfaction through providing quality services effectively and efficientlySmile it enhance your face value is a service quality stressed on periodic customer

service audits.

Maximization of Stakeholder value

Success through Team Work Integrity and people.


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Brief 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 forex 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 andoptions 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 analyzethe 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 its report on May 29, 2008. Further RBI and SEBI also issued

circulars in this regard on August 06, 2008.


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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

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 :-(Reportofthe RBI-SEBIstandingtechnicalcommittee on exchange traded currency

futures) 2008.

Purpose

The foreign exchange market is the mechanism by which currencies are valued relative to one

another, and exchanged. An individual or institution buys one currency and sells another in a

simultaneous transaction. Currency trading always occurs in pairs where one currency is sold

for another and is represented in the following notation: EUR/USD or CHF/YEN. The

exchange rate is determined through the interaction of market forces dealing with supply and

demand.

Foreign Exchange Traders generate profits, or losses, by speculating whether a currency will

rise or fall in value in comparison to another currency. A trader would buy the currency

which is anticipated to gain in value, or sell the currency which is anticipated to lose value

against another currency. The value of a currency, in the simplest explanation, is a reflection

of the condition of that country's economy with respect to other major economies. The Forex

market does not rely on any one particular economy. Whether or not an economy is

flourishing or falling into a recession, a trader can earn money by either buying or selling the

currency. Reactive trading is the buying or selling of currencies in response to economic or

political events, while speculative trading is based on a trader anticipating events.


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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 generally banks, financial institutions,

large concerns, etc. The large banks usually make markets in different currencies.

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 andsupplyforce 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.


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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

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.


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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 calledspread.

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.


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Introduction about Currency Derivative

Definition and Uses of Derivatives

A derivative security is a financial contract whose value is derived from the value of

underlying assets, such as a stock price, a commodity price, an exchange rate, an interest rate,

or even an index of prices. Rather than trade or exchange the underlying asset itself,

derivative traders enter into an agreement to exchange cash or assets over time based on the

underlying asset. A simple example of a futures contract is an agreement to exchange the

underlying asset at a future date.

Derivatives are often highly leveraged, such that a small movement in the underlying value

can cause a large difference in the value of the derivative.

Derivatives may be traded for a variety of reasons. A derivative enables a trader to hedge

some pre-existing risk by taking positions in derivatives markets that offset potential losses in

the underlying or spot market. In India, most derivatives users describe themselves as hedgers

(Fitch Ratings, 2004) and Indian laws generally require that derivatives be used for hedging

purposes only. Another motive for derivatives trading is speculation (i.e. taking positions to

profit from anticipated price movements). In practice, it may be difficult to distinguish

whether a particular trade was for hedging or speculation, and active markets require the

participation of both hedgers and speculators.

A third type of trader, called arbitrageurs, profit from discrepancies in the relationship of spot

and derivatives prices, and thereby help to keep markets efficient.

Rise of Derivatives market

The global economic order that emerged after World War II was a system wheremany less developed countries administered prices and centrally allocated resources. Even

the developed economies operated under the Bretton Woods system of fixed exchange rates.

The system of fixed prices came under stress from the 1970s onwards. High inflation

and unemployment rates made interest rates more volatile. The Bretton Woods system was


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Concept of Currency Derivative

A currency derivative is a contract between the seller and the buyer, whose value is to be

derived from the underlying asset, the currency amount. A derivative based on currency

exchange rates is a future contract which stipulates the rate at which a given currency can be

exchanged for another currency as at a future date.

A currency derivative is a product with benefits, such as:

Access to a new asset class for trading to all Resident Indians

Arbitrage opportunity for entities, who can access onshore and non-deliverableforward markets

Volatility and multiplier make it a significant trading option for traders Hedging current exposure:

y Importers and exporters can hedge future payables and receivablesy Borrowers can hedge Foreign Currency loans for interest or principal

payments

y Hedge for offshore investment for Resident Indians

Types of Currency Derivative Instrument

A derivative is a financial contract whose value is derived from the value of some other

financial asset, such as a stock price, a commodity price, an exchange rate, an interest rate, or

even an index of prices. The main role of derivatives is that they reallocate risk amongfinancial market participants, help to make financial markets more complete. This section

outlines the hedging strategies using derivatives with foreign exchange being the only risk

assumed.


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y Forwards: A forward is a made-to-measure agreement between two parties tobuy/sell a specified amount of a currency at a specified rate on a particular date in the

future. The depreciation of the receivable currency is hedged against by selling a

currency forward. If the risk is that of a currency appreciation (if the firm has to buy

that currency in future say for import), it can hedge by buying the currency forward.

E.g if RIL wants to buy crude oil in US dollars six months hence, it can enter into a

forward contract to pay INR and buy USD and lock in a fixed exchange rate for INR-

USD to be paid after 6 months regardless of the actual INR-Dollar rate at the time. In

this example the downside is an appreciation of Dollar which is protected by a fixed

forward contract. The main advantage of a forward is that it can be tailored to the

specific needs of the firm and an exact hedge can be obtained. On the downside, these

contracts are not marketable, they cant be sold to another party when they are no

longer required and are binding.

y Futures: A futures contract is similar to the forward contract but is more liquidbecause it is traded in an organized exchange i.e. the futures market. Depreciation of a

currency can be hedged by selling futures and appreciation can be hedged by buying

futures. Advantages of futures are that there is a central market for futures which

eliminates the problem of double coincidence. Futures require a small initial outlay (a

proportion of the value of the future) with which significant amounts of money can be

gained or lost with the actual forwards price fluctuations. This provides a sort of

leverage. The previous example for a forward contract for RIL applies here also just

that RIL will have to go to a USD futures exchange to purchase standardised dollar

futures equal to the amount to be hedged as the risk is that of appreciation of the

dollar. As mentioned earlier, the tailorability of the futures contract is limited i.e. only

standard denominations of money can be bought instead of the exact amounts that are

bought in forward contracts.

y Options: A currency Option is a contract giving the right, not the obligation, to buyor sell a specific quantity of one foreign currency in exchange for another at a fixed

price; called the Exercise Price or Strike Price. The fixed nature of the exercise price

reduces the uncertainty of exchange rate changes and limits the losses of open

currency positions. Options are particularly suited as a hedging tool for contingent


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cash flows, as is the case in bidding processes. Call Options are used if the risk is an

upward trend in price (of the currency), while Put Options are used if the risk is a

downward trend. Again taking the example of RIL which needs to purchase crude oil

in USD in 6 months, if RIL buys a Call option (as the risk is an upward trend in dollar

rate), i.e. the right to buy a specified amount of dollars at a fixed rate on a specified

date, there are two scenarios. If the exchange rate movement is favourable i.e the

dollar depreciates, then RIL can buy them at the spot rate as they have become

cheaper. In the other case, if the dollar appreciates compared to todays spot rate, RIL

can exercise the option to purchase it at the agreed strike price. In either case RIL

benefits by paying the lower price to purchase the dollar.

y Swaps: A swap is a foreign currency contract whereby the buyer and seller exchangeequal initial principal amounts of two different currencies at the spot rate. The buyer

and seller exchange fixed or floating rate interest payments in their respective

swapped currencies over the term of the contract. At maturity, the principal amount is

effectively re-swapped at a predetermined exchange rate so that the parties end up

with their original currencies. The advantages of swaps are that firms with limited

appetite for exchange rate risk may move to a partially or completely hedged position

through the mechanism of foreign currency swaps, while leaving the underlying

borrowing intact. Apart from covering the exchange rate risk, swaps also allow firms

to hedge the floating interest rate risk. Consider an export oriented company that has

entered into a swap for a notional principal of USD 1 mn at an exchange rate of

42/dollar. The company pays US 6months LIBOR to the bank and receives 11.00%

p.a. every 6 months on 1st January & 1st July, till 5 years. Such a company would

have earnings in Dollars and can use the same to pay interest for this kind of

borrowing (in dollars rather than in Rupee) thus hedging its exposures.


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Development of Derivative Markets in India

Derivatives markets have been in existence in India in some form or other for a long time. In

the area of commodities, the Bombay Cotton Trade Association started futures trading in

1875 and, by the early 1900s India had one of the worlds largest futures industry. In 1952

the government banned cash settlement and options trading and derivatives trading shifted to

informal forwards markets. In recent years, government policy has changed, allowing for an

increased role for market-based pricing and less suspicion of derivatives trading. The ban on

futures trading of many commodities was lifted starting in the early 2000s, and national

electronic commodity exchanges were created.

In the equity markets, a system of trading called badla involving some elements of

forwards trading had been in existence for decades. However, the system led to a number of

undesirable practices and it was prohibited off and on till the Securities andExchange Board

of India (SEBI) banned it for good in 2001. A series of reforms of the stock market between

1993 and 1996 paved the way for the development of exchange-traded equity derivatives

markets in India. In 1993, the government created the NSE in collaboration with state-owned

financial institutions. NSE improved the efficiency and transparency of the stock markets by

offering a fully automated screen-based trading system and real-time price dissemination. In

1995, a prohibition on trading options was lifted. In 1996, the NSE sent a proposal to SEBI

for listing exchange-traded derivatives. The report of the L. C. Gupta Committee, set up bySEBI, recommended a phased introduction of derivative products, and bi-level regulation

(i.e., self-regulation by exchanges with SEBI providing a supervisory and advisory role).

Another report, by the J. R. Varma Committee in 1998, worked out various operational

details such as the margining systems. In 1999, the Securities Contracts (Regulation) Act of

1956, or SC(R)Act, was amended so that derivatives could be declared securities. This

allowed the regulatory framework for trading securities to be extended to derivatives. The

Act considers derivatives to be legal and valid, but only if they are traded on exchanges.

Finally, a 30-year ban on forward trading was also lifted in 1999.

The economic liberalization of the early nineties facilitated the introduction of derivatives

based on interest rates and foreign exchange. A system of market-determined exchange rates

was adopted by India in March 1993. In August 1994, the rupee was made fully convertible

on current account. These reforms allowed increased integration between domestic and

international markets, and created a need to manage currency risk.


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K I stitut t K P 8

Derivatives Users in India

The use of derivatives varies by type of institution. Financial institutions, such as banks, have

assets and liabilities of different maturities and in different currencies, and are exposed to

different risks of default from their borrowers. Thus, they are likely to use derivatives on

interest rates and currencies, and derivatives to manage credit risk. Non-financial institutions

are regulated differently from financial institutions, and this affects their incentives to use

derivatives. Indian insurance regulators, for example, are yet to issue guidelines relating to

the use of derivatives by insurance companies.

In India, financial institutions have not been heavy users of exchange-traded derivatives so

far, with their contribution to total value of NSE trades being less than 8% in October 2005.

However, market insiders feel that this may be changing, as indicated by the growing share of

index derivatives (which are used more by institutions than by retail investors). In contrast to

the exchange-traded markets, domestic financial institutions and mutual funds have shown

great interest in OTC fixed income instruments. Transactions between banks dominate the

market for interest rate derivatives, while state-owned banks remain a small presence.

Corporations are active in the currency forwards and swaps markets, buying these

instruments from banks.

Some institutions such as banks and mutual funds are only allowed to use derivatives to

hedge their existing positions in the spot market, or to rebalance their existing portfolios.

Since banks have little exposure to equity markets due to banking regulations, they have little

incentive to trade equity derivatives. Foreign investors must register as foreign institutional

investors (FII) to trade exchange-traded derivatives, and be subject to position limits as

specified by SEBI. Alternatively, they can incorporate locally as broker-dealer. FIIs have a

small but increasing presence in the equity derivatives markets. They have no incentive to

trade interest rate derivatives since they have little investments in the domestic bond markets.

It is possible that unregistered foreign investors and hedge funds trade indirectly, using a

local proprietary trader as a front.

Retail investors (including small brokerages trading for themselves) are the major

participants in equity derivatives, accounting for about 60% of turnover in October 2005,

according to NSE. The success of single stock futures in India is unique, as this instrument

has generally failed in most other countries. One reason for this success may be retail


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K I stitut t K P

investors prior familiarity with badla trades which shared some features of derivatives

trading. Another reason may be the small size of the futures contracts, compared to similar

contracts in other countries. Retail investors also dominate the markets for commodity

derivatives, due in part to their long-standing expertise in trading in the havala or forwards

markets.

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.


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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 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.

Why Use of Currency Derivatives

Hedg ing:-Presume Entity A is expecting a remittance for USD 1000 on 27 August 08. Wants to

lock in the foreign exchange rate today so that the value of inflow in Indian rupee terms

is safeguarded. The entity can do so by selling one contract of USDINR futures since

one contract is for USD 1000.

Presume that the current spot rate is Rs.43 and

USDINR 27 Aug 08 contract is tradingat Rs.44.2500. Entity A shall do the following:

Sell one August contract today. The value of the contract is Rs.44,250.

Let us assume the RBI reference rate on August 27, 2008 is Rs.44.0000. The entity shall

sell on August 27, 2008, USD 1000 in the spot market and get Rs. 44,000. The futures

contract will settle at Rs.44.0000 (final settlement price = RBI reference rate).

The return from the futures transaction would be Rs. 250, i.e. (Rs. 44,250 Rs. 44,000).

As may be observed, the effective rate for the remittance received by the entity A is

Rs.44.2500 (Rs.44,000 + Rs.250)/1000, while spot rate on that date was Rs.44.0000.

The entity was able to hedge its exposure.


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K I stitut t K P 3

Speculation: Bullish, buy futuresTake the case of a speculator who has a view on the direction of the market. He would like

to trade based on this view. He expects that the USD-INR rate presently at Rs.42, is to

go up in the next two-three months. How can he trade based on this belief? In case he

can buy dollars and hold it, by investing the necessary capital, he can profit if say the

Rupee depreciates to Rs.42.50. Assuming he buys USD 10000, it would require an

investment of Rs.4,20,000. If the exchange rate moves as he expected in the next three

months, then he shall make a profit of around Rs.10000. This works out to an annual

return of around 4.76%. It may please be noted that the cost of funds invested is not

considered in computing this return.

A speculator can take exactly the same position on the exchange rate by using futures

contracts. Let us see how this works. If the INR- USD is Rs.42 and the three month

futures trade at Rs.42.40. The minimum contract size is USD 1000. Therefore the

speculator may buy 10 contracts. The exposure shall be the same as above USD 10000.

Presumably, the margin may be around Rs.21, 000. Three months later if the Rupee

depreciates to Rs. 42.50 against USD, (on the day of expiration of the contract), the futures

price shall converge to the spot price (Rs. 42.50) and he makes a profit of Rs.1000 on an

investment of Rs.21, 000. This works out to an annual return of 19 percent. Because of the

leverage they provide, futures form an attractive option for speculators.

Speculation: Bearish, sell futuresFutures can be used by a speculator who believes that an underlying is over-valued and is

likely to see a fall in price. How can he trade based on his opinion? In the absence of a

deferral product, there wasn't much he could do to profit from his opinion. Today all he

needs to do is sell the futures.

Let us understand how this works. Typically futures move correspondingly with the

underlying, as long as there is sufficient liquidity in the market. If the underlying price rises,

so will the futures price. If the underlying price falls, so will the futures price. Now take the

case of the trader who expects to see a fall in the price of USD-INR. He sells one two-

month contract of futures on USD say at Rs. 42.20 (each contact for USD 1000). He pays a

small margin on the same. Two months later, when the futures contract expires, USD-INR


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K I stitut t K P 3

rate let us say is Rs.42. On the day of expiration, the spot and the futures price converges. He

has made a clean profit of 20 paisa per dollar. For the one contract that he sold, this works

out to be Rs.2000.

Arbitrage:Arbitrage is the strategy of taking advantage of difference in price of the same or similar

product between two or more markets. That is, arbitrage is striking a combination of

matching deals that capitalize upon the imbalance, the profit being the difference between

the market prices. If the same or similar product is traded in say two different markets, any

entity which has access to both the markets will be able to identify price differentials, if

any. If in one of the markets the product is trading at higher price, then the entity shall buy

the product in the cheaper market and sell in the costlier market and thus benefit from the

price differential without any additional risk.

One of the methods of arbitrage with regard to USD-INR could be a trading strategy

between forwards and futures market. As we discussed earlier, the futures price and

forward prices are arrived at using the principle of cost of carry. Such of those entities who

can trade both forwards and futures shall be able to identify any mis-pricing between

forwards and futures. If one of them is priced higher, the same shall be sold while

simultaneously buying the other which is priced lower. If the tenor of both the contracts is

same, since both forwards and futures shall be settled at the same RBI reference rate, the

transaction shall result in a risk less profit.


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K I stitut t K P 33

Accounting of Currency Derivative

Though In India accounting of currency derivatives are not fully implemented, the

Accounting Standard (AS) 11, the Effects of Changes in Foreign Exchange Rates (revised

2003), has come with some accounting treatments:

An enterprise may enter into a forward exchange contract or another financial instrument that

is in substance a forward exchange contract, which is not intended for trading or speculation

purposes, to establish the amount of the reporting cur currency required or available at the

settlement date of a transaction. The premium or discount arising at the inception of such a

forward exchange contract should be amortized as expense or income over the life of the

contract. Exchange differences on such a contract should be recognized in the statement of

profit and loss in the reporting period in which the exchange rates change. Any profit or loss

arising on cancellation or renewal of such a forward exchange contract should be recognized

as income or as expense for the period.

Any premium or discount arising at the inception of a forward exchange contract is accounted

for separately from the exchange differences on the forward exchange contract.

Exchange difference on a forward exchange contract is the difference between (a) the foreign

currency amount of the contract translated at the exchange rate at the reporting date, or the

settlement date where the transaction is settled during the reporting period, and (b) the same

foreign currency amount translated at the latter of the date of inception of the forward

exchange contract and the last reporting date.

For enterprises entering into contract for trading or speculation purpose: A gain or loss

on a forward exchange contract to which paragraph the above not apply should be computed

by multiplying the foreign currency amount of the forward exchange contract by the

difference between the forward rate available at the reporting date for the remaining maturity

of the contract and the contracted forward rate (or the forward rate last used to measure a gainor loss on that contract for an earlier period).

y The gain or loss so computed should be recognized in the statement of profit and lossfor the period.

y The premium or discount on the forward exchange contract is not recognizedseparately.


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K I stitut t K P 34

Accounting as per international accounting standard: IAS 39

IAS 39 demands that hedging relationships have to be reported by demanding that both the

hedging transaction and underlying hedged transaction be reported. According to IAS 39,

there are three types of heading relationship, of which the following two are relevant:

1. Fair value Hedge: The hedging transaction secures the value of an asset or liability.The standard demands that changes in value of the hedged underlying transaction and

the derivative hedging transaction, i.e. the hedging relationship, be reported with

compensating effect on the results.

2. Cash flow hedge: If a future payment stream is hedged, profits and losses from thehedging transaction are recorded, to the extent to which the hedging relationship can

be classified as valid, in a separate item in the equity. The profits and losses recorded

in the equity are then redeemed against the results in the periods when a future cash

flow is no longer exclusively secured. This is the case, for example, if first of all an

order value is secured and later the order value is billed and receivable is produced.

As per standard practice under IAS 39: In case of Fixed assets related forward contracts, the

accounting treatment will be same for forward booking, valuation of contracts before actual

delivery of fixed assets will be from valuation reserve. On actual delivery the Fixed assets be

capitalized and the value in valuation reserve will be transferred to Fixed assets. Subsequent

valuation will be at mark to market and shown in Profit and loss account and on capitalization

transferred to Fixed assets. In case of Hedge relationship is broken like purchase deal is being

concealed or otherwise Balances of valuation reserve being transferred to Gain /loss in profit

and loss account.


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K I stitut t K P 35

Regulatory Framework

Evolution of a legal framework for derivatives trading in India

An important step towards introduction of derivatives trading in India was the promulgation

of the Securities Laws (Amendment) Ordinance, 1995, which lifted the prohibition on

options in securities (NSEIL, 2001). However, since there was no regulatory framework to

govern trading of securities, the derivatives market could not develop SEBI set up a

committee in November 1996 under the chairmanship of Dr. L.C. Gupta to develop

appropriate regulatory framework for derivatives trading. The committee suggested that if

derivatives could be declared as securities under SCRA, the appropriate regulatory

framework ofsecurities could also govern trading of derivatives. SEBI also set up a group

under the chairmanship of Prof. J.R. Varma in 1998 to recommend risk containment

measures for derivatives trading. The Government decided that a legislative amendment in

the securities laws was necessary to provide a legal framework for derivatives trading in

India. Consequently, the Securities Contracts (Regulation) Amendment Bill 1998 was

introduced in the Lok Sabha on 4th

July 1998 and was referred to the Parliamentary Standing

Committee on Finance for examination and report thereon. The Bill suggested that

derivatives may be included in the definition ofsecurities in the SCRA whereby trading in

derivatives may be possible within the framework of that Act. The said Committee submitted

the report on 17th

March 1999.

The Committee was of the opinion that the introduction of derivatives, if implemented, with

proper safeguards and risk containment measures, will certainly give a fillip to the sagging

market, result in enhanced investment activity and instill greater confidence among

investors/participants. The Committee was of the view that since cash settled contracts could

be classified as wagering agreements which can be null and void under Section 30 of the

Indian Contracts Act, 1872, and since index futures are always cash settled, such futures

contracts can be entangled in legal controversy. Therefore, the Committee suggested an

overriding provision as a matter of abandoned caution Notwithstanding anything

contained in any other Act, contracts in derivatives as per the SCRA shall be legal and valid.

Further, since Committee was convinced that stock exchanges would be better equipped to

undertake trading in derivatives in sophisticated environment it would be prudent to allow

trading in derivatives by such stock exchanges only. The Committee, therefore, suggested a


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K I stitut t K P 36

clause- The derivative shall be traded and settled on stock exchanges and clearing houses of

the stock exchanges, respectively in accordance with the rules and bye-laws of the stock

exchange. The Proposed Bill, which incorporated the recommendations of the said

Parliamentary Committee, was finally enacted in December 1999.

The Committee also recommended various operational/legal measures to safeguard the

integrity of the capital market and protect investors. These measures, inter alia, include the

following:

1. The Committee observed that Dr. L.C. Gupta Committee appointed by SEBI haddrawn out detailed guidelines pertaining to the regulatory framework on derivatives

prescribing necessary preconditions which should be adopted before the introduction

of derivatives. The Committee, therefore, recommended that these should be adhered

to fully.

2. The Committee felt that there was an urgent need to educate the Indian investors bycreating investment awareness among them by conducting intensive educational

programmes, so that they are able to understand their risk profiles in a better way.

3. Measures should be taken to strengthen the cash market so that they become strongand efficient.

4. The Committee felt that it is imperative that the regulatory authorities ensure a strongsurveillance/vigilance and enforcement machinery.

5. The Committee was of the view that since derivatives trading require a critical massof sophisticated investors supported by credit and stock analysts, SEBI should, in

consultation with the stock exchanges, endeavour to conduct certification programme

on derivatives trading with a view to educating the investors and market

intermediaries.

6. Keeping in view the swift movement of funds and the technical complexities involvedin derivatives transactions, the committee felt that there was a need to protect

particularly the small investors by preventing them from venturing in to options and

futures market, who may be lured by the sheer speculative gains. The Committee,

therefore, recommended that the threshold limit of the transactions should be pegged

not below Rs.2 lakhs.

7. The Committee was of the view that there is an urgent need to prescribe pronouncedaccounting standards in the case of investors/ dealers and also back office standards

for intermediaries with a view to reducing the possibility of concealing loss and


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K I stitut t K P 37

perpetrating the frauds by companies/intermediaries. The Committee also noted that

the need of accounting disclosure had also been recognized by Dr. L.C. Gupta

Committee. The committee, therefore, recommended that the Institute of Chartered

Accountants of India, in consultation with the stock exchanges, should formulate

suitable accounting standards and SEBI should prescribe the same before trading in

derivatives is commenced.

8. The Committee also asked the Government to consider exempting derivativestransactions from the imposition of stamp duty. It is important to note that the

suggestions and recommendations of the said Committee were implemented by the

statutory regulators. Thus the enactment of Securities Laws (Amendment) Act 1999

and repeal of 1969 notification provided a legal framework for securities based

derivatives trading on stock exchanges in India, which is co-terminus with framework

of trading of othersecurities allowed under the SCRA. The trading of stock index

futures started in June 2000 and later on, other products, such as, stock index options

and stock options and single stock futures were also allowed. The derivatives are

formally defined under the said Act of 1999 (No. 31 of 1999) to include: (a) a security

derived from a debt instrument, share, loan whether secured or unsecured, risk

instrument or contract for differences or any other form of security, and (b) a contract

which derives its value from the prices or index of prices or underlying securities. The

Act also clarified that, notwithstanding anything contained in any other law for the

time being in force, contracts in derivatives shall be legal and valid only if such

contacts are traded on a recognized stock exchange and settled on a clearing entity of

the recognised stock exchange in accordance with the rules and bye-laws of such

stock exchange, thus precluding OTC derivatives (this has implications for legal

validity of such derivatives, as discussed later). The detailed legal framework for

derivatives trading on stock exchanges was suggested by the L.C. Gupta Committee

on derivatives, which had submitted its report in March 1998. It not only provided a

conceptual basis for various regulatory features, but also suggested byelaws for

derivatives exchanges and clearing corporations. These bye-laws were required to be

adopted by the stock exchange and clearing entities before derivatives activity can

start within their jurisdiction.


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K I stitut t K P 38

International regulation of derivatives markets

The International Organisation of Securities Commissions (IOSCO) has been providing

international best practices and perspectives on derivatives markets. In 1990, the IOSCO

published the Principles for Oversight of Screen Based Trading Systems for Derivatives

Products. It was suggested that all the jurisdictions adopt (SEBI, being a member

organization, has adopted these principles,) the 10 non-exclusive general principles for the

oversight of screen based trading systems for derivatives products which identify areas of

common regulatory concern. These principles basically relate to compliance by system

sponsor with the regulatory requirements relating to legal standards, regulatory policies, risk

management mechanisms and adequate disclosures of attendant risks. These 10 principles

were reviewed by IOSCO and 4 additions were proposed in the year 2000 (IOSCO 2000) for

derivatives products operating on the cross-border basis. The 1990 principles also anticipated

IOSCO Objectives and Principles of Securities Regulations of 1998 relating to protection of

investors, fairness and transparency of markets and reduction of systemic risk. The additional

regulations suggested include, regulatory coordination and cooperation to avoid potential

duplication, inconsistencies and gaps, sharing of relevant information and adequate disclosure

and transparency of regulatory requirements in jurisdictions. The IOSCO report on the

International Regulation of Derivative Markets, Products and Financial Intermediaries

released in December 1996 provides a description of various models or approaches to the

regulation of derivatives markets based on regulatory summaries prepared on common

framework of analysis (IOSCO 1996b). It was observed that while there was no single model

for the regulation of derivatives markets, there was substantial similarity in perceived

regulatory objectives. The IOSCO framework identifies the three objectives of regulation,

which need to be specified by the regulatory framework of the securities markets. These are

market efficiency and integrity, customer protection/ fairness and financial integrity (IOSCO,

1996a).


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The forward contracts are also allowed to be booked for foreign currencies (other than

Dollar) and Rupee subject to similar conditions as mentioned above. The banks are also

allowed to enter into forward contracts to manage their assets - liability portfolio.

The cancellation and re-booking of the forward contracts is permitted only for genuine

exposures out of trade/business upto 1 year for both exporters and importers, whereas in case

of exposures of more than 1 year, only the exporters are permitted to cancel and re-book the

contracts. Also another restriction on booking the forward contracts is that the maturity of the

hedge should not exceed the maturity of the underlying transaction.

RBI Regulations in Cross currency options

The Reserve Bank of India has permitted authorised dealers to offer cross currency options tothe corporate clients and other interbank counter parties to hedge their foreign currency

exposures. Before the introduction of these options the corporates were permitted to hedge

their foreign currency exposures only through forwards and swaps route. Forwards and swaps

do remove the uncertainty by hedging the exposure but they also result in the elimination of

potential extraordinary gains from the currency position. Currency options provide a way of

availing of the upside from any currency exposure while being protected from the downside

for the payment of an upfront premium.

RBI Regulations

These contracts were allowed with the following conditions:

These currency options can be used as a hedge for foreign currency loans providedthat the option does not involve rupee and the face value does not exceed the

outstanding amount of the loan, and the maturity of the contract does not exceed the

un-expired maturity of the underlying loan.

Such contracts are allowed to be freely re-booked and cancelled. Any premiumpayable on account of such transactions does not require RBI approval

Cost reduction strategies like range forwards can be used as long as there is no netinflow of premium to the customer.


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K I stitut t K P 4

Banks can also purchase call or put options to hedge their cross currency proprietarytrading positions. But banks are also required to fulfil the condition that no stand

alone transactions are initiated.

If a hedge becomes naked in part or full owing to shrinking of the portfolio, it may beallowed to continue till the original maturity and should be marked to market at

regular intervals.

There is still restricted activity in this market but we may witness increasing activity in cross

currency options as the corporate start understanding this product better.

RBI Regulations in Foreign currency rupee swaps (FC-RE)

Another spin-off of the liberalization and financial reform was the development of a fledglingmarket in FC-RE swaps. A fledgling market in FC-RE swaps started with foreign banks and

some financial institutions offering these products to corporate. Initially, the market was very

small and two way quotes were quite wide, but the market started developing as more market

players as well as business houses started understanding these products and using them to

manage their exposures. Corporate started using FC-RE swaps mainly for the following

purposes:

Hedging their currency exposures (ECBs, forex trade, etc.) To reduce borrowing costs using the comparative advantage of borrowing in local

markets (Alternative to ECBs Borrow in INR and take the swap route to take

exposure to the FC currency)

The market witnessed expanding volumes in the initial years with volumes up to US$ 800

million being experienced at the peak. Corporate were actively exploring the swap market in

its various variants (such as principal only and coupon only swaps), and using the route not

only to create but also to extinguish forex exposures. However, the regulator was worried

about the impact of these transactions on the local forex markets, since the spot and forward

markets were being used to hedge these swap transactions.


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K I stitut t K P 4

So the RBI tried to regulate the spot impact by passing the below regulations:

The authorized dealers offering swaps to corporate should try and match demandbetween the corporate.

The open position on the swap book and the access to the interbank spot marketbecause of swap transaction was restricted to US$ 10 million.

The contract if cancelled is not allowed to be re-booked or re-entered for the sameunderlying.

The above regulations led to a constriction in the market because of the one-sided nature of

the market. However, with a liberalizing regime and a build-up in foreign exchange reserves,

the spot access was initially increased to US$ 25 million and then to US$ 50 million. The

authorized dealers were also allowed the use of currency swaps to hedge their asset liability

portfolio. The above developments are expected to result in increased market activity with

corporates being able to use the swap route in a more flexible manner to hedge their

exposures. A necessary pre-condition to increased liquidity would be the further development

and increase in participants in the rupee swap market (linked to MIFOR) thereby creating an

efficient hedge market to hedge rupee interest rate risk.


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K I stitut t K P 43

Foreign Exchange Risk Management:

Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on account of

sudden/unanticipated changes in exchange rates, quantified in terms of exposures. Exposure

is defined as a contracted, projected or contingent cash flow whose magnitude is not certain

at the moment and depends on the value of the foreign exchange rates. The process of

identifying risks faced by the firm and implementing the process of protection from these

risks by financial or operational hedging is defined as foreign exchange risk management.

This paper limits its scope to hedging only the foreign exchange risks faced by firms.

Necessity of managing foreign exchange risk

A key assumption in the concept of foreign exchange risk is that exchange rate changes are

not predictable and that this is determined by how efficient the markets for foreign exchange

are. Research in the area of efficiency of foreign exchange markets has thus far been able to

establish only a weak form of the efficient market hypothesis conclusively which implies that

successive changes in exchange rates cannot be predicted by analysing the historical

sequence of exchange rates. However, when the efficient markets theory is applied to the

foreign exchange market under floating exchange rates there is some evidence to suggest that

the present prices properly reflect all available information. This implies that exchange rates

react to new information in an immediate and unbiased fashion, so that no one party can

make a profit by this information and in any case, information on direction of the rates arrives

randomly so exchange rates also fluctuate randomly. It implies that foreign exchange risk

management cannot be done away with by employing resources to predict exchange rate

changes.


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K I stitut t K P 44

Foreign Exchange Risk Management Framework

Once a firm recognizes its exposure, it then has to deploy resources in managing it. A

heuristic for firms to manage this risk effectively is presented below which can be modified

to suit firm-specific needs i.e. some or all the following tools could be used.

Forecasts: After determining its exposure, the first step for a firm is to develop aforecast on the market trends and what the main direction/trend is going to be on the

foreign exchange rates. The period for forecasts is typically 6 months. It is important

to base the forecasts on valid assumptions. Along with identifying trends, a

probability should be estimated for the forecast coming true as well as how much the

change would be.

RiskEstimation: Based on the forecast, a measure of the Value at Risk (the actualprofit or loss for a move in rates according to the forecast) and the probability of this

risk should be ascertained. The risk that a transaction would fail due to market-

specific problems4 should be taken into account. Finally, the Systems Risk that can

arise due to inadequacies such as reporting gaps and implementation gaps in the

firms exposure management system should be estimated.

Benchmarking: Given the exposures and the risk estimates, the firm has to set itslimits for handling foreign exchange exposure. The firm also has to decide whether to

manage its exposures on a cost centre or profit centre basis. A cost centre approach is

a defensive one and the main aim is ensure that cash flows of a firm are not adversely

affected beyond a point. A profit centre approach on the other hand is a more

aggressive approach where the firm decides to generate a net profit on its exposure

over time.


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K I stitut t K P 45

Hedging: Based on the limits a firm set for itself to manage exposure, the firms thendecides an appropriate hedging strategy. There are various financial instruments

available for the firm to choose from: futures, forwards, options and swaps and issue

of foreign debt. Hedging strategies and instruments are explored in a section.

Stop Loss: The firms risk management decisions are based on forecasts which are butestimates of reasonably unpredictable trends. It is imperative to have stop loss

arrangements in order to rescue the firm if the forecasts turn out wrong. For this, there

should be certain monitoring systems in place to detect critical levels in the foreign

exchange rates for appropriate measure to be taken.

Reporting and Review: Risk management policies are typically subjected to review based on periodic reporting. The reports mainly include profit/ loss status on open

contracts after marking to market, the actual exchange/ interest rate achieved on each

exposure and profitability vis--vis the benchmark and the expected changes in

overall exposure due to forecasted exchange/ interest rate movements. The review

analyses whether the benchmarks set are valid and effective in controlling the

exposures, what the market trends are and finally whether the overall strategy is

working or needs change.


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K I stitut t K P 46

Factors affecting the decision to hedge foreign currency risk

Research in the area of determinants of hedging separates the decision of a firm to hedge

from that of how much to hedge. There is conclusive evidence to suggest that firms with

larger size, R&D expenditure and exposure to exchange rates through foreign sales and

foreign trade are more likely to use derivatives. First, the following section describes the

factors that affect the decision to hedge and then the factors affecting the degree of hedging

are considered.

Firm size: Firm size acts as a proxy for the cost of hedging or economies of scale.Risk management involves fixed costs of setting up of computer systems and

training/hiring of personnel in foreign exchange management. Moreover, large firms

might be considered as more creditworthy counterparties for forward or swap

transactions, thus further reducing their cost of hedging. The book value of assets is

used as a measure of firm size.

Leverage: According to the risk management literature, firms with high leveragehave greater incentive to engage in hedging because doing so reduces the probability,

and thus the expected cost of financial distress. Highly levered firms avoid foreign

debt as a means to hedge and use derivatives.

Li uidity and profitability: Firms with highly liquid assets or high profitability haveless incentive to engage in hedging because they are exposed to a lower probability offinancial distress. Liquidity is measured by the quick ratio, (i.e. quick assets divided

by current liabilities). Profitability is measured as EBIT divided by book assets.

Sales growth: Sales growth is a factor determining decision to hedge as opportunitiesare more likely to be affected by the underinvestment problem. For these firms,

hedging will reduce the probability of having to rely on external financing, which is

costly for information asymmetry reasons, and thus enable them to enjoy

uninterrupted high growth. The measure of sales growth is obtained using the 3-year

geometric average of yearly sales growth rates.

This highlights how risk management systems have to be altered according to characteristics

of the firm, hedging costs, nature of operations, tax considerations, regulatory requirements

etc.


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K I stitut t K P 47

Report on Project work

Title of the Project:

Scope and limitation of Currency Derivative in India

Objectives of the Project:

To analyse the scope of currency derivative in India. To study the factors that helped in development of currency derivative in foreign

country and a comparative analysis of all those factors with that of in India.

To study the legal regulation in Indian FOREX market. To find out suitable solution (like future, forward or option) to the customers

according to their risk taking ability.

To provide different hedging strategies.

Research Methodology and Data Collection

Most of the data required for the above study is collected from primary and secondary

methods.

Primary Data; Survey: To find out the scope and limitation of the Currency Derivative in

India, I had done one survey of a sample of 60 respondents, who had foreign currency

exposure. The questionnaire of the survey will be design by keeping all this point in to mind:

Classification of the respondent (i.e. Importer, Exporter, Financial Institutes,Professional, having any exposure in foreign currency)

Total foreign currency exposure in one year Awareness about product on Currency Derivative How keen people are interested in adopting Currency Derivative Analysis of the Risk Aversion level What type of the product can be provided to reduce their risk


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K I stitut t K P 48

Secondary Data:

Secondary data are data which have already been collected for purposes other than the

problem at hand.

But I will more focus on the Primary data which I will collect by preparing questionnaire and

I will frame it by asking both open ended and close ended questionnaire and for Secondary

data I will refer internet and journals.

Data relating to foreign exchange rate and their determinants are collected to analysis the

following:

To analyse the determinants of foreign exchange rate. To forecast of the exchange rate.

Primary Data will be analysed by using Graphs and tables and according to that the

suggestions and recommendations will be provided to the respondents.


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Primary Data Analysis

Category of Respondent

Frequency Percent Valid Percent Cumulative Percent

Valid financial Institute 6 10.0 10.0 10.0

Exporter 24 40.0 40.0 50.0

Importer 11 18.3 18.3 68.3

Both Exporter and Import 9 15.0 15.0 83.3

Professionals 10 16.7 16.7 100.0

Total 60 100.0 100.0

The graph shows that majority of respondents to my survey are exporters. The major reason for this is

that exporters are the one who have maximum exposure towards currency risks. After exporters,

importers have formed a crucial part of my survey. They are followed by professionals; corporate

engaged in export as well as import and Financial Institutes.


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K I stitut t K P 5

Name the Currency

This graph clearly shows that majority of foreign currency transactions are done in US Dollar. The

reason for this is that USD is the most powerful currency and it is accepted worldwide. US Dollar is

followed by Japanese Yen, which holds a substantial share in transaction of currencies. Surprisingly

Yen is much ahead of Pound and Euro has got a very little share of just 6.7 %

Frequency Percent Valid Percent

Cumulative

Percent

Valid USD 28 46.7 46.7 46.7

Pound 12 20.0 20.0 66.7

Euro 4 6.7 6.7 73.3

Yen 15 25.0 25.0 98.3

Any Other 1 1.7 1.7 100.0

Total 60 100.0 100.0


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K I stitut t K P 5

Nature of the Transactor

Frequency Percent Valid Percent

Cumulative

Percent

Valid Arbitrator 3 5.0 5.0 5.0

Speculator 5 8.3 8.3 13.3

Hedger 9 15.0 15.0 28.3

None Of the Above 43 71.7 71.7 100.0

Total 60 100.0 100.0

Transactor is the person who makes the transaction. Here I have tried to divide the transactors

in four different categories according to the purpose of transactions. The survey data shows

that almost 3/4th of the respondents belong to the categories other than arbitrators, speculators

and hedgers. I have kept them in the group called none of the above .Hedgers are 15% and

Speculators are 8.3%.

Cross Tabulation


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Amount for Derivatives * Total Amount

Total Amount

Total

Amount for

Derivat

foreign currency final

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