The project involves understanding of Foreign Exchange and Currency Hedging related to Indian Economy. This basically will deal into studying various factors leading to currency movements both domestic as well as international. To understand the importance of Currency Hedging to corporates and business houses, advantages and various shortcomings that they face. The project aims to understand the major issues in Currency Hedging, how Currency Hedging can be used to protect against currency volatility and seeks to find solutions to the problems faced in hedging. The project specifically focuses on how Currency Futures can be used to carry out Currency Hedging.
Initially the meaning & need for Currency Hedging is understood. Next, the various tools for Currency Hedging such as forwards, futures, options and natural hedges are understood. Further part explains in detail how Currency Futures can be used to carry out Hedging. The comparison, merits and demerits of different tools of Hedging is explained later. The Project gives the challenges for currency hedging and proposes certain solutions to the issues involved in hedging.
The practical experience of client involvement will be dealt through phases of interaction, acquisition and servicing. The overall understanding of hedging in currency and the practical implications that the client foresees is thus understood. Thus this project also portrays the marketing side of financial instrument, currency.
Almondz at a Glance
Almondz Global Securities Limited (AGSL), formerly the Allianz Securities Ltd is one of the leading Investment Banks in India. The company was incorporated in 1994 and is listed on the Bombay Stock Exchange. Its main business lines are:
Corporate Finance
Distribution of Financial Products
Private Clients
Portfolio Management Services
Equity Broking
AGSL's client base in the Corporate Finance segment covers all leading Public Sector Undertakings (PSUs), large corporates and the vast and increasingly important segment of SMEs. In the Debt markets, the company has relationships with over 4000 leading Provident Funds. In the distribution of third-party financial products, AGSL has built a large base of retail customers as well as country-wide network of 1500 franchisees.
In Equity Broking, AGSL is serving both the Retail and the Institutional Investors. The company has also set up a Private Clients business to advise and manage High Net Worth (HNI) clients.
The company has a strong presence across 18 major cities and is manned by teams of qualified & experienced professionals.
Services offered by the company include:
Equity - IPOs , Private Equity, Equity Broking - Retail , Equity Broking - Institutional, Equity Research, Portfolio Management Services
Debt- Private Placement of Debt, Debt Market, Portfolio Management (PMS) and Project Finance
Advisory -Infrastructure Advisory
Distribution -Mutual Fund, Equity, Tax Saving Instruments, Fixed Deposits, Insurance Products
Commodities and Brokerage
Insurance- Life Insurance Products, General Insurance Products and Reinsurance
Subsidiaries of the company include:
Almondz Capital & Management Services Ltd
Almondz Global Securities Ltd
Almondz Commodities Pvt. Ltd
Almondz Insurance Brokers Pvt. Ltd
Almondz Reinsurance Brokers Pvt. Ltd
Introduction
The project assigned to me was on Currency Hedging. This project increased my theoretical as well as practical knowledge. The project requires the basics about the Forex Market. Understanding the various platforms like derivatives, etc. that the company offers through Multi Commodity Exchange (MCX). This helped me understand how Forex Hedging is done through derivatives like Forward, Futures, Options, etc.
Also the factors influencing Currency Movements in Domestic as well as International economy is dealt with. The implications of Currency Volatility in each and every segment of the market are understood.
Currency is the medium of exchange. Every transaction is carried out in the world with the expectancy of currency in return. Therefore, it is of utmost importance that any changes in currency can affect millions. Any slight fluctuation in the currency can affect the economy accordingly.
Currency risk essentially comes from the movement in the exchange rate between two currencies. The price at which you will be able to buy or sell a certain amount of currency will be affected by the currency movement.
Any business or individual looking to reduce currency risk and remove a certain level of uncertainty from its future currency transactions, there is tool called as Hedging.
Globalization and integration of financial markets, coupled with progressive increase of cross-border flow of capital, have transformed the dynamics of Indian financial markets. This has increased the need for dynamic currency risk management.
Introduction to Currency Hedging
Meaning of Hedging
The best way to understand hedging is to think of it as INSURANCE. When people decide to hedge, they are insuring themselves against a negative event. This doesn't prevent a negative event from happening, but if it does happen and you're properly hedged, the impact of the event is reduced. They are like transferring the uncertainty. So, hedging occurs almost everywhere, and we see it every day. For example, if you buy a car insurance, you are hedging yourself against theft, accident etc. Similarly when you insure your machinery, godown or ware house, you are hedging against fires, break-ins or other unforeseen disasters. Hedging means taking position in futures market that is opposite to a position in a physical market with a view to reduce or limit risk arising of unpredictable changes in currency rate.
Corporates use hedging techniques to reduce their currency risks. Of course, nothing is free in this world, so one has to pay for this type of insurance in one form or another. Hedging is a technique by which one can manage risk. It is a tool by which you can reduce potential loss. The most commonly used hedging tools are forwards and futures.
Trading vs. Hedging
There are 2 basic differences between trading in currencies and hedging in currencies.
Risk: In case of trading, the trader is not in a pre-existing position of risk before he enters into a trade. However, he enters into a position of risk once he buys an MCX futures currency contract. However, in case of hedging, the importer/exporter is already in a position of risk arising from entering into a contract of import/export. However, he enters into a futures/forward contract in order to eliminate the risk arising from currency fluctuations and to fix a particular rate at which he would export/import.
Thus, hedgers have a real exposure to foreign exchange risk on account of their underlying business, while traders do not have risk on account of their underlying business.
Objective: The objective of a trader is to make a profit from currency movements while the objective of a person who enters into a hedging contract is not to make profit but to eliminate risk. Since majority volumes in the currency futures market relate to traders/speculators, they assume the price risk that hedgers attempt to lay off in the markets. In other words, hedgers often depend on speculators to take the other side of their trades (i.e. act as counter party) and to add depth and liquidity to the markets that are vital for the functioning of a futures market.
Need for Hedging
When you hedge, you are protecting yourself against currency risk. In other words, hedging is a tool for currency risk management. Currency risk is the risk arising out of fluctuations in exchange rates. Today, importers and exporters face the risk of their margins being eroded on account of excessive volatility in currency. Hedging allows the importers/exporters to focus on his core business and not worry about currency movements.
Earlier, the rupee was not very volatile. But, in the past few months, rupee has shown a lot of volatility. In 2011, rupee depreciated from Rs.43.80 to a dollar to Rs. 54.20 levels, a change of around 23%. However, in January the rupee logged its best monthly gains in 17 years to rise to Rs.49.05. The rupee volatility in the last 7 months has been given in the chart given on the next page.
Figure USDINR Movement Chart
Note: The various events are represented by numbers.
Dec 15: RBI Circular saying forward contracts once cancelled, cannot be rebooked.
Jan 31: The rupee logged its best monthly gains in more than 17 years in January
March 7: The rupee fell to a seven-week low early on Wednesday, extending a slide to a fifth consecutive session, on strong demand for dollars from oil refiners and slowing capital inflows as global risk appetite wanes.
Mar 22: Rupee off 2-month low on possible RBI dollar sales i.e. RBI intervention
Mar 30: Data released revealed that India's balance of payments fell into negative territory in the December quarter for the first time in three years
May 10: To curb the slide in the rupee, the Reserve Bank of India has asked exporters to convert 50% of their dollars held in Exchange Earner's Foreign Currency (EEFC) accounts into rupee. The central bank has also ruled that exporters can henceforth access the Forex Market for buying dollars only after they have utilized the balance in their EEFC accounts.
Thus, we can see that currency moves on account of a multitude of factors such as RBI intervention, FII inflows, FII outflows, inflation and interest rate differentials, current account deficit, changes in Govt. policy, etc.
This currency movement is outside the control of an enterprise. In other words, it relates to the external environment and can be a threat for importers, exporters, enterprises who have taken foreign currency loans and those who invest abroad. Though the external environment cannot be controlled, there are certain risk management tools available to an enterprise in order to manage currency risk. Hedging is one such tool.
Beneficiaries of Hedging
Importers and exporters: Importers need to protect themselves from rupee depreciation and exporters need to protect themselves from rupee appreciation.
Foreign bound students: If rupee depreciates, then students who want to study abroad will have to pay more rupees as their fees. Such a student can hedge the amount payable as fees.
Foreign currency denominated loans: There are many companies which take taken ECB/FCCB's, the value of these loans keeps on changing on account of rupee fluctuations. Thus, if the rupee depreciates, more rupees need to be paid while repaying these loans. Corporates can hedge these loans and protect themselves from currency volatility.
Foreign bound travelers: A person who wants to travel abroad has to protect himself from currency depreciation. Such a person can hedge the amount required as his tour expenditure.
Reasons for Rupee Depreciation
The possible reasons for Rupee depreciation include both domestic and international factors. After the peak recession time of 2008-09, Indian Rupee was hovering around 44-46 per dollar mark for almost 2 years, till mid of 2011. It then started to slide and breached the 50 per dollar mark in late 2011, mainly due to economic crisis in Europe.
After that Rupee appreciated a little bit, regained the below 50 per dollar mark. But from March 2012, Rupee again started its down fall, this time more seriously when compared to other developing currencies.
Recently, Indian Rupee breached the 56 per dollar mark, for the first time in the history. In general, European crisis is sited as the major reason by Government of India. But there are few of our domestic economic bugs also that are adding fuel to deepen the crisis.
Policy Impacts
The suspense of FDI in multi-brand retail can be well known example for this. Even though India made a few policy revivals in the area of single brand retail market, pharmaceuticals, etc. these were not enough to attract more foreign direct investment to India. Once we open our market, we have to consistently renew our economic policies and agendas to attract more investment without affecting our domestic interests.
Reduction in Foreign Direct Investment and Foreign Outflow
Negative policies not only cause reduction in FDI but it results in foreign outflow as well. Investors, as always, look for more opportunities and if, it seems like they have better destinations to park their money, definitely they will do it. That is the basic funda of open market.
Reduction in Export and Increase in Import
According to Finance Ministry, because of reduction in export and increase in import, on one side the fiscal deficit has increased and on the other, current account deficit is rising. Europe was an important export destination for the country and reduction in the demand there adversely hit Indian exports. Economic recovery was poor and fragile in European countries and this has affected India's changes to become a net exporter.
Political Uncertainty and Corruption
A coalition government has its own limitation. It chains the Government from initiating proactive economic reforms. The second regime of UPA was engulfed by a series of corruption. Starting from Common wealth games scan to Anna Hazare's campaign were enough to change the mindset of many foreign investors.
High Deficits
Currently we are facing huge pressure from the deficit side - both fiscal and current account. Government of India is spending a worthy amount as subsidies for fertilizers, food and oil. This has resulted in widening the deficit gap. High deficits are considered as reasons for weakness in local economy and can repel foreign investors.
Figure USDINR Chart
Effects of Rupee Depreciation both Positive and Negative
Positive Effects include:
Higher profits to Exporters
When a currency depreciates, the exporters make more profit because they get more of the local currency for every unit of foreign currency though the quantity of trade remains unchanged. The depreciating rupee will be positive for the Indian IT sector that generate more than 85 per cent of their $70 billion revenue from the overseas markets and this kind of appreciation in foreign currency will enhance their actual realisation of revenue in dollar terms.
Benefits to Indian Expatriates from US
Expatriates living outside India in US gain by rupee depreciation. Since rupee is depreciated from 43 to 55 against dollars, remittance of $1000 now makes Rs. 12000 more for an Indian.
Negative Effects include:
Inflation and Fiscal deficit to rise further
India is suffering from a nearing two digit inflationary pressure. A depreciation rupee will add fuel to this. It leads to high inflation, as India imports around 70 per cent of its crude oil requirement and the government will have to pay more for it in rupee terms. Due to the control on oil prices, the government may not easily pass the increased prices to the consumers. Further, this higher import bill will lead to rise in fiscal deficit for the government and will push the inflation.
Reduction in profit margin for Importers
India import industry will also have to pay more in rupee terms for procuring their raw materials, despite drop in global commodity prices, only because of a depreciating rupee against dollar. Corporate India is a net borrower of dollar and to that extent a depreciating rupee impacts its balance sheet adversely. Companies with foreign debt on their books are badly impacted. With the rupee depreciating against the dollar, these companies will need more rupees to repay their loans in dollar. This will increase their debt burden and lower their profits. Obviously, investors would do better to stay away from companies with high foreign debt.
Negative impact on FII flows to Indian market
Rupee depreciation is a huge risk for FIIs who are planning to invest in India. If an FII invest $10000, it can buy stock worth Rs 550000 @ current market price. Consider a scenario where after 1 year, the stock of FII made no loss, no profit and rupee depreciated to 60 against dollar. On stock sale the FII would get Rs 550000, but while converting to dollars, it ends up in loss.
Increase in the Import Bill
A depreciation of the local currency results in higher import costs for the country. Failure of a similar rise being experienced in the prices of exportable commodities is going to result in a widening of current account deficit of the country.
Increase in Cost of Borrowings
Interest rate differentials in domestic and global markets encourage the industry to raise money through foreign markets however a fall in the rupee value would negate the benefits of doing so.
Chronology of India's exchange rate policies
1947 (When India became member of IMF): Rupee tied to pound, Re 1 Rupee = 1 Pound
1949: Pound devalued; India maintained par with pound
1966: Rupee was devalued by 36.5%. At that time Rs 4.76 = $1, after devaluation it became Rs 7.50 = $1
1967: UK devalued pound, India did not devalue
August 1971: Rupee pegged to gold/dollar, international financial crisis
December, 1971: Dollar is devalued
December, 1971: Rupee is pegged to pound sterling again
1971-1979: The Rupee is overvalued due to India's policy of import substitution
1972: UK floats pound, India maintains fixed exchange rate with pound
1975: India links rupee with basket of currencies of major trading partners. Although the basket is periodically altered, the link is maintained until the 1991 devaluation.
1991: Rupee devalued by 18-19 %
1992: Dual exchange rate, LERMS, Liberalized Exchange Rate Management System
1993: Unified exchange rate: $1 = Rs 31.37
1993/1994: Rupee is made freely convertible for trading, but not for investment purposes
Measures by RBI
Forex Reserves: RBI can sell forex reserves and buy Indian Rupees leading to demand for rupee. But using forex reserves poses risk also, as using them up in large quantities to prevent depreciation may result in a deterioration of confidence in the economy's ability to meet even its short-term external obligations. And not using reserves to prevent currency depreciation poses the risk that the exchange rate will spiral out of control. Since both outcomes are undesirable, the appropriate policy response is to find a balance. Recent data shows that RBI had indeed intervened by selling forex reserves selectively to support Rupee.
http://www.managementcanvas.iimindore.in/icanvas/images/stories/deprciating_rupee_1.jpg
Figure FX Reserves
Rising Interest Rates: The rationale is to prevent sudden capital outflows and ultimately lead to higher capital inflows. But India's interest rates are already higher than most countries. This was done to tame inflationary expectations. So further rising interest rates would lead to lower growth levels.
c. Make Investments Attractive- Easing Capital Controls: RBI can take steps to increase the supply of foreign currency by expanding market participation to support Rupee. RBI can increase the FII limit on investment in government and corporate debt instruments. It can invite long term FDI debt funds in infrastructure sector. The ceiling for External Commercial Borrowings can be enhanced to allow more ECB borrowings.
2. Measures by Government: Government should take some measures to bring FDI and create a healthy environment for economic growth. Efforts should be made to invite FDI but much more needs to be done especially after the holdback of retail FDI and recent criticisms of policy paralysis. The government took steps recently to loosen rules for portfolio investment in the Indian market, indicating its desire to sustain external inflows. The measure to increase External Commercial Borrowings (ECB) to $10bn will help in borrowing in dollar at a less cost. It may take similar steps to encourage FDI as well, helping sustain external funding.
Impact of Currency Volatility on some sectors
The rupee has depreciated by more than 18 percent since May 2011, moreover with the rupee breaching the 53 dollar mark, profit margins of companies that import commodities or components have come under severe pressure, which resulted in price increases for the consumer.
The rupee depreciation will particularly hit the industrial sector and put higher pressure on their costs as items like oil, imported coal, metals and minerals, imported industrial intermediate products all are getting affected.
Although the prices of most of the imported commodities have fallen, the depreciating rupee has meant that the importer gets no respite as they need to pay more to purchase the same quantity of raw materials.
The depreciating rupee would keep the price of imported commodities elevated. Thus the industrial sector is bound to get adversely hit.
IT Sector
The IT sector earns around $60 billion a year from export of software and services.
A falling rupee increases the margins of export-oriented sectors. Infosys, Wipro and Tata Consultancy Services rose 16% to Rs 2,765, 17% to Rs 399 and 19% to Rs 1,161, respectively, between August 16, 2011, and December 30, 2011.
Pharmaceutical Sector
The size of the Indian pharmaceutical industry is $20 billion, or Rs 1 lakh crore, with exports accounting for $9 billion, or Rs 45,000 crore. Many domestic companies such as Lupin, Sun Pharmaceutical and Dr. Reddy's Laboratories have high exposure to the west.
A depreciating rupee has a mixed impact on the sector. Highly export-oriented companies gain. If the rupee falls further, Divis Laboratories, Glenmark Pharmaceuticals and Dr. Reddy's Laboratories can rise.
The rupee depreciation may not benefit export-driven pharmaceutical companies which have taken forward covers to hedge the currency risk. Cipla and IPCA Laboratories have some unhedged positions and so may marginally gain from the rupee depreciation.
Capital Goods
The capital goods sector was under a lot of pressure in 2011 with the result that the BSE capital goods index fell 47% to 8,068 between January 2011 and December 2011. There has been a marked slowdown in order inflows, and with interest rates rising, projects are either being postponed or shelved.
The sharp rupee fall has made the situation worse. A weakening rupee has a direct impact on manufacturing companies for two reasons. First, Indian companies are net importers. Second, they have loans and claims to international banks and will either have to pay more to settle the loans or refinance the debt with high-cost local loans.
A weakening rupee would have partially affected the sector as companies in India depend on technical knowhow from abroad. Also, although prices of metals on the London Metal Exchange have fallen, the companies here have not benefited because of the weakening rupee.
Oil Marketing Companies
Share prices of oil marketing companies (OMC) declined 45-50% between September 2011 and December 2011 as margins contracted due to higher input costs. The recent rupee depreciation has added to the woes of Indian Oil Corporation (IOC), Bharat Petroleum (BPCL) and Hindustan Petroleum (HPCL).
OMCs are struggling due to large under-recoveries in diesel, kerosene and LPG as they have to sell these fuels at subsidized prices.
The companies have urged the government to offset losses and are taking steps to cut cost and improve productivity. The additional cost of importing crude oil due to weakening rupee without a corresponding increase in retail prices has put a strain on them.
Figure Import Bill
The Minister of Petroleum and Natural Gas Shri S. Jaipal Reddy informed the Lok Sabha in a written reply that India's oil import bill in terms of value has increased from Rs 409,077 crore in 2009-10 to Rs 726,386 crore in 2011-12.
The increase in import bill of crude oil is due to increase in price of crude oil and petroleum products in the international market, depreciation of Rupee, increase in domestic consumption of petroleum products from 137.8 MMT in 2009-10 to 148.0 MMT in 2011-12 as well as on account of rise in the level of exports from 51.0 MMT in 2009-10 to 60.8 MMT in 2011-12.
Introduction to Currency Market
Foreign exchange rate is the value of a foreign currency relative to domestic currency. The exchange of currencies is done in the foreign exchange market, which is one of the biggest financial markets. The participants of the market are banks, corporations, exporters, importers etc. A foreign exchange contract typically states the currency pair, the amount of the contract, the agreed rate of exchange etc.
Exchange Rate
A foreign exchange deal is always done in currency pairs, for example, US Dollar - Indian Rupee contract (USD - INR); British Pound - INR (GBP - INR), Japanese Yen - U.S. Dollar (JPY¬USD), U.S. Dollar - Swiss Franc (USD-CHF) etc. Some of the liquid currencies in the world are USD, JPY, EURO, GBP, and CHF and some of the liquid currency contracts are on USD-JPY, USD-EURO, EURO-JPY, USD-GBP, USD-CHF, etc.
In a currency pair, the first currency is referred to as the base currency and the second currency is referred to as the 'counter/terms/quote' currency. The exchange rate tells the worth of the base currency in terms of the terms currency, i.e. for a buyer, how much of the terms currency must be paid to obtain one unit of the base currency.
Fixed Exchange Rate Regime and Floating Exchange Rate Regime
There are mainly two methods employed by governments to determine the value of domestic currency vis-a-vis other currencies: fixed and floating exchange rate.
Fixed exchange rate regime:
Fixed exchange rate, also known as a pegged exchange rate, is when a currency's value is maintained at a fixed ratio to the value of another currency or to a basket of currencies or to any other measure of value e.g. gold. In order to maintain a fixed exchange rate, a government participates in the open currency market. When the value of currency rises beyond the permissible limits, the government sells the currency in the open market, thereby increasing its supply and reducing value. Similarly, when the currency value falls beyond certain limit, the government buys it from the open market, resulting in an increase in its demand and value.
Floating exchange rate regime:
Unlike the fixed rate, a floating exchange rate is determined by a market mechanism through supply and demand for the currency. A floating rate is often termed "self-correcting", as any fluctuation in the value caused by differences in supply and demand will automatically be corrected by the market. For example, if demand for a currency is low, its value will decrease, thus making imported goods more expensive and exports relatively cheaper. The countries buying these export goods will demand the domestic currency in order to make payments, and the demand for domestic currency will increase. This will again lead to appreciation in the value of the currency. Therefore, floating exchange rate is self-correcting.
Factors Influencing Currency Exchange Rates
Currency exchange rates are typically affected by the supply and demand of a particular country's currency in the international foreign exchange market. The level of confidence in the economy of a particular country also influences the currency of that country.
Balance of Payments: It is a definite indicator of the demand and supply of foreign exchange. If a country is having favorable balance of payments position it implies that there is more supply of foreign exchange and therefore foreign currencies will tend to be cheaper vis-à-vis domestic currency. However, if the balance is unfavorable, it indicates that there is more demand for foreign exchange and the foreign currency will firm up.
Strength of the Economy: The relative strength of the economy also has an effect on the demand and supply of foreign currencies. If an economy is growing at a faster rate, it is generally in the long run expected to have a better performance on balance of trade. In the short run, increasing economic activity in the country may necessitate higher imports and exports may take some time to increase.
Fiscal Policy: If the government follows an expansionary policy by having lower interest rates, it will fuel the engine of economic growth and will result in better trade performance. However, if the government is following an expansionary policy by resorting to high budget deficit financing and monetizing the deficit, this will lead to high inflation in the country.
Interest Rate: High interest rates make speculative capital move between countries and this affects exchange rates. The capital is attracted provided there are no controls towards currencies yielding high interest rates. If interest rates of domestic currency are raised this will result in more demand for domestic currency and cause it to increase.
Monetary policy: It is a very effective tool for controlling money supply and is used particularly for keeping a tab on the inflationary pressures in the economy. Its main objective is to maintain money supply in the economy at a level which will ensure price stability, full employment and growth in the economy. If money supply is more, it will lead to inflation and the central bank will raise interest rates, sell government securities through open market operations and raise cash reserve requirements thus giving a signal for a tight money supply policy.
Political Stability: Expected changes in government due to elections or changes in incumbency in the government may affect exchange rates. However, whether the currency of the country concerned will become stronger or weaker will depend on the expected policies to be pursued by the new government.
Exchange Control Regime: Exchange control is generally aimed at disallowing free movement of capital flows and therefore affects exchange rates. This is done by keeping the price of the currency at an artificial level. If a country wants to boost its exports, it will keep the value of its currency low vis-à-vis the foreign currency. This will help the exporters in realizing more units of local currency for the same units of foreign currency and vice-versa if the government decides to follow liberal import policy.
Central Bank Intervention: Buying or selling of foreign currency in the market by the central bank with a view to increase the demand or supply is known as intervention. If a central bank is of the opinion that local currency is becoming stronger thereby affecting the exports, it buys foreign currency which increases the demand for foreign currency and will cause it to go up.
Quotes
In currency markets, the rates are generally quoted in terms of USD. The price of a currency in terms of another currency is called quote'. A quote where USD is the base currency is referred to as a direct quote' (e.g. 1 USD - INR 53.9950) while a quote where USD is referred to as the terms currency is an indirect quote' (e.g. 1 INR = 0.01852 USD).
USD is the most widely traded currency and is often used as the vehicle currency. Use of vehicle currency helps the market in reduction in number of quotes at any point of time, since exchange rate between any two currencies can be determined through the USD quote for those currencies. This is possible since a quote for any currency against the USD is readily available. Any quote not against the USD is referred to as cross' since the rate is calculated via the USD.
Tick Size
Tick size refers to the minimum price differential at which traders can enter bids and offers. For example, the Currency Futures contracts traded at the MCX have a tick size of Rs. 0.0025. So, if the prevailing futures price is Rs. 55.5000, the minimum permissible price movement can cause the new price to be either Rs. 55.4975 or Rs. 55.5025. Tick value refers to the amount of money that is made or lost in a contract with each price movement.
Spread
Spreads or the dealer's margin is the difference between bid price (the price at which a dealer is willing to buy a foreign currency) and ask price (the price at which a dealer is willing to sell a foreign currency). The quote for bid will be lower than ask, which means the amount to be paid in counter currency to acquire a base currency will be higher than the amount of counter currency that one can receive by selling a base currency.
Spot and Forward Transaction
The spot market transaction does not imply immediate exchange of currency, rather the settlement (exchange of currency) takes place on a value date, which is usually two business days after the trade date. The price at which the deal takes place is known as the spot rate (also known as benchmark price). The two-day settlement period allows the parties to confirm the transaction and arrange payment to each other.
A forward transaction is a currency transaction wherein the actual settlement date is at a specified future date, which is more than two working days after the deal date. The date of settlement and the rate of exchange (called forward rate) is specified in the contract. The difference between spot rate and forward rate is called "forward margin".
Tools for Hedging
Derivatives are financial contracts whose value is determined from one or more underlying variables, which can be a stock, a bond, an index, an interest rate, an exchange rate etc. The most commonly used derivative contracts are forwards and futures contracts and options. There are other types of derivative contracts such as swaps, etc. Currency derivatives can be described as contracts between the sellers and buyers whose values are derived from the underlying which in this case is the Exchange Rate. Currency derivatives are mostly designed for hedging purposes, although they are also used as instruments for speculation.
The market participant may enter into a spot transaction and exchange the currency at current time.
The market participant wants to exchange the currency at a future date. Here the market participant may either:
Enter into a futures/forward contract, whereby he agrees to exchange the currency in the future at a price decided now, or,
Buy a currency option contract, wherein he commits for a future exchange of currency, with an agreement that the contract will be valid only if the price is favorable to the participant.
The most commonly used tools of hedging are forwards and futures. One can also enter into an option contract in order to hedge.
Forward Contracts
Forward contracts are agreements to exchange currencies at an agreed rate on a specified future date. The actual settlement date is more than two working days after the deal date. The agreed rate is called forward rate and the difference between the spot rate and the forward rate is called as forward margin. Forward contracts are bilateral contracts (privately negotiated), traded outside a regulated stock exchange and suffer from counter-party risks and liquidity risks. Counter Party risk means that one party in the contract may default on fulfilling its obligations thereby causing loss to the other party.
Futures Contract
Futures contracts are also agreements to buy or sell an asset for a certain price at a future time. Unlike forward contracts, which are traded in the over-the-counter market with no standard contract size or standard delivery arrangements, futures contracts are exchange traded and are more standardized. They are standardized in terms of contract sizes, trading parameters, settlement procedures and are traded on a regulated exchange. The contract size is fixed and is referred to as lot size.
Since futures contracts are traded through exchanges, the settlement of the contract is guaranteed by the exchange or a clearing corporation and hence there is no counter party risk. Exchanges guarantee the execution by holding an amount as security from both the parties. This amount is called as Margin money. Futures contracts provide the flexibility of closing out the contract prior to the maturity by squaring off the transaction in the market.
The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be "short". The terminology reflects the expectations of the parties-the buyer hopes or expects that the asset price is going to increase, while the seller hopes or expects that it will decrease in near future.
Option Contract
An option is nothing but a contract that gives the buyer the right, but does not give the obligation, to buy or sell an underlying asset at a specific price on a specific date.
An option is a derivative contract between a buyer and a seller, where one party gives to the other party the right, but not the obligation, to buy from the First party the underlying asset on or before a specific day at an agreed-upon price. In return for granting the option, the party granting the option collects a payment from the other party. This payment collected is called the "premium" or price of the option.
Unlike the future and the forward contracts, options require a cash payment (premium) from the option buyer (holder of right to buy or sell) to the option seller (party granting the right). This initial payment is called as the option price or option premium. Option can be traded in both the exchange market and also on OTC (over the counter) markets. Options which are traded in the exchange market have less risk of default because a clearing corporation is involved in it.
There are mainly two types of options:
Call Option: A Call options is a type of option that gives the holder the right to buy an asset at a certain price within a specific time interval. The person who has the right to buy the underlying asset is known as the "buyer of the call option". The price at which the buyer has the right to buy the asset is agreed upon at the time of entering the contract. The price is known as the strike price of the contract. Buyer by exercising his right will buy the underlying asset if an only if the price of the underlying asset in the market is more than the strike price on or before the expiry date of the contract. Buyer here has the right to buy the asset only if he wants to but he is not obliged to buy the asset in any manner.
Put Option: A put option is also a contract that grants the right to the buyer of the option to sell the underlying asset on or before a specific day at an agreed upon price, but again does not give the obligation to do so. The price at which the buyer has the right to sell the asset is agreed upon at the time of entering the contract. This price is known as the strike price of the contract. Buyer here will exercise his right to sell the underlying asset if an only if the price of the underlying asset in the market is less than the strike price on or before the expiry date if the contract.
Swaps Contract
A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such as interest rate, foreign exchange rate, equity price or commodity price. Conceptually swap is either a portfolio of forward contracts, or as a long position in one bond coupled with a short position in another bond.
Natural Hedge
Natural Hedging involves to the extent possible, foreign currency outflows with inflows.
There are certain companies which have assets in foreign countries as well as they import a lot of raw materials from foreign countries. The offshore assets serve as a natural hedge against the depreciating currency. E.g. Tata Steel has a lot of assets in Europe (Corus) and it also imports a lot of raw materials for the purpose of producing steel.
Thus, if the rupee depreciates, the Balance Sheet is converted at a higher rate but it has to may much more for imports.
An example of 'operational hedging' is relocating the production facilities of Japanese car manufacturers for example who used to supply cars to the American market in the entirety, earlier used to export them from Japan. But now they have set up factories in the USA, thus reducing their exposure to the fluctuating Yen/dollar rate.
Similarly, an oil producer may expect to receive its revenues in U.S. dollars, but faces costs in a different currency; it would be applying a natural hedge if it agreed to, for example, pay bonuses to employees in U.S. dollars.
Strategies of Hedging through Currency Futures
Futures contracts act as hedging tools and help in protecting the risks associated with uncertainties in exchange rates. Anyone who is anticipating a future cash outflow (payment of money) in a foreign currency can lock-in the exchange rate for the future date by entering into a futures contract. For example, let us take the example of an oil-importing firm - ABC Co. The company is expected to make future payments of USD 100000 after 3 months in USD for payment against oil imports. Suppose the current 3-month futures rate is Rs. 45, then ABC Co. has two alternatives:
OPTION A: ABC Co. does nothing and decides to pay the money by converting the INR to USD. If the spot rate after three months is Rs. 47, the ABC Co. will have to pay INR 4,700,000 to buy USD 100000. Alternatively, if the spot price is Rs. 43.0000, ABC Co. will have to pay only INR 4,300,000 to buy USD 100000. The point is that ABC Co. is not sure of its future liability and is subject to risk of exchange rate fluctuations.
OPTION B: ABC Co. can alternatively enter into a futures contract to buy 1,00,000 USD at Rs. 45 and lock in the future cash outflow in terms of INR. In this case, whatever may be the prevailing spot market price after three months the company's liability is locked in at INR 4,500,000. In other words, the company is protected against adverse movement in the exchange rates.
This is known as hedging and currency futures contracts are generally used by hedgers to reduce any known risks relating to the exchange rate.
In a currency futures contract, the party taking a long (buy) position agrees to buy the base currency at the future rate by paying the terms currency. The party with a short (sell) position agrees to sell the base currency and receive the terms currency at the pre-specified exchange rate. When the base currency appreciates and the spot rate at maturity date (S) becomes more than the strike rate in the futures contract (K), the 'long' party who is going to buy the base currency at the strike rate makes a profit.
The party with the 'long' position can buy the USD at a lower rate and sell in the market where the exchange rate is higher thereby making a profit. The party with a 'short' position loses since it has to sell the base currency at a price lower than the prevailing spot rate. When the base currency depreciates and falls below the strike rate (K), the `long' party loses and a 'short' position gains. This is depicted as a pay-off diagram below:
Figure Graph depicting Pay-Off from an USDINR Futures Contract
Short Hedge
A short hedge involves taking a short position in the futures market. In a currency market, short hedge is taken by someone who already owns the base currency or is expecting a future receipt of the base currency.
An exporter, who is expecting a receipt of USD in the future, will try to fix the conversion rate by holding a short position in the USD-INR contract.
Exporter XYZ is expecting a payment of USD 1,000,000 after 3 months. Assume the spot exchange rate is INR 48.0000: 1 USD. If the spot exchange rate after 3-months remains unchanged, then XYZ will get INR 48,000,000 by converting the USD received from the export contract. If the exchange rate rises to INR 49.0000: 1 USD, then XYZ will get INR 49,000,000 after 3 months. However, if the exchange rate falls to INR 47.0000: 1 USD, then XYZ will get INR 47,000,000 thereby losing INR 1,000,000. Thus, XYZ is exposed to an exchange rate risk, which it can hedge by taking an exposure in the futures market.
By taking a short position in the futures market, XYZ can lock-in the exchange rate after 3 months at INR 48.0000 per USD (suppose the 3 month futures price is Rs. 48). Since a USD-INR futures contract size is of 1000 USD, XYZ has to take a short position in 1000 contracts. Whatever may be the exchange rate after 3-months, XYZ will be sure of getting INR 48,000,000. A loss in the spot market will be compensated by the profit in the futures contract and vice versa. This can be explained as under:
If USD strengthens and the exchange
rate becomes INR 49.0000 : 1 USD
If USD weakens and the exchange rate
becomes INR 47.0000 : 1 USD
Spot Market:
XYZ will get INR 49,000,000 by selling 1 million USD in the spot market.
Futures Market:
XYZ will lose INR (48 - 49)* 1000 = INR 1000 per contract. The total loss in 1000 contracts will be INR 1,000,000.
Net Receipts in INR:
49 million - 1 million = 48 million
Spot Market:
XYZ will get INR 47,000,000 by selling 1 million USD in the spot market.
Futures Market:
XYZ will gain INR (48 - 47)* 1000 = INR 1000 per contract. The total gain in 1000 contracts will be INR 1,000,000.
Net Receipts in INR:
47 million + 1 million = 48 million
An exporting firm can thus hedge itself from currency risk, by taking a short position in the futures market. Irrespective, of the movement, the exporter is certain of the cash flow.
Long Hedge
A long hedge involves holding a long position in the futures market. A Long position holder agrees to buy the base currency at the expiry date by paying the agreed exchange rate. This strategy is used by those who will need to acquire base currency in the future to pay any liability in the future.
An importer who has to make payment for his imports in USD will take a long position in USD¬INR contracts and fix the rate at which he can buy USD in future by paying INR.
An Importer, IMP, has ordered certain computer hardware from abroad and has to make a payment of USD 1,000,000 after 3 months. The spot exchange rate as well as the 3 months future rate is INR 48.0000: 1 USD. If the spot exchange rate after 3-months remains unchanged then IMP will have to pay INR 48,000,000 to buy USD to pay for the import contract. If the exchange rate rises to INR 49.0000 : 1 USD, then IMP will have to pay more - INR 49,000,000 after 3 months to acquire USD. However, if the exchange rate falls to INR 47.0000: 1 USD, then IMP will have to pay INR 47,000,000 (INR 1,000,000 less). IMP wants to remain immune to the volatile currency markets and wants to lock-in the future payment in terms of INR.
IMP is exposed to currency risk, which it can hedge by taking a long position in the futures market. By taking long position in 1000 future contracts, IMP can lock-in the exchange rate after 3-months at INR 48.0000 per USD. Whatever may be the exchange rate after 3-months, IMP will be sure of getting the 1 million USD by paying a net amount of INR 48,000,000. A loss in the spot market will be compensated by the profit in the futures contract and vice versa. This can be explained as under:
If USD strengthens and the exchange
rate becomes INR 49.0000 : 1 USD
If USD weakens and the exchange rate
becomes INR 47.0000 : 1 USD
Spot Market:
IMP has to pay more i.e. INR
49,000,000 for buying 1 million USD in the spot market.
Futures Market:
IMP will gain INR (49 - 48)* 1000 = INR 1000 per contract. The total profit in 1000 contracts will be INR 1,000,000.
Net Payment in INR:
- 49 million + 1 million = 48 million
Spot Market:
IMP will have to pay less i.e. INR 47,000,000 for acquiring 1 million USD in the spot market.
Futures Market:
The importer will lose INR (48-47)* 1000 = INR 1000 per contract. The total loss in 1000 contracts will be INR 1,000,000.
Net Payment in INR:
- 47 million - 1 million = 48 million
An importer can thus hedge itself from currency risk, by taking a long position in the futures market. The importer becomes immune from exchange rate movement.
Speculation in Currency Futures
Futures contracts can also be used by speculators who anticipate that the spot price in the future will be different from the prevailing futures price. For speculators, who anticipate a strengthening of the base currency will hold a long position in the currency contracts, in order to profit when the exchange rates move up as per the expectation. A speculator who anticipates a weakening of the base currency in terms of the terms currency, will hold a short position in the futures contract so that he can make a profit when the exchange rate moves down.
Suppose the current USD-INR spot rate is INR 48.0000 per USD. Assume that the current 3-months prevailing futures rate is also INR 48.0000 per USD. Speculator ABC anticipates that due to decline in India's exports, the USD (base currency) is going to strengthen against INR after 3 months. ABC forecasts that after three months the exchange rate would be INR 49.50 per USD. In order to profit, ABC has two options:
Option A: Buy 1000 USD in the spot market, retain it for three months, and sell them after 3 months when the exchange rate increases: This will require an investment of Rs. 48,000 on the part of ABC (although he will earn some interest on investing the USD). On maturity date, if the USD strengthens as per expectation (i.e. exchange rate becomes INR 49.5000 per USD), ABC will earn Rs. (49.50 - 48)*1000, i.e. Rs. 1500 as profit.
Option B: ABC can take a long position in the futures contract - agree to buy USD after 3 months @ Rs. 48.0000 per USD: In a futures contract, the parties will just have to pay only the margin money upfront. Assuming the margin money to be 10% and the contract size is USD 1000, ABC will have to invest only Rs. 4800 per contract. With Rs. 48,000, ABC can enter into 10 contracts. The margin money will be returned once the contract expires.
After 3 months, if the USD strengthens as per the expectation, ABC will earn the difference on settlement. ABC will earn (Rs 49.5000 - 48.0000) * 1000, i.e. Rs. 1500 per contract. Since ABC holds long' position in 10 contracts, the total profit will be Rs. 15000.
However, if the exchange rate does not move as per the expectation, say the USD depreciates and the exchange rate after 3 months becomes Rs. 47.0000 per USD, then in option A, ABC will lose only Rs. (48-47) * 1000 = Rs. 1000, but in option B, ABC will lose Rs. 10000 (Rs. 1000 per contract * 10 contracts).
Thus taking a position in futures market, rather than in spot market, give speculators a chance to make more money with the same investment (Rs. 48,000). However, if the exchange rate does not move as per expectation, the speculator will lose more in the futures market than in the spot market. Speculators are willing to accept high risks in the expectation of high returns.
Speculators prefer taking positions in the futures market to the spot market because of the low investment required in case of futures market. In futures market, the parties are required to pay just the margin money upfront, but in case of spot market, the parties have to invest the full amount, as they have to purchase the foreign currency.
MCX's Currency Derivatives Segment
The phenomenal growth of financial derivatives across the world is attributed to the fulfillment of needs of hedgers, speculators and arbitrageurs by these products.
Contract Specification
Underlying: US Dollar- Indian Rupee (USD-INR) exchange rate.
Trading Hours: The trading on currency futures is available from 9 a.m. to 5 p.m. from Monday to Friday.
Size of the contract: The minimum contract size of the currency futures contract at the time of introduction is USD 1000.
Quotation: The currency futures contracts are quoted in Rupee terms. However, the outstanding positions are in US Dollar terms.
Tenor of the contract: The currency futures contracts have a maximum maturity of 12 months.
Available contracts: All monthly maturities from 1 to 12 months are available.
Settlement mechanism: The currency futures contracts are settled in cash in Indian Rupee.
Settlement price: The settlement price is the Reserve Bank of India Reference Rate on the last trading day.
Final settlement day: Final settlement day is the last working day (subject to holiday calendars) of the month. The last working day is taken to be the same as that for Inter-bank Settlements in Mumbai. The rules for Inter-bank Settlements, including those for `known holidays' and subsequently declared holiday' are those laid down by FEDAI (Foreign Exchange Dealers Association of India). In keeping with the modalities of the OTC markets, the value date / final settlement date for the each contract is the last working day of each month and the reference rate fixed by RBI two days prior to the final settlement date is used for final settlement. The last trading day of the contract is therefore 2 days prior to the final settlement date. On the last trading day, since the settlement price gets fixed around 12:00 noon, the near month contract ceases trading at that time (exceptions: sun outage days, etc.) and the new far month contract is introduced.
Hedging through MCX futures can be carried out in four currency pairs viz.
US dollars to Indian rupees (USDINR)
Euro to Indian rupees (EURINR)
Japanese Yen to Indian rupees (JPYINR)
Great Britain Pound to Indian rupees (GBPINR)
The lot size is of 1000 dollars/1000 Pounds/1000 Euro.
Trading Hours
9:00AMto5:00PM (Monday to Friday)
Contract Size
US$1,000
Price Quotation
INR per USD , EUR ,GBP and JPY
Tick Size
INR0.0025
Minimum Initial Margin
1.75% on first day&1% thereafter
Contracts
All months with a maturity duration of 12 months
Settlement Mechanism
Cash Settled in Indian Rupee
Last Trading Day
2 workings days prior to last BD of expiry month
Final Settlement Rate
RBI USD INR Reference Rate
Final Settlement Date
Last working day of month, except Saturday.
Charges of Futures Contract
Calculation Base Price (Rs.)
54
85
69
0.66
Currency
USD
GBP
EUR
YEN
Lot Size
1000
1000
1000
100000
Expenses per crore (Rs.)
320
320
320
320
Brokerage single side
0.03%
0.03%
0.03%
0.03%
Expenses per lot (Rs.)
1.728
2.72
2.208
2.112
Brokerage expense (Rs.)
16.2
25.5
20.7
19.8
Service [email protected]% (Rs.)
2.00232
3.1518
2.55852
2.44728
Total expenses both side (Rs.)
38.13264
60.0236
48.72504
46.60656
Account opening charges
NIL
NIL
NIL
NIL
Maintenance charges (Rs.)
200
200
200
200
RBI Reference Rate
RBI reference rate is the rate published daily by RBI for spot rate for various currency pairs. The rates are arrived at by averaging the mean of the bid/offer rates polled from a few select banks during a random five minute window between 11:45 AM and 12:15 PM and the daily press on RBI reference rate is be issued every week-day (excluding Saturdays) at around 12.30 PM. The contributing banks are selected on the basis of their standing, market-share in the domestic foreign exchange market and representative character.
The RBI periodically reviews the procedure for selecting the banks and the methodology of polling so as to ensure that the reference rate is a true reflection of the market activity. The reference rate is a transparent price which is publicly available from an authentic source.
Settlement
Currency futures contracts have two types of settlements, the MTM settlement which happens on continuous basis at the end of each day, and the final settlement which happens on the last trading day of the futures contract.
Mark-to-Market settlement (MTM Settlement)
All futures contracts for each member are marked to market to the daily settlement price of the r The mark-to-market profit (loss) is calculated as under relevant futures contract at the end of each day.
For contracts executed during the day but not squared off during the day: Current Day's Settlement Price - Trade Price
If the contracts were executed as well as squared off during the day: Sell Price - Buy Price
If the contracts were brought forward from previous day close and squared off during the day: Trade Price - Previous Day Settlement Price
If the contracts were brought forward from previous day close but not squared off during the day: Current Day's Settlement Price - Previous Day Settlement Price
Final settlement for futures
On the last trading day of the futures contracts, after the close of trading hours, the Clearing Corporation marks all positions of a CM to the final settlement price and the resulting profit/loss is settled in cash.
Comparison between different tools of Hedging
There are different tools available for hedging such a forwards, futures, options and swaps.
There are certain advantages and disadvantages of each of these tools. Certain tools are more appropriate for certain category of enterprises. The comparison between them is therefore, essential.
Comparison between Futures and Options
The similarities between two types of derivative contracts - Futures and Options are as follows:
Both the contracts have a buyer and seller
Both the contracts have a set price for the underlying asset
Both the contracts have a set settlement date
The differences between futures and options are as follows:
The difference between two contracts is that in futures both the parties are under right as well as obligation to buy or sell and therefore face similar risk. Whereas in options, the buyer has only rights and no obligation and therefore he faces only the risk of premium paid and option seller is under obligation to buy or sell (depending on whether put option is sold or a call option is sold, respectively) and therefore faces unlimited risk. At the same time, the option buyer has chances to get unlimited upside and the option seller has limited upside equal to the premium received. The call option buyer would exercise the option only if the price of underlying asset is higher than the strike price and premium paid. Similarly the put option buyer would exercise the option if the price of the underlying asset is less than the strike price and the premium paid. Just like futures, options can be used for hedging, or to generate credited to the relevant CM's clearing bank account on T+2 working day following last trading day of the contract (contract expiry day). The final settlement price is the RBI reference rate for the last trading day of the futures contract. All open positions are marked to market on the final settlement price for all the positions which gets settled at contract expiry. Such marked to market profit / loss shall be paid to / received from clearing members.
Comparison between Forward and Futures Contract
Forward Contract
Futures Contract
Guarantee
No guarantee of settlement until the date of maturity only the forward price
Both parties must deposit an initial guarantee (margin)
Expiry date
Depending on the transaction
Standardized
Transaction method
Negotiated directly by the buyer and seller
Quoted and traded on the Exchange
Contract size
Depending on the transaction and the requirements of the contracting parties.
Standardized
Institutional guarantee
The contracting parties
Clearing House
Market regulation
Not regulated
Government regulated market
Risk
High counterparty risk
Low counterparty risk
Structure
Customized to customers need. Usually no initial payment required.
Standardized. Initial margin payment required.
Method of pre-termination
Opposite contract with same or different counterparty. Counterparty risk remains while terminating with different counterparty.
Opposite contract on the exchange.
Advantages of hedging through MCX
Better Rates: While hedging through MCX, importers/exporters get better rates as compared to the rates obtained through banks.
Counterparty Risk: If you hedge through bank, then there is counterparty risk. Counterparty risk implies that the bank might not honour the commitment it makes, if the bank itself goes into liquidation. However, in case of using MCX as a platform, it is guaranteed by the exchange. However, it has to be noted that the counterparty risk is extremely less in case of PSU banks and large private sector banks as they are in reasonably good shape. However, the level of trust that people place on smaller private sector banks and co-operative banks is much less and the perception of counterparty risk is much higher.
Small Lot Size: The lot size in case of MCX contracts is quite less. The lot size for an MCX contract is only $1000 i.e. approximately Rs. 55000. The margin money that needs to be paid is approximately 3 per cent which works out to RS.1650. Thus, a person who is hedging can pay margin money of Rs. 1650 and have an exposure of Rs. 55000.
Transparency: In case of a bank, the client does not know the difference between the bid and ask rates, whereas in case of MCX, the bid and ask rates are available on the screen. Hence, MCX offers much more transparency as compared to banks.
Disadvantages of hedging through MCX
Margin Money: It is the money that has to be deposited at the time of opening the account.eg. If a person wants an exposure of Rs 55000 he would have to deposit approximately Rs. 1650 as margin money. When a person hedg
