Currency Derivatives
Objectives How to the read the quotes Evolution of Foreign Exchange Market Factors affecting the Currency Market Current scenario Currency Futures Opportunities & Advantages Currency options Currency Futures specifications
Foreign Exchange Price of one currency viewed in relation to another currency is called a exchange rate What you see above are quotes to buy/sell three currency pairs. Currencies are pairs, in the above example, Euro against US Dollar or GBP against US Dollar
Interpret the quotes There are two ways to quote currency pairs in the FX market: direct quote and indirect quote Direct quote in US Dollars: Number of US Dollar required to buy 1 unit of foreign currency. eg. GBP/USD or EUR/USD1.2437 USD required to buy 1 USD. Indirect quote in US Dollars: Number of units of foreign currency that can be bought with 1 US Dollar eg. USD/JPY or 1 USD can buy 78.00 JPY
Direct Quote & Indirect Quote This is a direct quote in US Dollars The currency that comes on left, here Euro, becomes the base currency. Hence, in EUR/USD, the question is how many Dollars for 1 Euro One would require 1.2435 US Dollars to buy 1 unit of Euro This is an indirect quote in US Dollars USD is on the left, hence it is 1 unit of USD. One US Dollar can buy 55.5450 Indian Rupees
Direct Quote & Indirect Quote How much money do I make. If a client sells EUR/USD, he sells at the bid rate, i.e., 1.2434. Once a client sells EUR/USD, he becomes long on the US Dollar and short on Euro. Remember, the quote means 1.2434 US Dollar is required to buy 1 Euro. If a client sell EUR/USD @ 1.2434 and after an hour EUR/USD @ 1.2420, then the client makes 14 pips If a client buys USD/JPY, he buys at the offer rate, i.e., 78.03 Once a client buys USD/JPY, we becomes long on USD and short on JPY If a client buys USD/JPY @ 78.03 and after an hour USD/JPY @ 78.33, then the client makes 30 pips
Evolution of FX market Foreign Exchange Market is mainly a decentralized global market where trading of currencies takes place. Also known as fx/forex or currency market. Came into being in 1970s when countries shifted from fixed exchange rate system to floating exchange rate system Trades mainly in OTC market, where participants negotiate directly amongst themselves (96% - OTC; 4% - Exchanges). Main participants include banks, large corporate, hedge funds, central banks and financial institutions Retail participation (HNIs) is primarily through dedicated currency funds, as ticket size is usually quite large in OTC markets
Evolution contd. Trading in currencies started as a mechanism To facilitate international trade and investment, and To hedge foreign exchange risk But soon emerged as the largest alternative investment asset class in the world, because of its unique features: Continuous trading opportunity : i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday Standardization of underlying contract (trading on relative value between two currencies) Huge trading volume leading to high liquidity Variety of factors that affect exchange rates (sheer sensitivity to different news make it known as adults market in trading circle) Geographical dispersion (it is said currency market never sleeps) Higher leverage and hence opportunity to make higher profit /loss
How big is the pond Today, trading volume in currency market far exceeds any other asset class. Asset Class Approx. ADV (in USD billion) Currencies 4700 Fixed Income 2300 Commodities 1200-1300 Equities 300-350 ADV = Average Daily Volume Main trading centre are Tokyo, Singapore, London and New York Most active pairs are EUR/USD, USD/JPY, GBP/USD, known as G3 currencies, followed by G10 currencies (AUD/USD, USD/CAD etc) Of late, EM currencies are gaining momentum because of liberalized policies and higher growth potential
India Forex Market INR trades in a managed floating exchange rate regime INR is fully convertible on India s current account but not on capital account Forex transaction mainly confined to banks and network of dealers/brokers, known as OTC market. Entities having underlying exposure can only access OTC market Suitable for large entities having bigger exposure and greater access to banks Total volume approx USD 32-34 billion all combined (spot + forwards + swaps)
What is Currency Futures (CF)? Launched in August 2008 in consultation with SEBI and RBI. Futures are standardized version of forward contracts with fixed expiry and size Unlike OTC market where forward points are quoted separately, forward points are in-built in futures price Trades on regulated exchanges Aims to provide higher access to SMEs, HNIs and retail investors. Futures are cash settled contracts No delivery possible
Why Currency Futures (CF)? One of the fastest growing futures market presently in India Average daily volume of more than 25,000 cr.
Why Currency Options? Activity in exchange traded options is buzzing. Average daily volume of more than 4,000 cr.
Why Currency Futures (CF)? Daily average volatility of 0.6-1.00%, hence better control over portfolio Lower Exchange margin requirement Minimum Initial Margin requirement: 3-4% Kotak Securities Total Margin Charged 5% to 6% Hence, higher leverage of 18-20 times Better risk-reward ratio No STT (Securities Transaction Tax) Only cost involved Brokerage + Stamp Duty + SEBI fee + exchange trans. charges Brokerage: 0.02% or 10 per lot, whichever is higher (can be negotiated on volume) Stamp duty: 0.002% SEBI fee: 0.0002% Opportunity to churn in profit at minimum of 5 ticks (tick size 0.0025 paise)
What affects the currency movement? Long Term Interest rate differential (Change in interest rate - monetary policy) GDP growth Higher GDP growth potential entails stronger currency Medium Term Change in macro-economic indicators (Worsening of trade balance, current account deficit and fiscal deficit adversely affects the currency) Short Term Capital flows (FIIs, FDI or corporate flow) Higher inflow leads to stronger currency Performance of equity markets (Nifty & Rupee has inverse relationship) Movement in currencies of peer countries like Korea, Taiwan (EMs in Asia), or movement in crosses like EURUSD, USDJPY etc (overall risk sentiment in the market) Central bank intervention RBI intervenes sometimes to stem volatility and maintain fair value Key economic data announcements like inflation, IIPs etc.
Equity market & Rupee Nifty Index and USD/INR has inverse relationship (co-relation of plus 60%) On few days, this relationship may not work because of currency market positioning
India s macros: CAD and Rupee A widening Current Account Deficit is negative for Indian Rupee Oil & Gold command a lion share of imports Petro, jewelry & engg. goods command a lion share of exports
India s macros: FII inflows Monthly FII inflows (debt/equity combined) (Rs crore) Inflows dried in 2011, except for an LTRO lead push during Q1 2012
India s macros: Capital Account and Rupee Stress in BOP made Rupee one of the weak FX in the world Since July of 2011, INR depreciated @ 25%...
Rupee & the world markets Stress in the Eurozone causing spike in Spanish yields (%) and decline in equities
Supporting factors for Rupee INR 36 currency REER Annual change in Brent crude (%- red) & USD/INR (black) Line, QaINTBWREER, Cvalue(Last), (S1, S2) 30/04/2012, 93.4 104.21 Value 104 Value USD Bbl 80 60 Price USD 55.1700 54 53 52 100 40 51 50 96 20 49 48 0 47 91.273 92-13.001-20 46 45-40 44 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 1990 2000 2010.123.1234 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 2009 2010 2011 2012 [Delayed]
Supporting factors for Rupee Indian gold imports- USD Bn IIP (yellow) & Non-oil, non-gold imports (blue) India imported 655 tons in FY12 v/s 969 tons in FY11
Currency Futures - Opportunities Directional Views Taking directional call on different currency pairs against INR Price view on cross currency pairs like EUR/USD, USD/JPY GBP/USD through combination of futures contracts Hedging current exposure Importers and exporters can hedge their short term exposure Borrowers can hedge FCY loans for interest or principal payments Hedge for offshore investment by Resident Indians Trade & Capital Flows Remittances for trade or services or capital transactions Arbitrage Arbitrage opportunity between exchange, OTC and off-shore market, if any