What is Currency Future?
A currency future is a derivative contract with a currency as the underlying commodity. It is a contract that gives the buyer a right and obligation to buy (or sell) a standard quantity of a currency at a future date and at a price agreed between parties at the inception of the contract.
Currency futures are theoretically same as that of forward contracts in terms of the purpose it serves but currency futures are standardised exchange-traded financial instruments as compared to forward contracts, which are part of the OTC market. The exchange-traded nature of currency futures makes it more convenient in terms of ability to exit the position at any time due to high liquidity and tradability.
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The prices of currency futures closely move with the forward rates though currency futures are more determined by demand-supply arising out of activities like speculation in derivative markets. Any major deviation between two prices will provide arbitrage opportunities, which in any efficient market, will ensure that two prices move in tandem. A disadvantage in the case of futures contract is that it may not always be possible to create a perfect hedge as the contract amounts and maturity dates are standardised.
On the other hand, there will be no counterparty risk in the case of futures, being novated by the exchange-based clearing mechanism as compared to forward contracts. Positions in currency futures can be squared off at any time on or before the maturity date of the contract. Another disadvantage with regard to futures is that it requires the maintenance of initial and marked-to-market margin with the exchange.
This leads to daily cash flows pertaining to the futures position (based on difference between the contracted price and prevailing futures price) when compared to forward contracts where cash flow can occur only on maturity or closure of the contract. Currency futures were introduced in India on August 29, 2008 at the National Stock Exchange (NSE). The exchange-traded derivatives are also offered in MCX Stock Exchange and the United Stock Exchange in India.
Corporates can directly hedge their exposure through derivative exchange brokers or by online trading instead of a need for intermediation by banks required in the case of forward contracts. Banks can also use currency futures for hedging their own trading and banking book forex exposures as AD Category – I banks are allowed by RBI to become trading and clearing members of derivative exchanges. Banks can also do proprietary trading and offer trading and clearing services for corporates currency options and futures.
Banks have to follow these minimum prudential requirements in order to become trading and clearing members of derivative exchanges (for both options and futures):
- Minimum net worth of ₹500 crore
- Minimum CRAR of 10%
- Net NPA not exceeding 3%
- Net profit record for the last 3 years
The proprietary trading in exchange-traded currency derivative instruments should be within the Net Open Position (NOP) limits and Aggregate Gap Limits (AGL).
Currency Futures Specifications and Quotations
Figure that follows gives a snapshot extract of the currency futures quotes for several currencies prevailing on November 30, 2015 at NSE. The currency futures pertaining to four major currencies viz., USD, EUR, GBP and JPY are traded at NSE. The first column gives the contract symbol that also indicates the contract maturity date. Table gives the contract specifications applicable for currency future contracts listed at NSE.
The salient features are:
- The unit of trading for each contract is 1000 for USD, GBP and EUR and 100,000 for Japanese Yen contracts. For example, the minimum amount that can be purchased or sold in the case of USD-INR futures contract is 1000 dollars.
- The currency futures price is quoted in terms of the price of the underlying, i.e. the exchange rate of the respective currencies. For example, the last traded price of 66.9925 for the USD-INR futures contract maturing on 29th December, 2015 implies that $1000 can be exchanged for rupees at the exchange rate of INR 66.9925/USD. Alternatively, a buyer of USD-INR futures contracts to pay INR 66,992.50 for $1000 on the maturity date of the contract.
- The mode of settlement is in INR. The final settlement price is based on the “RBI reference rate” published by RBI in its press release (this is required as the spot forex markets are traded on the OTC basis).
Futures Settlement Process
The exchange-traded derivative products like futures and options (discussed earlier) are not settled on maturity by physical delivery of the underlying. Normally, all exchange-traded futures and options are cash settled based on the difference between the futures price contracted and the settlement price applicable on the maturity date. However, it is possible to close the contract by squaring off the position any time before maturity date at the prevailing market price.
Another feature of the exchange-traded derivative settlement process is the concept of “Marked-To-Market (MTM)” margining process. The primary objective of margining is to ensure that counterparties do not default on their commitment. When an investor purchases currency futures/options, he agrees to deliver the contracted amount of underlying, i.e. a currency against the home currency. However, on the maturity date, either of the counterparty may fail on his obligations.
The derivative exchange, along with the clearing house, guarantees the settlement of every trade by assuring that it will honour the commitment even when the counterparty fails. In order to facilitate this, the exchange requires a security deposit to be placed by counterparties, called initial margin, as a small percentage of the contract amount. Normally, the profit/loss arising out of the futures trading will be within the initial margin. However, as the spot and futures prices change every day, the deposit of initial margin as a percentage of the contracted amount also changes.
If the percentage of initial margin goes below a certain level called Maintenance Margin, the trader will be required to deposit a “Variation Margin” to bridge the gap in the initial margin available. This requires that contracts are valued at the end of everyday based on the closing price in order to ensure the adequacy of initial margin. This process of valuing the futures positions based on the latest market price is called ‘Marked-To-Market’ process. When a market participant sells a futures contract, he is said to have taken a “Short Position” in the market.
Similarly, a purchase is termed “Long Position”. Both these investors are required to maintain margins with the exchange. On the expiry date of the contract, the contract is settled on the basis of settlement price published by RBI called the “RBI Reference Rate”. The cash settlement involves calculating the difference between the contracted price and the settlement price and adjusting the same with the margin kept with the exchange. If cash settlement indicates a loss and if it is more than the margin kept with the exchange, the trader will be required to pay the difference amount.
Similarly, if it is a profit, the exchange will pay to the trader. However, it is important to note that a market participant can close his futures position at any time on or before the maturity date of the contract. It means a long position can be squared off (i.e. selling an offsetting futures contract) at the futures market price prevailing on that day and vice versa for a short position. Since the margin requirement is very low, derivative instruments allow for easy speculation and this is the reason as to why the volume of derivative trades meant for hedging is far below the overall volume of derivative trading.
A snapshot extract of the currency futures quotes for several currencies prevailing on November 30, 2015 at NSE is given in Figure:
Contract specifications for currency futures at NSE are given in Table:
|Unit of trading||1 – 1 unit denotes 1000 USD.||1 – 1 unit denotes 1000 EURO.||1 – 1 unit denotes 1000 POUND STERLING.||1 – 1 unit denotes 100000 JAPANESE YEN.|
|Underlying/Order Quotation||The exchange rate in Indian Rupees for US Dollars||The exchange rate in Indian Rupees for Euro.||The exchange rate in Indian Rupees for Pound Sterling.||The exchange rate in Indian Rupees for 100 Japanese Yen.|
|Tick size||0.25 paise||or INR 0.0025|
|Trading hours||Monday to Friday (9:00 am to 5:00 pm)|
|Contract trading cycle||12-month trading cycle|
|Last trading day||Two working days prior to the last business day of the expiry month at 12:30 pm.|
|Final settlement day||Last working day (excluding Saturdays) of the expiry month.|
The last working day will be the same as that for Interbank Settlements in Mumbai.
|Quantity Freeze||10,001 or greater|
|Base price||Theoretical price on the 1st day of the contract. On all other days, DSP of the contract.||Theoretical price on the 1st day of the contract. On all other days, DSP of the contract.||Theoretical price on the 1st day of the contract. On all other days, DSP of the contract.||Theoretical price on the 1st day of the contract. On all other days, DSP of the contract.|
|Price operating range||Tenure upto 6 months|
Tenure greater than 6 months
|+/-3 % of base price.|
+/- 5% of base price.
|Position limits||Details provided separately|
|Initial margin||SPAN Based Margin|
|Extreme loss margin||1% of MTM value of gross open position||0.3% of MTM value of gross open position||0.5% of MTM value of gross open position||0.7% of MTM value of gross open position|
|Calendar spreads||₹400 for spread of 1 month ₹500 for spread of 2 months ₹800 for spread of 3 months ₹1000 for spread of 4 months and more||₹700 for spread of 1 month ₹1000 for spread of 2 months ₹1500 for spread of 3 months and more||₹1500 for spread of 1 month ₹1800 for spread of 2 months ₹2000 for spread of 3 months and more||₹600 for spread of 1 month ₹1000 for spread of 2 months ₹1500 for spread of 3 months and more|
|Settlement||Daily settlement :T + 1|
Final settlement : T + 2
|Mode of settlement||Cash settled in Indian Rupees|
|Daily settlement price (DSP)||Calculated on the basis of the last half an hour weighted average price.|
|Final settlement price (FSP)||RBI reference rate||RBI reference rate||Exchange rate published by RBI in its Press Release captioned RBI reference Rate for US$ and Euro||Exchange rate published by RBI in its Press Release captioned RBI reference Rate for US$ and Euro|
Hedging With Currency Futures
Currency futures can be used for hedging forex exposures in the same way forward contracts are used. Currency futures have an advantage of being an exchange-traded derivative, which gives them more liquidity and tradability while they have the disadvantage of imperfect hedging. Since futures contracts are standardised in terms of size of contracts and maturity date, they do not allow forex exposures to be hedged perfectly.
Also, the futures contract requires deposit of initial margin and daily cash inflows/outflows owing to the mark-to-market mechanism. Suppose an importer has payables of JPY 1.15 million which he needs to pay in two months. Let today be 30th November 2015 and the payment be due on 20th January 2016. In the case of forward contracts, he can simply hedge this exposure by entering into a forward purchase contract with his banker for $1.15 million maturing on 20th January 2015.
In the case of currency futures, since the size of the contract and maturity date do not coincide with standard contracts, he first needs to identify a contract that matures near the liability date and also on the number of contracts required for hedging the exposure.
Number of contracts required = Total Exposure/Standard Contract size
= 11.5 contracts
Hence, for JPY 11.5 million, 11.5 contracts are required. Rounding off, he requires a minimum of 11 JPY-INR contracts. Since the exposure requires the future purchase of JPY, he needs to take a long position by buying 11 JPY-INR currency futures.
Looking at the quotes table above (applicable on November 30, 2015), the nearest futures contract for the payment date of 20th January, 2016 is the JPYINR270116 which will mature on 27th January 2016. Let us assume that the importer can purchase contracts at the available best ask rate of 54.76. This means he can purchase 100 Yen for ₹54.76 on 20th January 2016 irrespective of the spot exchange rate between JPY and INR on that day. Thus, theoretically, by purchasing currency futures, the importer can determine in advance the amount of rupee required to pay-off his liability and eliminate the exchange rate uncertainty.
Suppose the spot exchange rate on November 30, 2015 is ₹54 per 100 Japanese Yen. If no hedging is done with currency futures, and if the spot exchange rate applicable for delivery on 20th January, 2016 is 60, then the importer will be paying an additional ₹6 per 100 yen when compared to the current spot rate. On the other hand, if the spot rate is 50, his cost will be as much lower. He can remove this uncertainty by hedging with currency futures. Let us assume that the importer purchases 11 contracts at 54.76 maturing on 27th January, 2016.
Since the contract maturity is on 27th January while the liability is due on 20th January, 2016, the importer will have to close contracts before maturity. Let us say he needs to make the transfer on 18th January, 2016. The bank will debit his rupee account towards crediting the payee for value date 20th January at the ruling spot exchange rate. Simultaneously, the importer will need to square off his long position by selling 11 contracts.
It is important to note the following two points:
- If the liability date is the same as the contract maturity date (as it will be in the case of forward contracts), the contract will automatically go for settlement at the exchange on maturity date. There is no need to square off the trading position.
- In derivative markets, the futures price will be same as the price prevailing in the spot market on the contract maturity date. Hence, the settlement price will be same as the spot price. However, this will not be the case if the contract is squared off prior to the maturity date.
Let the importer square off his position by selling 11 contracts on 18th January, 2016. We shall now consider two cases:
Case (a): Spot exchange rate is 59 and futures price 58.60
The bank will debit the importer’s rupee account at the spot exchange rate of 59.
The closure of the futures position by selling futures contract will result in following cash flow:
Profit/(Loss) from futures position = 11 × 100,000 × (sale price – purchase price)
= 11 × 100,000 × (0.586 – 0.5476)
= + INR 42,240
Thus, the importer makes a profit of INR 42,240 due to rupee depreciation.
However, the importer pays ₹59 per 100 yen as compared to ₹54 prevailing on November 30.
Notional loss or additional cost due to rupee depreciation = 11, 50, 000 × (0.54 – 0.59)
= – INR 57,500
Thus, the additional cost in the spot market of 57,500 has been largely compensated with profit in futures position of 42,240 due to hedging.
Case (b): Spot Exchange Rate is 53 and Futures price 52.8
The bank will debit the importer’s rupee account at the spot exchange rate of 53.
The closure of the futures position by selling futures contract will result in the following cash flow:
Profit/(Loss) from the futures position = 11 × 100,000 × (sale price – purchase price)
= 11 × 100,000 × (0.528 – 0.5476)
= – (INR 21,560)
Thus, the importer makes a loss of INR 21,560 in the futures market due to rupee appreciation. However, the importer pays ₹53 per 100 Yen as compared to ₹54 prevailing on November 30.
Notional profit or decrease in cost due to rupee appreciation = 11,50,000 × (0.54 – 0.53) = + INR 11,500
In this case, loss in the futures market is compensated by the lower exchange rate in the spot market.
In the above cases, the profit/loss in the futures market does not match exactly with that in the spot market, resulting in imperfect hedging, due to the following reasons:
- Hedging is done for JPY 11,00,000 while the actual exposure is JPY 11,50,000
- The spot rate is different from the futures price on both the initial date of the contract and maturity date of the contract (this is termed the basis risk).
If the contract size is the same as the liability amount and if the liability date is same as the contract maturity date, the profit/loss in two markets will be exactly equal and the net profit/loss from the hedge will be zero. However, since futures price will be different from the spot price on the contract initiation date, the net gain/loss will not be zero even for a perfect hedge.
The notional net gain or loss will depend on the difference between spot and futures price on initiation. This net gain/loss is actually the cost of carry involved. Illustration 8 explains this concept. In the above example, hedging involved buying currency futures. The firm was short on JPY on the maturity date in the cash market and hence it took a long position in the futures market. This is called long hedge. Similarly, a short hedge would involve selling currency futures as it would be required in case of an exporter.
Illustration 8: An exporter wants to hedge his future receivables in pound sterling of GBP 10 million. The spot exchange rate is GBP-INR 100. The futures price for a contract having the same maturity date is 100.5. Is perfect hedging possible with the futures contract in this case? If the spot price is 102.5 on the maturity date, what is his loss or profit in the cash and futures market?
Solution: Since the maturity date of the contract is same as that of the receivables date and the size of the contract is in terms of 1000 units of GBP, perfect hedging is possible. The firm will sell 10000 pound sterling futures contract at 100.5. On the maturity date, the futures price will be same as that of the spot price at 102.5. Hence, the receivables will be sold at 102.5 and currency futures position will be squared off at 102.5.
The profit/loss from currency futures position = 10,000 × 1000 × (100.5 – 102.5)
= – INR 20 million
There is a loss of INR 20 million in the futures market.
However, the exporter could sell the receivables at an exchange rate of 102.5 as compared to the initial spot rate of 100. Hence, he would have got a notional profit. In other words, if the exporter has not hedged his position, his notional gain would be as follows: Notional profit in spot market position = 10,000,000 × (102.5 – 100) = INR 25 million Hence, the exporter makes a net gain of 5 million due to hedging. Theoretically, in a perfect hedge, the net profit/loss should be zero. However, difference of 5 million is due to the difference between the spot and futures price on the initial date.
This difference between the spot price of 100 and futures price of 100.5 is due to the cost of carry. To understand why a perfect hedge does not result in zero gain/loss, the concept of notional loss/gain can be interpreted in another way. Instead of hedging with futures, the exporter can also hedge with money market operations. He can borrow in pound sterling for a maturity amount equal to export receivables and convert it into rupee at the spot exchange rate. On the maturity date of the loan, he can use export receivables to pay-off the loan.
In this way, he can completely remove the exchange rate risk. However, his realisation of rupee amount will be less to the extent of interest payable on the GBP loan. However, we also need to consider the interest that he can earn on the converted rupee amount in the rupee money market (till export receivable date). The net gain/loss in the process is called the cost of carry, and is nothing but the difference between the spot and futures price on the initial date.
In an efficient market, the futures price will depend on the interest cost associated with currencies. In the above example, the net gain is due to the higher interest rate in the Indian market than the pound sterling market and resulting rupee depreciation involved. Conceptually, the net gain is the interest differential similar to forward markets (Refer a basic text on derivatives for concepts regarding the cost of carry and futures pricing).
Illustration 9: In Illustration 8, it was assumed that the maturity date of the receivables is same as that of the futures contract maturity date. If they are different, the spot rate will be different from the futures price on the maturity date. Explain the basis risk based on the following data:
Contract Initiation Date:
Spot exchange rate: GBP-INR 100
Futures price = GBP-INR 100.5
On date of realisation of receivables:
Spot exchange rate: GBP-INR 99.84
Futures price : GBP-INR 99.70
Solution: The basis risk arises owing to the fact that the futures price will not be same as the spot price on the settlement date, when the futures contract is required to be squared off before maturity. In this problem, because the two dates are not the same, the settlement rate for the futures contract is not same as the spot rate.
The net profit/loss due to basis risk can be calculated as follows:
Net profit/loss due to basis risk = Contract amount × Basis difference
= 10 million × [(Futures price – Spot price) on initiation date – (Futures price – Spot price) on maturity date]
= 10 million × [(100.5 – 100)- (99.70-99.84)]
= + INR 6.4 million
Hence, there will be net gain of INR 6.4 million due to hedging. This is explained in detail below.
Note: In the case of a perfect hedge, the net profit/loss will be solely due to difference between spot and futures price on contract initiation date as the difference will be zero for the maturity date. If the above is a case of perfect hedge, the net profit/loss will be 0.5 million.
Net profit/loss due to basis risk = Contract amount × Basis difference
= 10 million × [(futures price – spot price) on initiation date – (futures price – spot price) on maturity date]
= 10 million × [(100.5 – 100)- (0)]
= + INR 5 million
This is the case in the previous problem.
The hedging would involve selling GBP futures on the initial date and buying it back on the date of the realisation of receivables. The receivables will be sold at the spot rate of 99.85 and the currency futures position will be squared off at 99.70.
The profit/loss from currency futures position = 10,000 × 1000 × (100.5 – 99.70)
= + INR 8 million
There is a profit of INR 8 million in the futures market.
The exporter would sell the receivables at an exchange rate of 99.84 as compared to the current spot rate of 100. Hence, he has got a notional loss. In other words, if the exporter has not hedged his position, his notional gain/loss would be as follows:
Notional loss in the spot market position = 10,000,000 × (99.84-100) = – INR 1.6 million
Hence, the exporter makes a net gain of INR 6.4 million due to hedging.