Exchange-traded currency futures must be seen as distinct from currency forwards. While currency forwards (like the rupee forward) are forward contracts, the exchange-traded currency futures are structured, standardized, and carries the counter-guarantee of the clearing corporation (NSCCL for NSE; ISCCL for BSE and MCXCCL for MSEI).
A currency futures contract is a standardized contract, traded on an exchange, to buy or sell a certain underlying quantity of the currency pairs. Currency futures are always traded in pairs. These pairs can be rupee pairs like (USDINR, EURINR, and GBPINR) or they can be cross currency pairs like (USDJPY, EURUSD, and GBPUSD). Like in any futures trade, the profits or losses on currency futures are also unlimited. Currency futures are linear products because the profit for the buyer is a loss for the seller and vice-versa.
Key concepts to understand with respect to currency futures
To understand currency futures, there are some basic concepts to apprehend. Let us look at some key concepts.
Spot price: Is the price at which the underlying currency pair trades in the spot market. Futures market considers the RBI Reference rate as the benchmark spot rate.
Futures price: is the price at which the currency pair futures are traded in the CD segment of the currency futures market. It is also called the expected spot price or E (Sx).
Contract cycle: This is the time left to expiry of currency futures contract. Currency futures have 12 contracts outstanding at any point of time ranging from 1-month to 12-month.
Final Settlement Date: Last business day (same as Inter‐bank Settlements in Mumbai) is the final settlement date for currency futures contracts. All rules are as per FEDAI rules.
Expiry date: It is the date on which the currency futures contract actually expires and is also called Last Trading Day. It falls two working days prior to the final settlement date.
Contract size: Unlike index and commodity futures, the standard contract size in currency futures is in value terms (not in quantity terms). Lot sizes are; USDINR (USD 1000), EURINR (EUR 1000); GBPINR (GBP 1000) and JPYINR (JPY 100,000).
Initial margin: The amount to be deposited in the margin account when you initiate the currency futures contract (long or short) and is based on VAR (Value at Risk).
MTM margin: MTM margins are adjustments made to the margin account on a daily basis on account of favorable or adverse price movements.
Benefits of currency futures
Some of the major benefits of currency futures trading can be summarized as under:
- Currency futures help in price discovery for a currency pair and these futures price become the basis for the spot price.
- Currency futures allow the transfer of risk from a businessman who wants to reduce risk for a cost to another risk-taker looking to take on risk for a price.
- It s a useful tool to manage currency volatility and is a pre-requisite as India moves towards full convertibility on the capital account.
- Importers can hedge against depreciating Indian rupee by buying the USDINR futures. This limits the profit on currency but also limits the risk
- Exporters can hedge against appreciating Indian rupee by selling the USDINR futures. This limits the profit on currency but also limits the risk
- Foreign currency borrowers having known outflows can lock in the price at which they will convert the INR into dollars
- From a macroeconomic perspective, currency futures can be used to reduce the systemic risk arising due to rupee volatility
How currency futures score over forwards
While rupee forwards continue to remain an important source of hedging for most corporates in India, exchange traded futures are picking up. It has captured the imagination of small and medium sized businesses and once scale is achieved, even larger corporates and business will be interested in exchange traded currency futures. Here are some of the merits of currency futures over currency forwards.
- Pricing in currency futures is a lot more transparent since it is screen based unlike currency forwards where the price is set by a handful of banks
- A key benefit of currency futures is that it eliminates counterparty credit risk or default risk since all trades are guaranteed by the clearing corporation.
- Entry barriers to the currency futures are very few unlike the currency forward market which is only accessed by banks, institutions and ADs.
- It offers a mechanism for traders and speculators to take a view on currency without having any underlying exposure. That is not possible in currency forwards.
- Since futures are standardized, there is a ready secondary market and hence traders or hedgers in currency futures don’t have a liquidity issue
- The exchange margining system ensures that the chances of client defaults are reduced to a bare minimum.
However, large players still prefer the forward market as contracts can be customized to their unique requirements.
Concept of interest rate parity and pricing of currency futures
You may often wonder as to how are futures priced. Equities are priced or valued based on future cash flows of a company and that forms the basis of futures pricing. What about currencies. For example, how do you decide the price of the USDINR futures at the end of 12 months? How do you decide whether dollar should appreciate or weaken? The answer is the concept of Interest rate parity.
While there is a detailed model for interest rate parity we shall understand the concept at a basic level. If you can borrow in the US at 2% and invest in Indian bonds at 6%, what would you do? Assuming you can freely borrow in the US and invest in India, you will do exactly that and make 4% spread. However, in the real world the rupee will weaken by approx 4% (difference in interest rates) over 1 year. So if USDINR is Rs.70 today, it should be Rs.72.80 at the end of 1 year. The table below shows how this interest parity works.
USDINR Today |
Amount |
USDINR (1 year later) |
Amount |
Exchange rate |
Rs.70/$ |
Exchange rate after 1 yr |
Rs.72.80/$ |
You borrow |
$100,000 |
Converted value (A) |
$101,923 |
Convert to Rupees |
Rs.70,00,000 |
Interest on US loan @2% |
$1,400 |
Invest in Indian bonds at |
6% |
Net Profit (B) |
$523 |
Interest earned |
Rs.4,20,000 |
Profit in Rupees |
Rs.38.074 |
Amount received (A) |
Rs.74,20,000 |
|
|
Your actual profits are not Rs.4,20,000 but just Rs.38,074. That is because, the interest rate differential between the US and India is largely nullified by the depreciation of the rupee against the dollar. That is the reason the INR has always steadily weakened against the dollar. Interest parity concept is the basis for pricing currency futures.