What do we understand by strategies using currency futures? This would largely depend on what is the nature of the market participant we are referring. For example, a speculator / trader will have a different strategy, an arbitrageur will have a different strategy and the hedger with an underlying exposure will have a different strategy altogether. Before we get into strategy, let us understand the role played by these 3 categories of investors in greater detail.
Currency Futures Strategy Used By Different Market Participants
Broadly, there are 3 types of market participants in the currency futures market viz. traders, arbitrageurs and hedgers. Each of these participants has different risk profile.
- The hedger is the most conservative participant in the currency futures market as they have an underlying currency exposure and hence run currency risk. Their motivation to participate in currency futures is to purely manage the risk and not to make any profit out of the transaction.
- The trader is the high risk participant and takes positions in the currency futures based on their view of currencies.
- The arbitrageurs have lower risk profile because they buy in the spot market and sell in the futures or they can even arbitrage between forwards and futures. Arbitrage is like fixed-income because the arbitrageur only tries to play on the spread between two prices of a currency pair.
Hedgers: have a real underlying exposure to foreign currency. For example, an importer from Germany will have payables in Euros after a fixed period. An exporter to the US will have dollar receivables at a future date. The ECB / FCCB borrower has borrowed money in foreign currencies like USD / GBP / EUR etc. The interest and principal repayment has to be done in foreign currency so they also have an underlying exposure to the foreign currency. The hedger participates to lock in a price and reduce the uncertainty in forex rates. The objective of hedgers is purely to reduce the volatility in future cash flows.
Speculators or Traders: do not have any underlying exposure to foreign currency risk. They participate in the forex markets based on their view of which currency will appreciate or which currency weaken and position their trades accordingly. These traders take on directional market risk and their view often goes wrong. Speculators are important in the market because they trade on fine spreads thus create liquidity in the forex market.
Arbitrageurs: use the currency futures market to earn virtually risk-free income from the currency futures market when they see mispricing. Arbitrageurs buy currency in the spot and take an opposite position in the futures. For example, an arbitrageur will buy spot dollars and sell USDINR futures. The difference between the futures price and the spot price is the assured income for the arbitrageur as spot and futures expire at the same price on the currency futures expiry day. Arbitrageurs remove distortions in the market by arbitraging out such mispricing opportunities. Arbitrage can also be done between forwards and futures and that is quite common as there is often mispricing between the forward and futures price for the same expiry.
Currency Futures Payoffs for Importers and Exporters
Foreign currency risk arises either if you have a foreign currency payable at a future date or a foreign currency receivable at a future date. An importer has a foreign currency payable at a future date while an exporter has a foreign currency receivable at a future date. Like the importer, a foreign currency borrower also has a foreign currency payable at a future date.
How importers can use currency futures and the payoffs
An importer has a foreign currency payable at a future date. Importers typically import goods from other countries and the payment is normally in hard currencies like the US dollar. The importer will therefore want to protect their cash flows from any weakening of the rupee (strengthening of the foreign currency) as they would have to pay more rupees for the same amount of dollars in that case. Let us look at the case study below.
Illustration 1: Gaza Private Limited imports machine parts from the US and has to pay them in fixed dollars after a credit period of 3 months. In August 2019, Gaza imported parts worth $1,000,000 when the exchange rate was Rs.72/$. How can Gaza use currency futures to protect the underlying risk?
Strategy 1: Since the importer has dollar payables at the end of 3 months, they would be wary of rupee weakening. If rupee weakens from Rs.72 to Rs.77 in the next 3 months, then Gaza will require Rs.7.70 crore after 3 months to obtain the same $1 million and the company is not prepared for that. The answer would be to buy USDINR futures with 3 months expiry. This is how it would work.
Let us assume that the USDINR futures (3 months) are currently trading at Rs.72.50. Since the lot size of USDINR futures is $1000, they will need to buy 1000 lots to hedge the risk of $1 million payable at the end of 3 months.
Strategy payoff 1: To understand the payoff to Gaza at the end of 3 months, let us assume that the rupee weakens to $80/$ due to a sharp rise in trade deficit. Now what happens at the end of 3 months?
Bought 1000 lots of USDINR futures at Rs.72.50 worth Rs.7.25 crore notional values.
At the end of 3 months, the spot dollar is at Rs.80/$. So, Gaza will need Rs.8 crore to purchase $1 million worth of dollars to pay the client.
But since Gaza is long on USDINR 3 month futures, at Rs.72.50, this can be offloaded in the currency futures market at (say Rs.80.20). The gain on currency futures will be:
(80.20 – 72.50) X 1000 lots X $1000 per lot = Rs.77 lakhs (profit on long USDINR futures)
How the hedge works 1:
Total rupee outflow at the end of 3 months for $1 million = Rs.8 crore (@Rs.80/$)
Less: profit on long USDINR futures = Rs.77 lakhs
Net outflow for the importer = Rs.7.23 crore
In the above case, by hedging with long USDINR futures, Gaza has locked in its cost at around the rate 3 months back. That is how hedging works for the importer. What if the rupee had appreciated; would the importer not have lost? That is correct, but the purpose of hedging is not to make profits but to have predictable cash flows.
How exporters can use currency futures and the payoffs
An exporter has a foreign currency receivable at a future date. Exporters send goods abroad and also give credit period so they have dollars receivable at a future date. The exporter will want to protect their cash flows from any strengthening of the rupee (weakening of the dollar) as then they would receive fewer rupees for the same dollars.
Illustration 2: Zenith Ltd. exports garments to the US and receives in fixed dollars after a credit period of 3 months. In August 2019, Zenith exported garments worth $1,000,000 when the exchange rate was Rs.72/$. How to use currency futures in this case?
Strategy 2: Since the exporter has dollar receivables at the end of 3 months, they would be wary of rupee strengthening. If rupee strengthens from Rs.72 to Rs.67 in the next 3 months, then Zenith will able to convert $1 million into just Rs.6.70 crore. The answer would be to sell USDINR futures with 3 months expiry.
Let us assume that the USDINR futures (3 months) are currently trading at Rs.72.50. Since the lot size of USDINR futures is $1000, they will need to sell 1000 lots to hedge the risk of $1 million receivable at the end of 3 months.
Strategy payoff 2: To understand the payoff to Zenith at the end of 3 months, let us assume that the rupee strengthens to Rs.66/$ due to heavy FPI and FDI inflows. What happens at the end of 3 months?
Zenith sold 1000 lots of USDINR futures at Rs.72.50 worth Rs.7.25 crores of notional value.
At the end of 3 months, the spot dollar is at Rs.66/$. So, Zenith will get just Rs.6.60 crore against $1 million and that will be insufficient for onward payments.
But since Zenith is short on USDINR 3 month futures, at Rs.72.50, this can be offloaded in the currency futures market at (say Rs.66.20). The gain on currency futures will be:
(72.50 – 66.20) X 1000 lots X $1000 per lot = Rs.63 lakhs (profit on USDINR futures)
How the hedge works 2:
Total rupee inflow at the end of 3 months for $1 million = Rs.6.60 crore (@Rs.66/$)
Add: profit on short USDINR futures = Rs.63 lakhs
Net inflow for the exporter = Rs.7.23 crore
The exporter, by hedging by selling USDINR futures, has locked in cost at around the rate 3 months back. That is how hedging works for the exporter. What if the rupee had weakened; would the exporter not have lost? That is correct, but again this is about predictable cash flows.
Currency Futures Payoffs for Speculators and Arbitrageurs
For speculators the trading strategy is quite simple:
Buy USDINR futures if you expect the dollar to strengthen / rupee to weaken
Sell USDINR futures if you expect the dollar to weaken / rupee to strengthen
Traders take a directional view and either go long or short on the currency pair. The same logic will apply to EURINR pair, GBPINR pair etc.
Let us look at arbitrage between the forwards and futures for USDINR. Let us assume that the UDINR is quoting at Rs.71 in the forward market and at Rs.71.50 in the 1-month futures market. The arbitrage can be created as under:
Buy 100 lots ($1000 / lot) forward USDINR at Rs.71.00
Sell 100 lots ($1000 / lot) futures USDINR at Rs.71.50
If the RBI reference settlement price at the end of 1 month is Rs.75, then payoffs are:
Profit on forwards (Rs.4)
Loss on futures (Rs.3.50)
Net profit is Rs.0.50 per dollar or Rs.500 per lot ($1000 lot).
The beauty of the arbitrage is that the profit of Rs.500 per lot will remain constant irrespective of the price of expiry of the rupee on settlement date.