CURRENCY FUTURE: A Step into Future
By Preeti Modi, B.Com. ICWA, ACA.
E-mail : email@example.com
It was very proud day on 29th August, 2008 for NSE (National Stock Exchange) when Finance Minister inauguratesa new financial services product - Currency Futures.
Though currency futures products like currency swap, currency forwards and currency options were already allowed to corporates in India after Reserve Bank of India's (RBI) circular as on April 2007, but they were not traded on any recognised exchanges in India and were available like OTC products only.
OTC future and options in currencies had same economic purpose as the newly introduced exchange traded currency futures and options, there is fundamental difference between the two.
If an individual booked a currency forward (OTC) say US dollar- Indian rupee (INR) at certain rate then on maturity of forward contract, the obligations of individuals (forward purchaser and forward seller) equals forward price, at which contract was executed. So in case of OTC forward currency contract except on maturity, no money changes hands. While with the help of third party, i.e. clearing corporations of exchanges, on which contract will be traded; coming into picture between currency option, purchaser and currency option seller, there will be daily mark-to-market settlement between buyer and seller of contract based on the daily movement of prices of underlying currencies.
Hence, the exchange traded currency future will ensure that there will be no incidents of Indian corporates suffering due to unfavorable movements of currency rates in between option booking date and option expiry date since daily mark-to-market mechanism will ensure effective hedge. Had this facility been available to Indian corporates earlier, the extent of losses Indian corporates suffered could have been avoided
This introduction will bring complete foreign exchange derivative market in India same as developed countries.
Features of exchange traded currency future
Ü Initially only future contracts on US dollar- Indian rupee (INR) would be available. This means, the investors can hedge themselves when the exposure is in US dollar only.
Ü Minimum contract size will be US dollars 1000.00
Ü The currency future contract shall have maximum maturity of 12 months only. Of course the contract of varied maturity from 1 month to 12 months will be available.
Ü The currency future will be settled in Indian rupees only.
Ü Settlement price will be RBI’s reference rate on the last trading date.
With the introduction of currency futures different queries also arise side to side like, how will the currency futures work in India? What are the safeguards to ensure that our investment is protected in the currency futures market? Is it beneficial for the small traders?
To quest all our thrust, we will know all these one by one through few question answer provided here under:
How will the currency futures work in India?
Exchange traded currency futures will work just like future and options (F&O) in stock. Only difference is that in case of stock future and option, the underlying are stocks while in case of currency futures and options underlying will be various currencies of the world. This new scheme will provide the provision to trade currency future and options to recognised exchanges, same as stock future and options are being traded on National Stock Exchange (NSE) or Bombay Stock Exchange (BSE).
What is the difference between currency futures and forward market?
Exchange traded futures as compared to forwards serve the same economic purpose yet differ in fundamental ways. An individual entering into a forward contract agrees to transact at a forward price on a future date. On the maturity date, the obligation of the individual equals the forward price at which the contract was executed. Except on the maturity date, no money changes hands.
In the case of an exchange traded futures contract, mark to market obligations are settled on a daily basis. Mark to market is the practice of revaluing securities and financial instruments using current market prices and is most seen in the mutual fund industry where the current net asset value (NAV) gives the MTM price. Since the profits or losses in the futures market are collected / paid on a daily basis, the scope for building up of mark to market losses in the books of various participants gets limited.
Who are the regulators of currency futures in India?
The Reserve Bank of India is apex authority issuing guidelines for currency futures market in India. The Securities Exchanges Board of India the currency futures market regulator.
How is the price of currency decided in futures market?
The price of a currency or the foreign exchange rate is determined by simple demand- supply phenomenon. Basic economic theory teaches us that if the supply of good increases, and nothing else changes, the price of that good decreases and vice versa.
How are currencies traded?
Currencies are traded on the foreign exchange market, and the supply of a currency on that market will change over time. Foreign exchange supply increases due to a variety of reasons. These include rise in export earnings, higher foreign investment and greater speculation among others. Higher demand for foreign currency results from a surge in imports, higher investment in foreign locations and also speculation.
Does India need currency futures?
As there has been no currency future trading in India, companies were hedging their currency risk by entering into forward deals with banks where they agree to sell/buy the dollar at a future date and predefined exchange rate. As compared to currency futures, this method is less flexible, less liquid, and less transparent, therefore does not help companies fetch the maximum possible price. Despite these limitations, the dollar forward market in India has a daily turnover of around $3.5 billion.
Can currency futures help small traders?
The RBI guidelines have specified the minimum size of the contract at $1,000 and so that traders can even hedge small amounts of dollar exposure. Under the futures contract, an importer buys the required currency futures contract and “locks in” a price for the purchase of foreign currency. He thereby hedges (avoids) risk due to exchange rate fluctuations. An exporter, on the other hand, sells the expected currency futures contract “locks in” a price for the sale to hedge risks.
Benefit of exchange traded currency future contracts
Ü Daily mark to market settlement between parties concerned.
Ü Counter-party risk of non obligation of contract could be avoided due to intermediary like clearing corporation, which will become guarantor for both the parties.
Ü Introduction of exchange traded currency option will ensure equitable participation from both large and small investors in currency trading, as compared to OTC contract market, lot will be smaller. Minimum lot size of the newly introduced scheme has been fixed as US dollar 1000 only.
Ü It will lead to greater transparency, efficiency and accessibility in currency futures and option market.
It was combined effort of RBI-SEBI to start futures contracts in rupee-dollar contracts. The roadmap is to launch contracts on other currencies post the initial trading phase and need to continue to innovate and improve in the design of financial products, its customer service as well as all India delivery. The financial sector needs to be opened up to greater competition so as to be able to provide world class financial services at competitive rates. They should work towards removal of entry barriers to domestic corporate player and foreign financial firms in all segments of the financial services industry. All legal tangle in currency futures can be avoided for growth of exchange traded currency futures. When all these begin, this market will quadruple in size.
Now, I end up with the wishes of Mr. Finance Minister, what he said in the opening ceremony of Currency Futures that “I wish all success to NSE and I am hopeful that the other two exchanges which have received in-principle approval and other exchanges will soon offer this product.”