“PROJECT ON IMPACT OF CURRENCY DERIVATIVE ON INVESTORS IN INDIAN CAPITAL MARKET” MARKET ” Submitted in partial fulfillment of the requirement for the Award of Degree of Master of Business Administration 2011-2013
Under the Guidance of:-
Submitted By:
Mr. Manoj Verma
Ankit Kumar (Enroll No:-04514803911)
DEPARTMENT OF MANAGEMENT MAHARAJA AGRASEN INSTITUTE OF TECHNOLOGY
(Affiliated to G.G.S.I.P. University) Sector – 22, Rohini, Delhi -110086 An ISO 9001:2008 Certified Institute AICTE NBA Accredited Institute
1
Undertaking This is to certify that I ANKIT KUMAR had completed the Project titled “IMPACT OF CURRENCY DERIVATIVE ON INVESTORS IN INDIAN CAPITAL MARKET” under the guidance of MR. MANOJ VERMA in the partial fulfillment of the requirement for the award of degree of MBA from Maharaja Agrasen Institute of Technology (Affiliated to G.G.S.I.P. University), New Delhi. This is an original piece of work and I had neither copied nor submitted it earlier elsewhere.
Student Name and Signature
Course
Dated
2
Certificate This is to certify that the project titled “ IMPACT OF CURRENCY DERIVATIVE ON INVESTORS IN INDIAN CAPITAL MARKET ” is an academic work done by ANKIT
KUMAR submitted in the partial fulfillment of the requirement for the award of the Degree of MBA from Maharaja Agrasen Institute of Technology (Affiliated to G.G.S.I.P. University), New Delhi under my guidance and direction. To the best of my knowledge and belief the data and information presented by her in the project has not been submitted earlier.
Name and signature of Faculty Guide
Designation
3
ABBREVIATIONS INITIALS
TERMS
SEBI
Securities and Exchange Board of India
F&O
Future and Option
NSE
National Stock Exchange
BSE
Bombay Stock Exchange
MCX
Multi Commodity Exchange
NCDEX
National Commodity Exchange
NSDL
National Securities Depository Limited
MTM
Marking-to-market
GDP
Gross Domestic Product
ATM
At-the-money-option
OTC
Over The Counter
OPEC
The Organization of the Petroleum Exporting Counties
4
INDEX SERIAL NO.
TOPICS
1.1
OVERVIEW OF THE INDUSTRY
1.2
ABOUT THE TOPIC
1.2.1
RESEARCH METHODOLGY
1.2.2
OBJECTIVE OF THE STUDY
1.2.3
SCOPE OF THE STUDY
1.3
METHODOLGY
2
RESEARCH DESIGN
2.1
SOURCE OF DATA
2.2
SAMPLE DESIGN AND SAMPLE SIZE
2.3
TOOLS OF PRIMARY DATA COLLECTION
3
FINDINGS AND ANALYSIS
3.1
SUGGESTIONS
3.2
CONCLUSION
4
BIBLIOGRAPHY
5
WEBLIOGRAPHY
EXECUTIVE SUMMARY
5
India has the third largest investor base in the world after USA and Japan. Over 7500 companies are listed on the Indian stock exchanges (more than the number of companies listed in developed markets of Japan, UK, Germany, France, Australia, Switzerland, Canada and Hong Kong.). The Indian capital market is significant in terms of the degree of development, volume of trading, transparency and its tremendous growth potential. India’s market capitalization was the highest among the emerging markets. Total market capitalization of The Bombay Stock Exchange (BSE), which, as on July 31, 1997, was US$ 175 billion has grown by 37.5% percent every twelve months and was over US$ 834 billion as of January, 2007. Bombay Stock Exchanges (BSE), one of the oldest in the world, accounts for the largest number of listed companies transacting their shares on a nationwide online trading system. The two major exchanges namely the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) ranked no. 3 & 5 in the world, calculated by the number of daily transactions done on the exchanges. The Total Turnover of Indian Financial Markets crossed US$ 2256 billion in 2006 – An increase of 82% from US $ 1237 billion in 2004 in a short span of 2 years only. Turnover in the Spot and Derivatives segment both in NSE & BSE was higher by 45% into 2006 as compared to 2005. With daily average volume of US $ 9.4 billion, the Sensex has posted excellent returns in the recent years. Currently the market cap of the Sensex as on July 4th, 2009 was Rs 48.4 Lakh Crore with a P/E of more than 20. Derivatives trading in the stock market have been a subject of enthusiasm of research in the field of finance the most desired instruments that allow market participants to manage risk in the modern securities trading are known as derivatives. The derivatives are defined as the future contracts whose value depends upon the underlying assets. If derivatives are introduced in the stock market, the underlying asset may be anything as component of stock market like, stock prices or market indices, interest rates, etc. The main logic behind derivatives trading is that derivatives reduce the risk by providing an additional channel to invest with lower trading cost and it facilitates the investors to extend their settlement through the future contracts. It provides extra liquidity in the stock market. Derivatives are assets, which derive their values from an underlying asset. These underlying assets are of various categories like • Commodities including grains, coffee beans, etc. • Precious metals like gold and silver. • Foreign exchange rate. •Bonds of different types, including medium to long-term negotiable debt securities issued by governments, companies, etc. • Short-term debt securities such as T-bills. • Over-The-Counter (OTC) money market products such as loans or deposits. • Equities For example, a dollar forward is a derivative contract, which gives the buyer a right & an obligation to buy dollars at some future date. The prices of the derivatives are driven by the spot prices of these underlying assets. However, the most important use of derivatives is in transferring market risk, called Hedging, which is a protection against losses resulting from unforeseen price or volatility changes. Thus, derivatives are a very important tool of risk management. 6
There are various derivative products traded. They are; 1. Forwards 2. Futures 3. Options 4. Swaps “A Forward Contract is a transaction in which the buyer and the seller agree upon a delivery of a specific quality and quantity of asset usually a commodity at a specified future date. The price may be agreed on in advance or in future.” “A Future contract is a firm contractual agreement between a buyer and seller for a specified as on a fixed date in future. The contract price will vary according to the market place but it is fixed when the trade is made. The contract also has a standard specification so both parties know exactly what is being done”. “An Options contract confers the right but not the obligation to buy (call option) or sell (put option) a specified underlying instrument or asset at a specified price – the Strike or Exercised price up until or an specified future date – the Expiry date. The Price is called Premium and is paid by buyer of the option to the seller or writer of the option.” A call option gives the holder the right to buy an underlying asset by a certain date for a certain price. The seller is under an obligation to fulfill the contract and is paid a price of this, which is called "the call option premium or call option price". A put option, on the other hand gives the holder the right to sell an underlying asset by a certain date for a certain price. The buyer is under an obligation to fulfill the contract and is paid a price for this, which is called "the put option premium or put option price". “Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap) payments, based on some notional principle amount is called as a ‘SWAP’. In case of swap, only the payment flows are exchanged and not the principle amount”
7
OVERVIEW OF THE INDUSTRY
INTRODUCTION TO CAPITAL MARKET
8
The capital market is the market for securities, where Companies & governments can raise long-term funds. It is a market in which money is lent for periods longer than a year. A nation's capital market includes such financial institutions as banks, insurance companies, & stock exchanges that channel long-term investment funds to commercial & industrial borrowers. Unlike the money market, on which lending is ordinarily short term, the capital market typically finances fixed investments like those in buildings & machinery.
Nature & Constituents:
The capital market consists of number of individuals & institutions (including the government) that canalize the supply & demand for long term capital & claims on capital. The stock exchange, commercial banks, co-operative banks, saving banks, development banks, insurance companies, investment trust or companies, etc., are important constituents of the capital markets.
The capital market, like the money market, has three important Components, namely the suppliers of loan able funds, the borrowers & the Intermediaries who deal with the leaders on the one hand & the Borrowers on the other.
The demand for capital comes mostly from agriculture, industry, trade the government. The predominant form of industrial organization developed. Capital Market becomes a necessary infrastructure for fast industrialization. Capital market not concerned solely with the issue of new claims on capital, But also with dealing in existing claims.
HISTORY OF CAPITAL MARKET
9
Established in 1875, the Bombay Stock Exchange (BSE) is Asia's first stock exchange. In 12th century France the courratiers de change were concerned with managing & regulating the debts of agricultural communities on behalf of the banks. Because these men also traded with debts, they could be called the first brokers. A common misbelief is that in late 13th century Bruges commodity traders gathered inside the house of a man called Van der Beurze, & in 1309 they became the "Brugse Beurse", institutionalizing what had been, until then, an informal meeting, but actually, the family Van der Beurze had a building in Antwerp where those gatherings occurred; the Van der Beurze had Antwerp, as most of the merchants of that period, as their primary place for trading. The idea quickly spread around Flanders & neighboring counties & "Beurzen" soon opened in Ghent & Amsterdam.
In the middle of the 13th century, Venetian bankers began to trade in government securities. In 1351 the Venetian government outlawed spreading rumors intended to lower the price of government funds. Bankers in Pisa, Verona, Genoa & Florence also began trading in government securities during the 14th century. This was only possible because these were independent city states not ruled by a duke but a council of influential citizens. The Dutch later started joint stock companies, which let shareholders invest in business ventures & get a share of their profits - or losses. In 1602, the Dutch East India Company issued the first share on the Amsterdam Stock Exchange. It was the first company to issue stocks & bonds.
The Amsterdam Stock Exchange (or Amsterdam Beurs) is also said to have been the first stock exchange to introduce continuous trade in the early 17th century. The Dutch "pioneered short selling, option trading, debt-equity swaps, merchant banking, unit trusts & other speculative instruments, much as we know them" There are now stock markets in virtually every developed & most developing economies, with the world's biggest markets being in the United States, United Kingdom, Japan, India, China, Canada, Germany, France, South Korea & the Netherlands.
10
IMPORTANCE OF STOCK MARKET
Function and purpose
The stock market is one of the most important sources for companies to raise money. This allows businesses to be publicly traded, or raise additional capital for expansion by selling shares of ownership of the company in a public market. The liquidity that an exchange provides affords investors the ability to quickly & easily sell securities. This is an attractive feature of investing in stocks, compared to other less liquid investments such as real estate.
History has shown that the price of shares & other assets is an important part of the dynamics of economic activity, & can influence or be an indicator of social mood. An economy where the stock market is on the rise is considered to be an up-and-coming economy. In fact, the stock market is often considered the primary indicator of a country's economic strength & development. Rising share prices, for instance, tend to be associated with increased business investment & vice versa. Share prices also affect the wealth of households & their consumption. Therefore, central banks tend to keep an eye on the control & behavior of the stock market &, in general, on the smooth operation of financial system functions. Financial stability is the raison d'être of central banks.
Exchanges also act as the clearinghouse for each transaction, meaning that they collect & deliver the shares, & guarantee payment to the seller of a security. This eliminates the risk to an individual buyer or seller that the counterparty could default on the transaction. The smooth functioning of all these activities facilitates economic growth in that lower costs & enterprise risks promote the production of goods & services as well as employment. In this way the financial system contributes to increased prosperity. An important aspect of modern financial markets, however, including the stock markets, is absolute discretion. For example, American stock markets see more unrestrained acceptance of any firm than in smaller markets. For example, Chinese firms that possess little or no perceived value to American society profit American bankers on Wall Street, as they reap large commissions 11
from the placement, as well as the Chinese company which yields funds to invest in China. However, these companies accrue no intrinsic value to the long-term stability of the American economy, but rather only short-term profits to American business men & the Chinese; although, when the foreign company has a presence in the new market, this can benefit the market's citizens. Conversely, there are very few large foreign corporations listed on the Toronto Stock Exchange TSX, Canada's largest stock exchange. This discretion has insulated Canada to some degree to worldwide financial conditions. In order for the stock markets to truly facilitate economic growth via lower costs & better employment, great attention must be given to the foreign participants being allowed in.
Relation of the stock market to the modern financial system
The financial systems in most western countries has undergone a remarkable transformation. One feature of this development is disintermediation. A portion of the funds involved in saving & financing, flows directly to the financial markets instead of being routed via the traditional bank lending & deposit operations. The general public's heightened interest in investing in the stock market, either directly or through mutual funds, has been an important component of this process.
Statistics show that in recent decades shares have made up an increasingly large proportion of households' financial assets in many countries. In the 1970s, in Sweden, deposit accounts & other very liquid assets with little risk made up almost 60 percent of households' financial wealth, compared to less than 20 percent in the 2000s. The major part of this adjustment in financial portfolios has gone directly to shares but a good deal now takes the form of various kinds of institutional investment for groups of individuals, e.g., pension funds, mutual funds, hedge funds, insurance investment of premiums, etc. The trend towards forms of saving with a higher risk has been accentuated by new rules for most funds & insurance, permitting a higher proportion of shares to bonds. Similar tendencies are to be found in other industrialized countries. In all developed economic systems, such as the European Union, the United States, Japan & other developed nations, 12
the trend has been the same: saving has moved away from traditional (government insured) bank deposits to more risky securities of one sort or another
The stock market, individual investors, and financial risk
Riskier long-term saving requires that an individual possess the ability to manage the associated increased risks. Stock prices fluctuate widely, in marked contrast to the stability of (government insured) bank deposits or bonds. This is something that could affect not only the individual investor or household, but also the economy on a large scale. The following deals with some of the risks of the financial sector in general and the stock market in particular. This is certainly more important now that so many newcomers have entered the stock market, or have acquired other 'risky' investments (such as 'investment' property, i.e., real estate and collectables).
With each passing year, the noise level in the stock market rises. Television commentators, financial writers, analysts,&
market strategists are all overtaking each other to get
investors' attention. At the same time, individual investors, immersed in chat rooms & message boards, are exchanging questionable & often misleading tips. Yet, despite all this available information, investors find it increasingly difficult to profit. Stock prices skyrocket with little reason, then plummet just as quickly, & people who have turned to investing for their children's education & their own retirement become frightened. Sometimes there appears to be no rhyme or reason to the market, only folly.
This is a quote from the preface to a published biography about the long-term valueoriented stock investor Warren Buffett. Buffett began his career with $100, and $100,000 from seven limited partners consisting of Buffett's family and friends. Over the years he has built himself a multi-billion-dollar fortune.
13
ROLE OF CAPITAL MARKET
The primary role of the capital market is to raise long-term funds for governments, banks, & corporations while providing a platform for the trading of securities. This fundraising is regulated by the performance of the stock & bond markets within the capital market. The member organizations of the capital market may issue stocks & bonds in order to raise funds. Investors can then invest in the capital market by purchasing those stocks & bonds.
The capital market, however, is not without risk. It is important for investors to understand market trends before fully investing in the capital market. To that end, there are various market indices available to investors that reflect the present performance of the market.
Regulation of the Capital Market
Every capital market in the world is monitored by financial regulators & their respective governance organization. The purpose of such regulation is to protect investors from fraud & deception. Financial regulatory bodies are also charged with minimizing financial losses, issuing licenses to financial service providers, and enforcing applicable laws.
The Primary and Secondary Markets
The capital market is also dependent on two sub-markets – the primary market & the secondary market. The primary market deals with newly issued securities & is responsible for generating new long-term capital. The secondary market handles the trading of previously-issued securities, & must remain highly liquid in nature because most of the securities are sold by investors. A capital market with high liquidity & high transparency is predicated upon a secondary market with the same qualities.
14
ABOUT CURRENCY DERIVATIVES
15
DEFINITION OF FINANCIAL DERIVATIVES
Derivatives are financial contracts whose value/price is independent on the behaviour of the price of one or more basic underlying assets. These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future. These assets can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil, soybeans, cotton, coffee and what you have. A very simple example of derivatives is curd, which is derivative of milk. The price of curd depends upon the price of milk which in turn depends upon the demand and supply of milk.
The Underlying Securities for Derivatives are :
Commodities: Castor seed, Grain, Pepper, Potatoes, etc.
Precious Metal : Gold, Silver
Short Term Debt Securities : Treasury Bills
Interest Rates
Common shares/stock
Stock Index Value : NSE Nifty
Currency : Exchange Rate
16
INTRODUCTION TO CURRENCY DERIVATIVES
Each country has its own currency through which both national and international transactions are performed.
All the international business transactions involve an
exchange of one currency for another. For Example,
If any Indian firm borrows funds from international financial market in US dollars for short or long term then at maturity the same would be refunded in particular agreed currency along with accrued interest on borrowed money. It means that the borrowed foreign currency brought in the country will be converted into Indian currency, and when borrowed fund are paid to the lender then the home currency will be converted into foreign lender’s currency. Thus, the currency units of a country involve an exchange of one currency for another. The price of one currency in terms of other currency is known as exchange rate . The foreign exchange markets of a country provide the mechanism of exchanging different currencies with one and another, and thus, facilitating transfer of purchasing power from one country to another. With the multiple growths of international trade and finance all over the world, trading in foreign currencies has grown tremendously over the past several decades. Since the exchange rates are continuously changing, so the firms are exposed to the risk of exchange rate movements. As a result the assets or liability or cash flows of a firm which are denominated in foreign currencies undergo a change in value over a period of time due to variation in exchange rates. This variability in the value of assets or liabilities or cash flows is referred to exchange rate risk .
Since the fixed exchange rate system has been fallen in the early 1970s,
specifically in developed countries, the currency risk has become substantial for many business firms. As a result, these firms are increasingly turning to various risk hedging products like foreign currency futures, foreign currency forwards, foreign currency options, and foreign currency swaps. 17
INTRODUCTION TO CURRENCY FUTURES
A futures contract is a standardized contract, traded on an exchange, to buy or sell a certain underlying asset or an instrument at a certain date in the future, at a specified price. When the underlying asset is a commodity, e.g. Oil or Wheat, the contract is termed a “Commodity futures contract. When the underlying is an exchange rate, the contract is termed a “Currency futures contract”.
Currency Futures Contract
In other words, it is a contract to exchange one currency for another currency at a specified date and a specified rate in the future. Therefore, the buyer and the seller lock themselves into an exchange rate for a specific value or delivery date. Both parties of the futures contract must fulfil their obligations on the settlement date. Currency futures can be cash settled or settled by delivering the respective obligation of the seller and buyer. All settlements however, unlike in the case of OTC markets, go through the exchange. Currency futures are a linear product, and calculating profits or losses on Currency Futures will be similar to calculating profits or losses on Index futures. In determining profits and losses in futures trading, it is essential to know both the contract size (the number of currency units being traded) and also what the tick value is. A tick is the minimum trading increment or price differential at which traders are able to enter bids and offers. Tick values differ for different currency pairs and different underlying.
18
OVERVIEW OF THE FOREIGN EXCHANGE MARKET IN INDIA
During the early 1990s, India embarked on a series of structural reforms in the foreign exchange market. The exchange rate regime, that was earlier pegged, was partially floated in March 1992 and fully floated in March 1993. The unification of the exchange rate was instrumental in developing a market-determined exchange rate of the rupee and was an important step in the progress towards total current account convertibility, which was achieved in August 1994.
The following four currency futures are allowed on the Indian exchanges.
Symbol USD EUR JYP GBP
Country United States Euro members Japan Great Britain
Nickname Geenback Fiber Yen Cable
India is 16th largest forex market in the world. The daily global FX
turnover
Currency Dollar Euro Yen Pound
is USD 4 Trillion. Market Share in World FX Market has increased from 0.1% (in 1998) to 0.9% ( 2010)
Daily FX Indian Market volume is $50 bn
59% of the total market USD – INR
Daily Currency Futures Turnover – Rs 32000 Crs. (NSE + MCX –SX)
Main trading centers are London, NY, Tokyo, Singapore &now In MUMBAI
USD-INR volatility has seen an average increase of over 9% p.a.
Available FX Derivatives: Futures, Forwards, Options & Swaps
CURRENCY DERIVATIVE PRODUCTS
19
Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. We take a brief look at various derivatives contracts that have come to be used.
FORWARD:
A forward contract is customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price. The exchange rate is the time the contract is entered into. This is known as forward exchange rate or simply forward rate.
FUTURE :
A currency futures contract provides a simultaneous right and obligation to buy and sell a particular currency at a specified future date, a specified price and a standard quantity. Future contracts are special types of forward contracts in the sense that they are standardized exchange-traded contracts.
SWAP
Swap is private agreements between two parties to exchange cash flows in the future according to a prearranged formula.
OPTIONS:
In other words, a foreign currency option is a contract for future delivery of a specified currency in exchange for another in which buyer of the option has to right to buy (call) or sell (put) a particular currency at an agreed price for or within specified period.
20
FUTURE TERMINOLOGY
SPOT PRICE:
The price at which an asset trades in the spot market. The transaction in which securities and foreign exchange get traded for immediate delivery. Since the exchange of securities and cash is virtually immediate, the term, cash market, has also been used to refer to spot dealing. In the case of USD/INR, spot value is T + 2.
FUTURE PRICE:
The price at which the future contract traded in the future market.
CONTRACT CYCLE :
The period over which a contract trades. The currency future contracts in Indian market have one month, two month, and three month up to twelve month expiry cycles. In NSE/BSE will have 12 contracts outstanding at any given point in time.
VALUE DATE / FINAL SETTELMENT DATE:
The last business day of the month will be termed the value date /final settlement date of each contract. The last business day would be taken to the same as that for inter bank settlements in Mumbai. The rules for inter bank settlements, including those for ‘known holidays’ and would be those as laid down by Foreign Exchange Dealers Association of India (FEDAI).
EXPIRY DATE:
It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. The last trading day will be two business days prior to the value date / final settlement date.
CONTRACT SIZE :
21
The amount of asset that has to be delivered under one contract, also called as lot size. In case of USD/INR it is USD 1000.
COST OF CARRY :
The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance or ‘carry’ the asset till delivery less the income earned on the asset. For equity derivatives carry cost is the rate of interest.
INITIAL MARGIN:
When the position is opened, the member has to deposit the margin with the clearing house as per the rate fixed by the exchange which may vary asset to asset. Or in another words, the amount that must be deposited in the margin account at the time a future contract is first entered into is known as initial margin.
MARKING TO MARKET:
At the end of trading session, all the outstanding contracts are reprised at the settlement price of that session. It means that all the futures contracts are daily settled, and profit and loss is determined on each transaction. This procedure, called marking to market, requires that funds charge every day. The funds are added or subtracted from a mandatory margin (initial margin) that traders are required to maintain the balance in the account. Due to this adjustment, futures contract is also called as daily reconnected forwards.
MAINTENANCE MARGIN:
22
Member’s account are debited or credited on a daily basis. In turn customers’ account are also required to be maintained at a certain level, usually about 75 percent of the initial margin, is called the maintenance margin. This is somewhat lower than the initial margin.This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.
TICK SIZE/PIP & TICK VALUE
Tick Size is the minimum tradable price movement that an exchange makes in a currency pair. For example, 1 pip=one hundredth of 1%=0.0001. Tick value is the change in value of 1 lot of the future contract for every tick movement. For example; If a trader takes long position in 1lot of USD/INR currency future contract at 53.3020 & if future price increased by 1 paisa to 53.3125, then the trader would make a profit of Rs 10 i.e.
1 pip = 0.0001 100pips = INR0.01 per USD Hence profit is
0.01*1000 = INR 10
BID PRICE & ASK PRICE:
The Bid price is the highest or the best among all prices that the buyers are willing to pay to the seller at that particular period of time. The Ask price is the price at which seller at the exchange are ready to sell their currency to the buyers.
LONG POSITION & SHORT POSITION:
Taking a long position in currency futures means a trader will “buy” a futures contract with the expectation that the price will rise in the future. On the other hand taking a short position means that a trader will “sell” a futures contract with the expectation that the price will decrease in the future.
BASIS:
23
Basis refers to difference between the spot rate & the future contract price
BASE CURRENCY & QUOTE CURRENCY:
The first currency in the currency pair is referred to as the base currency & the second currency in a currency pair is called the quote currency. In USD/INR currency pair
USD- Base currency
& INR-Quote currency.
FOREIGN EXCHANGE QUOTATIONS
Foreign exchange quotations can be confusing because currencies are quoted in terms of other currencies. It means exchange rate is relative price. For Example,
If one US dollar is worth of Rs. 53 in Indian rupees then it implies that 53 Indian rupees will buy one dollar of USA, or that one rupee is worth of 0.0188 US dollar which is simply reciprocal of the former dollar exchange rate. Direct- $1 = Rs. 53.6200
Indirect. Re 1 = 0.0188
24
USES OF CURRENCY FUTURES
HEDGING:
Exchange-traded currency futures are used to hedge against the risk of rate volatilities in the foreign exchange markets. Here, we give two examples to illustrate the concept and mechanism of hedging Suppose an edible oil importer wants to import edible oil worth USD 100,000 and places his import order on July 15, 2008, with the delivery date being 4 months ahead. At the time when the contract is placed, in the spot market, one USD was worth say INR 52 But, suppose the Indian Rupee depreciates to INR 52.25 per USD when the payment is due in October 2011, the value of the payment for the importer goes up to INR 5,225,000 rather than INR 5,200,000. The hedging strategy for the importer, thus, would be: Current Spot Rate (15th July '11)
: 52.0000
Buy 100 USD - INR Oct '11 Contracts
(1000 * 52.0000) * 100 (Assuming the Oct '11
on 15th July ’11
contract is trading at 52.0000 on 15th July, '11)
Sell 100 USD - INR Oct '11 Contracts in Oct '11 Profit/Loss (futures market)
: 52.0000 1000 * (52.25 – 52.00) * 100 = 25,000
Purchases in spot market @ 52.25 Total : 52.25 * 100,000 cost of hedged transaction
100,000 * 52.25 – 25,000 = INR 5,22,000
SPECULATION:
Take the case of a speculator who has a view on the direction of the market. He would like to trade based on this view. He expects that the USD/INR rate presently at Rs.53, is to go up in the next two-three months. How can he trade based on this belief? In case he can buy dollars and hold it, by investing the necessary capital, he can profit if say the Rupee depreciates to Rs.53.50. Assuming he buys USD 10000, it would require an investment of Rs.5,30,000. If the exchange rate moves as he expected in the next three months, then he shall make a profit of around Rs.5000. This works out to an annual
25
return of around 4.76%. It may please be noted that the cost of funds invested is not
considered in computing this return. A speculator can take exactly the same position on the exchange rate by using futures contracts. Let us see how this works. If the INR/USD is Rs.52 and the three month futures trade at Rs.52.40. The minimum contract size is USD 1000. Therefore the speculator may buy 10 contracts. The exposure shall be the same as above USD 10000. Presumably, the margin may be around Rs.21, 000. Three months later if the Rupee depreciates to Rs. 52.50 against USD, (on the day of expiration of the contract), the futures price shall converge to the spot price (Rs. 52.50) and he makes a profit of Rs.1000 on an investment of Rs.21, 000. This works out to an annual return of 19 % . Because of the leverage they provide, futures form an attractive option for speculators.
ARBITRAGE:
Arbitrage is the strategy of taking advantage of difference in price of the same or similar product between two or more markets. That is, arbitrage is striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices.. One of the methods of arbitrage with regard to USD-INR could be a trading strategy between forwards and futures market. As we discussed earlier, the futures price and forward prices are arrived at using the principle of cost of carry. Such of those entities who can trade both forwards and futures shall be able to identify any mis-pricing between forwards and futures. If one of them is priced higher, the same shall be sold while simultaneously buying the other which is priced lower. If the tenor of both the contracts is same, since both forwards and futures shall be settled at the same RBI reference rate, the transaction shall result in a risk less profit.
26
TRADING PROCESS AND SETTLEMENT PROCESS
Like other future trading, the future currencies are also traded at organized exchanges. The following diagram shows how operation take place on currency future market:
27
It has been observed that in most futures markets, actual physical delivery of the underlying assets is very rare and hardly it ranges from 1 percent to 5 percent. Most often buyers and sellers offset their original position prior to delivery date by taking an opposite positions. This is because most of futures contracts in different products are predominantly speculative instruments.
REGULATORY FRAMEWORK FOR CURRENCY FUTURES
With the expected benefits of exchange traded currency futures, it was decided in a joint meeting of RBI and SEBI on February 28, 2008, that an RBI-SEBI Standing Technical Committee on Exchange Traded Currency and Interest Rate Derivatives was constituted.
28
COMPARISION OF FORWARD AND FUTURES CURRENCY CONTRACT
BASIS
Size
FORWARD
FUTURES
Structured as per requirement of the parties
DeliveryDate
Tailored on individual needs
Method of
Established by the bank or
transaction
broker through electronic media
Banks, brokers, forex dealers, Participants
multinational companies, institutional investors,
Standardized Open auction among buyers and seller on the floor of recognized exchange. Banks, brokers, multinational companies, institutional investors, small traders, speculators,
arbitrageurs, traders, etc. Margins
Standardized
arbitrageurs, etc.
None as such, but compensating
Margin deposit required
Maturity
bank balanced may be required From one week to 10 years Actual delivery or offset with
Settlement
cash settlement. No separate
market and variation margin
clearing house
requirements At recognized exchange
Market place
Accessibility
Delivery Secured
Over the telephone worldwide and computer networks
Standardized Daily settlement to the
floor with worldwide communications
Limited to large customers banks, institutions, etc.
hedging facilities or has risk capital to speculate
More than 90 percent settled by
Actual delivery has very less
actual delivery
even below one percent Highly secured through
Risk is high being less secured
margin deposit.
CONTRACT SPECIFICATIONS FOR USD - INR
29
Symbol
USD/INR
Instrument Type
FUTCUR
Unit of trading
1 (1 unit denotes 1000 USD)
Underlying
USD
Quotation/Price Quote
Rs. per USD
Tick size
0.25 paise or INR 0.0025
Trading hours Contract trading cycle Last trading day
Monday to Friday 9:00 a.m. to 5:00 p.m. 12 month trading cycle. Two working days prior to the last business day of the expiry month at 12 noon. Last working day (excluding Saturdays) of the expiry
Final settlement day
month. The last working day will be the same as that for Interbank Settlements in Mumbai.
Base price
Theoretical price on the 1st day of the contract. On all other days, DSP of the contract.
Minimum initial margin 1.75% on first day & 1% thereafter. Extreme loss margin Settlement Mode of settlement
1% of MTM value of gross open position. Daily settlement : T + 1 Final settlement : T + 2 Cash settled in Indian Rupees DSP shall be calculated on the basis of the last half an
Daily settlement price
hour weighted average price of such contract or such other
(DSP)
price as may be decided by the relevant authority from time to time.
Final settlement price (FSP)
RBI reference rate
BENEFITS OF CURRENCY FUTURES
30
Greater accessibility to potential participants (Online / Offline platforms).
Standardized Contracts, small lot size – US$ 1,000. Encourages retail and SME participation.
Electronic Settlement of MTM Profits / Losses: Control and track losses.
No counterparty default risk.
Large number of market participants.
High Transparency – Real time dissemination of prices.
No requirement of underlying document to book the FCY.
Cost efficient: Low brokerage thus lower transaction cost.
Intraday volatility (43 Bps): Short term profits for the traders.
Lower margins: 3- 3.5% of the contract value compared to average of 1015% on index/stock futures.
Indian Currency Futures Market-Present Status
Currency Futures trading was launched in India on 29th Aug, 2008 on NSE.NSE & MCX’SX are the major two exchanges presently.BSE is almost non-active.
31
Times of India- Aug 31 st, 2009
It has been exactly one year since the trading in Rupee – Dollar futures was introduced in India. Since then the currency derivative segment has grown by over 1500% in terms of daily average turnover. From about $ 60 million per day in August – September 2008, the current rate is nearly $1 billion per day in each of the two.
The Financial Express – Feb 6 th, 2010
The total turnover in the segment has increased incredibly from $ 3.4 bn in October2008 to $84 bn in December 2009. The average daily volume reached $4 bn in December 2009. India had witnessed enhanced FIIs thus Indian currency is becoming an important currency in world market . According to BIS, the total share of Indian rupee in total daily average foreign exchange has increased from 0.1% in 1998 to 0.9% in April 2007. Since the exchange rate is volatile during the last few years and hence increased importance of ETF.
32
Currency Movement
Major Events in International and Indian Monetary System
1.
Free float of currencies - 1973.
2.
Oil crisis in 1973 - quadrupling of oil prices
3.
European Currencies float against US$ - 1978
4.
Post emergency years
5.
Majority Govt. formed - 1984-85
6.
Liberalization of Indian Economy: devaluation of INR - 1991
7.
East and South East Asian Currency crisis - 1997
8.
Nuclear tests by India - 1998
9.
Robust economic growth in India
10. High crude oil and commodity prices
33
Currency Movement Impact Importer
Exporter
Imports Goods & Services
Exports Goods & Services
Payments in foreign currency
Receivables in foreign currency
Buys currency from the bank
Sells currency to the bank
Re - STRONG
→ Gain
Re - STRONG
→ Loss
Re - WEAK
→ Loss
Re - WEAK
→ Gain
Factors: Appreciation of INR
Events likely to impact USD/INR rate
General trend for demand/supply of USD
Increase in exports of Excess inflow of USD India RBI is selling USD to meet demand for the dollar NRI Forex remittance is increasing Positive trade balance
Impact on
Impact on
USD
INR
Depreciates
Appreciates
Depreciates
Appreciates
Increase in USD inflow
Depreciates
Appreciates
Increase in USD inflow
Depreciates
Appreciates
in the country Supply
of
USD
increases
34
Factors: Depreciation of INR Events likely to impact USD/INR rate
General trend for demand/supply of USD
Impact on USD
Impact on INR
Increase in imports of India
Demand for USD increases
Appreciates
Depreciates
Rise in global prices of commodities
Demand for USD rises due to costlier imports
Appreciates
Depreciates
FIIs buying back USD Excessive USD outflow
Appreciates
Depreciates
RBI is buying USD to absorb excess USD due to forex inflows
Appreciates
Depreciates
Absorption of excess USD liquidity
PRICING FUTURES –i) INTEREST RATE PARITY PRINCIPLE
35
For currencies which are fully convertible, the rate of exchange for any date other than spot is a function of spot and the relative interest rates in each currency. The assumption is that, any funds held will be invested in a time deposit of that currency. Hence, the forward rate is the rate which neutralizes the effect of differences in the interest rates in both the currencies. The forward rate is a function of the spot rate and the interest rate differential between the two currencies, adjusted for time. In the case of fully convertible currencies, having no restrictions on borrowing or lending of either currency the forward rate can be calculated as follows;
Future Rate = (spot rate) {1 + interest rate on home currency * period}/ {1 + interest rate on foreign currency * period}
PRICING FUTURES – ii) COST OF CARRY MODEL
Pricing of futures contract is very simple. Using the cost-of-carry logic, we calculate the fair value of a futures contract. Every time the observed price deviates from the fair value, arbitragers would enter into trades to capture the arbitrage profit. This in turn would push the futures price back to its fair value. The cost of carry model used for pricing futures is given below: F=Se^(r-rf)T
Where: r = Cost of financing (using continuously compounded interest rate) rf = one year interest rate in foreign T = Time till expiration in years E = 2.71828 This relationship is known as interest rate parity relationship and is used in international finance. To explain this, let us assume that one year interest rates in US and India are say 7% and 10% respectively and the spot rate of USD in India is Rs. 53
36
It may be noted from the above equation, if foreign interest rate is greater than the domestic rate i.e. rf > r, then F shall be less than S. The value of F shall decrease further as time T increase. If the foreign interest is lower than the domestic rate, i.e. rf < r, then value of F shall be greater th77an S. The value of F shall increase further as time T increases.
HEDGING WITH CURENCY FUTURES
Exchange rates are quite volatile and unpredictable, it is possible that anticipated profit in foreign investment may be eliminated, rather even may incur loss. Thus, in order to hedge this foreign currency risk, the traders’ often use the currency futures. For example, a long hedge (I.e.., buying currency futures contracts) will protect against a rise in a foreign currency value whereas a short hedge (i.e., selling currency futures contracts) will protect against a decline in a foreign currency’s value. It is noted that corporate profits are exposed to exchange rate risk in many situation. For example, if a trader is exporting or importing any particular product from other countries then he is exposed to foreign exchange risk. Similarly, if the firm is borrowing or lending or investing for short or long period from foreign countries, in all these situations, the firm’s profit will be affected by change in foreign exchange rates. In all these situations, the firm can take long or short position in futures currency market as per requirement. The general rule for determining whether a long or short futures position will hedge a potential foreign exchange loss is: Loss from appreciating in Indian rupee= Short hedge Loss from depreciating in Indian rupee= Long hedge
37
RESEARCH METHODOLOGY
38
OBJECTIVE OF THE STUDY
1. To study the exchange traded currency future. 2. To study how currency derivative impact the investor market , and how currency
movement influence the indian forex market 3. To study & analyze the impact of different Macro-Economic indicators on Indian Currency. •
Inflation
•
Crude Oil Prices
•
Gross Domestic product (GDP)
•
S&P CNX Nifty
4. To understand the practical considerations and ways of considering currency Future price.
5 .To analyze different currency derivatives products
39
SCOPE OF THE STUDY
1. Study mainly concentrates on USD/INR EXHANGE RATE contracts though NSE has introduced trading in currency futures based on •
Euro(EUR)-INR
•
Pound Sterling(GBP)-INR
•
Japanese Yen (JPY)-INR exchange rates
2. The main factor that affects the USD/INR EXHANGE RATE or any other currency is the Demand/supply dynamics for the individual currencies. However the Demand/supply dynamics is influenced by many other factors such as interest rates, inflation, money supply, trade trade
balance, growth in imports, imports, exports, capital flows, flows, and overall economic
growth in the country and global developments. Due to time time constra constraint intss only only four four major major econom economic ic indica indicator torss are select selected ed for analysis •
Inflation
•
Crude Oil Prices
•
Gross Domestic product (GDP)
•
S&P CNX Nifty
40
METHODOLOGY
o f the general Research design:- A research design is the determination and statement of research approach or strategy adopted/or the particular pa rticular project. It is the heart of planning. If the design adheres to the research objective, it will ensure that the client's needs will be served. In this project Exploratory Research design method is used Source of the Data Collection:- The data is colleceted through both the means of
primary and secondary data collection •
In primary data collection- Questionnaires are prepared, whereas
•
In secondary data collection -information is collected from various
•
sites and books
Sample Design:Sample Size: The Total sample size was 50
Sampling Method: - The study is based on the non-probability sampling and wherein
convenience sampling was used to collect the data by picking out people in the most convenient and fastest way to immediately get their reactions. METHOD OF DATA COLLECTION:•
PRIMARY DATA:- primary data is collected through Questionnaires, two different questionnaires were prepared For individuals & For exporters & importers
41
•
SECONDAY DATA:1. The secondary data is also collected from the newspapers, magazines, different
websites report submitted by RBI/SEBI committee and NCFM/BCFM modules periodicals. 2. A major bulk of the data has been obtained from India Infoline Ltd.
42
FINDINGS & ANALYSIS
43
Ques. Are you an active investor?
Interpretation:in our study we came to know that 47% of the people were active investor, whereas 53% of the people were generally students and were not active investor
44
Ques. what kind of investment you prefer the most?
Interpretation:From the study we can make out that, most of the people prefer secured investment like gold/silver or fixed deposit , which can provide them sort of fixed returns and few people investment in highly flexible market with high risk.
45
Ques. What is your profit margin?
Interpretation:- the profit margin of our respondents were not that high , most of them were below 10% , hence it is beneficial for them to invest into currency , as with low profit margin , they can invest into something with good and secured returns
46
Ques. Do you know about currency derivative as an investment option?
Interpretation:- In the whole research process, we derived that, 47% of the people were aware about currency derivative as an investment option whereas, 53% of the people were unaware…it means currency derivative as an investment option is growing at high rate in terms of awareness.
47
Ques. What factors that attract you to invest in currency?
Interpretation:From past 5 years currency has shown high depreciation in indian rupee vis a vis usd, hence most of the importers and exporters have preferred currency derivative as an option of investment as it has shown high returns & good leverages.
48
Ques. where do you find yourself as currency derivative investor?
Interpretation: Not many of our investor, were quite aware about currency derivative. Hence they were unaware about the good returns associated with this investment option. Hence it gve us a varied market to tap those customers too
49
Ques. Do You Know About the Current Scenario Of Returns In Currency Derivative?
Interpretation:33% of our respondents knew about current scenario of returns in currency derivative , whereas 67% of our respondents are unaware.., so we could derive that there is huge scope for our organization to tap these unaware respondents , and tell them about the high and secured returns in currency derivative market.
50
TABLE Table of Correlation between Rates of Inflation & USD/INR EXHANGE Rate
Year
Annual Averages of Currency rate
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
43.11 44.95 47.19 48.6 46.55 45.33 44.11 45.33 41.29 43.41 48.35 45.65 46.61
51
GDP growth (annual %) 7.39 4.03 5.22 3.77 8.37 8.28 9.32 9.27 9.82 4.93 9.1
8.81 7.2
RESEARCH FINDINGS
•
Thus higher Inflation leads to weakening of Domestic Currency.
•
INR has appreciated with every upward movement shown by Nifty Index over a period of time.
•
People are not much aware about currency derivative as an investment option, hence there is scope for a wider market , by creating awareness
•
Higher GDP leads to appreciation of Domestic Currency.
•
Higher contribution of currency derivative leads to better returns, which strengthens the investor market (i.e. b.s.e & n.s.e)
•
Currency derivative is an secure investment , and from our study we could derive that people generally prefer those investment option which has low risk and better returns
•
There is a limit of USD 100 million on open interest applicable to trading member who are banks. And the USD 25 million limit for other trading 52
members so larger exporter and importer might continue to deal in the OTC market where there is no limit on hedges. •
In India RBI and SEBI has restricted other currency derivatives except Currency future, at this time if any person wants to use other instrument of currency derivatives in this case he has to use OTC.
SUGGESTIONS
•
Currency Future need to change some restrictions it imposed such as cut off limit of 5 million USD, Ban on NRI’s and FII’s and Mutual Funds from Participating.
•
In OTC there is no limit for trader to buy or short Currency futures so there demand arises that in Exchange traded currency future should have increase limit for Trading Members and also at client level, in result OTC users will divert to Exchange traded currency Futures.
•
In India the regulatory of Financial and Securities market (SEBI) has Ban on other Currency Derivatives except Currency Futures, so this restriction seem unreasonable to exporters and importers. And according to Indian financial 53
growth now it’s become necessary to introducing other currency derivatives in Exchange traded currency derivative segment.
54
CONCLUSION
Our research shows that , there is huge scope for new investor to invest in currency derivative , as it provide good returns , and have safeguard investors’ money , in case of high price fluctuations .a derivative contract makes investor secure and risk free in future , when he has to enter into contract in near future, and price movement of currency , does not affect his business.
The currency future gives the safe and standardized contract to its investors and individuals who are aware about the forex market or predict the movement of exchange rate so they will get the right platform for the trading in currency future. Because of exchange traded future contract and its standardized nature gives counter party risk minimized.
Initially only NSE had the permission but now MCX has also started currency future. It is shows that how currency future covers ground in the compare of other available derivatives instruments. Not only big businessmen and exporter and importers use this but individual who are interested and having knowledge about forex market they can also invest in currency future.
Exchange between USD-INR markets in India is very big and these exchange traded contract will give more awareness in market and attract the investors.
55
APPENDICES
56
QUESTIONNAIRE ON INDIVIDUALS PERCEPTION TOWARDS CURRENCY DERIVATIVE
1.Name __________
2.Address _____________________________
3.E-Mail Id ____________________________
4.Contact No.____________
5.Age ________
6.occupation Business. Profession service student Other: ______
7.IF Business business type_________
57
8.Are you an active investor? YES NO
9.what kind of investment you prefer the most? Fixed Deposit Insurance Mutual Fund Equity Commodity Real Estate Currency derivative Gold/ Silver PPF/PF
10. How Do you rate your risk taking ability? Low Medium High
11.While investing your money ,which factors you prefer the most? Liquidity Low Risk High Return 58
Other: (specify)__________
12. what is your annual income? below -200000 200000-500000 500000-1000000 1000000 & above 13. what Is your profit margin? Below 10% 10-15% 15-25% above 25%
14.Do You Know About Currency Derivative as an Investment option? * YES NO
15.what factors that attract you to invest in currency? High Leverage Good Returns Professional Management Other:
16.Do You Know about "IIFL"? YES 59
NO
17.where do you find yourself as currency derivative investor? Unaware partially aware fully aware aware of only specific schemes 18.Do You Know About the Current Scenario Of Returns In Currency Derivative? yes No
60
