Foreign Exchange Markets in India-Futures Versus Forward Trading

8/3/2019 Foreign Exchange Markets in India-Futures Versus Forward Trading

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Foreign exchange market in India has made

significant strides in the recent years gaining

depth and volumes and introduction of

i n cr ea s in g n um be r o f d e ri v at i ve s

instruments for hedging against price risk.

Further, with the rapid increase in global

integration of financial markets and to

facilitate the increased cross boarder transfer

of funds, the RBI has permitted exchange

tr ade o f c ur re nc y f uture s i n 2 00 8.

Consequently, currency futures contracts

were introduced for trading on the National

Stock Exchange Ltd (NSE) with the effect

from Aug 29, 2008. Following this, two more

exchanges, Bombay Stock Exchange (BSE)

and Multi Commodity Exchange-Stock

Exchange (MCX-SX), also started offering

currency futures trade in Sept and Oct

respectively, in 2008. Soon after their

introduction, trading in currency futures

picked up momentum rather quickly and the

total volumes reached Rs.5.14 lakh crore by

theendofMay2009.

The main advantage of currency futures over

its closest substitute product, viz., forwards

which are traded over-the-counter (OTC) lies

in price transparency, elimination of

counterparty credit risk and greater reach in

terms of easy accessibility to all. However,

futures trading also involves speculators and

arbitragers who dont have any underlying

physical exposure but participate in trading

with profit motive. As a result, there are

apprehensions that the excessive speculation

may adversely affect both futures as well as

the underlying spot markets. Considering

these developments, an attempt is made to

study the pattern of trade, comparative

economics forex derivatives and the impact

of futures on forwards and spot.

The

trends in the trade of forex forwards

indicated that majority of the trades were

concentrated in the tenor of 6 months to one

year followed by less than 30days and 30-

90days tenor. The shares of less than 30days

and 30-90 days were almost equal during

most of the time though, the trade

concentration in the shortest tenor (


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Table 1: Tenor-wise trade analysis (%)

Source: .Rakshitra,May2009

Exchange traded futures:

Data & Methodology

Test Statistics:

Comparative economics of forwards and

futures

Spread

Currency futures

gained significant volumes soon after their

introduction on domestic exchanges and

have grown many folds, from about Rs 5

thousand crore in September 2008 to Rs.124

thousand crore in May 2009. Unlike the case

of OTC forward market, where trading is well

diversified across different tenors and the

long tenors are relatively more active, futures

volumes have largely been confined to near

month contracts accounting for about 90 per

cent. Although three trading platforms are

available for trading, the BSE could not gain

much volume while the MCX-SX and NSE

have been contributing nearly equal share to

the total traded volumes of currency futures

market.

Data on forward rates for various term

structures were collected from traded as well

as polled data. Source for traded data was the

CCIL while the polled rates were collected

from the RBI. The extent of match/mismatch

between the polled and traded forward rates

were studied for pooled as well as individual

categories of major trading members such as

foreign banks, nationalized banks and

private banks. Further, in order to bring

comparability, the traded data were collated

into different term structures like 1-month, 3-

month, 6-month and one-year.

The data were analyzed using simple

statistical tools such as correlations and t-

tests to find out the extent of association

between the data of two sources viz., traded

and polled. T-test for paired two sample

means was used in order to test the statistical

significance of mean differences in the data

from the two sources.

: Simultaneous trade of foreign

exchange on different platforms as well as in

t he O TC m ar ke t p ro vi de s a rb it ra ge

opportunity if there is any significant

< 30Days

30 to 90Days

90 to180 Days

180 to365 Days

> 1Year

2002-03 16.1 22.9 22.4 37.2 1.4

2003-04 22.5 24.8 20.2 31.8 0.7

2004-05 20.0 24.1 17.9 36.3 1.8

2005-06 22.8 24.2 15.2 36.2 1.6

2006-07 25.6 25.1 17.2 30.5 1.6

2007-08 31.5 25.8 17.2 24.5 1.0

2008-09 23.6 23.4 18.6 32.0 2.4

Apr -09 33.2 19.3 12.4 34.2 0.9

May-09 20.2 20.1 12.9 45.2 1.7

Apr-May 09 26.8 19.7 12.7 39.6 1.3

TotalVolume

Share (%)

(Rs. crore) 1M 2M 3M

Sep-08 5174.5 84.3 9 6.7

Oct-08 16663.1 83.9 8 8.1

Nov-08 31083.2 81.1 10 8.9

Dec-08 45776.6 87.2 9 3.8

Jan-09 48394.9 86.7 9 4.3

Feb-09 63956.3 87.9 9 3.1

Mar-09 99461.2 86.6 9 4.4

Apr-09 77921.8 92.1 6 1.9

May-09 124900.7 93.3 5 1.7

Table 2: Trends in trade volumes of currency futures

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169C O L L E C T I O N O F A R T I C L E S


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difference in the rates traded across different

platforms. Lesser the spread, efficient are the

markets. Hence, the spread between the

exchange traded futures and OTC forwards

was calculated and tested for its statistical

significance. In addition, the RBI also fixes

daily exchange rates for reference based on

the polled information and the exchange

traded futures have to be settled based on the

RBIs reference rate.

Table 3: Spread among exchange rates from

three different sources

The results based on paired t-statistic

indicated that the daily average spreads

among all three exchange rates were falling in

the range of 5 to 11 paise and was found to be

statistically significant. Among the three

different exchange rates, the OTC forward

rates were the lowest, followed by the

exchange traded futures and polled rates by

the RBI. As a result, the spread between

traded forward rate and polled forward rate

by the RBI was found to be the maximum at

11.38 paise.

The daily average spread between futures and

polled forward rates during the initial three

months of futures trade was the lowest at 5.05paise. However, the futures rates moved

relatively closer to traded forwards,

apparently due to the existence of arbitrage

activity. The spread between futures and

traded forwards narrowed to 3.09 paise, while

the spread between the futures and polled

forward rates widened to 7.01 paise during

Jan-Mar 09 despite the fact that the futurescontracts are settled based on the RBI

reference rate.

Thus, on average, the daily average spread

between the traded exchange rates has

narrowed to half within six months of

introduction of futures trading, suggesting

that the foreign exchange markets in India

are becoming efficient over a period.

Volatility in the three exchange

rates was measured by using the standard

deviation and coefficient of variation for

different periods. The results indicated that

the volatility was relatively lower, though

only marginally, in the case of OTC traded

forwards and futures compared to the polledRBI reference rate in the three periods

considered for the study.

Although the increase in volatility during

Sep-Dec08 coincided with the introduction

of futures, the volatility level in Jan-Mar 09

returned to the level that existed prior to the

introduction of futures. Hence, the rise in

Volatility:

Spread

(paise)

t-stat ?value

Between Sep08 and Dec 08

Futures - Fwd traded 6.33 -2.465 0.008

Fwd polled - Futures 5.05 2.627 0.005

Fwd polled - Fwd traded 11.38 -6.202 0.000

Between Jan 09 and Mar 09




Between Sep08 and Mar 09




C O L L E C T I O N O F A R T I C L E S170

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volatility during Sep-Dec 08 could possibly

be on account of the turmoil in the global

markets that transmitted to Indian markets

during the same period. Thus, there was no

significant change in the volatility of foreign

exchange markets after the introduction of

trading futures contracts.

Table 4: Volatility trends in exchange rate

Cost of trading becomes another important

factor for the participants to choose the

platform and product for trading. For the

sake of comparability, total costs involved

from the entry into the contract till the

delivery or settlement of the contract.

: The cost of trading in case of

forwards, as they are over the counter

contracts, comes into picture only when it

enters into the settlement guaranteed clearing

system (provided by the CCIL in India). If it is

mutually settled out of the guaranteedsettlement system then there are no costs in

case of OTC contracts (forwards). However,

majority of the trades are settled through the

guaranteed settlement provided by the CCIL

and fees charged by the CCIL becomes cost of

trading for forwards. The details of the costs

involved in the settlement of forwards

through CCIL are specified in Table 5.

Table 5: Charges per trade accepted per

segment

: In the case of

futures, there are two major

c os ts t ha t i nv ol ve i n

t ra di ng o n e xc ha ng e

platform apart from the

brokerage; one is in the

form of margins and the other is the

transaction charges. Margin costs are not

paid out costs to the exchange but are held by

the exchange till the settlement day, adjusting

daily on a mark-to-market basis and settled at

the expiry of contracts.

Though the exchanges normally charge

transaction fee for using the platform to

trade, at present, transaction costs for trading

in currency futures are nil, plausibly to

encourage and promote the participation in

futures. Nevertheless, the participants have

to pay a nominal fee of Rs 20/- per croretowards SEBI turnover fee and outstanding

fee of Rs.10/- per million per month on the

outstanding contract, based on its residual

maturity. To illustrate, a participant with a

position of Rs.10 million in a futures

contract that expires after five months will

have to pay Rs.500 per month towards

outstanding fee. However, the charges are

Costs involved in trading

Forwards

Futures

Source: www.ccilindia.com

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Standard Deviation Co-efficient of Variation (%)

OTCtraded

forwardFutures

Polled RBIreference

rate

OTCtraded

forwardFutures

Polled RBIreference

rate

Apr-Aug 1.216 NA 1.246 2.880 NA 2.943

Sep-Dec 1.680 1.713 1.743 3.506 3.569 3.629

Jan-Mar 1.227 1.246 1.256 2.462 2.500 2.515

Sep-Mar 1.776 1.791 1.815 3.645 3.672 3.718

Trade Value (in USD) Charges

Less than 1 million Rs 90/-

1 million to less than 3 million Rs 110/-




20 million and above Rs 200/


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levied daily on a pro-rata basis. This may also

be a reason for the concentration of trades in

near month contract especially in view of the

zero transaction costs that facilitate frequent

rollover of contracts.

In addition, brokerage charges also need to be

considered when the trading is done through

brokers in both forward and futures trading.

Although precise information is not

available on the level of brokerage, the

brokerage charges of futures trading reported

to be considerably lower than that in forward

(OTC) trading. Nevertheless, brokeragecharges are optional in both markets.

Thus, taking into account of various costs

involved except the brokerage charges,

trading on exchange

appears to be relatively

costly even when the

transaction charges are

not yet levied by the

exchanges. Further, as

e vi de n t f ro m t he

composition of trade in

e s t a b l i s h e d f o r e x

d e ri v a ti v es m a rk e t

(OTC), majority (about

50%) of t rades are

concentrated in longer

tenors of 6 months to 1-year. If such long-

term hedgers want to use futures platform,

they need to rollover their position to meet

their requirement, as the liquidity is largely

concentrated in the near month contract in

futures markets. Once the exchanges start

charging transaction costs, the rollover in

currency futures may become expensive.

There was no perceptible impact of futures

trading on forward trade volumes as the

trading in both derivatives exhibited a

similar growth trend. Trade volumes inforwards declined steadily after Oct 08

except in Dec 08, coinciding with the

initiation of currency futures trade. But, the

period also coincided with the deepening of

global financial crisis that led to less activity

in financial markets in general. The decline

in activity was evident from the similar

pattern of fall in spot market volumes duringthe corresponding period as shown in Chart

1. Further, the trade activity in futures and

forwards showed a similar growth trend since

the introduction of futures.

Thus, based on the available trends in futures

and forwards so far, it is not evident that the

futures trading has caused any significant

shift in OTC forward volumes. In addition,

considering the nature and concentration of

trade in both the markets (OTC and futures)

and in view of the similar trends in their

volumes, it appears that at present the

Impact of futures on forward trade

Growth trends in Foreign Exchange Volumes

-60

-40

-20

0

20

40

6080

100

120

Growth(%)

FWD Spot Futures

Apr-08

May-08

Jun-08

Jul-08

Aug-08

Sep-08

Oct-08

Nov-08

Dec-08

Jan-09

Feb-09

Mar-09


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objective of participation in both markets is

different. The OTC market is predominantly

used by hedgers with physical exposure, while

futures market apparently used mostly for

the arbitrage and speculation purposes.

Hence, there was no notable shift in volumes

from forwards to futures, despite the rapid

and significant increase in futures volumes.

Since the futures contracts are standardized

with a fixed amount of quantity that may not

match the actual requirement of the

participants many times. As a result, the

participants may prefer to take positions in

OTC market where the contracts can be

customized to their required amount or size.

Another difficulty the hedgers may face in

case of futures is the mismatch between the

date of requirement and the maturity date of

the contract. The hedgers who actually

interested to take the delivery will find it

difficult when the date of maturity of the

contract does not match with the date of their

requirement.

Another important factor that may be

discouraging the participation in futures is

the position limits. The exchange fixes the

upper limit on the position taken by each

participant. The details of the limits fixed by

the exchanges are given below. Because of

these limitations, the participants cannot

take position beyond this limit and to the

extent they need and hence it becomes a

constraint.

Lack of physical delivery option and only

cash settlement in futures trading becomes a

problem for hedgers when they have payment

obligations in foreign currency. Hence, this

may discourage participants, who need

physical delivery of foreign currency.

Another important factor that discourages

the active trading in futures is the restriction

of foreign institutional investors (FIIs)

participation. According to guidelines of the

Reserve Bank of India, trade participation of

FIIs in futures trading is not yet allowed.

The facility to easily enter into and exit from

the contract encourages participation from

those who do not have specifications of

physical delivery in the terms of quantity,

maturity date and position limits which

g en er al ly a re t he s pe cu la to rs a nd

arbitrageurs.

Factors discouraging futures trading

Mismatch of Contract size:

Mismatch in maturity:

Position limits:

No physical delivery

Restriction on the participation of FIIs

Factors encourage futures trading

Easy entry and exit

Clients Trading Members Banks

higher of 6% of total open interest or

USD 10 million

higher of 15% of the total open interest

or USD 50 million

higher of 15% of the total open interest

or USD 100 million

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Anonymity and Transparency in dealing

Conclusions

Since the deals occur online on the exchange

platform, there is transparency in pricing and

arriving at the deal.

The existing trends so far suggest that despite

the significant rise in futures volumes, there

was no notable shift in volumes from

forwards to futures market. The fee structure

and near-month liquidity in currency futures

possibly attracted the participation of

arbitragers and speculators, while the hedgers

continued to prefer OTC forward contracts

due to the flexibility and customization

p ar ti cul ar ly i n c as e o f l on g t erm

requirements. Thus, the remarkable growth

in futures could not bring any notable

changes in forward markets so far since the

purpose as well as nature of participation in

futures appeared to be different from that of

the forwards market.


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Foreign Exchange Markets in India-Futures Versus Forward Trading

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