“PROJECT ON IMPACT OF CURRENCY DERIVATIVE ON INVESTORS IN INDIAN CAPITAL 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 -110086An ISO 9001:2008 Certified Institute

AICTE NBA Accredited Institute

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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

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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

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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

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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.• EquitiesFor 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.

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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.

There are various derivative products traded. They are;1. Forwards2. Futures3. Options4. 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”

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OVERVIEW OF

THE

INDUSTRY

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INTRODUCTION TO CAPITAL MARKET

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.

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HISTORY OF CAPITAL MARKET

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.

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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

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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,

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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 value-

oriented 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.

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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.

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ABOUT CURRENCY DERIVATIVES

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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

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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.

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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.

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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 Country Currency Nickname

USD United States Dollar Geenback

EUR Euro members Euro Fiber

JYP Japan Yen Yen

GBP Great Britain Pound Cable

India is 16th largest forex market in the world. The daily global FX turnover

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

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CURRENCY DERIVATIVE PRODUCTS

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.

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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.

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CONTRACT SIZE:

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.

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MAINTENANCE MARGIN:

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.

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BASIS:

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

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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)

Buy 100 USD - INR Oct '11 Contracts

on 15th July ’11

: 52.0000

(1000 * 52.0000) * 100 (Assuming the Oct

'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 cost of hedged transaction

: 52.25 * 100,000

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

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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 FORWARD FUTURES

SizeStructured as per requirement of

the partiesStandardized

DeliveryDate Tailored on individual needs Standardized

Method of

transaction

Established by the bank or

broker through electronic media

Open auction among buyers

and seller on the floor of

recognized exchange.

Participants

Banks, brokers, forex dealers,

multinational companies,

institutional investors,

arbitrageurs, traders, etc.

Banks, brokers,

multinational companies,

institutional investors, small

traders, speculators,

arbitrageurs, etc.

MarginsNone as such, but compensating

bank balanced may be requiredMargin deposit required

Maturity From one week to 10 years Standardized

Settlement

Actual delivery or offset with

cash settlement. No separate

clearing house

Daily settlement to the

market and variation margin

requirements

Market placeOver the telephone worldwide

and computer networks

At recognized exchange

floor with worldwide

communications

AccessibilityLimited to large customers

banks, institutions, etc.

hedging facilities or has risk

capital to speculate

DeliveryMore than 90 percent settled by

actual delivery

Actual delivery has very

less even below one percent

Secured Risk is high being less securedHighly secured through

margin deposit.

29

CONTRACT SPECIFICATIONS FOR USD - INR

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 hoursMonday to Friday

9:00 a.m. to 5:00 p.m.

Contract trading cycle 12 month trading cycle.

Last trading dayTwo working days prior to the last business day of the

expiry month at 12 noon.

Final settlement day

Last working day (excluding Saturdays) of the expiry

month.

The last working day will be the same as that for

Interbank Settlements in Mumbai.

Base priceTheoretical 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 1% of MTM value of gross open position.

SettlementDaily settlement : T + 1

Final settlement : T + 2

Mode of settlement Cash settled in Indian Rupees

Daily settlement price

(DSP)

DSP shall be calculated on the basis of the last half an

hour weighted average price of such contract or such other

price as may be decided by the relevant authority from

time to time.

30

Final settlement price

(FSP)RBI reference rate

BENEFITS OF CURRENCY FUTURES

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 10- 15%

on index/stock futures.

Indian Currency Futures Market-Present Status

31

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.

Times of India- Aug 31st, 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 6th, 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

Impact on

USD

Impact on

INR

Increase in exports of

India

Excess inflow of USD

in the countryDepreciates Appreciates

RBI is selling USD to

meet demand for the dollar

Supply of USD

increasesDepreciates Appreciates

NRI Forex remittance is

increasingIncrease in USD inflow Depreciates Appreciates

Positive trade balance Increase in USD inflow Depreciates Appreciates

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

Absorption of excess USD liquidity

Appreciates Depreciates

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 balance, growth in imports, exports, capital flows, and overall economic

growth in the country and global developments.

Due to time constraints only four major economic indicators are selected for analysis

Inflation

Crude Oil Prices

Gross Domestic product (GDP)

S&P CNX Nifty

40

METHODOLOGY

Research design:- A research design is the determination and statement of the general

research approach or strategy adopted/or the particular 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

YearAnnual Averages of Currency

rate

GDP growth

(annual %)1999 43.11 7.392000 44.95 4.032001 47.19 5.222002 48.6 3.772003 46.55 8.372004 45.33 8.282005 44.11 9.322006 45.33 9.272007 41.29 9.822008 43.41 4.932009 48.35 9.12010 45.65 8.812011 46.61 7.2

51

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 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.

52

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

growth now it’s become necessary to introducing other currency derivatives in

Exchange traded currency derivative segment.

53

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.

54

APPENDICES

55

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_________

56

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

57

High Return

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"?

58

YES

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

59

BIBLIOGRAPHY

NCFM: Currency future Module.

BCFM: Currency Future Module.

Report of the Internal Working Group on Currency Futures .Reserve Bank of India,

Report of the RBI-SEBI standing technical committee on exchange traded

(Currency futures)

WEBLIOGRAPHY

www.sebi.gov.in

www.mcx-sx.com

www.nseindia.com

www.investopedia.com

www.worldbank.org

www.indiainfoline.com

www.indexmundi.com

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