A currency derivative is basically a risk management instrument that allows entities with Fx-fluctuations risk the ability to take long or small positions to hedge against opposite short/long positions.
Companies are exposed to foreign currency risk in a competitive market where imports and exports are integral parts of a business's operations.
Forward: An OTC contract that is customized between two parties, where settlement occurs at a predetermined date and price. Banks deal in it.
Futures This is an exchange-traded standardized contract between two people that allows them to buy and sell underlying at a certain price.
Options This is an exchange-traded contract that gives you the option to buy or sell the underlying without any obligation.
Swaps This is an agreement between two people to swap principal and interest. The cash flow in one direction will be in a different currency than the other.
Exporters A weakening Rupee can adversely impact the exporter's profit margin, but a strengthening Rupee will boost it.
Importers A strengthening of Rupee can positively affect an importer's payments for goods, as they fall when Rupee appreciates.
BorrowersIn today's globalized world, Indian companies prefer loans in foreign currencies to rupee loans. Accepting a loan comes with risk due to fluctuations in the exchange rate.
A business must sell foreign currency: This includes Indian exporters and companies receiving capital infusions. Repatriation from abroad of investment money i.e. Company that has raised money abroad.
Businesses need to purchase foreign currency: This applies to importers of goods and services into India. A company must repay capital raised from overseas, as well as individuals who plan to spend in foreign currencies.
Below are some entities that are at risk from Fx-fluctuations.
Portfolio diversification, price discovery and hedge
Futures > Cash + Carry (i.e. Interest rate; Sell Futures and Buy Cash Options Cash + Cost Of Carry (i.e. Interest rate; Buy Futures and Cash
Futures 2 > Futures 1 + Cost of Carry; Sell Futures 2 and Buy Futures 1 Futures 2 < Futures 1 + Cost of Carry; Buy Futures 2 and Sell Futures 1
As with all assets, the value of a currency depends on the forces of supply and demand. The currency's value is also affected by a variety of factors. It will fluctuate depending on economic conditions, general market conditions, future interest rates, changes in prices, performance of stock markets, and performances of Asian currencies.
1. To protect themselves against the appreciation of foreign currencies, traders can lock-in a predetermined buying price. Base currencies can be locked-in at a pre-determined price.
2. Trader who want to avoid depreciation of foreign currencies. Base currencies can be locked-in at a pre-determined selling price
Specification of Currency Futures Contracts:
|Hours of operation||:||Monday through Friday 9:00am to 5:00pm|
|Months of Contract||:||12 months in the next calendar month|
|Size of the contract||:||USD 1000, EUR 1000. GBP 1000. JPY 1,00,000.|
|Tick Size||:||0.25 paisa/INR 0.0025 for 1 USD|
|Last trading day||:||Two working days before the last business day in the expiry month at 12.15 o'clock noon|
|Final Settlement date||:||Last day of the expiry period (sans Saturdays)|
|Settlement||:||Daily settlement: T+ 1 / Final settlement: T+ 2|
|Daily settlement||:||Average price weighted by price in the last half hour of trading|
|Final settlement||:||Rate of the RBI at expiry|
Specifications for Currency Options:
|Symbol||:||1-1 unit denotes 1000 USD|
|Type of instrument||:||OPTCUR|
|Option Type||:||Premium Style European Call-and-Put Options|
|Premium||:||In INR, premium quoted|
|Unit of trading||:||1 contract unit denotes USD 1000|
|Order Quotation/Underlying:||:||The exchange rate between Indian Rupees and US Dollars|
|Tick Size||:||0.25 paise ie INR 0.0025|
|Hours of operation||:||Monday through Friday, 9.00 am to 5:05 pm|
|Contract trading||:||Three monthly serial contracts, followed by three quarterly contracts of the cycle|
|Strike Price||:||12 In-the-money, 12 Out the-money and 1 Near the-money. (25CE, 25 PE).|
|Strike Price Intervals||:||INR 0.25|
|Price Bands||:||An indicative price range for a contract based on the delta value. It is updated daily.|
|Maximum Quantity Limit||:||10000 lots per order|
|Base Price||:||Theoretical price for the first day of the contract. All other days, DSP.|
|Expiry/Last trading day||:||Two working days before the end of the month at 12:.30 pm.|
|Exercise before expiry||:||All long in-the-moneys open contracts shall automatically be exercised at the final settlement amount.|
|Final Settlement Day||:||The expiry month's last working day (save Saturdays) will be the same day as the Interbank Settlements in Mumbai.|
|Initial Margin||:||SPAN-based margin|
|Settlement of premium||:||The buyer must pay the premium in cash on T+1 Day|
|Settlement||:||Daily Settlement: T+1Final Settlement: T+2|
|Mode of Settlement||:||Indian Rupees: Cash settlement|
|Final Settlement Price (FSP).||:||The date of expiry of the contract is the RBI reference rate|
One currency can be bought and sold in every currency transaction. For example, You can buy USD for INR with a USD call or INR put. An INR Put and a USD Put are also available to sell USD for INR.
Other basic options, such as Strike price, Expiration date, and Style, are identical to any other underlying option.
A trader with a long directional view on currency can either buy or sell a Call option. A trader with a short directional view of currency can also sell Call option or purchase Put option.
If Call and Put are purchased, the downside risk is only limited to the premium paid. However, upside risk is unlimited and vice versa.
Options combinations strategies work best when the market view is moderately bearish/bullish, rangebound or uncertain. The goal is to lower the overall premium.
Bull & Bear Call - Put spread, Straddle, Butterfly and Covered Protective Call are some examples of instruments.