This chapter aims to provide readers with an in-depth knowledge on ETC markets with major emphasis on currency futures which have been recently launched in India, and are traded on various exchanges, viz., NSE, MCX and USE. ETC refers to ‘exchange traded contracts’ whereby each counterparty deals with exchange. Exchange acts as an intermediary and guarantees the settlement and performance of obligations by counterparties. The contents of this chapter are organized in the following order:
1. Currency Futures: Introduction
2. Market Participants in Currency Futures Segment
3. Currency Futures: Technical Aspects
4. Concept of Margin in ETC Markets
5. Advantages of Currency Futures Market
6. NSE and Thomson Reuters Screenshots
7. Summary Statement and Ledger Formats
8. Difference Between ETC and OTC
A currency futures contract is a standardized version of a forward contract which is traded on a regulated exchange. It is an agreement to buy or sell a specified quantity of an underlying currency on a specified date in future at a specified rate (e.g. USD 1 = INR 44.00) (Note: USD is abbreviation for US dollar and INR for Indian rupees). The counter-party risk (credit risk) in a futures contract is eliminated by the presence of clearing house/corporation, which guarantees all settlements, and thus eliminates the default risk.
Thus, introduction of ETC futures has helped in overall development of foreign exchange market in the country. Any ‘Resident Indian’ or company, including banks and financial institutions, can participate in futures market. However, at present, foreign institutional investors (FIIs) and non-resident Indians (NRIs) are not permitted to participate in currency futures market.
RBI has allowed banks to participate in currency futures market. AD category I banks which fulfil stipulated prudential requirements are eligible to become a clearing member and/or trading member of currency derivatives segment of various exchanges. All other banks including urban and state co-operative banks can participate in currency futures market only as clients.
Currency futures can also help small traders as the minimum size of USD/INR futures contract is USD 1,000. This is within the reach of small traders. All transactions on the exchange are anonymous and executed on a price-time priority ensuring that best price is available to all categories of market participants irrespective of their size. Also since the profits or losses in the futures market are collected or paid on a daily basis, the scope of accumulation of losses for participants gets limited.
An individual with no exposure to foreign exchange risks can invest purely as an investor and benefit from exchange rate fluctuations just as one benefits by investing in equities market on exchange. However, like stock market, currency futures exchange is also risky and one can incur loss, in case the view taken goes wrong.
Exchange traded currency futures also enables hedging against currency risks. On a currency exchange platform, one can buy or sell currency futures. An importer can buy futures to ‘lock in’ a price for purchase of actual foreign currency at a future date, and similarly, an exporter can sell currency futures on the exchange platform and lock in price for sales of foreign exchange at a future date.
Risks in currency futures pertain to movements in the currency exchange rate. There is no rule of thumb to determine whether a currency rate will rise or fall or remain unchanged. A judgement on this aspect is a domain of experts with deep knowledge and understanding of variables that affect currency rates.
Internationally, exchanges such as Chicago Mercantile Exchange (CME), Johannesburg Stock Exchange (JSE), Euronext, Liffe, and Tokyo Financial Exchange (TFX), trade in currency futures.
This includes large, medium and SME enterprises which wish to hedge their export- or import-related foreign exchange exposures.
This includes those who do not have any underlying currency exposure but they seek to profit from these markets by taking directional or volatility views.
This includes those who want to benefit from price differentials between OTC and futures market.
Note: It is because of strict provisions of margin requirement, the risk of default in such type of future contract is nil. Profit and losses are to be settled on a daily basis; hence, risk is nil. Investor can withdraw any amount during the period of contract from his account over and above the initial margin amount. Drawing must be done only if specific instruction is given in question.
Clients can also monitor the rates/contracts quoted in the exchange. They can check the contracts and quotes on the NSE or MCX-SX Web sites. The rates available with the dealer through the exchange terminal would be the same.
Clients can also verify the contracts entered by the dealers on their behalf. Dealers would be sending a contract note to the client within 24 hours of trade. They can then verify trades from the NSE or MCX-SX Web site from ‘Trade Verification’ link to see whether the deals entered into by dealers on his behalf have actually been entered or not.
The following NSE screenshot has been taken from ‘NSE FX Tracker’ screen. This contains information on prevailing price, volume, open interest and other relevant trade statistics for the benefit of market participants.
The following screenshot from Thomson Reuters provides information on live prices, today’s open, high, low, close, volume and open interest.
Screenshot 4.2 Thomson Reuters
As a part of dealing system on exchange, broker at the end of every day provides its clients with a summary of transactions done, brokerage charged and ledger. An illustrative summarized bill and ledger summary is mentioned further. The actual format of each broker may vary.
There is a spot market (cash market) where the transaction for purchase–sale item is against cash for immediate delivery. There is another market called ‘future market’ where the same item is traded for future dated delivery, but the contract will be entered today. The rate, quantity and delivery date will be decided today but actual transaction will be at future date. The item transacted is to be carried for future date. Hence, normally prices in the future market are more than the spot price.
The actual price for future may be different from fair future price:
It provides an opportunity for arbitrage.
The futures contract in GBP/INR for value three months is quoted at 96.50. Prevailing spot rate for GBP/INR is 92. Calculate continuously compounded risk-free rate of interest implied in this contract.
Fair future price = Spot price × er × t = 96.50 = 92 × er × t × 0.25 = 1.04891
er0.25 = 0.04, r = 16 per cent (approx.) therefore, continuously compounded risk-free rate is 16 per cent p.a.
The spot rate of USD/INR is 40. The risk-free rate for the investor is 5 per cent. The three months futures rate is 42. Should an Indian exporter sell USD using three months futures contract?
Fair future price = Spot price × er × t = 40 × e0.05 × 3/12 = 40 × (1.0125) = 40.50
Decision
Actual future price = 42 and Equilibrium or Fair price = 40.50
Since actual future price (INR 42) > Fair future price (INR 40.50)
Future price is overvalued. Under such conditions, he should enter into a contract of selling future at INR 42.
An exporter has hedged USD 1 against INR at 45 for value 30 September 2011. Initial margin money taken by the broker is INR 1 and the exchange follows marked to market policy strictly. Calculate margin requirement for each of the dates below.
Date | Market rate | ITM/ATM/OTM | Amount in INR charged from/passed to the client |
---|---|---|---|
1 August | 44.00 | ITM | – |
3 August | 44.50 | ITM | – |
5 August | 43.00 | ITM | – |
7 August | 45.00 | ATM | – |
9 August | 47.00 | OTM | −1 |
11 August | 48.00 | OTM | −1 |
13 August | 47.00 | OTM | +1 |
15 August | 46.00 | OTM | +1 |
17 August | 44.00 | ITM | – |
19 August | 42.00 | ITM | – |
21 August | 41.00 | ITM | – |
23 August | 43.00 | ITM | – |
25 August | 45.00 | ATM | – |
27 August | 47.00 | OTM | −1 |
29 August | 49.00 | OTM | −2 |
31 August | 42.00 | ITM | +3 |
3 September | 46.00 | OTM | – |
6 September | 47.00 | OTM | −1 |
9 September | 42.00 | ITM | +1 |
12 September | 41.00 | ITM | – |
15 September | 40.00 | ITM | – |
18 September | 42.00 | ITM | – |
21 September | 48.00 | OTM | −2 |
24 September | 42.00 | ITM | +2 |
27 September | 44.00 | ITM | – |
30 September | 43.00 | ITM | – |
An importer has hedged USD 1 payable against INR at 45 for value 30 September 2011. Initial margin taken by the broker is INR 1 and the exchange follows marked to market policy strictly. Calculate margin requirement for each of the following dates.
Date | Market rate | ITM/ATM/OTM | Amount in INR charged from/passed to the client |
---|---|---|---|
1 August | 44.00 | OTM | – |
3 August | 44.50 | OTM | – |
5 August | 43.00 | OTM | −1 |
7 August | 45.00 | ATM | +1 |
9 August | 47.00 | ITM | – |
11 August | 48.00 | ITM | – |
13 August | 47.00 | ITM | – |
15 August | 46.00 | ITM | – |
17 August | 44.00 | OTM | – |
19 August | 42.00 | OTM | −2 |
21 August | 41.00 | OTM | −1 |
23 August | 43.00 | OTM | +2 |
25 August | 45.00 | ATM | +1 |
27 August | 47.00 | ITM | – |
29 August | 49.00 | ITM | – |
31 August | 42.00 | OTM | −2 |
3 September | 46.00 | ITM | +2 |
6 September | 47.00 | ITM | – |
9 September | 42.00 | OTM | −2 |
12 September | 41.00 | OTM | −1 |
15 September | 40.00 | OTM | −1 |
18 September | 42.00 | OTM | +2 |
21 September | 48.00 | ITM | +2 |
24 September | 42.00 | OTM | −2 |
27 September | 44.00 | OTM | +2 |
30 September | 43.00 | OTM | −1 |
The following data relates to the calculated Ltd.’s share price:
Current price per share | INR 180 |
Price per share in future market–six months | INR 195 |
It is possible to borrow money in the market for securities transactions at 12 per cent p.a.
Required:
Fair price of future = Cash price + Cost to carry interest cost
Actual price for six months future transaction = INR 195
(Today’s quotation in future market)
Actual price is not equal to fair price, hence arbitrage is possible.
Actual price is more, hence arbitrager will sell future.
He will buy spot by raising loan.
He will raise a loan of INR 180 and purchase that share in cash market. He sells that share in future market at INR 195 (delivery at six months)
At six months time:
The loan repayment = 180 + 10.80 = 190.80
Sale realization under future sale = INR 195
Net gain = Sale realization − Loan paid = 195 − 190.80 = INR 4.20
The price of XYZ Ltd. stock on 31 December 2010 was INR 220 and the future price of the same stock on the same date, i.e., 31 December 2010 for March 2011 was INR 230. Other features of the contract and related features are as follows:
Time to expiration | Three months (0.25 years) |
Borrowing rate | 15 per cent p.a. |
Annual dividend on the stock | 25 per cent payable before 21 March 2011 |
Calculate theoretical value (fair value) of a future, assuming paid-up value per share is INR 10.
Fair future price = Cash price + Cost to carry − Dividend
Actual future price = 230
Actual future price is more than the fair future price. The person will sell the future by raising loan.
At three months,
Sale value under future | 230 |
Dividend redeemed | 2.50 |
232.50 | |
Less: Loan repayment | 228.25 |
Gain | 4.25 |
Current NIFTY is 1800 and minimum lot is 100. Risk-free rate is 8 per cent p.a. c.c [per annum continuously compounded] and the futures period is three months. What is the fair future value of three months NIFTY futures?
Fair future value = spot price × ert = 1800 × e0.08 × (3/12) = INR 1,836.36
Therefore, fair future value for 100 lots will be 100 × 1,836.36 = 183,636
The shares of Brown and Pages Ltd. are being traded at INR 250 on the BSE. Its futures for one month, two months and three months are also available on the BSE. If the risk-free rate is 12 per cent p.a. and no dividends are expected during this period, what should be the equilibrium price of these futures?
The equilibrium for different futures would be:
One month futures: F = Spot Price × ert = INR 250 × e0.12 × 0.83 = INR 252.50
Two months futures: F = Spot Price × ert = INR 250 × e0.12 × 0.167 = INR 255.05
Three months futures: F = Spot Price × ert = INR 250 × e0.12 × 0.25 = INR 257.61
Working Note: the time period (t) of these futures is one month, two months and three months, i.e. 0.083 years, 0.167 yrs, and 0.25 yrs. The spot price(s) is INR 250 and risk free rate (r) is 12 per cent p.a. c.c.
Determine value of six months future on Y Ltd. Shares from following data:
Current price = INR 80 Dividend (after three months) = INR 3 R = 10 per cent p.a. c.c
Fair future value = (Spot price − Present value of dividend) × ert
Where spot price = 80;
Present value of expected dividend
= Dividend × e–rt = 3 × e0.10 × 6/12 = 3 × 0.975325 = 2.93
Therefore, fair future value
= (80 − 2.93) × e(0.10 × 6/12) = 77.07 × 1.05127 = 81.02
Calculate the price of a six months futures contract on a share which is currently priced at INR 75. The share is expected to pay a INR 2 dividend four months from today. The continuously compounded risk-free rate is 12 per cent per annum. The contract size is 100. If the contract value is INR 7,400 what steps (action) would follow. In case it is INR 7,800 what would you do?
Fair future price = (Spot price − Present value of dividend income) × ert
Working notes: Present value of dividend income
Decision: Actual future price fair future price
AFP | FFP | Valuation | Future market | Spot market |
---|---|---|---|---|
7400 | 7760 | Under | Buy | Sell |
7800 | 7760 | Over | Sell | Buy |
Or decision:
When actual value is INR 7400:
Since actual future value < fair future value, stock is undervalued in the future market.
For arbitrage gain, sell the stock in the spot market, buy it in the future market.
When actual value is INR 7,800:
Since actual future value > fair future value, stock is overvalued in the future market.
For arbitrage gain: buy the stock in the spot market, sell the stock in the future market.
Additional analysis: gain or loss: on expiration, i.e., at the end of six months
Sell the stock in the spot market at INR 7,500 and invest the proceed at risk free
Rate of interest @ 12 per cent c.c for six months and collect at the end of six months
INR 7500 × e0.12 × 6/12 or 7500 × 1.0618, i.e.
Loss on dividend income to be received otherwise
(200 × e2/12 × 0.12 or 200 × e0.02 or 200 × 1.02020)
Purchase stock in the future market as contracted
Gain 359.76
(Here we have assumed that arbitrageur holds 100 shares of the given stock initially)
Repayment including interest @ 12 per cent c.c for borrowing and buying stock in the spot market
(7500 × e0.12 × 6/12 or 7500 × 1.06189)
Dividend to be received on stock purchased
(200 × e2/12 × 0.12 or 200 × e0.02 or 200 × 1.02020)
Sell the stock in the future market as contracted
Gain 40.24
The following data relate to Anant Ltd.’s share:
Current price share | INR 1,800 |
Six months future’s price/share | INR 1,950 |
Assuming it is possible to borrow money in the market for transactions in securities at 12 per cent per annum, you are required to calculate the theoretical minimum price of a six months forward purchase.
Calculation of theoretical minimum price of a six months forward contract.
Theoretical minimum price = INR 1,800 + (INR 1,800 × 12/100 × 6/12) = INR 1,908
The settlement price of December Nifty futures contract has been provided below. The broker requires initial margin of 8 per cent and maintenance margin of 6 per cent on the deal. The index closed at the following levels on the next five days.
Days | 1 | 2 | 3 | 4 | 5 |
---|---|---|---|---|---|
Closing price | 1,340 | 1,360 | 1,300 | 1,280 | 130 |
Initial Margin (IM) = INR 10,480 (1310 × 100 × 0.08)
Maintenance Margin (MM) = INR 7,860 (1310 × 100 × 0.06)
Note: Initial margin and maintenance margin are same for both long and short positions
Day | Settlement price | Opening balance | Mark-to-market C/F | Deposit | Closing balance |
---|---|---|---|---|---|
1 | 1340 | 10480 | +3000 | 13480 | |
2 | 1360 | 13480 | +2000 | 15480 | |
3 | 1300 | 15480 | −6000 | 9480 | |
4 | 1280 | 9480 | −2000 | 3000 | 10480 |
5 | 1305 | 10480 | +2500 | 12980 |
Net profit on the contract = 3000 + 2000 − 6000 − 2000 + 2500
Additional analysis:
Why has margin call of INR 3,000 been made at the end of Day 4?
At the end of day 4, the balance falls below maintenance margin of INR 7860, i.e., it falls to
Whatever balance falls below maintenance margin, one has to maintain the balance up to the initial margin.
Hence, margin call of INR 3,000 (10,480 − 7,480) has been made.
Day | Settlement price | Opening balance | Mark-to-market C/F | Deposit | Closing balance |
---|---|---|---|---|---|
1 | 1340 | 10480 | +3000 | 3000 | 10480 |
2 | 1360 | 10480 | −2000 | 8480 | |
3 | 1300 | 8480 | +6000 | 14480 | |
4 | 1280 | 14480 | +2000 | 16480 | |
5 | 1305 | 16480 | −2500 | 13980 |
Net profit (loss) on the contract: −3000 − 2000 + 6000 + 2000 − 2500 = 500
Or simply (1310 − 1305) × 100 = 500
Time to expiration | Three months (0.25 years) |
Borrowing rate | 15 per cent p.a. |
Calculate theoretical value (fair value) of the future of the currency pair.
Date | Market rate | In the money/Out of money/At the money | Remarks |
---|---|---|---|
5 June | 44.75 | ||
8 June | 45.00 | ||
14 June | 45.15 | ||
17 June | 44.55 | ||
21 June | 44.65 | ||
23 June | 44.35 | ||
25 June | 44 | ||
27 June | 44.15 | ||
30 June | 44.50 |
Answer the following questions:
(Assume no initial margin being taken for calculation purposes)
Date | Market rate | In the money/Out of money/At the money | Remarks |
---|---|---|---|
5 June | 44.75 | ||
8 June | 46.00 | ||
14 June | 46.15 | ||
17 June | 45.55 | ||
21 June | 45.65 | ||
23 June | 45.35 | ||
25 June | 45 | ||
27 June | 45.15 | ||
30 June | 45.50 |
Answer the following questions:
(Assume no initial margin being taken for calculation purposes)
Date | Market rate | ITM/ATM/OTM | Amount in INR charged from/passed to the client |
---|---|---|---|
1 August | 44.00 | ||
3 August | 44.50 | ||
5 August | 43.00 | ||
7 August | 45.00 | ||
9 August | 47.00 | ||
11 August | 48.00 | ||
13 August | 47.00 | ||
15 August | 46.00 | ||
17 August | 44.00 | ||
19 August | 42.00 | ||
21 August | 41.00 | ||
23 August | 43.00 | ||
25 August | 45.00 | ||
27 August | 47.00 | ||
29 August | 49.00 | ||
31 August | 42.00 | ||
3 September | 46.00 | ||
6 September | 47.00 | ||
9 September | 42.00 | ||
12 September | 41.00 | ||
15 September | 40.00 | ||
18 September | 42.00 | ||
21 September | 48.00 | ||
24 September | 42.00 | ||
27 September | 44.00 | ||
30 September | 43.00 |
Date | Market rate | ITM/ATM/OTM | Amount in INR charged from/passed to the client |
---|---|---|---|
1 August | 44.00 | ||
3 August | 44.50 | ||
5 August | 43.00 | ||
7 August | 45.00 | ||
9 August | 47.00 | ||
11 August | 48.00 | ||
13 August | 47.00 | ||
15 August | 46.00 | ||
17 August | 44.00 | ||
19 August | 42.00 | ||
21 August | 41.00 | ||
23 August | 43.00 | ||
25 August | 45.00 | ||
27 August | 47.00 | ||
29 August | 49.00 | ||
31 August | 42.00 | ||
3 September | 46.00 | ||
6 September | 47.00 | ||
9 September | 42.00 | ||
12 September | 41.00 | ||
15 September | 40.00 | ||
18 September | 42.00 | ||
21 September | 48.00 | ||
24 September | 42.00 | ||
27 September | 44.00 | ||
30 September | 43.00 |
Current price per share | INR 160 |
Price per share in the future market—six months | INR 168 |
Dividend per share at six months time | INR 2.50 |
It is possible to borrow money in the market for securities transactions @ 12 per cent p.a.
Date | : Spot |
Cash BSE Sensex 30 | : INR 5, 750 |
Interest rate | : 6 per cent p.a. (not compounded continuously) |
Dividend yield | : 4 per cent p.a. (not compounded continuously) |
Days till expiry | : 91 |
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