Currency Derivatives Trading
Currency derivatives refer to Future and Options contracts that can buy or sell specific quantity of a currency pair at a particular rate on a future date. These derivatives are similar to the Stock Futures and Options trades but here the underlying asset being traded is a currency pair like USD/INR or JPY/INR or GBP/INR or EUR/INR and not stocks. A Currency Futures Contract differs from a Forward Contract since the latter is an over the counter product while the former is an agreement to buy or sell a currency pair at a specific price on a specific but pre determined date. Currency Futures contracts have several advantages over the Forward Contracts. These are Price transparency as you know in advance about the price at which the transaction will take place.
No chances of counter-party credit risk.
Currency derivative trading is carried out on the trading system of USE, MCX SX and NSE called the NEAT-CDS or the National exchange for Automated Trading- Currency Derivatives Segment trading system. This system offers a fully automated screen based trading system for currency futures as well as online monitoring. Trading in currency derivatives is possible after a trade account is opened and the stipulated funds or collaterals are deposited with the trading member of an exchange trading in currency derivatives. The clearing and settlement of all currency derivatives trade executed on NSE is done by the National Securities Clearing Corporation Limited or NSCCL. The organization also acts as a legal counter party to all currency derivatives trade and thus guarantees their financial settlement.
Currency Futures Merits
Trading in currency futures is a highly lucrative option and offers several advantages over other forms of currency trade.
Low brokerage charges are a key highlight of this type of forex trading. The presence of large number of players in the market allows the brokers to earn adequate fees without charging hefty fees.
Futures and Options trading provide investors an opportunity to trade directly on the platform of a currency exchange.
Fixed lot or contract sizes as determined by the exchanges.
Under normal market conditions the retail transaction cost is less than 0.1%.
The market is highly liquid and thus transactions are carried out instantaneously.
You can trade in currency futures through your online account while sitting at home or office or anywhere else.
The exchange rates are not influenced by a single factor or authority because of the presence of so many players.
Trading in currency options contracts is very simple if you are aware about the various features and rules governing this type of trading. All currency option contracts have three basic characteristics: the exercise price, the expiration date and time to expiration. The exercise price is also called the fixed price or the strike price and refers to the price at which the holder of the contract can buy or sell the underlying currency pair. The expiration date is the final date by which the contract holder has to exercise her right to buy or sell the underlying currency pair.
The main features of standard exchange traded currency options in India are:
The underlying currency for a currency option is USD/INR spot rate.
The options are basically European style call and put options.
The contract size is U$1000. While the premium is quote in terms of the Indian rupee, the outstanding position is mentioned in terms of US dollar.
The term of these contract is 12 months or less.
All these contracts are to be settled in cash in Indian rupees.
The settlement price for these contracts is the Reserve Bank of India’s reference rate on the date of expiry of the contracts.
As we know, currency options are derivatives that give the holder the right but not the obligation to buy or sell a currency pair at a pre-agreed exchange rate (strike price) on a specified date. We need to be aware about certain key terms for understanding the pricing of currency options. These include the spot price which is the price of the asset at the time of the trade and the forward price which is the price of the asset for delivery at a future time. Investors should also know that a call option gives the holder the right to buy while a put option gives the holder the right to sell. Each transaction involves sale of one currency and purchase of another.
The various factors which influence the pricing of currency options are:
The Exchange Rate- As the exchange rate of a currency pair increases the call premium also increases. The put premium, however, decreases in such a scenario.
The Strike Price or the Pre-Decided Price- An increase in the strike rate leads to a decline in the call premium and a increase in put premium.
Interest Rates – Increased interest rates lead to increase in the value of call option and decrease in the value of Put option.
The Time to Maturity- This is a very important factor and as the time to maturity increases the call the put options become more valuable.
Volatility in the Forex Market- Increased volatility means high uncertainty about the movement of exchange rates and thus the option contract. Higher interest rates benefit the owner of a call option while a decline in interest rate is beneficial to the owner of a put option.
Investors need to have an adequate understanding about the various options strategies if they wish to maximize their returns and limit their risk. Traders and investors need to learn the techniques of using options as a trading vehicle. They need to identify whether to buy or sell a call option or a put option.
There are two types of traders:
Traders who have a long directions view on currency- Such traders hope to benefit from the increase in the price of the currency pair held by them. These traders should opt for purchase of a call option or sale of a put option.
Traders who have a Short directional view on a currency. Such traders hope to benefit from the decline in the value of currency pair owned by them. These traders should sell a call option or choose to buy a put option.
The downside risk on purchase of call or put options is limited to the amount of premium paid but the upside is unlimited. In contrast the downside risk in transactions involving sale of call or put options is unlimited while the upside potential is limited to the premium amount. Example 1: Say if an importer from India enters into a contract to import 1000 barrels of oil, the payment for which is to be made in USD on December 1, 2012. Also the price of each barrel of oil has been fixed up at USD 100 per barrel at the prevailing exchange rate of 1USD=INR 40. In such a case the cost of one barrel is Rs 4000. Now if the importer faces the risk of the strengthening of the USD in the next few months and thus increased cost of oil in terms of INR.
Currency Option Merits Currency Options are contracts that grant the holder the right but not the obligation to buy or sell a currency pair at a pre-specified exchange rate on a specific date. For acquiring this right, the holder pays a premium or fees to the broker. These currency options are one of the best methods for individuals as well as organizations to hedge against the adverse movements in exchange rates. For example an investor who believes that USD/INR rate is going to increase may buy a call option on USD/INR so that he/she can benefit from an increase in the value of the USD. Currency Options are highly advantageous for: businesses having an international exposure. importers and exporters as they allow them to deal with the changing currency prices. By offering protection against currency changes, these options allow businesses to enter into a level playing field with their international counterparts. These options are highly useful for companies bidding for international projects. Use of currency options allows them to hedge against the possible changes in the currency rates or uncertainty related to one’s cash flows.
|Underlying||US dollars-Indian Rupee||Euro-Indian Rupee||Pound Sterling-Indian Rupee||Japanese Yen-Indian Rupee|
|Contract size||USD 1000||EUR 1000||GBP 1000||JPY YEN 100000|
|Tick Size||Rs 0.0025|
|Expiry Day||Last working day of the month|
|Trading Cycle||12 months trading cycle|
|Last Trading Day||Two working days prior to the last business day of the expiry month at 12 noon|
|Settlement Basis||Daily Mark to Market settlement will be on a T+1 basis and Final settlement will be cash settled on T+2 basis.|
|Settlement price||Daily mark to market settlement price will be the closing price of the futures contracts for the trading day and final settlement price shall be the RBI reference rate fixed by RBI two working days prior to the final settlement date.|
|Final Settlement||Last working day (excluding Saturdays) of the expiry month|
|Size of Contract||1 contract is for 1000 USD (Lot size)|
|Underlying||US Dollar - Indian Rupee spot rate|
|Quotation||Premium in Rupee terms. Outstanding position in USD terms|
|Type of option||Premium styled European Call and Put options|
|QTick size||0.25 paisa or INR 0.0025|
|Trading hours||Monday to Friday ( 9:00 a.m. to 5:00 p.m. )|
|Available contracts||Three serial monthly contracts followed by three quarterly contracts of the cycle March/June/September/December|
|Last trading day||Two working days prior to the last business day of the expiry month at 12 noon.|
|Strike price||Minimum of twelve in-the-money, twelve out-of the-money and one near-the-money strikes would be provided for all available contracts|
|Strike interval||25 paise or INR 0.25|
|Final settlement day||Last working day (excluding Saturdays) of the expiry month. The last working day would be taken to be the same as that for Interbank Settlements in Mumbai. The rules for Interbank Settlements, including those for ‘known holidays’ and ‘subsequently declared holiday’ would be those as laid down by FEDAI.|
|Exercise at Expiry||On expiry date, all open long in-the-money contracts, on a particular strike of a series, at the close of trading hours would be automatically exercised at the final settlement price and assigned on a random basis to the open short positions of the same strike and series|
|Initial margin||The Initial Margin requirement would be based on a worst scenario loss of a portfolio of an individual client comprising his positions in options and futures contracts on the same underlying across different maturities and across various scenarios of price and volatility changes. In order to achieve this, the price range for generating the scenarios would be 3.5 standard deviation and volatility range for generating the scenarios would be 3%. The sigma would be calculated using the methodology specified for currency futures in SEBI circular no. SEBI/DNPD/Cir-38/2008 dated August 06, 2008 and would be the standard deviation of daily logarithmic returns of USD-INR futures price. For the purpose of calculation of option values, Black-Scholes pricing model would be used. The initial margin would be deducted from the liquid net worth of the clearing member on an online, real time basis.|
|Extreme loss margin||Extreme loss margin equal to 1.5% of the Notional Value of the open short option position would be deducted from the liquid assets of the clearing member on an on line, real time basis. Notional Value would be calculated on the basis of the latest available Reserve Bank Reference Rate for USD-INR|
|Calendar spreads||A long currency option position at one maturity and a short option position at a different maturity in the same series, both having the same strike price would be treated as a calendar spread. The margin for options calendar spread would be the same as specified for USD-INR currency futures calendar spread. The margin would be calculated on the basis of delta of the portfolio in each month. A portfolio consisting of a near month option with a delta of 100 and a far month option with a delta of – 100 would bear a spread charge equal to the spread charge for a portfolio which is long 100 near month currency futures and short 100 far month currency futures.|