11 Financial Derivatives

2 5. Currency Future i.It is a Financial Contract to Buy or Sell the underlying Currency, the price of which (Currency Future) is agreed today for settlement at a specified future date. Since currency future are Exchange Traded products hence it is settled on daily basis till last trading day of the contract.

3 ii. Operational Issues : a)Currently there are four types of Currency future available in India. USD INR GBP INR EUR INR JPY INR b)Chicago Merchantile Exchange is the largest exchange for currency future products. The trading currency (or price currency) of such products are USD. Trading or Price Currency = INR Underlying or Base Currency = Foreign Currency

4 c)Features about USD INR Currency Future : Only Cash Settlement is Allowed Underlying Currency : USD Trading Currency : INR Contract Size : USD 1000 Contract Cycle : 12 consecutive month contract Expiry Date : Last Working day of the month Last Trading Day : 2 days before Contract Expiry date Settlement Basis : T + 1 except the last settlement which is settled at T + 2 T = Transaction Day Tick Size :.25 paisa or.0025 Rs Minimum price movement allowed in currency future price

5 d) Types of MARGIN required for Currency Future Initial Margin M-T-M Margin Mark to Market or Variation Margin Contract Life 2 Working Day t = 0 t = 1 t = 2 Entering into Contract. IM is required Last Trading Day Contract Expiry Day

6 Buyers or Sellers of Currency Future would pay Initial Margin ( Security Deposit) at the time of entering into contract. After that, on daily basis Settlement will take place and the settlement amount is called MTM. From t = 0 to t = 1 MTM is settled on T + 1 basis except the MTM of last trading day ( t = 1) which is settled at T + 2 On Daily Basis, the Exchange declares a price for settlement and this price is called DSP ( Daily Settlement Price) and the last day settlement price is called FSP (Final Settlement Price).

7 DSP = If is calculated (by the exchange) by taking weighted Average of Future Prices during last half an hour of the trading. FSP = It is the reference rate declared by RBI at t = 1. This is always SPOT Rate. Collection of Initial margin is either in Cash or in Liquid Assets ( MF, Bonds) specified by the exchange. Settlement of MTM is always in Cash

8 How IM is decided by the Exchange ? It is calculated in such a way so that maximum loss for One day is covered in Normal Market Conditions. To cover 99 % VAR (Value at Risk) Over 1 day horizon. Calculation of MTM and FSP D1 D2 D3 D4 D5 t = 0 t = 1 Entered into Currency Last Trading Day Future Contract at FSP Contracted Price

9 MTM 1 = DSP 1 - Contracted Price MTM 2 = DSP 2 - DSP 1 MTM 3 = DSP 3 - DSP 2 MTM 4 = DSP 4 - DSP 3 MTM 5 = FSP - DSP 4 The alternate way to calculate total profit is to count all day MTM during the life of Contract. In case currency Future existing position is cancelled out (Closed out) before the last trading. The Profit / Loss (Short Cut) would be different in Exit Price & Contract Price. Settlement on T + 1 Settlement on T + 2 Shortcut = FSP - Contract PriceTotal Profit / Loss

10 In Practice IM is given in Liquid Assets form ( Like Fixed Deposit, Mutual Funds, Shares etc) It is paid more than required by the Exchage the market check. The market check IM on real time basis hence sufficient of IM is necessary. In Exam if nothing is given in question we can assume that IM is sufficient at all time and then calculate only MTM.

11 Introduction of Maintenance Margin Money Can be taken away by customer No Margin Call Margin Call Upper Limit Initial Margin ( IM ) Lower Limit Maintenance Margin ( IM ) No Margin call : It is the limit within which a limit is fixed when the customer will not be asked for any margin call. As soon as the limit fall more than Maintenance Margin he is required to refill the limit. Maintenance Margin is always Set below Initial Margin.

12 Spread Margin We can create spread position in future market by either : Buying for t = 1 and simultaneously Selling for t = 2 Or Selling for t = 1 and simultaneously Buying for t = 2 The Underlying for the future contract should be the Same.

13 How to Hedge Forex Risk Using Currency Future ? Adopt Strategies similar to Forward Contract at t = 0 and cancel out the contract at t = 1 (Date on which asset or liability is to be settled). Since Future allows only Cash Settlement. Exporter: Spot Position (Normal Purchase or Sale) Record Asset Short (sale) t = 0 t = 1 t = 2 Currency Future Short (sale) Long (Buy) Cancel out Future Contract Expiry Date

14 Tick Size & Tick Value Minimum price movement allowed. [That is up & down in the price of derivative allowed by the exchange] Currency Future For $ denominated currency option & Currency Option Future (unless otherwise given).0025 Rs.0001 $ = 1 Pip Tick Value = Tick Size × Contract Size For 1 tick movement how much profit or loss can be made per contract. E.g. USD INR Future =.0025 × 1000 = 2.5 Rs