Currency Derivatives Workbook PDF - NISM Series I

1  Workbook for NISM-Series-I: Currency Derivatives Certification Examination National Institute of Securities Markets www.nism.ac.in 2 This workbook has been developed t...

1  Workbook for NISM-Series-I: Currency Derivatives Certification Examination National Institute of Securities Markets www.nism.ac.in 2 This workbook has been developed to assist candidates in preparing for the National Institute of Securities Markets (NISM) NISM-Series-I: Currency Derivatives Certification Examination (NISM-Series-I: CD Examination). Workbook Version: September 2022 Published by: National Institute of Securities Markets © National Institute of Securities Markets, 2022 5th Floor, NCL Co-operative Society, Plot No. C - 6, E - Block, Bandra Kurla Complex, Bandra (East), Mumbai - 400051 National Institute of Securities Markets Patalganga Campus Plot IS-1 & IS-2, Patalganga Industrial Area Village Mohopada (Wasambe) Taluka-Khalapur District Raigad-410222 Website: www.nism.ac.in All rights reserved. Reproduction of this publication in any form without prior permission of the publishers is strictly prohibited. 3  Foreword NISM is a leading provider of high end professional education, certifications, training and research in financial markets. NISM engages in capacity building among stakeholders in the securities markets through professional education, financial literacy, enhancing governance standards and fostering policy research. NISM works closely with all financial sector regulators in the area of financial education. NISM Certification programs aim to enhance the quality and standards of professionals employed in various segments of the financial services sector. NISM’s School for Certification of Intermediaries (SCI) develops and conducts certification examinations and Continuing Professional Education (CPE) programs that aim to ensure that professionals meet the defined minimum common knowledge benchmark for various critical market functions. NISM certification examinations and educational programs cater to different segments of intermediaries focusing on varied product lines and functional areas. NISM Certifications have established knowledge benchmarks for various market products and functions such as Equities, Mutual Funds, Derivatives, Compliance, Operations, Advisory and Research. NISM certification examinations and training programs provide a structured learning plan and career path to students and job aspirants who wish to make a professional career in the Securities markets. Till March 2022, NISM has certified nearly 15 lakh individuals through its Certification Examinations and CPE Programs. NISM supports candidates by providing lucid and focused workbooks that assist them in understanding the subject and preparing for NISM Examinations. The book covers basics of the currency derivatives, trading strategies using currency futures and currency options, clearing, settlement and risk management as well as the regulatory environment in which the currency derivatives markets operate in India. It will be immensely useful to all those who want to have a better understanding of various derivatives products available in the exchange-traded currency derivatives markets in India. Dr. C.K.G.Nair Director 4 Disclaimer The contents of this publication do not necessarily constitute or imply its endorsement, recommendation, or favoring by the National Institute of Securities Markets (NISM) or the Securities and Exchange Board of India (SEBI). This publication is meant for general reading and educational purpose only. The statements/explanations/concepts are of general nature and may not have taken into account the particular objective/ move/ aim/ need/ circumstances of individual user/ reader/ organization/ institute. Thus, NISM and SEBI do not assume any responsibility for any wrong move or action taken based on the information available in this publication. Therefore, before acting on or following the steps suggested on any theme or before following any recommendation given in this publication user/reader should consider/seek professional advice. The publication contains information, statements, opinions, statistics and materials that have been obtained from sources believed to be reliable and the publishers of this title have made best efforts to avoid any errors. However, publishers of this material offer no guarantees and warranties of any kind to the readers/users of the information contained in this publication. Since the work and research is still going on in all these knowledge streams, NISM and SEBI do not warrant the totality and absolute accuracy, adequacy or completeness of this information and material and expressly disclaim any liability for errors or omissions in this information and material herein. NISM and SEBI do not accept any legal liability whatsoever based on any information contained herein. While the NISM Certification examination will be largely based on material in this workbook, NISM does not guarantee that all questions in the examination will be from material covered herein. Acknowledgement This workbook has been jointly developed by the Certification Team of National Institute of Securities Markets and Mr. Amit Singhal of Cube Edugains Pvt. Ltd. and this version of the workbook has been reviewed by Mr. Sunil Gawde, NISM Empanelled Resource Person NISM gratefully acknowledges the contribution of the Examination Committee for NISM- Series-I: Currency Derivatives Certification Examination consisting of representatives of the currency derivatives exchanges and industry experts. 5 About NISM Certifications The School for Certification of Intermediaries (SCI) at NISM is engaged in developing and administering Certification Examinations and CPE Programs for professionals employed in various segments of the Indian securities markets. These Certifications and CPE Programs are being developed and administered by NISM as mandated under Securities and Exchange Board of India (Certification of Associated Persons in the Securities Markets) Regulations, 2007. The skills, expertise and ethics of professionals in the securities markets are crucial in providing effective intermediation to investors and in increasing the investor confidence in market systems and processes. The School for Certification of Intermediaries (SCI) seeks to ensure that market intermediaries meet defined minimum common benchmark of required functional knowledge through Certification Examinations and Continuing Professional Education Programmes on Mutual Funds, Equities, Derivatives Securities Operations, Compliance, Research Analysis, Investment Advice and many more. Certification creates quality market professionals and catalyzes greater investor participation in the markets. Certification also provides structured career paths to students and job aspirants in the securities markets. About the NISM-Series-I: Currency Derivatives Certification Examination The examination seeks to create a common minimum knowledge benchmark for persons working in the currency derivative segment, in order to enable a better understanding of currency markets and exchange traded currency derivatives products, better quality investor service, operational process efficiency and risk controls. Examination Objectives On successful completion of the examination the candidate should: Know the basics of currency markets and specifically Exchange Traded Currency Derivatives markets. Understand the trading, clearing and settlement mechanisms related to Exchange Traded Currency Derivatives markets and basic investment strategies that use currency futures and options products. Know the regulatory environment in which the Exchange Traded Currency Derivatives markets operate in India. Assessment Structure The NISM-Series-I: Currency Derivatives Certification Examination (NISM-Series-I: CD Examination) will be of 100 marks consisting of 100 questions of 1 mark each and should be completed in 2 hours. There will be negative marking of 25% of the marks assigned to each question. The passing score for the examination is 60%. How to register and take the examination To find out more and register for the examination please visit www.nism.ac.in 6 Important  Please note that the Test Centre workstations are equipped with either Microsoft Excel or Open Office Calc. Therefore, candidates are advised to be well versed with both of these softwares for computation of numericals.  The sample questions and the examples discussed in the workbook are for reference purposes only. The level of difficulty may vary in the actual examination. 7  This page has been intentionally kept blank 8 Table of Contents Chapter 1: Introduction to Currency Markets............................................................ 13 1.1 Brief History of Foreign Exchange Markets................................................................ 13 1.2 Major Currencies and Currency Pairs......................................................................... 15 1.3 Basics of Currency Markets and Peculiarities in India................................................ 20 1.4 Exchange Rate Arithmetic- Cross Rate........................................................................ 30 1.5 Impact of Economic Factors on Currency Prices........................................................ 31 1.6 Economic Indicators.................................................................................................... 33 Chapter 2: Foreign Exchange Derivatives................................................................... 35 2.1 Derivatives - Definition............................................................................................... 35 2.2 Key Economic Functions of Derivatives...................................................................... 36 2.3 Derivative Products..................................................................................................... 37 2.4 Growth Drivers of Derivatives..................................................................................... 42 2.5 Market Participants in Currency Derivatives Market................................................. 43 2.6 Exchange-Traded Derivatives vs. OTC Derivatives...................................................... 44 2.7 Rationale for Introducing Exchange Traded Currency Derivatives in India................ 46 Chapter 3: Exchange Traded Currency Futures........................................................... 48 3.1 Currency Futures - Definition...................................................................................... 48 3.2 Pay Off Charts of Futures Contract............................................................................. 52 3.3 Contract Specification of Exchange Traded Currency Futures Contracts................... 54 3.4 Contract Value............................................................................................................ 57 3.5 Advantages and Limitations of Future Contracts in Comparison to Forward............ 59 3.6 Interest Rate Parity and Pricing of Currency Futures................................................. 61 Chapter 4: Exchange Traded Currency Options.......................................................... 65 4.1 Basics of Options......................................................................................................... 65 4.2 Difference between Futures and Options.................................................................. 66 4.3 Style of Options........................................................................................................... 67 4.4 Moneyness of an Option............................................................................................. 67 4.5 Basics of Option Pricing and Options Greeks.............................................................. 68 4.6 Option Pricing Methodology....................................................................................... 75 4.7 Implied Volatility (IV)............................................................................................... 77 4.8 Pay off Diagrams for Options.................................................................................. 78 9 4.9 Contract Specification of Exchange Traded Currency Options............................... 86 4.10 Comparison of Exchange Traded Currency Option and OTC Currency Option....... 89 Chapter 5: Strategies Using Exchange Traded Currency Derivatives............................ 92 5.1 Market Participants................................................................................................. 92 5.2 Hedging Through Exchange Traded Currency Derivatives......................................... 95 5.3 Option Trading Strategies......................................................................................... 100 5.4 Use of Currency Derivatives by Speculators.......................................................... 119 5.5 Use of Currency Derivatives by Arbitragers.............................................................. 121 5.6 Trading Spread Using ETCD....................................................................................... 123 5.7 Limitation of Exchange Traded Currency Derivatives for Hedgers........................... 124 Chapter 6: Trading Mechanism in Exchange Traded Currency Derivatives................ 125 6.1 List of Entities in Trading System.............................................................................. 125 6.2 Exchange Trading System......................................................................................... 127 6.3 Order Management.................................................................................................. 135 6.4 Risk Management and Order Routing...................................................................... 141 6.5 Price Limit Circuit Filter............................................................................................. 145 6.6 Trading Cost.............................................................................................................. 146 Chapter 7: Clearing, Settlement and Risk Management in Exchange Traded Currency Derivatives............................................................................................................. 148 7.1 Clearing and Settlement Mechanism........................................................................ 148 7.2 List of Entities in Clearing and Settlement of ETCD.................................................. 149 7.3 Interoperability of Clearing Corporation.................................................................. 151 7.4 Clearing Mechanism................................................................................................. 153 7.5 Determination of Settlement Obligation.............................................................. 154 7.6 Position Limits....................................................................................................... 156 7.7 Settlement............................................................................................................. 160 7.8 Fund Settlement.................................................................................................... 163 7.9 Risk Management.................................................................................................. 164 7.10 Margin Collection by Clearing Corporation........................................................... 173 7.11 Core Settlement Guarantee Fund......................................................................... 178 Chapter 8: Regulatory Framework for Exchange Traded Currency Derivatives.......... 182 8.1 Securities Contracts (Regulation) Act, 1956 [SC(R)A]............................................ 183 10 8.2 RBI-SEBI Standing Technical Committee on Exchange Traded Currency and Interest Rate Derivatives.............................................................................................................. 184 8.3 Foreign Exchange Management Act, 1999............................................................ 185 8.4 SEBI Regulation and Guideline.............................................................................. 186 8.5 RBI Regulation and Guideline................................................................................ 188 8.6 Regulatory Guideline on Participation of Various Entities in ETCD...................... 191 8.7 Eligibility Criteria for Members............................................................................. 194 Chapter 9: Accounting and Taxation........................................................................ 201 9.1 Accounting Guideline and Disclosure Requirements............................................... 201 9.2 Taxation of Exchange Traded Currency Derivatives:................................................ 211 Chapter 10: Code of Conduct and Investor Protection Measure............................... 214 10.1 SEBI’s Code of Conduct for Brokers....................................................................... 214 10.2 Investor Grievance................................................................................................. 216 10.3 Investor Protection Fund....................................................................................... 225 10.4 Arbitration............................................................................................................. 226 10.5 Execution of Power of Attorney (PoA) by the Client in favour of the Stock Broker / Stock Broker and Depository Participant........................................................................ 231 10.6 Risk Disclosure to Client and KYC.......................................................................... 232 Appendix A: Sample Questions............................................................................... 240 11  This page has been intentionally kept blank 12 Chapter 1: Introduction to Currency Markets LEARNING OBJECTIVES: After studying this chapter, you should know about:  History of foreign exchange markets and overview of international currency markets  Major currency pairs in forex trading  Basics of currency markets Peculiarities in India  Exchange rate arithmetic  Economic indicators and its impact on currency markets 1.1 Brief History of Foreign Exchange Markets The current currency rate mechanism has evolved over thousands of years of the world community trying with various mechanism of facilitating the trade of goods and services. Initially, the trading of goods and services was by barter system where in goods were exchanged for each other. For example, a farmer would exchange wheat grown on his farmland with cotton with another farmer. Such system had its difficulties primarily because of non-divisibility of certain goods, cost in transporting such goods for trading and difficulty in valuing of services. For example, how does a dairy farmer exchange his cattle for few liters of edible oil or one kilogram of salt? The farmer has no way to divide the cattle! Similarly, suppose wheat is grown in one part of a country and sugar is grown in another part of the country, the farmer has to travel long distances every time he has to exchange wheat for sugar. Therefore, the need to have a common medium of exchange resulted in the innovation of money. People tried various commodities as the medium of exchange ranging from food items to metals. Gradually metals became more prominent medium of exchange because of their ease of transportation, divisibility, certainty of quality and universal acceptance. People started using metal coins as medium of exchange. Amongst metals, gold and silver coins were most prominent and finally gold coins became the standard means of exchange. The process of evolution of medium of exchange further progressed into development of paper currency. People would deposit gold/ silver coins with bank and get a paper promising that value of that paper at any point of time would be equal to certain number of gold coins. This system of book entry of coins against paper was the start of paper currency. With time, countries started trading across borders as they realized that everything cannot be produced in each country or cost of production of certain goods is cheaper in certain countries than others. The growth in international trade resulted in evolution of foreign exchange (FX) i.e., value of one currency of one country versus value of currency of other country. Each country has its own “brand” alongside its flag. When money is branded, it is called “currency”. Whenever there is a cross-border trade, there is need to 13 exchange one brand of money for another, and this exchange of two currencies is called “foreign exchange” or simply “forex” (FX). The smooth functioning of international trade required a universally accepted foreign currency to settle the internal trade and a way to balance the trade imbalances amongst countries. This led to the question of determining relative value of two currencies. Different systems were tried in past to arrive at relative value of two currencies. The documented history suggests that sometime in 1870 countries agreed to value their currencies against value of currency of other country using gold as the benchmark for valuation. As per this process, central banks issue paper currency and hold equivalent amount of gold in their reserve. The value of each currency against another currency was derived from gold exchange rate. For example, if one unit of gold is valued at Indian Rupees (INR) 10,000 and US dollar (USD) 500 than the exchange rate of INR versus USD would be 1 USD = INR 20. This mechanism of valuing currency was called as gold standard. With further growth in international trade, changing political situations (world wars, civil wars, etc.) and situations of deficit/ surplus on trade account forced countries to shift from gold standard to floating exchange rates. In the floating exchange regime, central bank’s intervention was a popular tool to manage the value of currency to maintain the trade competitiveness of the country. Central bank would either buy or sell the local currency depending on the desired direction and value of local currency. Fiat money is a government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it. The value of fiat money is derived from the relationship between supply and demand and the stability of the issuing government, rather than the worth of a commodity backing it. Most modern paper currencies are fiat currencies, including the U.S. dollar, the euro, and other major global currencies. The gold standard is not currently used by any government. Britain stopped using the gold standard in 1931 and the U.S. followed suit in 1933 and abandoned the remnants of the system in 1973. The gold standard was completely replaced by fiat money, a term to describe currency that is used because of a government's order, or fiat, that the currency must be accepted as a means of payment. In the U.S., for instance, the US dollar is fiat money, and for India, it is the Indian rupee. During 1944-1971, countries adopted a system called Bretton Woods System. This system was a blend of gold standard system and floating rate system. As part of the system, all currencies were pegged to USD at a fixed rate and USD value was pegged to gold. The US guaranteed to other central banks that they can convert their currency into USD at any time and USD value will be pegged to value of gold. Countries also agreed to maintain the exchange rate in the range of plus or minus 1% of the fixed parity with US dollar. With adoption of this system, USD became the dominant currency of the world. The Bretton Woods Agreement remains a significant event in world financial history. The two Bretton Woods Institutions it created in the International Monetary Fund and the World Bank played an important part in helping to rebuild Europe in the aftermath of World War II. By 1973 the Bretton Woods System had collapsed. Countries were then free to choose any exchange arrangement for their currency, except pegging its value to the price of 14 gold. They could, for example, link its value to another country's currency, or a basket of currencies, or simply let it float freely and allow market forces to determine its value relative to other countries' currencies. Hence, there was the need of a market where the exchange rates will be determined on a real time basis based on the information flowing through the markets. Since the Forex market was where currencies have always been exchanged, it was well poised to take up this role. The Forex market therefore came into prominence when the world went off the gold standard. This is because during the gold standard, there were no exchange rates to determine! It is only after gold was removed as the common denominator between currencies that all of them became freely floating and there was a need to value them against one another. Developed countries gradually moved to a market determined exchange rate (For e.g. USD, EUR, JPY etc.) and developing countries adopted either a system of pegged currency or a system of managed rate. In pegged system, the value of currency is pegged to another currency or a basket of currencies. The benefit of pegged currency is that it creates an environment of stability for foreign investors as they know the value of their investment in the country at any point of time would be fixed. Although in long run it is difficult to maintain the peg and ultimately the central bank may change the value of peg or move to a managed float or free float. In managed float, countries have controls on flow of capital and central bank intervention is a common tool to contain sharp volatility and direction of currency movement. A clean float, also known as a pure exchange rate, occurs when the value of a currency, or its exchange rate, is determined purely by supply and demand in the market. A clean float is the opposite of a dirty float (also known as managed float), which occurs when government rules or laws affect the pricing of currency. A dirty float (managed float) is an exchange rate regime in which the exchange rate is neither entirely free (or floating) nor fixed. Most countries intervene from time to time to influence the price of their currency in what is known as a managed float system. For example, a central bank might let its currency float between an upper and lower price boundary. If the price moves beyond these limits, the central bank may buy or sell large lots of currency in an attempt to rein in the price. For e.g. If domestic currency quickly depreciates against USD, central bank may sell dollar and buy local currency. 1.2 Major Currencies and Currency Pairs A currency pair is the dynamic quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market. Currency quotations use the abbreviations for currencies that are prescribed by the International Organization for Standardization (ISO) in standard ISO 4217. ISO currency codes are the three-letter alphabetic codes that represent the various currencies used throughout the world. When combined in pairs, they make up the symbols and cross rates used in currency trading. The most traded currency pairs in the world are called the Majors. The list includes following currencies: Euro (EUR), US Dollar (USD), Japanese Yen (JPY), Pound Sterling (GBP), Australian Dollar (AUD), Canadian Dollar (CAD), and the Swiss Franc (CHF). These currencies follow free floating method of valuation. Amongst these currencies the most 15 active currency pairs are: EURUSD, USDJPY, GBPUSD, AUDUSD, USDCAD, USDCNY and USDCHF. According to Bank for International Settlement (BIS) survey of April 2019, the share of different currency pairs in global average daily foreign exchange market turnover is as given below: Currency Share (%) EUR/USD 24.0 USD/JPY 13.2 GBP/USD 9.6 AUD/USD 5.4 USD/CAD 4.4 USD/CNY 4.1 USD/CHF 3.5 USD/HKD 3.3 USD/INR 1.7 USD/others 19.1 Others/others 11.7 Total 100 Source: BIS Triennial Central Bank Survey 2019 *Net-net basis, daily averages in April 2019, in per cent Currency pairs that are not associated with the U.S. dollar are referred to as minor currencies or crosses. These are usually derived from major non-USD currencies like EUR, GBP, and JPY. These pairs have slightly wider spreads and are not as liquid as the majors, but they are sufficiently liquid markets, nonetheless. For instance, Euro crosses include EUR/GBP, EUR/JPY, and EUR/CHF. Exotic Pairs stand out from these pairs because they contain a major currency (usually USD) and a currency from a developing or emerging market. This exposes traders to currencies from Asia, Africa, the Middle East, and more. An example of an exotic currency pairs are USD/TRY (U.S. dollar/Turkish Lira), USD/SEK (US Dollar/Swedish Krona), EUR/TRY (Euro/Turkish Lira) etc. 1.2.1 Major Currencies US Dollar (USD) U.S. dollar (USD) is the home denomination of the world's largest economy, the United States. U.S. banknotes are issued in the form of Federal Reserve Notes, popularly called greenbacks due to their predominantly green color. The monetary policy of the United States is conducted by the Federal Reserve System, which acts as the nation's central bank. It was founded in 1913 under the Federal Reserve Act in order to furnish an elastic currency for the United States and to supervise its banking system. As with any currency, the dollar is supported by economic fundamentals, including gross domestic product (GDP), manufacturing and employment reports. 16 The US Dollar is by far the most widely traded currency. In part, the widespread use of the US Dollar reflects its substantial international role as “investment” currency in many capital markets, “reserve” currency held by many central banks, “transaction” currency in many international commodity markets, “invoice” currency in many contracts, and “intervention” currency employed by monetary authorities in market operations to influence their own exchange rates. In addition, the widespread trading of the US Dollar reflects its use as a “vehicle” currency in foreign exchange transactions, a use that reinforces its international role in trade and finance. For most pairs of currencies, the market practice is to trade each of the two currencies against a common third currency as a vehicle, rather than to trade the two currencies directly against each other. The vehicle currency used most often is the US Dollar, although very recently EUR also has become an important vehicle currency. Thus, a trader who wants to shift funds from one currency to another, say from Indian Rupees to Philippine Pesos, will probably sell INR for US Dollars and then sell the US Dollars for Pesos. Although this approach results in two transactions rather than one, it may be the preferred way, since the US Dollar/INR market and the US Dollar/Philippine Peso market are much more active and liquid and have much better information than a bilateral market for the two currencies directly against each other. By using the US Dollar or some other currency as a vehicle, banks and other foreign exchange market participants can limit more of their working balances to the vehicle currency, rather than holding and managing many currencies, and can concentrate their research and information sources on the vehicle currency. Use of a vehicle currency greatly reduces the number of exchange rates that must be dealt with in a multilateral system. In a system of 10 currencies, if one currency is selected as the vehicle currency and used for all transactions, there would be a total of nine currency pairs or exchange rates to be dealt with (i.e. one exchange rate for the vehicle currency against each of the others), whereas if no vehicle currency were used, there would be 45 exchange rates to be dealt with. In a system of 100 currencies with no vehicle currencies, potentially there would be 4,950 currency pairs or exchange rates [the formula is: n(n- 1)/2]. Thus, using a vehicle currency can yield the advantages of fewer, larger, and more liquid markets with fewer currency balances, reduced informational needs, and simpler operations. Euro (EUR) Euro is the currency of 19 European Union and over 343 million Europeans as of 2019. Like the US Dollar, the Euro has a strong international presence and second-largest and second-most traded currency in the international markets for the related different types of transactions after the United States dollar. The euro is managed and administered by the Frankfurt-based European Central Bank (ECB) and the Eurosystem (composed of the central banks of the eurozone countries). As an independent central bank, the ECB has sole authority to set monetary policy. The Eurosystem participates in the printing, minting and distribution of notes and coins in all member states, and the operation of the eurozone payment systems. 17 Japanese Yen (JPY) The Japanese Yen is the third most traded currency in the world. It has a much smaller international presence than the US Dollar or the Euro. The Yen is very liquid around the world, practically around the clock. It is also widely used as a third reserve currency after the US dollar and the Euro. British Pound/Pound Sterling (GBP) Until the end of World War II, the Pound was the currency of reference. The nickname Cable is derived from the telegrams used to update the GBPUSD rates across the Atlantic. Sterling is the fourth most-traded currency in the foreign exchange market, after the United States Dollar, the Euro, and the Japanese Yen. The currency is heavily traded against the Euro and the US Dollar, but less presence against other currencies. It is also the fourth most-held reserve currency in global reserves. Swiss Franc (CHF) The Swiss Franc is the currency of Switzerland and is represented with the symbol CHF. The Swiss franc is considered a safe-haven currency. Given the stability of the Swiss government and its financial system, the Swiss franc usually faces a strong upward pressure stemming from increased foreign demand. Switzerland's independence from the European Union also makes it somewhat immune to any negative political and economic events that occur in the region. Indian Rupee (INR) The Indian rupee is the official currency of India. The rupee is subdivided into 100 paise. The issuance of the currency is controlled by the Reserve Bank of India. The Reserve Bank manages currency in India and derives its role in currency management on the basis of the Reserve Bank of India Act, 1934. The Indian rupee has a market-determined exchange rate. However, the Reserve Bank of India trades actively in the USD/INR currency market to impact effective exchange rates. Thus, the currency regime in place for the Indian rupee with respect to the US dollar is a de facto controlled exchange rate. This is sometimes called a "managed float". Other rates (such as the EUR/INR and JPY/INR) have the volatility typical of floating exchange rates. Unlike China, India have not followed a policy of pegging the INR to a specific foreign currency at a particular exchange rate. RBI intervention in currency markets is solely to ensure low volatility in exchange rates, and not to influence the rate (or direction) of the Indian rupee in relation to other currencies. According to Bank for International Settlement (BIS) survey of April 2019, the percentage share of various currencies in the global average daily foreign exchange market turnover is as follows: Currency % Share USD 88.3 EURO 32.3 JPY 16.8 18  GBP 12.8 INR 1.7 Others 48.1 TOTAL 200* * As two currencies are involved in each transaction, the sum of shares in individual currencies will total to 200%. *Net-net basis, daily averages in April 2019, in per cent Source: BIS Triennial Central Bank Survey 2019 1.2.2 Overview of International Currency Markets The international currency market is a market in which participants from around the world buy and sell different currencies. Participants include banks, corporations, central banks, investment management firms, hedge funds, retail forex brokers, and investors. The international currency market is important because it helps to facilitate global transactions, including loans, investments, corporate acquisitions, and global trade. Foreign Exchange Market (Forex) is an inter-bank market that took shape in 1971 when global trade shifted from fixed exchange rates to floating rate regimes. Forex transactions are a set of transactions among forex market agents involving exchange of specified sums of money in a currency unit of any given nation for currency of another nation at an agreed rate as of any specified date. During exchange, the exchange rate of one currency to another currency is determined by supply and demand. Moreover, a corporate willing to hedge his currency exposure may also take appropriate positions in the market. For currency market, the concept of a 24-hour market has become a reality. In financial centers around the world, business hours overlap; as some centers close, others open and begin to trade. For example, UK and Europe opens during afternoon (as per India time) time followed by US, Australia and Japan and then India opens. The market is most active when both US and Europe is open. In the New York market, nearly two-thirds of the day’s activity typically takes place in the morning hours. Activity normally becomes very slow in New York in the mid-to late afternoon, after European markets have closed and before the Tokyo, Hong Kong, and Singapore markets have open. Given this uneven flow of business around the clock, market participants often will respond less aggressively to an exchange rate development that occurs at a relatively inactive time of day and will wait to see whether the development is confirmed when the major markets open. Some institutions pay little attention to developments in less active markets. Nonetheless, the 24-hour market does provide a continuous “real-time” market assessment of the currency price and flow of influences and attitudes with respect to the traded currencies, and an opportunity for a quick judgment of unexpected events. With many traders carrying pocket monitors, it has become relatively easy to stay in touch with market developments at all times. 19 The Forex market is a worldwide decentralized over-the-counter1 financial market for the trading of currencies. The scope of transactions in the global currency market is constantly growing, with development of international trade and abolition of currency restrictions in many nations. With access to all of the foreign exchange markets generally open to participants from all countries, and with vast amounts of market information transmitted simultaneously and almost instantly to dealers throughout the world, there is an enormous amount of cross-border foreign exchange trading among dealers as well as between dealers and their customers. As per Triennial Central Bank Survey of Foreign Exchange and Over-the-counter (OTC) Derivatives Markets in 2019, average daily turnover of OTC foreign exchange is approximately USD 6.6 trillion. Growth of FX derivatives trading, especially in FX swaps, outpaced that of spot trading. OTC Foreign Exchange Turnover by Instrument Instrument Turnover Spot Transactions 1,987 Outright forwards 999 Foreign exchange swaps 3,203 Currency swaps 108 FX Options & Other 298 OTC Foreign Exchange Turnover 6595 Exchange Traded Derivatives 127 * Daily averages, in billions of US dollars Source: BIS Triennial Central Bank Survey 2019 At any moment, the exchange rates of major currencies tend to be virtually identical in all the financial centers where there is active trading. Rarely are there such substantial price differences among major centers as to provide major opportunities for arbitrage. In pricing, the various financial centers that are open for business and active at any one time are effectively integrated into a single market. 1.3 Basics of Currency Markets and Peculiarities in India 1.3.1 Currency pair Unlike any other traded asset class, the most significant part of currency market is the concept of currency pairs. In currency market, while initiating a trade you buy one currency and sell another currency. Therefore, same currency will have very different value against every other currency. For example, same USD is valued at say 78 against INR and say 115 against JPY. This peculiarity makes currency market interesting and relatively 1 Over-the-counter generally indicate transaction undertaken other than Stock Exchanges and including electronic trading platform. 20 complex. For major currency pairs, economic development in each of the underlying country would impact value of each of the currency, although in varying degree. The currency dealers have to keep abreast with latest happening in each of the country. 1.3.2 Base Currency / Quotation Currency Every trade in FX market is a currency pair: one currency is bought with or sold for another currency. We need to identify the two currencies in a trade by giving them a name. The names cannot be “foreign currency” and “domestic currency” because what is foreign currency in one country is the domestic currency in the other. The two currencies are called “base currency” (BC) and “quoting currency” (QC). The BC is the currency that is priced, and its amount is fixed generally at one unit. The other currency is the QC, which prices the BC, and its amount varies as the price of BC varies in the market. What is quoted throughout the FX market anywhere in the world is the price of BC expressed in QC. For the currency pair, the standard practice is to write the BC code first followed by the QC code. For example, in USDINR, USD is the base currency and INR is the quoted currency; and what is quoted in the market is the price of one USD expressed in INR. If you want the price of INR expressed in USD, then you must specify the currency pair as INRUSD. Therefore, if a dealer quotes a price of USDINR as 75, it means that one unit of USD has a value of 75 INR. Similarly, GBPUSD = 1.34 means that one unit of GBP is valued at 1.34 USD. Please note that in case of USDINR, USD is base currency and INR is quotation currency while in case of GBPUSD, USD is quotation currency and GBP is base currency. In the interbank market, USD is the universal base currency other than quoted against Euro (EUR), Sterling Pound (GBP), Australian Dollar (AUD). Currency pairs are quoted based on their bid (buy) and ask prices (sell). The bid price is the price that the forex broker will buy the base currency from you in exchange for the quote or counter currency. The ask—also called the offer—is the price that the broker will sell you the base currency in exchange for the quote or counter currency. When trading currencies, you're selling one currency to buy another. Conversely, when trading commodities or stocks, you're using cash to buy a unit of that commodity or a number of shares of a particular stock. Currency pairs can also be separated into two types, direct and indirect. In a direct quote, the foreign currency is the base currency, while the local currency is the quote currency. An indirect quote is just the opposite: the domestic currency is the base currency, and the foreign currency is the quote currency. The way currency pairs are quoted can vary depending on the country in which the trader lives—most countries use direct quotes, while some countries prefer indirect quotes. Most pairs using the U.S. dollar are direct quotes. 1.3.3 Forex Market Generally there are two distinct segment of OTC foreign exchange market. The foreign exchange market in India may be broadly divided into two segment. One segment is called 21 as “interbank” market and the other is called as “merchant/retail” market. The participants in the interbank segment are banks holding Authorised Dealer (AD) licenses under the Foreign Exchange Management Act (FEMA), 1999. Transactions in this segment are conducted through trading platforms provide by Clearing Corporation of India Limited (CCIL), Refinitiv (formerly Thomson Reuters) etc. before being settled by CCIL (for Cash, Tom, Spot and Forward USD-INR transactions) through a process of multilateral netting. Interbank FX market has a network of banks and institutions who trade in currencies among themselves. These transactions are generally of very high volume and make up for the bulk of the global forex market volume. The currency desks of different trading banks transact continuously, which keeps the currency exchange rate uniform. The retail forex market, on the other hand, has a large number of traders. The trading volume is, however, less than the interbank market as the value per transaction is low. The mechanism of quoting price for both buying and selling is called as market making. For example, your close by vegetable vendor will quote prices only for selling and he will not quote prices for buying it. While in a wholesale market, the vegetable wholesaler will quote prices for buying vegetable from farmer and will also quote prices for selling to vegetable retailer. Thus, the wholesaler is a market maker as he is quoting two way prices (for both buying and selling). Similarly, dealers in interbank market quote prices for both buying and selling i.e., offer two way quotes. Retail Customers in India with a need to buy/sell foreign exchange can have multiple avenues. They can do so over the phone with an AD Bank or through proprietary electronic dealing platforms of individual banks and Multi-Bank Portals (MBPs). In one-to- one negotiated dealing over the phone, customers with large order size command more negotiating power compared to the ones having smaller forex requirement. Banks also follow the practice of fixing “card rates” for the various forex pairs at the beginning of the day at which purchases and sales from/to retail customers would be made regardless of the intraday movement of the currency. To provide transparent and fair pricing in the retail forex market RBI in 2019, has introduced an electronic trading platform for buying/selling foreign exchange by retail customers of banks. The platform, FX-Retail, is rollout by the Clearing Corporation of India Limited (CCIL) in August 2019. Forex trading in India typically takes place over-the-counter (including Electronic trading platform) for spot, forward and swaps (major trading venues for interbank spot market are Refinitiv D2 and FX Clear while forex swaps are largely transacted outside platform on a bilateral basis), futures are traded on exchanges, i.e., National Stock Exchange (NSE), Bombay Stock Exchange (BSE) and Metropolitan Stock Exchange of India Ltd. (MSEI). Options are traded both OTC as well as on Exchanges. In majority of the “merchant” market, merchants are price takers and banks are price givers. Although few large merchants or corporates may ask banks to quote two way prices as such merchants may have both side interest i.e., interest to sell or buy or both. 1.3.4 Two way quotes In interbank market, currency prices are quoted with two way price. In a two way quote, 22 the prices quoted for buying is called bid price and the price quoted for selling is called as offer or ask price. Please note that these prices are always from the perspective of the market maker and not from the perspective of the price taker. Let us understand it with an example. Suppose a bank quotes USDINR spot price as 75.0550/75.0600 to a merchant. In this quote, 75.0550 is the bid price and 75.0600 is the offer price or ask price. This quotes means that the bank is willing to buy one unit of USD for a price of INR 75.0550 and is willing to sell one unit of USD for INR 75.0600. Thus a merchant interested to buy one unit of USD will get it for a price of INR 75.06 i.e. the price at which bank is willing to sell and merchant interested to sell one unit of USD will receive Rs. 75.05 i.e. the price at which bank is willing to buy. The difference between bid and offer price is called as “spread”. Please note that the price quoted by a market maker is valid for certain quantity of the currency pair and it may vary if the amount for which quote is sought is higher. Spread is an important parameter to note while assessing market liquidity, efficiency of market maker and market direction. Clearly, a narrow spread indicates a higher liquidity and higher efficiency of the market maker. In USDINR spot market, the spreads are wide at the time of opening and gradually start narrowing as the market discovers the price. Similarly, for a USD 100 mn transaction the spread is likely to be higher when compared to the spread for USD 1 mn transaction. There are certain market norms for quoting the two way quotes. Some of the important norms are as follows: 1. The bid price (lower price) is quoted first followed by offer price (higher price) 2. The offer price is generally quoted in abbreviated form. In case the currency pair is quoted upto four decimal places then offer price is quoted in terms of last two decimal places and if the currency pair is quoted in two decimal places, then offer price is quoted in terms of two decimal places. Let us look at market norm for quoting two way prices for popular currency pairs: Currency Actual Bid-Offer Abbreviated Bid- Comments2 pair Price Offer Price USDINR 75.0525/75.0575 75.0525/75 Price generally quoted upto 4 decimal EURUSD 1.1225/1.1230 1.1225/30 Price generally quoted upto 4 decimal GBPUSD 1.3365/1.3370 1.3365/70 Price generally quoted upto 4 decimal USDJPY 115.55/115.57 115.55/57 Price generally quoted upto 2 decimal 2 Certain currency pairs like EURUSD, GBPUSD also quoted upto 5 decimal. 23 1.3.5 Appreciation/ Depreciation Exchange rates are constantly changing, which means that the value of one currency in terms of the other is constantly change. Changes in rates are expressed as strengthening or weakening of one currency vis-à-vis the other currency. Changes are also expressed as appreciation or depreciation of one currency in terms of the other currency. Whenever the base currency buys more of the quotation currency, the base currency has strengthened / appreciated, and the quotation currency has weakened / depreciated. For example, if USDINR has moved from 75.00 to 75.25, the USD has appreciated against INR and the INR has depreciated against USD. Similarly, to say that USD looks strong over next few months would mean that USDINR pair may move towards 76.00 from the current levels of 75.25. Hence, when you buy a currency pair, clearly it implies that you expect the value of the pair to go up. Consider this example – USD INR = 75, one would buy the pair, hoping for the price of the pair to hit 76.50. Now if the price of the pair is expected to increase, then it implies that going forward 1 unit of base currency can buy more units of quotation currency i.e. 1 USD to buy more INR. In other words, if the value of the pair goes up then the power of the base currency goes up while at the same time the quotation currency weakens. This translates to you being bullish on the base currency and bearish on the quotation currency at the same time. Similarly, if you sell the USD INR pair, it implies that you anticipate the base currency to buy lesser amount of quotation currency. This translates to you being bearish on base currency and bullish on the quotation currency. Given this, “appreciation/depreciation of a currency” refers to the following situations– a. Base currency appreciate when it can buy more units of quotation currency. For example, USD INR moves from 75 to 76 it means the base currency (USD) strengths and the quotation currency (INR) weakens. b. Quotation currency strengths when the base currency buys lesser units of quotation currency. For example, USD INR moves from 76 to 75 it means the base currency (USD) weakens and the quotation currency (INR) strengthens. Please note that appreciation and depreciation of one currency is always in terms of other currency. Hence, it is possible that USD can appreciate against INR, however at the same time USD may depreciate against EUR. 1.3.6 Market Timing In India, for OTC market FEDAI (Foreign Exchange Dealers' Association of India) has stipulated market timings for inter-bank INR forex transactions. The normal market hours for FCY/INR transactions in Inter-bank forex market as well as client transactions in India is from 9.00 a.m. to 5.00 p.m. IST on all working days. A. Authorised dealers may undertake customer (persons resident in India and persons resident outside India) and inter-bank transactions on all working days beyond normal market hours. 24  B. Transactions with persons resident outside India, through their foreign branches and subsidiaries may also be undertaken on all working days beyond normal market hours. C. However, value Cash transactions may be undertaken only upto 5.00 pm IST, except in case of individual person (including joint account or proprietary firm). D. Transactions, including value cash transactions, for individual persons (including joint account or proprietary firm) can be undertaken even on Saturdays, Sundays and holidays as per banks internal policy. E. Any transaction undertaken beyond the market hours prescribed above, bank must ensure that: NOOP (Net Overnight Open Position) Limit is maintained all the time [including transactions executed from EOD to 9.00 am IST (market opening time) next working day]. F. Spot date Roll over for FCY/INR transactions will take place at 12.00 midnight IST. G. For the purpose of Foreign Exchange business, Saturday will not be treated as a working day except for transactions as stated in (D) above. H. NOOP Limit is maintained all the time [including transactions executed from EOD to 9.00 am IST (market opening time) next working day]. Central bank has prescribed certain net overnight open position limit for various banks. The Foreign Exchange Exposure Limits of Authorised Dealers would be dual in nature.  Net Overnight Open Position Limit (NOOPL) for calculation of capital charge on forex risk.  Limit for positions involving Rupee as one of the currencies (NOP-INR) for exchange rate management. For banks incorporated in India, the exposure limits fixed by the Board should be the aggregate for all branches including their overseas branches and Off-shore Banking Units. For foreign banks, the limits will cover only their branches in India. NOOP limit may be fixed by the boards of the respective banks and communicated to the Reserve Bank immediately. However, such limits should not exceed 25 percent of the total capital (Tier I and Tier II capital) of the bank, or any other condition specified by RBI from time to time. 1.3.7 Forex Rates Base rate is the rate derived from ongoing market rate, based on which buying / selling rates are quoted for merchant transactions. The interbank rates are normally for spot deliveries are considered as base rate. Hence, for quoting rates for merchant transaction on cash basis (i.e. value Today), the base rate will be adjusted to the extent of cash/spot differences. The member banks are free to determine their own charges for various types of forex transactions, keeping in view the advice of RBI that such charges are not to be out of line with the average cost of providing services. Banks should take care to ensure that customers with low volume of activities are not penalised. 25 Banks also follow the practice of fixing “card rates” for the various forex pairs at the beginning of the day at which purchases and sales from/to retail customers would be made regardless of the intraday movement of the currency. However, on the days of high volatility, banks revise the card rate multiple times during the day. The difference between IBR and card rate is high to cover the risk of price fluctuation. Card rate could vary significantly from bank to bank. 1.3.8 Price discovery Forex market in India is predominantly a wholesale market, dominated by banks, forex brokers and corporate clients. Customers are priced off-market by banks. Trading in forex and related derivatives takes place OTC as well as on exchanges. Major trading venues for interbank spot market are Refinitiv D2 and FX Clear, while forex swaps are largely transacted outside platform on a bilateral basis. The interbank price discovery is happened on these platforms. These platforms offer order matching as well as negotiated mode. Spot trading market is well distributed through the day, while in case of forex forwards, volumes typically increase gradually during the day, with the last two hours having relatively higher volumes. The current market hours for USD/INR spot/ forward/ options, starts at 9 am and closes at 5 pm. These current timings overlap with the trading hours of Asian markets (including their closing) as well as first half of a European trading day. This allows Indian markets to have a reasonably good price discovery based on news in global markets during these hours. There are, however, some market hours, especially the US market opening (after India closes) and Asia opening (before India opens), during which the Indian markets are shut, which have a bearing on the prices in Indian markets. Domestic markets are closed during important currency trading sessions such as New York time and Tokyo time. Hence, any major domestic or international event or data release during hours when the Indian markets are closed, are not priced in by the residents and this may impact the opening rates of the Rupee. In extreme cases, it may manifest in a gap-up or gap-down at market opening, on the next day. Non-Delivery Forward (NDF)3 volumes especially for USDINR pair have increased in the recent period, they have begun to play an important role in both price discovery and driving volatility, particularly during heightened uncertainty period. RBI has introduced an electronic trading platform for buying/selling foreign exchange by retail customers of banks. The platform, FX-Retail, is rolled out by the Clearing Corporation of India Limited (CCIL) on August 05, 2019, to provide transparency while enhancing competition and lead to better pricing for retail customers. 1.3.9 FBIL Reference Rate The reference rates for USD/INR and other major currencies are computed and disseminated by the Financial Benchmarks India Private Limited (FBIL). FBIL is recognised by Reserve bank of India as an independent Benchmark administrator and has assumed 3 A non-deliverable forward (NDF) is a cash-settled, and usually short-term, currency forward contract. The notional amount is never exchanged, hence the name "non-deliverable." 26 the responsibility of computation and dissemination of reference rate for USD/INR and exchange rate of other major currencies with effect from July 10, 2018. The FBIL reference rate is calculated for USD/INR, GBP/INR, EUR/INR and JPY /INR. FBIL computes and publishes since July 10, 2018, the USD/INR, EUR/INR, GBP/INR and JPY/INR reference rates on a daily basis on all Mumbai business days at around 13.30 hours. FBIL computes and publishes the USD/INR reference rate using the transaction level data available on the electronic trading platforms between 11.30 and 12.30 hours. A 15-minute random window is selected within the 11.30 and 12.30 hours for the computation of USD/INR reference rate. Normally, the data are sourced from the electronic platforms of Refinitiv and CCIL. Cross currency reference rates for INR/ 1 EUR, INR/ 1 GBP, INR/100 JPY are calculated using the EUR/USD, GBP/USD and USD/JPY quotes in the selected 15- minute window. Computation methodology The USD/INR Reference Rate (USD/INR) will be computed based on the data in respect of the actual spot US dollar/Indian rupee transactions taking place on electronic platforms during the one-hour time window from 11.30 Hours to 12.30 Hours on each business day in Mumbai. Normally, the data will be sourced from Refinitiv (formerly Thomson Reuters) and CCIL platforms. If the transaction data is not available on one of the two platforms due to network failure or for any other reason, the rate will be calculated on the basis of transactions data obtained from the other platform. The transactions data for a 15 minutes’ time-period within the one-hour time window from 11.30 Hours to 12.30 Hours and selected randomly will be used for computation of the USD/INR reference rate. The threshold criteria of ten transactions with aggregate amount of USD 25 million will be required to be met for calculating the reference rate. A +/- 3 Standard Deviation (SD) rule will be applied to the transaction data, as above, to remove the outliers. The Reference Rate will be set equal to the volume-weighted average of the surviving transactions, after the removal of the outliers. If the first randomly selected time-period of 15 minutes does not contain adequate number of transactions satisfying the threshold criteria, a second random time-period of 15 minutes will be generated. This process will be repeated up to a maximum of 5 times to obtain adequate number of transactions that satisfy the threshold criterion. If all the 5 randomly selected time-periods fail to produce sufficient number of transactions that satisfy the threshold criterion, the transactions data pertaining to the whole one-hour window from 11.30 Hours to 12.30 Hours will be taken into account for calculating the Reference Rate, provided they meet the threshold criterion. In case of systems/network failures, if adequate transactions data is still not available, the reference rate will be computed using the polled submissions as under: I. A panel of Category -I authorised dealer banks selected on the basis of their USD/INR inter-bank market turnover will be maintained for the purpose of polled submission. The submission can be made over a 15-minute time window around 13.00 Hours. The quotes will be collected from the empaneled AD Banks over the designated e-mail id. The banks in the panel, as above, will submit the bid and offer quotes for spot USD/INR rate up to four 27 decimal places. A minimum of five quotes will be required for calculation of the reference rate. The USD/INR reference rate will be published upto 4 decimal places. For calculation of EUR/INR, GBP/INR and JPY/INR reference rates, the ruling spot cross currency rates for EUR/USD, GBP/USD and USD/JPY will be obtained from any electronic platform. All the cross-currency rates will be taken from the same randomly selected time-period of 15 minutes between 11.30 Hours to 12.30 Hours that will be used for the calculation of USD/INR reference rate. This will be done by obtaining from any electronic platform the closing prices of each cross-currency pair as depicted in the one-minute charts over the 15- minute time-period. The mean of the closing prices, so obtained, will be crossed with the USD/INR reference rate to calculate the EUR/INR, GBP/INR and JPY/INR reference rates. In case of non-availability of cross currency quotes in the above- mentioned window, for each currency pair, the average of the last 15 minutes’ quotes from the 1-minute chart of the previous day New York close (16.46 -17.00 New York Time) may be considered The reference rates in respect of EURO and GBP will be published for 1 unit of Euro and GBP and the reference rate in respect of JPY will be for 100 units of JPY. EUR/INR and GBP/INR Reference rates will be published up to 4 decimal places and JPY/INR reference rate will be published up to 2 decimal places. The FBIL reference rates will be published at around 13.30 Hours on all business days, i.e., excluding Saturday, Sunday and bank holidays in Mumbai Forward Premia Curve FBIL announces the benchmark rates for US Dollar - Indian Rupee Forward Premia for Overnight and from 1 month to 12 months tenor on a daily basis except Saturdays, Sundays and public holidays. The benchmark rates are determined based on the USD/INR transactions data reported upto 3 PM on the CCIL platform. For calculation of Overnight rate, the Cash-Tom transactions upto 12 noon are used. The Rolling Forward Premia in rupees and percentage term are calculated from the month-end forward transactions and the rolling forward transactions. 1.3.10 Settlement date and Value date Forex rates can be quoted as spot or, forward contracts. When buyers and sellers agree to trade at the current exchange rate for immediate delivery, it is known as spot transaction or cash transaction. The word “immediate” has different meaning in this case. It can “at that instance” can go upto maximum of two days. In forex market parlance, the trade date is the day on which both parties agree to buy and sell. The settlement date/value date is the day on which currencies are actually transferred between the buyer and seller. On settlement/value date, the buying or selling actions will be realized by settlement of payment and receipt. Depending upon the gap between trade and value date, spot forex trading can either be categorized as cash, tom or spot transaction. 28 Ready or cash The transaction to be settled on the same day. Tom The delivery of foreign exchange to be made on the business day next to the date of transaction. The most important value date is the “spot” value date, which is settlement after two business days. In practice, it can be after “two business days” because the settlement takes place in two different centers that may have different holidays. The correct definition of spot value date is settlement on second business day, subject to both centers being open on that day. If one of them is closed, then the settlement will be on the next business day (which could be third or fourth, etc., after the trade date) on which both centers are simultaneously open. It is also possible to settle the transaction before spot date. The price at which settlement takes before spot date is a derived price from spot price and is not a traded price. For a currency pair for which spot date is at T+2 and if settlement happens on the trade date, the settlement price is called as “cash” rate and if happens one day after trade date, the price is called as “tom” rate. The picture below represents cash, tom, spot and forward value dates on a time line: T T+1 T+2 Trade date and Tom Spot Forward also cash date Please note the use of word business days in the definition of spot value date. It is important to understand how to calculate the exact spot date when there are holidays after trade date. Any settlement date after spot value date is called “forward” value dates, which are standardized into 1-month, 2-month, etc. after spot value date. In a forward contract both parties enter into a contract on a given day and lock in a fixed rate on specific future date. In such types of contract, the terms of the purchase (buy or sell) are agreed up front (trade execution date), but actual exchange take place on a date in the future (maturity date). On the maturity date, both parties exchange the pre negotiated rate. For example, an Indian company which is likely to earn foreign currency i.e., Euro on account of an export order after one month, may enter into a contract today ( trade execution date) to sell Euro and receive Indian Rupees after 1 month ( maturity date). The rate is fixed on the trade date and the rate is known as forward- 1 month rate. Suppose on trade date, the Indian exporter agrees to sell EUR 1000 and receive INR 84000 after one month. Thus on the maturity date i.e. after one month, he delivers EUR 1000 and receives INR 84000. Such types of forward contracts are known as outright forward contracts (OFTs). The forward OTC market can provide quotes for booking a forward contract for any maturity. However, the liquidity is high for maturity less than one year and beyond that liquidity is less. With respect to settlement, the settlement is mainly physical settlement 29 i.e. with exchange of actual currencies. This is unlike currency futures market, where prices are available for month end maturity contract and the settlement is always on net settlement basis. 1.4 Exchange Rate Arithmetic- Cross Rate For some currency pairs prices are not directly available and are rather derived by crossing the prices of underlying currency pairs. Crossing the prices to arrive at price of the currency pair could involve either multiplication or division of the underlying prices. In market parlance, the price of currency pair for which direct prices is not available is called as cross rate. In this section, we will explain the method and rationale of crossing the prices. Although there are methods like chain rule, Left Hand-Right hand etc. prescribed in various books, we would explain the derivation of cross rate using simple commercial logic. We will take example of EURINR, GBPINR and JPYINR. 1.4.1 EURINR The underlying currency pairs for deriving prices of EURINR are EURUSD and USDINR. Let us assume following prices: EURUSD: 1.1125 / 1.1150; USDINR: 75.64 / 75.65 Please recollect, the prices in currency pair is quoted in terms of value of one unit of base currency. While calculating cross rates, it is important to keep in mind which is the base currency and that the price is being calculated for one unit of base currency in terms of quotation currency (also called as term currency). Therefore, for EURINR currency pair, we have to calculate the price of 1 EUR in terms of INR. Let us start the computation of cross rate, using the buy side argument i.e. price of buying 1 EUR in terms of INR. As understood from underlying currency pairs, the price of EUR is directly available only in terms of USD. Therefore, you need to sell INR to buy USD; and further sell the USD received to buy EUR. It is important to identify this FX conversion path of selling one currency and buying another to calculate the cross rate. Now we need to use appropriate prices (bid price versus offer price) of underlying currency pairs. To buy 1 unit of USD, the applicable price is 75.65 INR (offer side) i.e., you need INR 75.65 to buy 1 unit of USD. Now you need to sell certain units of USD (received by selling INR) to buy 1 unit of EUR. The price for buying 1 unit of EUR is 1.1150 USD (offer side). Therefore, how many INR you need to spend to buy 1.1150 USD? The answer to this question would be the price of buying 1 unit of EUR in terms of INR. We identified the price of buying 1 unit of USD as 75.65. Therefore, price of buying 1.1150 units of USD would be 1.1150 x 75.65 INR i.e. 84.3498 INR. Therefore, the price of buying 1 unit of EUR in terms of INR is 84.3498 INR. Similarly, you could use the logic for selling 1unit of EUR and derive its price in terms of INR. The price comes to 84.1495 (1.1125 x 75.64). 30 Therefore, the cross rate for EURINR would be 84.1495 / 84.3498. 1.4.2 GBPINR The underlying currency pairs are GBPUSD and USDINR. Assume GBPUSD price as 1.3300 / 1.3325 and USDINR as 75.64 / 75.65, the price for GBPINR works out to be 100.6012 / 100.8036. You should identify the FX conversion path and appropriate price levels to arrive at the above cross rate. 1.4.3 JPYINR For JPYINR, the market convention is to quote price of 100 JPY in terms of INR. In all other pairs mentioned above, the convention is price of 1 unit of base currency in terms of quotation currency. The computation of JPYINR from USDJPY and USDINR is slightly different from the computation of GBPINR or EURINR. In case of GBPINR and USDINR computation, USD is base currency for one currency pair and quote currency for other currency pair. However in case of JPYINR, USD is base currency for both the currency pairs. We will describe below the computation of JPYINR from USDJPY and USDINR. Assume USDJPY price as 115.08 / 115.09 and USDINR as 75.64 / 75.65. Let us start the computation of cross rate, using the buy side argument i.e. price of buying 100 JPY in terms of INR. As understood from underlying currency pairs, the price of JPY is directly available only in terms of USD. Therefore, you need to sell INR to buy USD; and further sell the USD to buy JPY. It is important to identify this FX conversion path of selling one currency and buying another to calculate the cross rate. Now we need to use appropriate prices (bid price versus offer price) of underlying currency pairs. To buy 1 unit of USD, the applicable price is 75.65 INR (offer side) i.e., you need INR 75.65 to buy 1 unit of USD. Now you need to sell one unit of USD (received by selling INR) and buy JPY. The price for selling one unit of USD is 115.08 (bid side). Therefore, you get 115.08 JPY by spending 75.65 INR. Thus price of buying 1 JPY is 75.65/115.08 i.e. 0.6574 INR or in other words price of buying 100 JPY is 65.74 INR. Similarly, price of selling 1 JPY is 75.64/115.09 i.e. 0.6572 or in other words price of selling 100 JPY is 65.72 INR. Thus price of JPYINR (for 100 JPY) would be 65.72 / 65.74 INR. In the above examples, we have elaborated computing cross rates using underlying rates. Similarly, you could use one underlying rate and cross rate to calculate the other underlying rate. For example, using EURINR and USDINR rate, EURUSD rate could be calculated. 1.5 Impact of Economic Factors on Currency Prices Just like how the equity prices are linked to fundamental strength of the company, similarly in very long term, price of one currency versus other is linked to relative economic strength of the country. In short term, factors like demand supply mismatch, global risk appetite, important political events etc. may determine currency price. There are multiple factors impacting the value of the currency at any given point of time. Some of the factors are of the local country while others could be from global markets. For 31 example, the value of INR against USD is a function of factors local to India like gross domestic product (GDP) growth rate, balance of payment situation, deficit situation, inflation, interest rate scenario, policies related to inflow and outflow of foreign capital. It is also a function of factors like prices of crude oil, value of USD against other currency pairs and geopolitical situation. All the factors are at work all the time and therefore some factors may act towards strengthening of currency and others may act towards weakening. It becomes important to identify the dominating factors at any point of time as those factors would decide the direction of currency movement. For example, economic factors in India might be very good indicating continued inflow of foreign capital and hence appreciation of INR. However, in global markets USD is strengthening against other currency pairs (on account of multiple factors). In this situation local factors are acting towards strengthening and global factors towards weakening of INR. One needs to assess which factors are more dominating at a point of time and accordingly take decision on likelihood of appreciation or depreciation of INR. In the very short term, demand supply mismatch would also have bearing on the direction of currency’s movement. The extent of impact of demand supply mismatch is very high on days when market is illiquid or on currency pairs with thin trading volumes. For USDINR, demand supply factors have considerable impact on the currency movement. For example, on some day INR may appreciate on account of large USD inflow (ECB conversion/ large FDI/ central bank intervention or any other reason) despite the trend of weakness driven by economic factors. Once the USD inflow is absorbed by the market, INR may again depreciate. Therefore, it is important to keep track of such demand supply related news. To assess the impact of economic factors on the currency market, it is important to understand the key economic concepts, key data releases, their interpretation and impact on market. Since currency market is a globalized market and the value of currency is always determined against another currency, therefore the analysis in FX market also means analysis of economic conditions in other major countries of the world. The interpretation of changing values of economic indicators on currency value could be difficult. It cannot be said with certainty that an indicator showing robust economic health of the country would mean strengthening of the currency of that country. The exact impact would be a function of relative health of other economies, global risk appetite among investors and market expectation. For example, during global financial crisis of 2008 and 2009, USD strengthened against all major currencies like EUR, GBP and JPY. This was despite US running record high fiscal deficit and its economy not doing well. Some of the important economic factors that have direct impact on currency markets are inflation, balance of payment position of the country, trade deficit, fiscal deficit, GDP growth, policies pertaining to capital flows and interest rate scenario. 32 1.6 Economic Indicators Given below are key economic indicators and their impact on currency price/currency market. 1.6.1 Gross Domestic Product (GDP) GDP represents the total market value of all final goods and services produced in a country during a given year. A GDP growth rate higher than expected may mean relative strengthening of the currency of that country, assuming everything else remaining the same. 1.6.2 Industrial Production The Index of Industrial Production (IIP) shows the changes in the production in the industrial sector of an economy in a given period of time, in comparison with a fixed reference point in the past. In India, the fixed reference point is 2011-12 and the IIP numbers are reported using 2011-12 as the base year for comparison. A healthy IIP number indicates industrial growth, and which could result in relative strengthening of the currency of that country. 1.6.3 Consumer Price Index (CPI) CPI is a statistical time-series measure of a weighted average of prices of a specified set of goods and services purchased by consumers. The indicator measures level of inflation in the economy for the basket of goods and services which are generally brought by the people. A rising CPI means a rising prices for goods and services and is an early indicator of inflation. Assessing the impact of CPI on value of currency is difficult. If rising CPI means likely increase in interest rate by the central bank, the currency may strengthen in the short term but may start weakening in the long run as rising inflation and rising interest may start hurting the growth of the economy. In India, Reserve Bank of India has started using CPI as the main indicator for measuring inflation and designing its policies to manage it. 1.6.4 The Real Interest Rate in the Economy The understanding of the real rate of interest in the economy is an extension of the inflation concept. For example, if the 10-year G-Sec has a yield of 6.5% and if the inflation is at an average of 2% then the real interest rate is 4.5%. Normally, there is a positive relationship between the real interest rates and the INR value. That is why it is seen that whenever the RBI hikes rates, the INR actually sees an appreciation in value because the higher rates of interest would have increased the real rates of interest proportionately. There is also another portfolio angle to this. When real interest rates are high, we see more flows into debt from Foreign Portfolio Investors (FPIs). As more dollars flow in, the additional supply of dollars in the market tends to make the INR stronger. 1.6.5 Current Account and Trade Deficit The excess of imports over exports i.e. trade deficit, is a key factor to track as it influences the direction in which the currency trades. In general, narrowing the trade deficit is a 33 positive for the domestic currency. For a country like India, the figures pertaining to import / export, current account deficit and balance of payments are very important. During periods of risk aversion, any development resulting in widening current account deficit results in weakening of INR. However, during periods of risk appetite, market tends to ignore small changes in current account deficit. 1.6.6 Non-farm payrolls (NFP) Nonfarm payrolls represent the number of jobs added or lost in the economy over the last month, not including jobs relating to the farming industry, government jobs, household jobs and employees of non-profit organization that provide assistance to individuals. For US, the data is released monthly by the Bureau of Labor Statistics, and it is one of the most important indicators analyzed by market participants. A rising and positive number means that the economy is adding jobs and is good for the currency. 1.6.7 Retail Sales It is a coincident indicator and shows how strong is consumer spending. For US market, the report is published around 13th or 14th of each month by United States Census Bureau. A retail sales number higher than expected may mean relative strengthening of the currency of that country. The report is amongst the top economic indicators tracked by FX dealers to assess direction for USD. 1.6.8 Central Bank Actions Market also tracks minutes of the central bank meetings and the key policy decisions. Some of the important announcements from central bank meetings are their interest rate decisions, CRR (cash reserve ratio). Market also actively looks forward to central bank’s perspective on state of the economy. Intervention in foreign exchange markets is a tool on which EME central banks have extensively relied on this instrument over the past two decades, as reflected in a significant increase in their FX reserves. FX intervention helps address the challenges from exchange rate swings. It is noticed that not all indicators are important at a particular point in time. It is important to find out which indicators are getting most of the attention of market any given point in time. For example, sometimes market will give lot of importance to crude price and commodity prices while at other times may not give too much importance to it and rather focus on employment numbers and interest rate situation. 34 Chapter 2: Foreign Exchange Derivatives LEARNING OBJECTIVES: After studying this chapter, you should know about:  Meaning of derivatives  Types of derivatives products and its functions  Difference between exchange traded and OTC derivatives 2.1 Derivatives - Definition Derivative is something that is derived from another called the underlying. The underlying is independent, and the derivative is dependent on and derived from the underlying. The derivative cannot exist without the underlying. This is the general definition of derivative. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the "underlying". However, accounting standards like FAS 133 (in the US), IAS 39 (in the EU) and AS 30 (in India) impose more qualifications for derivatives. For example, IAS 39 and AS 30 require the following three criteria to be satisfied for financial derivatives. 1. Value of derivative is linked to the value of underlying 2. Trade settled on a “future” date 3. On trade date, there should be no full cash outlay FAS 133 requires an additional qualification: 4. Trade must settle (or capable of being settled) on net basis and not on gross basis. The first requirement implies that the price of derivatives is determined by the price of underlying, and not by the demand-supply for derivative. The underlying is the raw material and derivative is the finished product. If the underlying price goes up (or down), the derivative price will go up (or down) regardless of demand-supply for derivative. The “future” date in the second requirement means that the settlement of the derivative must be later than that for underlying. For example, if the underlying settles on two business days after trade date (T+2), the derivative on that underlying must settle later than T+2; if the underlying settles in T+5, the derivative on that underlying must settle later than T+5; and so on. The third requirement provides “leverage”: ability to buy the underlying without fully paying for it immediately or sell it without delivering it immediately. Derivatives are classified into five asset classes: interest rate, credit, equity, forex and commodity. In each asset class, there are four generic products: forward, futures, swap and option. Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity linked derivatives remained the sole form of such 35 products for almost three hundred years. Financial derivatives came into spotlight in the post 1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover. Derivatives are tools to manage price risk. How you manage risk depends on your approach to risk. If you want to take risk , you will trade in derivatives which is called speculation. When you want to avoid risk, you manage it one of the three ways: elimination (called hedging); insurance and minimization (called diversification). The following table summarizes the approaches to market risk management. The following table summarizes the approaches to risk management. Approach Explanation Speculation Taking risk (more formally called “trading”) It results in the possibility of positive return (i.e. profit) or negative return (i.e. loss) in future Hedging You are already exposed to risk and hedging eliminates that risk and locks in the future return at a known level. Insurance You are already exposed to risk and insurance selectively eliminates the negative return but retains the positive return. It has an explicit upfront cost, unlike speculation and hedging, which do not have any cost. It requires a particular derivative called option to implement it. Diversification It reduces both return and risk but in such a way that risk is reduced more than return so that risk is minimized per unit return (or, alternately, return is maximized per unit risk). 2.2 Key Economic Functions of Derivatives Though the economic role of derivatives is Risk Management. Like other segments of financial market, derivatives market serves following functions:  Hedging risk exposure: Since the value of the derivatives is linked to the value of the underlying asset, the contracts are primarily used for hedging risks. For example, an investor may purchase a derivative contract whose value moves in the opposite direction to the value of an asset the investor owns. In this way, profits in the derivative contract may offset losses in the underlying asset.  Price discovery: Derivative market serves as an important source of information about prices. Prices of derivative instruments such as futures and forwards can be used to determine what the market expects future spot prices to be. In most cases, the information is accurate and reliable. Thus, the futures and forwards markets are especially helpful in price discovery mechanism. 36  Market efficiency: It is considered that derivatives increase the efficiency of financial markets. By using derivative contracts, one can replicate the payoff of the assets. Therefore, the prices of the underlying asset and the associated derivative tend to be in equilibrium to avoid arbitrage opportunities.  Access to unavailable assets or markets: Derivatives can help organizations get access to otherwise unavailable assets or markets. By employing interest rate swaps, a company may obtain a more favorable interest rate relative to interest rates available from direct borrowing.  Price Stability: It has been seen that many countries central banks uses derivatives for stabilising the currency prices. In India RBI also intervene in forex market through derivatives for INR stability.  Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.  Speculation: This is not the only use, and probably not the most important use, of financial derivatives. Financial derivatives are considered to be risky. If not used properly, these can lead to financial destruction in an organisation. However, these instruments function as a powerful instrument for knowledgeable traders to expose themselves to calculated and well understood risks in search of a reward, that is, profit.  Derivatives market helps shift of speculative trades from unorganized market to organized market. Risk management mechanism and surveillance of activities of various participants in organized space provide stability to the financial system. Market Participants must understand that derivatives, being leveraged instruments, have risks like counterparty risk (default by counterparty), price risk (loss on position because of price move), leverage risk (magnifying the gain and losses), liquidity risk (inability to exit from a position), legal or regulatory risk (enforceability of contracts), operational risk (fraud, inadequate documentation, improper execution, etc.) and may not be an appropriate avenue for someone of limited resources, trading experience and low risk tolerance. A market participant should therefore carefully consider whether such trading is suitable for him/her based on these parameters. Market participants who trade in derivatives are advised to carefully read the Risk Disclosure Document, given by the broker to his clients at the time of signing agreement. 2.3 Derivative Products As specified earlier, derivatives can be classified into five asset classes: interest rate, credit, equity, forex(currency) and commodity. In each asset class, there are four generic products: forward, futures, swap and option. We will examine this product with currency as asset class. A foreign exchange derivative (currency derivative) is a financial derivative whose payoff depends on the foreign exchange rates of two (or more) currencies. In 37 Indian context “Foreign exchange derivative contract”4 means a financial contract which derives its value from the change in the exchange rate of two currencies at least one of which is not Indian Rupee, or which derives its value from the change in the interest rate of a foreign currency and which is for settlement at a future date, i.e. any date later than the spot settlement date, provided that contracts involving currencies of Nepal and Bhutan shall not qualify under this definition. “Exchange traded currency derivatives'” means a standardised foreign exchange derivative contract traded on a recognised stock exchange to buy or sell one currency against another on a specified future date, at a price specified on the date of contract 2.3.1 Forwards It is a contractual agreement between two parties to buy/sell an underlying asset at a certain future date for a particular price that is pre-decided on the date of contract. Both the contracting parties are committed and are obliged to honour the transaction irrespective of price of the underlying asset at the time of delivery. Since forwards are negotiated between two parties, the terms and conditions of contracts are customized. These are Over-the-counter (OTC) contracts. Contracts are mainly settled in delivery. However, in certain cases, they are settled in cash on expiration date. Generally, no margin or mark to market is collected for such contracts. Foreign exchange forward’ means an OTC derivative involving the exchange of two currencies on a specified date in the future (more than two business days later) at a rate agreed on the date of the contract. For e.g.: “XYZ” has exported cashews to the US and the total value of the shipment is $5,000,000 (Dollar 5 million) which is due after 3 months. The current rate (spot rate) for exchange is 1 USD = INR 75.10. “XYZ” enters into forward agreement with the bank to realize the proceeds after 3 months at the rate of INR 75.80 per dollar. Agreed rate of 1USD=INR 75.80 shall be the forward rate for the particular transaction. How does this type of forward cover benefit XYZ?  Assurance that company will realise inflow of Rs. 37.90 Crs. (5,000,000*75.80)  If the rupee appreciates to Rs.74.50/USD or remain same at Rs 75.10/USD, does not have much to worry because they have already locked in the exchange forward rate of Rs.75.80/USD  Businesses generally have payables against their receivable. Company confident that the inflow will take care of the payable with minimum risk of cash flow uncertainty  Notional loss in case rupee weakens beyond Rs. 75.80/USD. 2.3.2 Futures 4 Foreign Exchange Management (Foreign exchange derivative contracts) Regulations, 2000 38 A futures contract is similar to a forward, except that the deal is made through an organized and regulated exchange rather than being negotiated directly between two parties. Indeed, we may say futures are standardize exchange traded forward contracts. The futures contracts are standardized in terms of lot size, underlying, expiry date etc. Contracts are mainly settled in cash; however in certain cases they are settle in physically on expiration date. Margins and mark to market are applicable for such contracts. Settlement guarantee is provided by the clearing corporation of the Exchanges. Currency Futures means a standardized foreign exchange derivative contract traded on a recognized stock exchange to buy or sell one currency against another on a specified future date, at a price specified on the date of contract, but does not include a forward contract. 2.3.3 Options An Option is a contract that gives the right, but not an obligation, to buy or sell the underlying on or before a stated date and at a stated price. While buyer of option pays the premium and buys the right, writer/seller of option receives the premium with obligation to sell/ buy the underlying asset, if the buyer exercises his right. Call Option gives buyer of an option the right to buy the asset and put option gives buyer of an option the right to sell the asset. In case of futures/forwards it is an obligation on both buyer as well as seller to settle the contract, however in option the buyer of an option has right but not the obligation to buy/sell the underlying asset. ‘Foreign exchange option (Currency Option)’ is an option that gives the buyer the ri