The Hindu Business Line : How a currency futures contract works

The launch of currency futures trading in the Indian stock market was a significant step towards enabling participants to hedge their currency risks through trading in the US dollar-rupee future platform. The following Q&A explains how a currency futures contract works, the benefits and shortcomings of such trading.

What is currency futures?

Currency futures refers to 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.

How can one trade on currency futures?

Currency futures are permitted in dollar-rupee presently. The contract size is $1000 with maximum maturity of 12 months. The contracts can be quoted and settled in Indian rupees. Only “persons resident in India” can purchase/sell currency futures to hedge an exposure to foreign exchange rate risk or otherwise.

The client can open an account with one of brokers (trading bank) and provide margin for trades. He will then place an order on the exchange through the broker.

As the order gets executed, the client will continue funding margins till the order gets executed or squared off.

What are the safety mechanisms/policy measures which have been deployed by the RBI?

An important control introduced by the RBI is the quantum of open position that any person/bank accessing the exchange market can hold. This will therefore enable the steady growth of the market.

How lucrative will it be for a customer to trade on currency futures?

The OTC forex market is a fairly commoditised and liquid market. Hence, the price discovery benefits may not be substantial. The important benefit will be that this will for the first time allow individuals/business entities to take on forex risk, whether as a proactive risk management measure or to profit from currency movements.

Would you like to mention the impediments to trading on currency futures?

There are certain shortcomings of futures compared to OTC market. The major disadvantages are:

Trade in futures requires daily margining. This involves cash flow and cost of funding whereas the OTC forwards market has no upfront cost.

Securities transaction tax and other taxes computation is unclear at this point in time. Gains from futures trades may be considered as speculative gains and not trades for hedging purposes.

Small lots may make it difficult for corporate clients to hedge their exposures.

Can you give us your perspective on the structure of currency forward market in India?

Currently, the forex market in India exists entirely as an Over The Counter (OTC) market — in a form where it is transacted bilaterally between two parties, one of which would necessarily be a bank authorised by the RBI to deal in forex. Transactions are largely customised and the price discovery is fairly good as the market itself is a liquid one.

The most significant aspect of the market is that, from a regulatory perspective, it is essential to have an underlying transaction where there is a forex risk (either in the form of an underlying trade transaction or in the form of an underlying liability which results in foreign currency being payable/receivable in the future).

What is the difference you find between currency forward and exchange traded currency futures?

Exchange traded currency future is 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.

Both OTC and exchange have their own advantages. The OTC market enables more customised access to market.

For instance, if an exporter wants to hedge his position for a specified amount and for value a specified date, he can do so on the OTC market. However, the exchange traded market will enable dealing through the exchange for a standard lot only and such contract would also be for a certain standard date, both of which may differ from the exporter’s specific requirement.

Further, in the OTC market, banks largely enable customers to undertake these contracts without the need for margining. This is because they take a credit exposure to the client on account of the contract.

However, in case of exchange-traded futures, customers are required to post margin for their trades and this will help in eliminating counter-party risk, as all trades are with the exchange.

The third difference is that in the current forwards market, the customer can take exposure only to the extent of their underlying, while in the case of exchange traded market, there is no requirement to submit proof of underlying. However, there is a limit on the extent of open position that can be held.

Is exchange traded currency futures an investment product?So far, the OTC forward market was enabling risk management (largely offloading or transforming existing currency risk of a customer).

With the change in regulation in relation to the underlying, exchange-traded currency futures will enable resident Indians and businesses to prospectively take a view on the forex market.

Hence, it can be used not only as a risk offloading tool but it can also be an alternative investment within the prescribed limit.

Do you think the presence of the exchange-traded currency futures would have mitigated losses incurred by small and large companies, which got exposure to currency derivatives?

It is pertinent to note that exchange traded currency futures is merely changing the methodology of dealing — through an exchange in a standardised form, instead of a bilateral form as is the norm in the OTC market.

It does not change the fact that once a customer has taken a view on the market, he can either profit from it (if his view goes right) or lose from it (if the view goes contrary).

(The author is Head – Global Markets Group, ICICI Bank.)