FOREIGN EXCHANGE DERIVATIVES

FOREIGN EXCHANGE DERIVATIVES (Part 1)

Key Concept 1: Derivatives - Definition

• Definition: A derivative is a financial instrument that derives its value from an underlying asset, such as commodities, currencies, or interest rates.
• Details: The value of a derivative is dependent on the value of the underlying asset, and it cannot exist without it. Derivatives are used to manage price risk and can be classified into five asset classes: interest rate, credit, equity, forex, and commodity.

Key Concept 2: Types of Derivatives

• Classification: Derivatives can be classified into five asset classes, with four generic products in each class: forward, futures, swap, and option.
• Details: Each product has its unique characteristics, such as forwards being over-the-counter (OTC) contracts with customized terms and conditions, while futures are standardized exchange-traded forward contracts.

Key Concept 3: Functions of Derivatives

• Hedging: Derivatives are used to hedge against price risk, allowing investors to manage their exposure to potential losses.
• Price Discovery: Derivatives markets provide valuable information about future prices, helping investors make informed decisions.
• Market Efficiency: Derivatives increase market efficiency by allowing investors to replicate the payoff of underlying assets, reducing arbitrage opportunities.
• Access to Unavailable Assets: Derivatives provide access to assets or markets that may not be available otherwise, such as interest rate swaps.
• Price Stability: Derivatives can be used to stabilize prices, such as currency prices, by central banks.

Key Concept 4: Approaches to Risk Management

• Speculation: Taking risk to potentially earn a profit, also known as trading.
• Hedging: Reducing risk by locking in a known return, often used to manage price risk.
• Insurance: Eliminating negative returns while retaining potential profits, often using options.
• Diversification: Reducing risk by spreading investments across different assets, minimizing risk per unit of return.

Key Concept 5: Derivative Products

• Forwards: OTC contracts to buy or sell an underlying asset at a predetermined price on a future date.
• Futures: Standardized exchange-traded forward contracts, settled mainly in cash.
• Foreign Exchange Forwards: OTC derivatives involving the exchange of two currencies on a specified date in the future, at a rate agreed on the date of the contract.

Key Concept 1: Currency Derivatives

• Definition: Currency derivatives are financial instruments that derive their value from the value of underlying currencies.
• Details: They are used to manage currency risk and speculate on future currency movements.

Key Concept 2: Types of Currency Derivatives

• Futures: 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.
• Options: 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.
• Swaps: An agreement made between two parties, to exchange cash flows in the future, according to a prearranged formula.
• Forward Contracts: A customized contract to buy or sell the underlying asset with cash for settlement on a future date.

Key Concept 3: Characteristics of Derivatives

• Generic Derivatives: Forward, Futures, Swaps, and Options.
• Key Features:
  • Forward: Customized contract, settlement on a future date.
  • Futures: Standardized contract, settlement on a future date.
  • Swaps: Exchange of cash flows over a period.
  • Options: Right to buy or sell on a future date.
• Underlying Assets: Interest Rate, Equity, Currency, Commodity, and Credit.

Key Concept 4: Growth Drivers of Derivatives

• Increased Volatility: In asset prices in financial markets.
• Integration of Markets: National financial markets with international financial markets.
• Technological Breakthrough: Advances in high-speed processors, network systems, and data entry methods.
• Risk Management Tools: Development of sophisticated tools for risk management.
• Innovations: Combination of risks and returns over a large number of financial assets.

Key Concept 5: Market Participants in Currency Derivatives

• Hedgers: Reduce risk associated with prices of underlying assets.
• Speculators/Traders: Predict future price movements and take positions in derivative contracts.
• Arbitragers: Exploit price differences in different markets to make a profit.
• Roles: Market participants may play different roles in different market circumstances.

FOREIGN EXCHANGE DERIVATIVES (Part 3)

Introduction to Foreign Exchange Derivatives in India

• Regulations: In India, a person, whether resident in India or resident outside India, may enter into a foreign exchange derivative contract or exchange-traded currency derivative contract in accordance with provisions contained in Foreign Exchange Management Act (FEMA), 1999, Foreign Exchange Management (Foreign exchange derivative contracts) Regulations, 2000, and other guidelines/regulations provided by financial sector regulators like Reserve Bank of India (RBI), Securities and Exchange Board of India (SEBI), Insurance Regulatory and Development Authority of India (IRDAI), Pension Fund Regulatory and Development Authority (PFRDA), or any other statutory authority empowered to regulate a financial institution under Indian laws.

Exchange-Traded Derivatives vs. OTC Derivatives

• Definition:
  • OTC Derivatives (OTCD): Privately negotiated and settled contracts between two parties.
  • Exchange-Traded Derivatives (ETD): Screen-based order matching platform and settled contracts with the aid of an Exchange and a Clearing Corporation.
• Key Differences:
  • Transparency: ETDs are more transparent compared to OTCDs.
  • Customization: OTCDs can be customized to specific requirements, whereas ETDs are standardized.
  • Counterparty Risk: OTCDs have counterparty credit risk and settlement risk, which are eliminated in ETDs through a trade guarantee by the Clearing Corporation.
  • Settlement: ETDs are settled through a Clearing Corporation, which acts as a central counterparty (CCP), whereas OTCDs are settled directly between the parties involved.

Role of Exchange and Clearing Corporation

• Exchange: Provides a platform for trade execution, bringing buyers and sellers together.
• Clearing Corporation:
  • Role: Settles trades with a trade guarantee by becoming a central counterparty (CCP) to both the buyer and the seller.
  • Process: Achieved through novation, where the original trade between the buyer and seller is replaced by two trades, one between the buyer and the Clearing Corporation, and another between the seller and the Clearing Corporation.
  • Protection: Protects itself from counterparty credit risk and settlement risk through margining and mark-to-market processes.

Advantages and Limitations of ETDs

• Advantages:
  • Transparency
  • Elimination of counterparty risk
  • Access to all types of markets
  • Low cost of trading
  • Credit agnostic
• Limitations:
  • Standardization may lead to imperfect hedges
  • Cash settlement may not be helpful to actual hedgers
  • Daily mark-to-market and margin requirements may create operational issues

Rationale for Introducing Exchange-Traded Currency Derivatives in India

• Need for Hedging Currency Risks: Unpredicted movements in exchange rates expose investors to currency risks, which can be hedged using currency futures.
• Benefits:
  • Enables investors to hedge currency risks
  • Contributes to better price discovery and possibly lower transaction costs
  • Invites arbitragers, speculators, and traders who take bets on exchange rate movements
  • Facilitates international risk sharing through trade in assets, promoting investment and aggregate demand in the economy

Expansion of Exchange-Traded Hedging Tools

• Introduction of Currency Options: Recognized stock exchanges were permitted to introduce currency options to expand exchange-traded hedging tools.
• Introduction of Cross-Currency Pairs: Exchange-traded currency futures and options were introduced in three cross-currency pairs (EUR-USD, GBP-USD, and USD-JPY) to enable direct hedging of exposures in foreign currencies and to permit execution of cross-currency strategies.