EXCHANGE TRADED CURRENCY FUTURES

EXCHANGE TRADED CURRENCY FUTURES (Part 1)

Key Concept 1: Introduction to Currency Futures

Definition: A futures contract is an agreement made through an organized exchange to buy or sell a fixed amount of a commodity or a financial asset on a future date at an agreed price.
Details: Futures markets were innovated to overcome the limitations of forwards. A trader who buys futures contracts generally takes a long position and the one, who sells futures, takes a short position.

Key Concept 2: Features of Futures Contract

Contract Terms: The exchange decides all the contract terms of the contract other than price.
Key Features:
- Contract between two parties through Exchange
- Centralised trading platform i.e. Exchange
- Price discovery through free interaction of buyers and sellers
- Margins are payable by both the parties
- Expiry date decided today (standardized)
- Quantity decided today (standardized lot size)

Key Concept 3: Currency Futures Terminology

Underlying Asset: The value of the futures contract is derived from the value/price of the underlying asset, which in this case is the exchange rate in Indian Rupees for US Dollars, Euro, Pound Sterling, Japanese Yen.
Key Terms:
- Spot price/rate: The price at which the underlying asset (currency pairs) trades in the spot market
- Futures price: The current price of the specified futures contract
- Quotation: It specifies how the price is quoted for the futures contract
- Contract Cycle: A period over which a contract trades
- Expiry date: The day on which trading ceases in the contract
- Tick Size: The minimum move allowed in the price quotations
- Contract size/Lot Size: The amount of the asset that has to be delivered for a single contract

Key Concept 4: Positions in Derivatives Market

Long Position: Outstanding/ unsettled buy position in a contract is called “Long Position”
Short Position: Outstanding/ unsettled sell position in a contract is called “Short Position”
Open Position: Outstanding/ unsettled either long (buy) or short (sell) position in various derivative contracts
Opening a Position: Means either buying or selling a contract, which increases the client’s open position (long or short)
Closing a Position: Means either buying or selling a contract, which essentially results in the reduction of a client’s open position (long or short)

Exchange Traded Currency Futures

Long Futures Position

Definition: A long futures position is a contract to buy the underlying asset at a predetermined price on a specific date.
Details: The long futures position makes profits when prices rise. The payoff graph for futures displays a linear or symmetrical style.

Short Futures Position

Definition: A short futures position is a contract to sell the underlying asset at a predetermined price on a specific date.
Details: The short futures position makes profits when prices fall.

Payoff Graph for Long and Short Futures

The payoff graph for futures displays a linear or symmetrical style.
Key Points:
- Long futures position: makes profits when prices rise.
- Short futures position: makes profits when prices fall.

Contract Specification of Exchange Traded Currency Futures Contracts

Regulatory Framework: Exchange traded currency futures are regulated by SEBI as well as RBI.
Contract Details:
- Underlying: US Dollar-Indian Rupee (USDINR), Euro-Indian Rupee (EURINR), Pound Sterling-Indian Rupee (GBPINR), Japanese Yen-Indian Rupee (JPYINR)
- Unit of Trading: 1 contract denotes 1000 units of the underlying currency
- Price Quotation: The exchange rate in Indian Rupees for 1 unit of the underlying currency
- Contract Value: Trade price * 1000
- Tick Size: Rs. 0.0025 (0.25 paise)
- Base Price: Theoretical price on the 1st day of contract, on all other day’s daily settlement price of the contract
- Price Band: No daily price bands, but operating ranges will be kept at +/-3% of the base price for contracts with tenure up to 6 months and +/- 5% of the base price for contracts with tenure greater than 6 months

Cross Currency Futures Contracts

Underlying: Euro-US Dollar (EURUSD), Pound Sterling-US Dollar (GBPUSD), US Dollar-Japanese Yen (USDJPY)
Unit of Trading: 1 contract denotes 1000 units of the underlying currency
Price Quotation: The exchange rate in US Dollars for 1 unit of the underlying currency
Contract Value: Trade price * 1000 (in quote currency)
Tick Size: USD 0.0001, JPY 0.01
Base Price: Theoretical price on the 1st day of contract, on all other day’s daily settlement price of the contract
Price Band: No daily price bands, but operating ranges will be kept at +/-3% of the base price for contracts with tenure up to 6 months and +/- 5% of the base price for contracts with tenure greater than 6 months

Contract Value and Lot Size

Contract Size: 1000 units of the underlying currency
Price Quotation: The exchange rate in Indian Rupees for 1 unit of the underlying currency
Contract Value per Lot: Trade price * 1000 (or trade price * 100000/100 for JPYINR)
Example:
- Currency Pair: USDINR, EURINR, GBPINR, JPYINR
- Contract Size: 1000 USD, 1000 EUR, 1000 GBP, 100000 JPY
- Trade Price: INR 83.0000, INR 89.0000, INR 104.00, INR 55.00
- Number of Lots: 5, 10, 15, 20
- Total Contract Value: INR 415000, INR 890000, INR 1560000, INR 1100000

EXCHANGE TRADED CURRENCY FUTURES (Part 3)

Contract Specifications

Contract Value: Calculated as trade price * contract size
Tick Size: The minimum price movement of a contract, e.g., INR 0.0025 for USDINR contracts
Price Movement: The change in contract value for each tick size change, e.g., INR 2.50 for USDINR contracts

Contracts Involving Other Currencies

Currency Pairs: EURUSD, GBPUSD, USDJPY
Contract Size: 1000 EUR, 1000 GBP, 1000 USD
Price Quotation: The exchange rate in US Dollar for 1 Euro, 1 Pound Sterling, or 1 US Dollar in Japanese Yen
Contract Value per Lot: Trade price * contract size (in quote currency)
Total Contract Value: Contract value per lot * number of lots

Comparison of Foreign Exchange Forward and Currency Futures

Operational Mechanism: Bilateral OTC transactions vs. centralized trading platform
Terms of Contracts: Customized vs. standardized
Price Discovery: Negotiation vs. free interaction of buyers and sellers on a centralized platform
Liquidity: Low vs. high
Settlement: Bilateral physical delivery vs. clearing and settlement through a clearing corporation

Advantages and Limitations of Future Contracts

Advantages of Futures:
- Price Transparency
- Elimination of Counterparty Credit Risk
- Access to all types of market participants
- Lower Liquidity Risk
- Generally Lower Impact Cost
- Easy Entry and Exit
Limitations of Futures:
- May lead to imperfect hedge
- Standardized contract size and settlement dates
- Cash-settled, requiring access to cash/spot market for actual delivery
- Operational issues related to mark-to-market settlement and margin

Interest Rate Parity and Pricing of Currency Futures

Concept of Interest Rate Parity: The difference between future exchange rate and spot exchange rate is approximately equal to the difference in domestic and foreign interest rates
Formula for Calculating Arbitrage-Free Forward Price: F = S × (1 + RQC × Period) / (1 + RBC × Period)
Quick Estimate of Forward Premium: F = S + (S × (RQC – RBC) × Period)

Key Concept 1: Interest Rate Parity and Futures Pricing

Interest Rate Parity: The concept that the difference in interest rates between two currencies determines the futures price.
Futures Pricing Formula: F = S x (1 + r - rf) * t, where F is the futures price, S is the spot price, r is the interest rate of the quote currency, rf is the interest rate of the base currency, and t is the time till expiration.

Key Concept 2: Premium and Discount

Premium: A currency is said to be at a premium when its future value is higher than its spot value.
Discount: A currency is said to be at a discount when its future value is lower than its spot value.
Key Conclusion: The future value of a currency with a high interest rate is at a discount to the value of the currency with a low interest rate.

Key Concept 3: Theoretical Price Computation

Theoretical Price Formula: F = S x e^(r-rf)*t, where e is approximately 2.71828.
Factors Affecting Theoretical Price: Interest rates of the quote and base currencies, time till expiration, and the spot price.

Sample Questions and Answers

Settlement Method for USDINR Futures: The correct answer is b. Physical / Based on Delivery.
Last Trading Day for EURINR Monthly Futures Contract: The correct answer is b. Two working days prior to the last business day of the expiry month.
Profit/Loss on GBPINR Futures Contract: The correct answer is b. Make loss of Rs. 1.