STRATEGIES USING EXCHANGE TRADED CURRENCY DERIVATIVES

STRATEGIES USING EXCHANGE TRADED CURRENCY DERIVATIVES (Part 1)

Key Concept 1: Market Participants

Hedgers: Traders who wish to protect themselves from the risk involved in price movements of underlying assets, i.e., foreign currency. Their objective is to reduce or mitigate the foreign currency risk using Exchange-Traded Currency Derivatives.
Speculators: Market participants who do not have a real exposure to foreign currency risk. They assume FX risk by taking a view on the market direction and hope to make returns by taking the price risk.
Arbitragers: Participants who serve as a link between the spot and derivatives markets. They continuously hunt for profit opportunities across markets and products and seize those by executing trades in different markets and products simultaneously.

Key Concept 2: Hedging Through Exchange-Traded Currency Derivatives

Derivative Contract: The choice of derivative contract to be used as a hedge depends on the currency pair being traded.
Type of Hedge: The type of hedge to be taken (long or short) depends on whether the participant has to receive or pay foreign currency.
Contract Month: The choice of contract month depends on the timing of expected receipt or payment of foreign currency.

Key Points for Hedging

For receipt of foreign currency, either sell futures or buy a put option.
For payment of foreign currency, either buy futures or buy a call option.
The contract month should be chosen such that the date of receipt or payment of foreign currency is close to but prior to the expiration date of the contract.

Example of Hedging

An exporter who expects to receive EUR after three months will choose a contract that expires in three months.
An importer who expects to pay USD after one month will choose a contract that expires in one month.

Trading Using Exchange-Traded Currency Derivatives

Derivatives Contract: The choice of derivatives contract to be used depends on the currency pair being traded.
Type of Trade: The type of trade (buy or sell) depends on the trader's view of the market direction.
Contract Month: The choice of contract month depends on the timing of the expected movement in the foreign currency.

STRATEGIES USING EXCHANGE TRADED CURRENCY DERIVATIVES (Part 2)

Key Concepts in Hedging Currency Risk

Hedging: A strategy used to mitigate FX risk by taking a position in a derivative that offsets the risk associated with an underlying asset or transaction.
Currency Futures: A type of derivative contract that allows investors to buy or sell a currency at a fixed exchange rate on a specific date in the future.
Effective Currency Price: The final price paid or received by an exporter or importer after hedging their currency risk using currency futures.

Calculating Effective Currency Price

Underlying Trade Transaction: The actual transaction where the exporter or importer buys or sells a currency.
Futures Contract: The derivative contract used to hedge the currency risk.
Combined Effect: The net effect of the change in the spot price and the change in the futures price.

Example: Exporter Hedging Currency Risk

An exporter sells four-month futures at a price of 81.75 to hedge against a potential depreciation of the INR.
The exporter receives USD on March 15, 2024, and converts it to INR at the prevailing spot price of 83.
The exporter squares up the futures contract at 83.05, resulting in a net negative change of Rs 1.30.
The combined effect is a net positive change of Rs 0.70 (Rs 2 - Rs 1.30).
The effective price is Rs 81.70 (Rs 81 + Rs 0.70).

Example: Importer Hedging Currency Risk

An importer hedges half of their total exposure using currency futures at a rate of 81.50.
The importer settles the futures contract at 82.05, resulting in a net positive change of Rs 0.55.
The effective price is Rs 81.725, calculated by deducting the inflow from the hedged position from the spot price.

Other Uses of Currency Derivatives

Investment in Gold: Currency derivatives can be used to remove the USDINR risk embedded in a gold ETF.
Investment in Assets Outside India: Currency derivatives can be used to hedge the currency risk associated with investing abroad.
Trade Remittance from Multiple Transactions: Currency derivatives can be used to hedge the EURUSD risk for import payments.
Payment in Foreign Currency for Education Abroad: Currency derivatives can be used to hedge the currency risk associated with paying education fees in USD.

Option Trading Strategies

Option Spreads: Involves combining options of the same type on the same underlying asset but with different strikes and maturities.
Vertical Spreads: Created by using options with the same expiry but different strike prices.
Bullish Vertical Spread: A strategy used when the underlying view on the market is positive.

STRATEGIES USING EXCHANGE TRADED CURRENCY DERIVATIVES (Part 3)

Vertical Spreads

Definition: A vertical spread is a strategy that involves buying and selling options of the same type (calls or puts) with different strike prices, but with the same expiry date.
Details:
- Bull Call Spread: Involves buying a call option with a lower strike price and selling a call option with a higher strike price.
- Bull Put Spread: Involves selling a put option with a higher strike price and buying a put option with a lower strike price.
- Bear Call Spread: Involves selling a call option with a lower strike price and buying a call option with a higher strike price.
- Bear Put Spread: Involves buying a put option with a higher strike price and selling a put option with a lower strike price.

Key Characteristics of Vertical Spreads

Limited Profit and Limited Loss: Vertical spreads result in limited profit and limited loss positions.
Net Premium: The net premium paid or received is the difference between the premium paid for the long option and the premium received for the short option.
Break-Even Point (BEP): The BEP is the price at which the trade becomes profitable.

Examples of Vertical Spreads

Bull Call Spread: Buy a call option with a strike price of 83.00 and sell a call option with a strike price of 83.50.
Bull Put Spread: Sell a put option with a strike price of 83.00 and buy a put option with a strike price of 82.50.
Bear Call Spread: Sell a call option with a strike price of 83.00 and buy a call option with a strike price of 83.50.
Bear Put Spread: Buy a put option with a strike price of 83.00 and sell a put option with a strike price of 82.50.

Horizontal Spreads

Definition: A horizontal spread involves positions in options of the same type and the same strike price, but different expiry dates.
Details: Also known as time spread or calendar spread, this strategy involves buying and selling options with the same strike price but different expiry dates.
Rationale: The trader believes that the difference in the time values of these two options would shrink or widen.

STRATEGIES USING EXCHANGE TRADED CURRENCY DERIVATIVES (Part 4)

This section covers various strategies used in exchange-traded currency derivatives, including diagonal spreads, straddles, and more.

Diagonal Spread

Definition: A diagonal spread involves a combination of options on the same underlying but having different expiry dates as well as different strikes.
Details: These spreads are complicated in nature and execution, and it's not possible to draw a payoff diagram due to the different maturities of the two legs.

Straddle

Definition: A straddle involves two options with the same strike price and same maturity.
Details: A long straddle position is created by buying a call and a put option of the same strike and same expiry, while a short straddle is created by shorting a call and a put option with the same strike and same expiry.

Long Straddle

Definition: Buying both a call and a put at the same strike price to profit from significant price movements in either direction.
Key Points:
- Maximum loss is limited to the sum of the premiums paid.
- Profit is made when the price moves significantly in either direction, after recovering the premium.
- Two break-even points (BEPs) exist, at "Strike - Total Premium" for the long put position and "Strike + Total Premium" for the long call position.
- This strategy is used when the trader is uncertain about the direction of the currency price movement but expects significant movement.

Short Straddle

Definition: Selling both a call and a put at the same strike price to profit from stable prices and collect premiums.
Key Points:
- This strategy is the opposite of a long straddle.
- The trader expects the currency prices to remain stable, with little movement.
- The payoff chart is inverted compared to a long straddle, with profits made when the price remains stable and losses incurred when the price moves significantly.
- This strategy results in a limited profit but unlimited loss and should be undertaken with caution.

Strategies Using Exchange Traded Currency Derivatives

Strangle Strategy

Definition: A strangle strategy is similar to a straddle, but with different strike prices for the call and put options.
Details:
- It involves buying a call option and a put option with different strike prices, both of which are out-of-the-money.
- The premium required for this strategy is lower compared to a straddle.
- The maximum loss is limited to the sum of the premiums of the two options.
- The strategy starts making money when the exchange rate moves sharply in either direction, beyond a certain point.

Long Strangle

Definition: A long strangle is a strategy where a trader buys a call option and a put option with different strike prices, both of which are out-of-the-money.
Details:
- The maximum profit is unlimited in both directions (up or down).
- The maximum loss is limited to the sum of the premiums of the two options.
- The strategy has two break-even points (BEPs), beyond which the trader starts making a profit.
- The trader incurs a loss until the exchange rate crosses either of the BEPs.

Short Strangle

Definition: A short strangle is a strategy where a trader sells a call option and a put option with different strike prices, both of which are out-of-the-money.
Details:
- The strategy is opposite to a long strangle.
- The trader's view is that the exchange rate will remain stable over the life of the options.
- The payoffs for this position are exactly opposite to that of a long strangle.
- The short position makes money when the long position is in loss and vice versa.

Key Points

Break-Even Points (BEPs): The points at which the trader starts making a profit.
Maximum Loss: The maximum amount that can be lost in a trade.
Maximum Profit: The maximum amount that can be gained in a trade.
Out-of-the-Money: Options that have a strike price that is not favorable to the trader, resulting in a lower premium.
Premium: The price of an option contract.
Strike Price: The price at which the underlying asset can be bought or sold.

STRATEGIES USING EXCHANGE TRADED CURRENCY DERIVATIVES (Part 6)

Key Concepts

Butterfly Spread: A neutral strategy that combines both bull and bear spreads, with fixed risk and capped profits and losses.
Long Call Butterfly: A strategy that involves buying 1 ITM call, selling 2 ATM calls, and buying 1 OTM call, with strike prices at equal distance from the current price.
Hedging Strategies with Currency Options: Strategies used to manage risk, including buying protection with put options and call options.

Butterfly Spread

Definition: A combination of bull and bear spreads, using four options and three different strike prices.
Details: Includes multiple strategies, such as long call butterfly spreads, short call butterfly spreads, long put butterfly spread, short put butterfly spread, and iron butterfly spread.

Long Call Butterfly

Definition: A neutral strategy where the trader expects very low volatility in the underlying price.
Details: Involves buying 1 ITM call, selling 2 ATM calls, and buying 1 OTM call, with strike prices at equal distance from the current price.

Hedging Strategies with Currency Options

Buying Protection with Put Options

Definition: A strategy used to compensate for potential losses associated with a declining currency value.
Details: Involves buying put options to lock in a floor return while retaining upside potential.
Example: An export company buys put options to hedge against a potential decline in USDINR prices.

Buying Protection with Call Options

Definition: A strategy used to hedge against a potential appreciation of the currency.
Details: Involves buying call options to lock in a ceiling price while retaining downside potential.
Example: An import company buys call options to hedge against a potential appreciation of USDINR prices.

Key Points

Butterfly Spread: Limited risk and capped profits and losses.
Hedging Strategies: Used to manage risk and lock in prices.
Currency Options: Can be used to hedge against potential losses or gains in currency values.

STRATEGIES USING EXCHANGE TRADED CURRENCY DERIVATIVES (Part 7)

Protective Call: A strategy used by importers to lock-in a maximum payable amount while still enjoying the benefits from a decline in the exchange rate.
Bull Call Spread: A cheaper alternative to buying plain vanilla call options, where an importer buys an ATM or ITM call option on USDINR and reduces its cost by selling an OTM call option.

Use of Currency Derivatives by Speculators

Speculation: Speculators take a view on the currency with an objective to profit from it.
Example 1: A trader shorts 100 lots of the 6-months USDINR futures contract at a price of 83.90, expecting the INR to appreciate against the USD.
Example 2: A trader goes long 3-months contracts of 500 USDINR futures at a price of 83.10, expecting the INR to depreciate against the USD.
Cross Rate Arithmetic: EURINR = EURUSD * USDINR, allowing traders to execute views on currency pairs.

Use of Currency Derivatives by Arbitragers

Arbitrage: Arbitragers look for mispricing in the market and execute simultaneous buy and sell trades to capture the mispricing and make a profit.
Example: A trader notices a difference in pricing between the 6-month USDINR currency futures and the 6-month forward in the OTC market, and executes an arbitrage trade to capture the mispricing.
Triangular Arbitrage: Involves identifying and exploiting the arbitrage opportunity resulting from price differences among three different currencies in the forex market.
Risks: Arbitragers carry risks such as time gaps between execution of orders, illiquidity, and differences in settlement modes, which can result in naked positions and additional risks.

Strategies Using Exchange Traded Currency Derivatives

Execution of Trades: The execution of trades in exchange-traded currency derivatives involves considering the settlement procedures, such as cash settlement in the currency future market versus delivery-based settlement in the currency forward market.
Arbitrage: Arbitrageurs must ensure that both contracts are settled at the same price or be able to reverse both transactions at the same price, while also factoring in transaction costs and impact costs.

Trading Spreads Using ETCD

Definition of Spread: Spread refers to the difference in prices of two futures or option contracts, requiring a good understanding of the particular currency pair and interest rate parity.
Factors Affecting Spread Movement: Spread movement is based on factors such as interest rate differentials, liquidity in the banking system, and monetary policy decisions.
Calendar Spread: A calendar spread involves buying or selling a particular month contract and taking an opposite position in the same contract of a different month, with the same underlying but different maturities.
Example of Calendar Spread: A trader sells a near-month USDINR futures contract and buys a mid-month futures contract, aiming to profit from the widening spread between the two contracts.

Limitations of Exchange-Traded Currency Derivatives for Hedgers

Imperfect Hedging: Exchange-traded currency derivatives contracts are standard and mainly cash-settled, leading to imperfect hedging and basis risk for hedgers.
Maturity Date Mismatch: The maturity dates of the contracts may not match the exposure to be hedged, resulting in imperfect hedging.
Lot Size Limitations: The standard lot size of USDINR contracts (1000 USD) may not match the exact amount to be hedged, leading to over-hedging or under-hedging.
Time/Price Mismatch: The time and price of canceling a contract in ETCD may not match the time and price of actual underlying settlement, resulting in a potential loss of value.
Long-Term Hedging Limitations: ETCD contracts are generally available only for maturities up to 1 year, making it difficult for companies to hedge their exposure over a longer term.

Key Takeaways

Transparency and Flexibility: Despite limitations, exchange-traded currency derivatives offer transparency, small lot sizes, flexibility in trading, guaranteed settlement, and ease of trade execution.
Regulatory Guidelines: Market participants must ensure they are trading within the guidelines provided by FEMA, RBI, SEBI, and their respective regulatory guidelines.