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Understanding Derivatives
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Wednesday 29 August 2012
There is nothing more conducive to change than the power of money.
Money is what makes the world go round, or more technically, currency is what makes the world spin on its axis. From being the medium of exchange for goods and services to being the backbone of your retirement plan, currency is what defines your work, life and bank balance.
So what is currency?
Every country is the world chooses the medium of exchange for transactions. Simply put, this is what we call currency. Each country hence would have its purchasing power based on the strength its currency wields in terms of other currencies. This purchasing power of any currency is determined and decided similar to any other commodity in the market - by understanding its demand in relation to the availability of its supply. If there are many people vying to buy a particular currency in relation to its supply, the position of that currency would strengthen. If however, its supply exceeds demand, then the position would weaken.
A currency's demand is created by two factors, the country's exports and its attractiveness as an investment destination for global players and financial institutions. Rising exports and greater foreign capital inflows would lead to rising demand of that currency and its consequent strengthening. In the same way, rising imports, reduced exports or capital outflows would impact the currency position adversely.
Given its volatile nature in an equally dynamic and challenging global marketplace, currency offers itself to be an ideal underlying asset for its own class of Derivatives. As we all know, a financial Derivative is a Contract of future price movements of an underlying asset. Given the fast growing and fast changing global economy, currency prices fluctuate almost daily, requiring players to continuously hedge positions to minimize risk, or encourage speculation to maximize profit.
Thus, Currency Derivatives are Contracts between the seller and the buyer, whose value is to be derived from the underlying currency asset. A derivative based on currency exchange rates is a future contract which stipulates the rate at which a given currency can be exchanged for another currency as at a future date.
Exchange Traded Currency Derivatives were first created and traded on the Chicago Mercantile Exchange (CME) in 1972. The FX Contract emphasized the U.S. rejection of the Bretton Woodsagreement which had fixed world exchange rates to a gold standard after World War II. By creating another type of market in whichFutures could be traded, CME Currency Futures expanded the reach of risk managementbeyond commodities, which were till then, the main Derivative Contracts being traded.When some commodity traders at the CME did not have access to inter-bank exchange markets in the early 1970s, they established the International Monetary Market (IMM) and launchedtrading in seven currency futures on 16th May, 1972. Ten years later, in December 1982, the Philadelphia Stock Exchange (PHLX)listed the first Currency Options Contract - Pound Sterling/USD.
The Forex market in India can be broadly segmented into the OTC (spot, forwards and swaps) Contracts and Exchange-Traded Currency Futures. Of this, Spot Forex trading volume constitutes around 50% of total trading turnover while the remaining is contributed by Forwards, Exchange-Traded Futures, OTC Options and Swaps.
Out of the total turnover of USD 24/27 billion, the OTC market chips in more than 75% in terms of trading volume. Non Deliverable Forwards (NDF), which came into existence in the 1990s, and has since grown in size. NDFs were mainly designed for emerging markets with capital controls where currencies could not be delivered offshore. Exchange-Traded derivatives generate 25% of the total turnover in Indian markets.
Currency Derivatives Contracts usually work on the expected appreciation and depreciation of currency. What does this mean? Let us take for example that the Indian Rupee is currently trading at INR 50 per USD. Should the price of the INR drop versus the USD ie, should it drop to INR 45 per USD, we would say that the rupee has appreciated in value. However, should the price of the INR increase to INR 55 per USD that would mean that the price of the rupee has depreciated in value.
Because Futures Contracts in the currency market are marked-to-market daily, investors can exit their obligation to buy or sell the currency prior to the Contract's delivery date by closing out their positions. As with all Derivative Contracts, the price is determined when the Contract is signed and the currency is exchanged on an agreed delivery date, which is usually sometime in the distant future.
Currency Futures are mainly executed to hedge against foreign exchange risk. For companies and corporations that engage in regular imports and exports of goods and services, the risk exposure is extremely high and thus, executing these Contracts help minimize risk and maximize available productivity and profits.
The eligibility criteria for trading members in an Indian Currency Futures segment is subject to a balance sheet networth requirement of Rs. 1 crore while the clearing member is subject to a balance sheet networth requirement of Rs. 10 crores.
To minimize investor risk and to avoid extreme price fluctuations in India, the Foreign Exchange Management Act is the law which regulates the Forex market and the regulatory authority for the Indian Forex market is the Reserve Bank of India (RBI). The Exchange Traded Currency Futures market is regulated by SEBI through recognized Stock Exchanges. Only Authorized Dealers (ADs) as licensed by the RBI can participate directly in Forextrading and these are usually Scheduled Commercial Banks.
Everyone in India, except for FIIs and NRIs etc. is allowed to trade in the Currency Futures market and thus, there are many players in the market - from high net worth individuals to banks to corporations, everyone enters this market to take advantage of an ever changing environment to make profits or reduce risk... is this for you, we will learn more in the next session of Currency Derivatives!
Labels: stocks, understandingDerivatives
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