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Understanding Derivatives

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The Money Buzzaar!

Friday 21 September 2012

While we have understood what comprises money, it is time now to understand what constitutes the world where money is traded - every second, every minute and every day!

As money is the medium of exchange for global transactions, it does follow that money itself would have a unique marketplace that would lend itself to the unique vagaries and volatilities of the Derivative market. Given high economic growth and liberalisation of capital flows, trading one currency for another lends itself to high risk exposure and hence, creates demand for risk management and hedging instruments as provided by Derivative Contracts. This special arena to make the best of what Currency Derivatives has to offer is what we call the Currency Derivative Marketplace.

Currency Derivatives primarily perform as efficient risk management tools for FOREX Trading and fulfil the need to protect players from global volatility and exposure. The Currency Derivatives Market in India is broadly segmented into the Over-The-Counter (OTC) Contracts and Exchange Traded Currency Futures. The OTC segment comprises Spot Trades, Forward Contracts and Swaps.

OTC Contracts are contracts or negotiations directly between two parties, without the formality of an Exchange. Most Currency Derivatives such as Spots, Forwards etc are usually traded in such a manner. The OTC Market is by far the largest contributor to the Currency Derivative market place with banks and other focused currency players. While the global OTC market is highly unregulated and high risk, in India, the OTC landscape has evolved in a fairly regulated, ethical and transparent manner. The RBI has also indicated that works in progress for designing a centralised trade reporting system for all OTC derivatives for better systemic oversight and market transparency. Clearing Corporation of India Ltd (CCIL) guarantees the settlement of all trades done in the OTC forwards market in India. OTC Derivatives offers flexibility of customisation in size to size and structure, thereby catering to specific risk management needs of banks and corporations.

Exchange Traded Currency (ETC) Derivative in India, were introduced to bring the Indian Currency Markets in line with their International counterparts. In adherence to global standards, there was a need to regulate the Indian market with appropriate guidelines for governance and transparency. Exchange traded derivatives in India is attaining popularity as average daily turnover in ETC is nearly 20 percent of the average daily turnover in the OTC. There are three exchanges where the derivatives on currency are traded, they are: the National Stock Exchange, the USE and on the MCX-SX.

Exchange Traded Currency Futures are an extension of the erstwhile OTC markets, simply with added risk management measures, reduced exposure to currency volatility and more number of participants. Exchange Traded Futures also provide for high levels of transparency, liquidity and standardization of Contracts. Trading of such Contracts on the Exchange has also opened up avenues for retail participation in Currency Derivatives, thereby increasing the number of players and participants significantly.

As with every market place, the Currency Derivative Market Place also has its own set of jargon. To begin with, the current rate of exchange at which you can buy a currency in lieu of another is known as the Spot Exchange Rate while the Forward Exchange Rate refers to a future rate of exchange for delivery of underlying currency assets.

Currency Derivative Contracts are known as Forwards which are based on Currency Exchange rates that usually take into consideration the possible price of a currency on a specified date. Forward Contracts are usually preferred by Corporations and Individuals who trade in goods and services that leave them highly exposed to price volatility. In a Forward Contract parties agree on a particular price estimated on a date in the future. On the said date, parties will have to honour the Contract and pay the difference in the prevailing market price and Contract price, if any. Forwards are prevalent in the OTC Markets.

An extension of the Forwards Contract is the Futures. Similar to the Forwards, Futures have one main distinction - they are traded on the Exchanges thereby having the added benefits of being regulated and transparent with a larger number of possibilities and participants.

Currency Futures can be bought and sold on the Currency Exchanges through members of the Exchange. In India, FIIs and NRIs are not permitted to trade in Currency Futures, but can limit their trades only to Interest Rate Futures. Currency Futures Contracts can be traded through MCX SX, NSE and USE and are usually executed in the following permutations -
  • US Dollar - Indian Rupee (USD INR)
  • Euro - Rupee (EUR INR)
  • Great Britain Pound - Indian Rupee (GBP INR)
  • Japanese Yen - Indian Rupee (JPY INR)
Exchange traded Currency Derivative Contracts have many significant characteristics -
  • You can undertake small Contracts up to USD 1000 or one single Contract at a time without additional costs
  • The Markets - both OTC and Exchange Traded - are extremely transparent with easy access to information regards price etc
  • As a trader, you are not exposed to FOREX exposure. Your participation is limited only to the terms of the specified Contract
  • The Indian Markets are in line with the governance and other norms of the International Markets
  • The Indian Market for Exchange traded Currency Derivatives is one of the largest such Market in the world.
The Markets are new and exciting for all investors to participate and avail of the benefits of making money out of money. How to do this? - We will find out more in our next post.

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