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The ABC of currency futures trading

Protecting investment returns from foreign exchange risk has become critical in a scenario where lending rates are rising and the foreign currency markets have been fluctuating. Gaurav Choudhury decodes the currency futures market.

india Updated: Aug 07, 2008 21:57 IST
Gaurav Choudhury

The Reserve Bank of India on Wednesday issued guidelines for currency futures market in India. Investment professionals, traders and policy makers, in general, are facing a tough climate. Equity markets have been depressed for the past few weeks, inflation and lending rates are rising and the foreign currency markets have been fluctuating. In such a scenario, protecting investment returns from foreign exchange risk becomes critical. Gaurav Choudhury decodes the currency futures market:

How is the price of a currency determined?

The price of a currency or the foreign exchange rate is determined by simple demand-supply phenomenon. Basic economic theory teaches us that if the supply of good increases, and nothing else changes, the price of that good decreases. Conversely, if the demand for the good increases and supply remains same, its price will increase.

How and why does the demand and supply of a currency increase and decrease?

Currencies are traded on the foreign exchange market, and the supply of a currency on that market will change over time. Foreign exchange supply increases due to a variety of reasons. These include rise in export earnings, higher foreign investment and greater speculation among others.

Conversely, higher demand for foreign currency results from a surge in imports, higher investment in foreign locations and also speculation.

What are currency risks?

Currency risks are mainly involved in international trade in commodities and services, as also in investment flows, when the currency of one county vis-à-vis that of another is not stable. It is not difficult to visualize that in both international trade and investment, currency risks go hand-in-hand with interest rate and credit risks.

What is the need of currency futures?

In the absence of currency futures trading in India, companies were hedging their currency risk by entering into forward deals with banks where they agree to sell/buy the dollar at a future date and predefined exchange rate. As compared to currency futures, this method is less flexible, less liquid, and less transparent, therefore does not help companies fetch the maximum possible price. Despite these limitations, the dollar forward market in India has a daily turnover of around $3.5 billion.

How will this help small traders?

The RBI guidelines have specified the minimum size of the contract at at $1,000 and so that traders can even hedge small amounts of dollar exposure. Under the futures contract, an mporter buys the required currency futures contract and “locks in” a price for the purchase of foreign currency. He thereby hedges (avoids) risk due to exchange rate fluctuations. An exporter, on the other hand, sells the expected currency futures contract “locks in” a price for the sale to hedge risks.

How is a currency futures different from a forward market?

Exchange traded futures as compared to forwards serve the same economic purpose yet differ in fundamental ways. An individual entering into a forward contract agrees to transact at a forward price on a future date. On the maturity date, the obligation of the individual equals the forward price at which the contract was executed. Except on the maturity date, no money changes hands.

In the case of an exchange traded futures contract, mark to market obligations are settled on a daily basis. Mark to market is he practice of revaluing securities and financial instruments using current market prices and is most seen in the mutual fund industry where the current net asset value (NAV) gives the MTM price. Since the profits or losses in the futures market are collected / paid on a daily basis, the scope for building up of mark to market losses in the books of various participants gets limited.